Is it worth the risk to defer compensation?
Periodically, we are asked by senior executives in our client base to review a “new” offering from their employer called a Non-Qualified Deferred Compensation Plan (“NQDC Plan”). Much like a traditional 401k, these are plans designed to allow certain employees to actually defer the receipt of pay (and all relevant taxation) to a date much later down the road. However, unlike a traditional 401k, these plans allow for the deferral of a LARGE amount of one’s pay, upwards of 75%, regardless of one’s income.
At first blush, the allure of deferring state and federal taxes sounds enticing…but for various reasons, we’ve advised staunchly AGAINST these types of plans for many years. Here’s a few reasons why we’ve historically been critical of these plans:
As these plans are only offered to a select few, they are considered Non-Qualified versus Qualified deferred compensation plans. As such, they are viewed as a general liability of the prevailing company, and, in a case of business continuation issues, any or all of the assets in these plans can be lost to debtors of the company.
Although the taxation on these amounts is deferred, all relevant local, state and federal taxes are due upon ultimate receipt by the employee.
Although the employee can direct the timing of the ultimate payment of these plans, the termination of employment often triggers an immediate payment for all deferred amounts immediately creating a massive one-time tax bill.
Current tax rates are historically quite low. Unless an employee believes their retirement tax bracket will be materially less than their current tax bracket, the additional risks taken in NQDC plans is NOT worth the risk.
For all of the above reasons, Dashboard has been strongly advising clients against utilizing NQDC plans. However, with the new state tax laws just proposed in IL (4.95% increasing to 7.85% for income in excess of $250,000) as well as various other states who are set to increase their state taxes, there might just be a planning opportunity here.
If an employee knows with absolute certainty his/her retirement destination is a state that either does not have a state tax (FL, TN, TX, NV) or has a materially lower state tax, a NQDC plan might be worth considering. There is still a fair amount on inherent risks within a NQDC plan, but if the avoidance (not deferral, but actual avoidance) of an onerous state tax can be accomplished, it should be considered.
Historically, we at Dashboard have advised against using NQDC plans for reasons discussed herein. However, with many states (IL included) proposing a significant state tax increase, the opportunity to AVOID onerous state tax should be considered.
One main determination that remains to be seen is the states’ taxing authorities determination of “who gets to tax the realized income from a NQDC plan”. Currently, it is commonly understood that the taxation on deferred income occurs based upon the state of residence where the income is received NOT earned. However, this is a fluid environment, and many states are beginning to aggressively pursue the “deferring employee” based on where the income was earned, not where it was received.
At Dashboard, we still believe that NQDC plans carry much more risk than a qualified deferred compensation plan. However, if you’re facing a material future increase in state taxes like those of us in IL who are looking at a potential 58% increase in state taxes (7.85% future tax - 4.95% current tax = 2.9% addl. tax / 4.95% = 58% TAX INCREASE), it’s your choice to either accept the risk and try to “Keep your Fair Share” or to “Pay your Fair Share”. The decision is up to you, but let’s make informed and thoughtful decisions now and for the future.