As a top-level executive, 401(k), 403(b), and IRA retirement savings plans are likely of little use to you due to your income level and contribution restrictions. When I work with executives in regards to retirement planning and tax avoidance, stock options and nonqualified deferred compensation plans are usually two of the topics of discussion. Employee stock options tend to be factored into executive income when you join a company, while nonqualified deferred compensation plans tend to be programs offered that you need to opt into.
In short, nonqualified deferred compensation plans are great savings vehicle alternatives to 401(k) plans that offer favorable tax treatment for top-level executives. Having an understanding of strategic nonqualified deferred compensation plan tax treatment options can help you make an educated decision about opting in or continuing to utilize your deferred compensation plan.
Understanding Nonqualified Deferred Compensation Plans
Before we get into specific strategies, let’s walk through a quick overview of what exactly a nonqualified deferred compensation plan is. A deferred compensation plan is an agreement between an employee and an employer. The plan stipulates that a percentage or specific dollar amount of an employee’s income is earmarked for the employer to hold in a nonqualified account. This income is then paid out to the employee at a predetermined date.
Although the income is held in a nonqualified account, no income tax is due until you withdraw the money at the predetermined date. At this time, the deferred compensation will be taxed as regular income. The only taxation due when the income is placed in the deferred compensation plan is Medicare and Social Security tax.
One thing you need to be aware of when opting into a nonqualified deferred compensation plan is the IRS Section 409A requirements. If your plan does not meet these particular requirements, your deferred compensation plan could potentially trigger excess taxes, which could include an income tax of 20%. Some of these requirements include notifying your employer in writing about your intent to defer a portion of your income and determining how the compensation will be paid out. You also must make the election before the work period begins and ensure the election is irrevocable.
Nonqualified Deferred Compensation Plan Tax Treatment Strategies
Now that we have a general understanding of how nonqualified deferred compensation plans work, let’s look at some tax treatment options that can help you make a more informed decision about opting in or continuing contributions into your plan. Your executive wealth manager can help you decide which strategy makes most sense for you by assessing your short-term and long-term plans, and any life events or circumstances that could affect when you take your distributions.
Lump Sum Strategy
This strategy is as straightforward as it sounds. To implement a lump sum strategy, you work with your employer to determine a future date in which you will receive the entirety of your deferred compensation in a single lump sum payment.
This strategy is effective for top-level executives who will have a drastic decrease in income in the future and know exactly when that will be. For example, if you know that you will retire from your current executive role in the year 2030, you can set a distribution date for the full amount of your deferred compensation to be paid in that given year.
The upside is that your income will be lower in the year you receive your distribution, so the income taxes paid should be less than if you took the distribution during your working years. You also get all of your money out of the general fund of your employer. This is important to note because your deferred compensation plan can be subject to creditors in the event that your employer files bankruptcy.
Much like the lump sum strategy, the installment strategy is relatively straightforward in that you work with your employer to set a predetermined date in which you will begin to receive distributions from your deferred compensation plan spread over the course of years. This could be distributed as often as monthly during the distribution cycle if you so choose and the plan from your employer allows it.
If you believe that your employer will continue to remain solvent after your employment ends, this is a great strategy to use during your retirement years because it allows you to spread out the taxation, rather than incurring all of the income taxation in one given year.
Many nonqualified deferred compensation plans stipulate a minimum time restriction of deferred income. For example, you cannot withdraw funds from your deferred compensation plan within the first five years of deferring the income. However, many don’t set a stipulation on the number of deferred compensation accounts you can contribute to or the consecutive years in which you can receive distributions from those accounts.
This is particularly helpful when deferring income for an event, such as a child or multiple children attending college, because the ladder strategy allows you to set multiple distribution dates in consecutive years coinciding with a life event. For example, if you have a child that will be attending college starting in 2025, you could set up separate deferred compensation accounts (using different investment strategies internally to reflect the distribution date) with separate distributions dates of 2025, 2026, 2027, 2028, and beyond. This is typically more tax-effective than receiving all of the funds for your child’s tuition in one year because you spread it out over a number of years.
How an Advisor Can Help with Nonqualified Deferred Compensation Plans
Many top-level executives spend a considerable amount of time generating income that is set aside in vehicles such as a nonqualified deferred compensation plan. However, many don’t have the time to adequately plan when and how to receive that income. An experienced executive financial advisor can help you analyze your current cash flow and future income generation needs while factoring in your taxable liabilities that are tied to your income.
Nonqualified deferred compensation plans can be powerful tools for top-level executives when it comes to taxation and wealth accumulation, but they are best used when incorporated into an overall financial plan that addresses your individual needs and concerns. The right financial advisor can help you accomplish all of these and more.
K. Wade Carpenter, CFP®, AIF®, ChFC®, CLU®, is an innovative wealth manager serving corporate executives and entrepreneurs from coast to coast. Throughout his more than 25-year career, Wade’s focus on C-level clients has made him a top strategist for executives with equity compensation packages. For more information on how Wade and the Carpenter Team can advise you on nonqualified deferred compensation plan tax treatment options, reach out today for a complimentary consultation.
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