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Do Not Fall into the Income Deferral Trap

Do Not Fall into the Income Deferral Trap

Non-Qualified Deferred Compensation Plans Aren’t Worth the Risk

A Non-Qualified Deferred Compensation (NQDC) plan sounds like a cool and fancy benefit for executives. After all, a NQDC plan provides a way to defer compensation on a pre-tax basis to minimize earned income in a given year, thereby reducing current income tax liability. This sounds great, particularly during high income earning years when you’re likely in a high tax bracket. And let’s be honest…no one likes paying taxes. However, it is paramount to remember that NQDC plans only defer taxes – they do not avoid taxation. What's more, NQDC plans are fraught with risk. At Dashboard, we believe NQDC plans can be a deceitful trap, and there are alternative solutions to accomplish similar outcomes.

There are three big risks associated with NQDC plans that you should understand before choosing to utilize such a plan to defer income. 

EMPLOYMENT RISK

Age discrimination is a real trend. AARP cites a recent report based on data obtained via a national Health and Retirement Study that indicates over half of workers age 50+ have left their long-held jobs involuntarily. This trend has likely only been exacerbated through the pandemic crisis. If you become one of them, oftentimes the entire balance of your NQDC plan is paid out as earned income immediately upon termination, which will very likely incur a rather large tax burden. In fact, we’ve seen circumstances where individuals ended up paying more in taxes due to a lump sum distribution of their NQDC plan than if they had simply taken the earned income and paid tax along the way. If you choose to participate in a NQDC plan via your employer, make sure you know what the rules are should you leave the company either voluntarily or involuntarily. 

COMPANY RISK

NQDC plans, unlike qualified deferred compensation plans such as a 401(k), are a general obligation of the company. If the company becomes insolvent, the NQDC plan can easily be assumed by creditors and the participants could lose their entire account balance. Now you may be thinking, “I work for a big, solid company…it won’t go away any time soon.” While it’s easy to default to the “it won’t happen to me” mentality, don’t fool yourself. If the COVID-19 pandemic has taught us anything, it's that no company is infallible.

Let’s add some perspective…The Fortune 500 is Fortune magazine’s annual list of the 500 largest US companies ranked by total revenue. This list has been published since 1955. To be a Fortune 500 company is widely considered a mark of prestige. Only about 10% of companies currently on the Fortune 500 list were also on the initial list back in 1955. Ok, 65 years is a long time…so how about a shorter timeframe? Let’s say 15 years – less than 40% of companies currently on the Fortune 500 list were also on the list in 2005. And the “big name” FAANG tech companies (Facebook, Apple, Amazon, Netflix, and Google) that everyone always seems to be talked about? Only two of them were on the list 15 years ago. If you were hoping to rely on your NQDC plan to provide a retirement income stream for 15-20 years, you could easily find yourself among the majority of companies that have not maintained their prominence. Remember brands like Blockbuster, Enron, RadioShack, Bear Stearns, Toys R Us, Smith Barney, etc.? Did you ever think these companies would effectively disappear? Think twice about the longevity of your employer before electing to participate in their NQDC plan. 

 TAX LAW RISK

There are two sides of tax law that are relevant to this discussion: Federal taxation and State taxation.

Federal Taxation
No matter what, you will owe Federal Income Tax on any deferred compensation when you pull funds out of the NQDC plan. Current Federal tax rates are historically very low. Experience tells us these rates will likely rise after they are set to expire in 2025. What's more, with the COVID-19 pandemic crisis, the US Government just pumped trillions of dollars into the economy via monetary stimulus. As they say "the bill will come due", and how has every government in the world throughout history created more cash? That's right – it raised taxes. So, be honest...in 10 years do you think Federal tax rates will be lower or higher than they are today? If you think they'll be higher, why would you defer taxation now and pay a higher tax rate down the road?

State Taxation
There is a misconception that you can avoid State Income Tax by deferring compensation via a NQDC plan and waiting to distribute funds until you can change residency to a State with a low or zero State Income Tax Rate. Unfortunately, it's not that simple. Based on current IRS rules, States can and often do tax deferred compensation based on where the income was earned, not where it is received. Current legislation stipulates that the only means by which deferred compensation would not be taxed by the State in which income was earned is if the participant elects to effectively annuitize the distribution of funds from the NQDC plan in equal annual installments over a minimum of 10 years. That means you are not only exposed to the risk of tax rates increasing over time, but also the company risks discussed in #2 above for an additional decade. What's more, if such annual payments are not distributed properly by your employer, the entire deferred balance will become taxable to you in that same year, and there will be significant penalties assessed to you, the participant. 

Now that we have discussed the three main risks involved with NQDC Plans, let’s look at alternative solutions. The primary reason to use a NQDC plan is to defer income and relevant taxation, but there are other methods available: 

Take advantage of employer-sponsored retirement plans to contribute the maximum employee deferral annually on a pre-tax basis. In 2020, the individual contribution limits are $19,500 for those under age 50 and $26,000 for those age 50+. However, the total annual contribution limits in 2020 for additions to a Defined Contribution Plan (which includes employee deferrals and employer matching) are $57,000 for those under age 50 and $63,500 for those age 50+. The most common method of meeting this higher Defined Contribution Plan limit is via Profit Sharing. 

If you are self-employed, you can fund a SEP IRA up to the maximum of $57,000 in 2020. Note, there is no catch-up provision to allow for additional contributions for those age 50+ with a SEP IRA.  

If you are generally healthy, consider switching to a High Deductible Health Plan and fund a Health Savings Account (HSA) on a pre-tax basis up to the maximum limit ($7,100 for a family in 2020). 

Contribute the maximum to your Traditional IRA – $6,000 under age 50 and $7,000 age 50+ in 2020. Note, you must fall below the IRS Modified Adjusted Gross Income limits (phaseout begins at $104,000 MAGI for a married couple) to qualify for a full or partial tax deduction. 

If you do find yourself in a lower tax bracket after retirement and you have not elected to participate in a NQDC plan, fret not! Simply perform systematic Roth conversions of IRA or pre-tax 401(k) assets to fully take advantage of these lower brackets over time, and…voila! You have achieved a similar result, but without the risks discussed above! 

While these alternatives may not grant you maximum deferral power – after all you could defer your entire salary if you chose to do so within a NQDC plan – we, at Dashboard, believe these strategies inherently carry far less risk.

Before you choose to participate in a NQDC plan via your employer, ask yourself “Is it really worth the risk?” 

 

Converting a traditional IRA into a Roth IRA has tax implications. Additionally, each converted amount may be subject to its own five-year holding period. Investors should consult a tax advisor before deciding to do a conversion.