So far, our discussion has emphasized the tax and nontax aspects of employer-provided qualified defined benefit and defined contribution plans. In addition to or perhaps in lieu of these types of qualified plans, employers may offer nonqualified deferred compensation plans to certain employees.
Nonqualified Plans versus Qualified Defined Contribution Plans
Deferred compensation plans permit employees to defer (or contribute) current salary in exchange for a future payment from the employer. From an employee’s perspective, the tax consequences of contributions to and distributions from nonqualified plans are simi- lar to those for qualified defined contribution plans. For example, just as with defined contribution plans, employee contributions to nonqualified deferred compensation (NQDC) plans reduce the employee’s taxable income in the year of contribution.13 Also, just as with qualified plans, employees are not taxed on the balance in their accounts until they receive distributions. Finally, like distributions from qualified plans, distributions from NQDC plans are taxed as ordinary income.
LO 13-3 Traditional 401(k) Plans Roth 401(k) Plans
EXHIBIT 13-5 Traditional 401(k) Plan versus Roth 401(k) Plan Summary
Employer contributions allowed
Tax consequences to employer
Tax consequences to employee
Distributions
• Yes.
• Contributions deductible when paid.
• Contributions are deductible.
• Taxed as ordinary income.
• No 10 percent penalty if the taxpayer is at least 59ẵ years of age or at least 55 years of age and retired at time of distribution.
• If life annuity or joint and survivor annuity, no penalty even if not 55 years of age.
• Minimum distributions required by April 1 of the later of (1) the year after the year in which the employee reaches 70ẵ or (2) the year after the year in which the employee retires.
• Failure to meet minimum distribution timing and amount requirements triggers 50 percent penalty.
• No.
• Not applicable.
• Contributions are not deductible.
• Qualified distributions not taxed.
• Qualified distributions when account is open for at least 5 years and employee has reached age 59ẵ.
• No 10 percent penalty on taxable part of nonqualified distribution if the taxpayer is at least 59ẵ years of age or at least 55 years of age and retired at time of distribution.
• If life annuity or joint and survivor annuity, no penalty even if not 55 years of age.
• Minimum distribution requirements and penalties are the same as for traditional 401(k) plans.
• If nonqualified distribution, nontaxable percentage of distribution is the ratio of contributions to total account value.
13Technically, employees participating in NQDC plans defer the receipt of current salary and employers credit the employee’s account for the amount of the deferral. This has the same effect as if the employee had actually made a deductible contribution ( for AGI) to her account, as an employee participating in a defined contribu- tion plan would do.
For employers, NQDC plans are treated differently than qualified plans. For ex- ample, because nonqualified plans are not subject to the same restrictions that govern qualified plans, employers may discriminate in terms of who they allow to participate in the plan. In fact, employers generally restrict participation in nonqualified plans to more highly compensated employees. Employers are also not required to fund non- qualified plans. That is, they do not have to formally set aside and accumulate funds specifically to pay the deferred compensation obligation when it comes due. Rather, they typically retain funds deferred by employees under the plan, use the funds for business operations, and pay the deferred compensation out of their general funds when it becomes payable.
Because employers retain, control, and generate income on funds deferred by em- ployees under nonqualified plans, employers are allowed to deduct only actual pay- ments of deferred compensation to employees. That is, employers cannot deduct the amount of deferred compensation they accrue each year. Thus, for tax purposes, an employer may not deduct the deferred compensation when an employee initially earns it, even though the company becomes liable for the deferred compensation payment.
In contrast, for financial accounting purposes, companies generally expense deferred compensation in the year employees earn it and record a corresponding deferred com- pensation liability.14
Employee Considerations
Should employees participate in nonqualified plans when given the chance? The decision obviously involves several considerations. First, employees must decide whether the ben- efits they expect to receive from qualified retirement plans (or other sources) will be ad- equate to provide for their expected costs during retirement. Next, they should consider whether they can afford to defer current salary. This may not be a significant concern for most eligible participants, however, because nonqualified plans are generally available only to highly compensated employees who may not have the liquidity concerns that lower-compensated employees may face. Also, employees should consider the expected after-tax rate of return on the deferred salary relative to what they could earn by receiving that salary currently and personally investing it.
Generally, larger employers allow employees participating in nonqualified plans to choose how their deferred compensation will be invested from among alternative investments provided under the plan (money market, various bond funds, and stock funds, among others). However, because employers do not actually invest compensa- tion deferred under the plan on the employee’s behalf, the employer credits the em- ployee’s account as if the employee’s contributions had been invested in the employee’s
CBA provides a nonqualified deferred compensation plan under which executives may elect to defer up to 10 percent of their salary. Dave Allan has been participating in the plan by deferring a portion of his salary each year for the last 15 years. The balance in his deferred compensation account is cur- rently $2,000,000. In keeping with a fixed payment schedule Dave elected under the plan, he re- ceives a $50,000 distribution. What amount of tax must Dave pay on the distribution (recall that his marginal tax rate is 35 percent)?
Answer: $17,500 ($50,000 × .35).
Example 13-13
THE KEY FACTS Nonqualified Deferred
Compensation Plans
• Employee defers current income in exchange for future payment.
• Employee is taxed when payment is received.
• Employee generally selects investment choices up front to determine return on deferral.
• Just as for traditional deferred compensation plans, after-tax rate of return depends on before-tax rate of return, marginal tax rate at time of deferral, and marginal tax rate at time of distribution.
