Nonqualified executive benefits plans and savings capacity

In our last article, we discussed savings capacity in qualified defined contribution and defined benefit plans. Now, we will discuss different types of nonqualified deferred compensation (NQDC) plans.

First, we need to discuss the differences between qualified and nonqualified plans.

A qualified retirement plan has to follow the Employee Retirement Income Security Act (ERISA) and be offered to all employees equally. There are many rules around ERISA, but the major differences are the fact that qualified plans must be offered to all rank-and-file employees, and plan testing assures that one employee segment does not substantially benefit more than other segments.

On the flipside, a nonqualified plan can be offered exclusively to a select management group – or so-called “top hat” group – of employees, including an owner, and it is not tested for funding equality. We will go into more detail around the pros and cons of deferred compensation plans in another article focusing on the types of plans and income deferral amounts.

NQDC plans refer to supplemental executive retirement plans (SERPs); voluntary deferral plans; wraparound 401(k) plans; excess benefit plans; and equity arrangements, bonus plans and severance pay plans.

Advantages of NQDC plans include savings and tax benefits in excess of qualified plan limits for a participating employee. The IRS imposes strict limitations on the amount of money you contribute to a qualified retirement plan, such as a 401(k). Deferred compensation plans have no such federally mandated limits, though employers may specify a contribution limit based on your compensation.

If you are a highly compensated employee, you can maximize contributions to your 401(k) and then continue to build your retirement savings through an NQDC plan – theoretically without limit; however, employers could decide to put restrictions on the level of additional deferral. The ability to defer any amount of compensation also reduces your annual taxable income. This can, in turn, put you in a lower tax bracket, further decreasing your tax liability each year. However, deferred compensation is still subject to FICA and FUTA taxes in the year it vests and no longer has a substantial risk of forfeiture.

Many NQDC plans offer investment options similar to 401(k) plans – such as mutual funds and stock options – but they also may include other alternative investments, along with guaranteed products. We will discuss these in another article.

To be clear, NQDC plans aren't just fancy deposit accounts for high-income earners. Instead, they allow you to grow your wealth over time. However, you can invest on a larger scale because your contributions are unlimited, increasing the potential for more significant gains.

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Brickhouse Consulting (brickhouse-consulting.com) is a fee-only consulting firm with expertise in advanced financial planning strategies for business owners and sole practitioners. We focus our financial expertise on educating clients about opportunities for tax-efficient retirement savings and income plans and how those plans integrate into their exit or succession plan. As part of our services, we mathematically model scenarios to demonstrate the effects of varying strategies and help clients select a strategy for implementation. For information or to schedule a free videoconference introduction, send an email to info@brickhouse-consulting.com.