Credit: Shutterstock photoRetirement savings options have expanded dramatically over the last four decades. Defined contribution plans such as 401ks have progressively become the primary source of private sector savings since the early 1980s. Unfortunately, for those in a higher income range, annual dollar value caps associated with contributions are imposed. In 2014, the maximum annual salary deferral for an employee is $17,500.00 ($23,000.00 if over age 50). One alternative solution to help mitigate current tax liability is the use of the Non-Qualified Deferred Compensation Plan (NQDC).
An NQDC plan can be established by a small business owner or by a large Fortune 500 company, and falls outside the regulatory scope of the Employee Retirement Income Security Act (ERISA). Under an NQDC plan, contributions made to the plan by an employee are deferred income which may include salary, bonus, commissions and etc. These contributions can be as much as 50% of an individual's compensation. In making the salary deferral contribution, the employee reduces his or her adjusted gross income ( AGI ). This not only lowers taxable wages, but also may reduce an individual's exposure to the Alternative Minimum Tax ( AMT ). Reducing AMT exposure may create additional tax benefits such as increasing the availability of itemized deductions like mortgage interest and property taxes.
These plans are typically either account based or non-account based plans. Contributions to account based plans may be met with a company match, and earn a fixed or variable interest rate. Some plans will opt to offer various investment options not unlike a 401k plan. Under a non-account based plan, the benefits function similar to a defined benefit plan…which is similar to a pension plan that provides an annual lifetime income at the commencement of benefits.
In the case of a small business owner, due to the greater flexibility of plan participation resulting from operating outside of ERISA laws, plans can be offered only to key employees . This can greatly reduce the administrative and funding costs, while offering significant tax advantages to the business owner. However, since the plan is not income to the employee, the plan does not become a deduction for the business until benefits commence. Due to the lack if an immediate tax benefit to the employer, many of these plans are unfunded future obligations.
While there can be substantial immediate tax benefits to an employee contributing dollars to a NQDC plan, there are inherent disadvantages. Among those disadvantages would be that the plan is a liability of the corporation and subject to the general creditors of the company. This is in contrast to a qualified plan in which vested plan assets belong exclusively to the employee. As a result of this liability, some employers have purchased insurance to help cover the liabilities of the plan should a company be liquidated. However, this benefit is the same as that of a general creditor and does not guarantee that the insurance will be sufficient to meet the unfunded liability. So when an employee opts to contribute deferred income, they should seriously consider the long term fiscal health of their employer. This becomes difficult for a younger employee who may be affiliated with a prosperous company, but couldn't possibly forecast the fiscal health of an organization in 20 years with any certainty. It is possible that some or all of your salary deferral saved over many years could be confiscated by creditors of the company.
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This article was originally published on MarketIntelligenceCenter.com
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