• Payment is not guaran- teed. If employer doesn’t pay, employee becomes
unsecured creditor. 14Employers record additional expense and liability as earnings on the deferred compensation accumulate.
deemed investment choices. The description of Coca-Cola Company’s nonqualified retirement plan, presented in Exhibit 13-6, illustrates this concept.
Just as with qualified defined contribution plans, other than Roth 401(k) plans, an employee’s after-tax rate of return on deferred compensation depends on the employee’s investment choices and on the employee’s marginal tax rates at the time of the contribu- tion and at the time of the distribution.
Example 13-14
As a new executive with CBA, Lisa Whitlark is eligible to participate in the company’s nonqualified de- ferred compensation (NQDC) plan. Recall that CBA provides a plan under which executives may elect to defer up to 10 percent of their salary. In her first year with CBA, Lisa elects to defer $40,000 of sal- ary ($400,000 × 10%) under the plan. Because her current marginal income tax rate is 32 percent, she saves $12,800 in taxes by deferring the salary ($40,000 × 32%). Consequently, her after-tax cost of deferring the compensation is $27,200 ($40,000 − $12,800). Lisa plans to receive a distribution from the nonqualified plan in 20 years when she expects her marginal tax rate to be 32 percent. She se- lects a stock index fund as her deemed investment choice. She expects the fund to provide an 8 percent before-tax rate of return on her $40,000 deferral. What will Lisa receive after taxes from her
$40,000 deferral?
Answer: $126,778 after-tax accumulation, computed as follows:
Description Amount Explanation
Contribution to plan $ 40,000 Deferral of 10 percent of her current salary Times future value factor × 1.0820 8 percent annual rate of return for 20 years Future value of deferred compensation 186,438 Value of deferral/distribution 20 years after
deferral
Minus: taxes payable on distribution (59,660) $186,438 value of account × 32 percent marginal tax rate
After-tax proceeds from distributions $126,778 Value of account minus taxes payable on distribution
Deferred Compensation Plan. The Deferred Compensation Plan is a nonqualified and unfunded deferred compensation program offered to approximately 1,000 U.S. based Company employees in 2016. International service associates do not participate in the Deferred Compensation Plan.
Eligible participants may defer up to 80% of base salary and up to 95% of their annual incentive.
The Company has the benefit of full unrestricted use of all amounts deferred under the Deferred Compensation Plan until such amounts are required to be distributed to the plan participants.
Gains and losses are credited based on the participant’s election of a variety of deemed investment choices. The Company does not match any employee deferral or guarantee a return.
Participants’ accounts may or may not appreciate and may depreciate depending on the performance of their deemed investment choices. None of the deemed investment choices provide returns at above-market or preferential rates. All deferrals are paid out in cash upon distribution. Participants may schedule a distribution during employment or may opt to receive their balance after separation from service.
EXHIBIT 13-6 Description of Nonqualified Retirement Plan Excerpt from Coca-Cola Company’s proxy statement
Source: Excerpt from Coca-Cola Company’s proxy statement.
Deferring salary to a future period can be an effective tax planning technique, par- ticularly when the employee anticipates her marginal tax rate will be lower in the year she will receive the deferred compensation than it is in the year she defers the salary. In fact, if employees had complete flexibility as to when they could receive distributions from deferred compensation plans, they would likely accelerate distributions from deferred compensation plans into years they knew with certainty would have relatively low mar- ginal tax rates. This strategy is limited, however, by rules requiring employees to specify the timing of the future payments when they decide to participate in deferred compensa- tion plans.15
Employees considering participating in nonqualified deferred compensation plans should also consider the potential financial risks of doing so. Recall that employers are not required to fund nonqualified plans. So there’s always the possibility that the em- ployer may become bankrupt and not have the funds to pay the employee on the sched- uled distribution dates. If the employer is not able to make the payments, the employee becomes an unsecured creditor of the company and may never receive the full compensa- tion owed to her. Consequently, the employee should evaluate the financial stability of the company when deciding whether to defer compensation under the employer’s plan.
Employer Considerations
It’s pretty clear that nonqualified plans can provide significant benefits to employees.
How might employers benefit from providing nonqualified plans? First, employers may benefit if they are able to earn a better rate of return on the deferred compensation than the rate of return they are required to pay employees participating in the plan. In addition, employers can use nonqualified plans to achieve certain hiring objectives. For example, nonqualified plans could be a component of a compensation package a company may use to attract prospective executives. Deferred compensation can also be used to compensate an employee when the employer’s percentage contribution to the employee’s qualified retirement account is limited by the annual contribution limit. Deferred compensation is not subject to the qualified retirement account contribution limits.
Likewise, deferring compensation may be an important tax planning tool for employ- ers when their current marginal tax rates are low (they are experiencing net operating losses so their current marginal tax rate is 0 percent) and they expect their future marginal tax rates when deferred compensation is paid to be significantly higher because they expect to return to profitability (unless tax rates increase, the marginal rate would be 21 percent).
In effect, deferring compensation into a year with a higher marginal tax rate increases the after-tax benefit of the compensation deduction, which reduces the after-tax cost of the compensation to the employer. Recent tax legislation has dramatically reduced corporate tax rates and thus increased the after-tax cost of paying current compensation. The extent to which the corporate rate reduction affects the popularity of nonqualified deferred com- pensation plans remains to be seen.
Exhibit 13-7 summarizes and compares qualified retirement plans and nonqualified deferred compensation plans.