Do you work for an employer who offers you a non-qualifying deferred compensation plan (NQDC)? What is that? How it works? Should you use it?
“Put simply, it’s a plan that allows you to take part of your salary or bonus, and avoid paying taxes on it today by putting it into a plan that has rules.” specials as to when and how you can remove it. », Said Dana Anspach, president and founder of Sensible money.
It seems relatively easy to understand, she said in an interview.
But there are several types of unqualified lazy dialing arrangements, and the rules for each type are slightly different. “Also, each plan may offer certain options and these differ from plan to plan,” she said.
The first thing to know is if the deferred compensation plan is a 457 plan or a 409A plan?
According to Anspach, 457 plans are offered by a state or local government and work much like a 401 (k). Another type of 457 plan can be offered by a tax-exempt non-government entity and this type has a different set of rules.
The 409A plan, which is what Anspach sees most often with his company’s clients, is a deferred compensation plan offered by for-profit companies. “We see them offered by big public companies like Microsoft, big private companies and by partnerships or small private entities like law firms and medical practices,” she said.
And when it comes to 409A plans, plan participants often need unique solutions.
One of Anspach’s clients, a partner lawyer in a large firm, is a case in point. “During his working years, each year he could choose to carry part of his salary into the deferred compensation plan,” she said.
And when you do that, you have to make the choice to defer part of your compensation before the start of the year. “So if you have access to a deferred compensation plan, in the fall of this year you would make a choice as to what percentage of your salary or bonus you want to contribute to the plan the following year,” said Anspach. . “Once you’ve made the choice, you can’t change your mind about this year.”
And the following year you can choose to participate again or change the amount, but once you choose the year you are stuck. “It’s very different from a 401 (k) where you can go in and change your contribution amount or stop or start it anytime,” Anspach said.
Multiple distribution choice options
When you make a contribution choice, you also make a distribution choice. “This means you now choose when and how the funds are paid to you,” Anspach said.
For example, you can choose payment on termination, or some plans allow you to choose a specific year. You can often designate the funds to be paid out as a lump sum or in installments, say over five, 10 or 15 years, she said.
“In the attorney’s case, his election made it clear that his deferred compensation was to be paid over five years the year following his dismissal,” Anspach said. “And, because he was independent – a partner in the law firm – he owed not only income taxes, but also FICA taxes – the employee and the employer shared the amounts received.”
Now if you are an employee most of the time you pay the FICA taxes the moment you postpone and then when the funds come out you only pay tax on the amount distributed, she said. .
Things to consider when structuring distributions from a 409A
“Choosing your deferrals to be tax-efficient is an area where we see the greatest room for improvement,” said Anspach. “Many participants don’t understand the rules and can randomly choose when funds are paid out. When we project their retirement income that sometimes means a giant lump sum termination right when there might have been a way to structure it around other elements of their plan.
Indeed, there is a lot to consider when structuring distributions from a 409A.
One example is one of Anspach’s clients, an employee of a large tech company that has contributed to the NQDC since 2015. “Each year he makes two choices, one for part of his salary, the other for for part of her bonus, “she said.” Some of these elections were to be paid at random as a lump sum, some at the end, one in 2032 and one in 2050. Other elections were to be held in five years, and some over ten years. “
Considering all of the payments, Anspach had to create a custom schedule to estimate the impact of when those distributions hit their tax return. “Then, in the future, she recommended that all election options be paid in installments over 15 years from the termination of employment,” she said. “We also recommended that he change some of his previous elections, so that he did not face a tax bomb the year he retired.”
Of course, one of the lesser known rules regarding 409A plans is this. When you change elections, you should also push back the start date by at least five years. “So you can’t move a payment back in time – only defer it for at least five years from your previous date,” Anspach said. “And if the date is unknown, such as ‘on termination’, then when you change it, it will be five years after the end date of your termination.”
Plus, you need to make changes at least 12 months before the payout date and often at least 12 months before termination, she said.
Tax cuts and the risk of sequencing
There are also other hidden risks with 409A plans.
A prime example is a distribution election plan that Anspach recently developed for a highly paid employee of a private company. This client had his deferred compensation plan set to pay as a lump sum upon retirement, which would have created about $ 1.5 million in taxable income for him that year, she said.
And in addition to a hard fiscal blow, taking a lump sum distribution creates a risk of sequence. “All of the plan’s investments will be cashed on a single date in the future,” Anspach said. “It’s a lot to ride in one day. If you have a huge liquidity event like this, you need to adjust your investments accordingly. “
In this case, Anspach recommended that the customer postpone the distribution for another five years and charge it over five years. “This spreads the tax debt over years when its rate will be lower, and also reduces its risk of having to cash it all in during a big market downturn,” she said.
Deferred compensation plans are unfunded liabilities of a business
This strategy, however, extends a different kind of risk, Anspach said. “Deferred compensation plans are unfunded liabilities of a business,” she said. “If his business goes downhill, his deferred payment could be in jeopardy. In his case, he felt completely confident in the future of his business and decided that extending tax liability and reducing exposure to streak risk was the right choice. But there are times when someone can feel more secure by removing everything as quickly as possible. “
But these are things you need to work on on a case-by-case basis, Anspach said.
Other things to consider: Before funding your NQDC, consider fully funding your Health Savings Account (HSA) first, then your 401 (k). “And when choosing investments for your NQDC, coordinate the investments based on when you need the money,” Anspach said.
How to make an investment plan
What investments should you buy?
When should you buy them?
How long do you hold them?
Does it make sense to own bonds right now?
What about crypto, is it a fad or the next big thing?
In this free webinar, Sensible Money’s Dana Anspach provides you with a framework to help you answer these questions and develop an investment plan that matches your goals, time horizon, and future cash flow needs.
Dana will cover:
• Key elements of an investment plan
• The impact of taxes
• When to buy and when to sell
• What to do when the media says, “Bonds / stocks / real estate / gold / crypto is / is not the place to be these days.”
• How investment plans should vary depending on your goals
Date and time: Thu, May 20, 2021, 8:00 p.m. – 9:30 p.m. EDT