Many business owners and executives would like to save more money for retirement than they’re allowed to sock away in their 401(k) plan. For 2017, the annual elective deferral contribution limit for a 401(k) is just $18,000, or $24,000 if you’re 50 years of age or older.
This represents a significantly lower percentage of the typical owner-employee’s or executive’s salary than the percentage of the average employee’s salary. Therefore, it can be difficult for these highly compensated employees to save enough money to maintain their current lifestyle in retirement. That’s where a nonqualified deferred compensation (NQDC) plan comes in.
NQDC plans enable owner-employees, executives and other highly paid key employees to significantly boost their retirement savings without running afoul of the nondiscrimination rules under the Employee Retirement Income Security Act of 1974 (ERISA). These rules apply to qualified plans, such as 401(k)s, and prevent highly compensated employees from benefiting disproportionately in comparison to rank-and-file employees. NQDC plans are essentially agreements that the business will pay out at some future time, such as at retirement. Since these plans do not need to comply with ERISA nondiscrimination rules, or are subject to the IRS contribution limits and distribution rules that apply to qualified retirement plans, businesses can tailor benefit amounts, payment terms and conditions to the participants’ specific needs.
There are several types of NQDC plans. The most common are as follows:
• Excess benefit plans
• Wraparound 401(k) plans
• Supplemental executive retirement plans (SERPs)
• Section 162 executive bonus plans
• Salary-reduction plans
The key to a NQDC plan
Since the promised compensation is not yet transferred to the participant, it’s not considered earned income and therefore, it is not currently taxed. This allows the compensation to grow tax-deferred.
Naturally, there are challenges to consider. NQDC plans are subject to strict rules under Internal Revenue Code Sections 409A and 451, and plan loans generally are not allowed. However, attracting and retaining top executive talent is a business imperative, and a NQDC plan can help your business win the talent race with a powerful benefits package.