Solving the Tax-Deferred Savings Gap for Highly Compensated Employees

A Qualified 401(k) vs Nonqualified 409A Plan Primer

Insight By
Mike Iley

As pension programs have largely become a thing of the past, the 401(k) is now the retirement savings vehicle of choice for most employers. If designed properly, a 401(k) allows employees to set aside a significant amount of their income in preparation for retirement. Studies show that the average person needs to save 15% of their income throughout their working years to replace at least 80% of their income in retirement years. This savings rate is much higher for individuals that started late on their retirement savings.

The problem:  With the annual IRS 401(k) contribution limit of $19,500 per year (2020 limit) and a $6,500 catch-up for employees 50 or older, your highly compensated employees are left with a significant gap in their ability to save for retirement.  

[1] Chart assumptions detailed in the footnotes.

The solution:  By offering a Nonqualified Deferred Compensation (NQDC) plan, you can provide a simple solution allowing a select group of key and highly compensated employees the opportunity to defer additional pretax compensation over and above the annual limits of a 401(k) plan. NQDC plans are commonly referred to as “401(k) spillover plans,” as the excess savings rate desired by the highly compensated employee can be set to spill over into a NQDC plan.

NQDC plans are governed under IRS Code Section 409A. While similarities with 401(k) plans exist, important tax, financial, and operational differences should be considered. The table below compares the plans and their impact from a company and a participant perspective.

Company Perspective

401(k) Qualified Plan 409A Nonqualified Plan
Eligibility
  • All eligible employees
  • A select group of highly compensated and key employees
Contribution Limits
  • IRS 402(g) contribution and catch-up limits
  • Eligible compensation limits
  • Discrimination testing
  • No limits required. However, some employers may place a cap on deferrals to ensure payroll taxes/other withholdings can be made from payroll
  • No eligible compensation limits
  • No discrimination testing. Plan can discriminate with regard to plan eligibility and company contribution/match by employees
Taxation: Contributions (Liability)
  • Employee elective contributions are currently tax deductible and subject to FICA/Medicare
  • Employer contributions are not subject to FICA/Medicare
  • Contributions are not tax-deductible
  • Employee elective contributions are subject to FICA/Medicare
  • Employer elective contributions, if any, are subject to FICA/Medicare upon vesting
Taxation: Distributions (Liability)
  • Distributions to participants have no tax impact on the company
  • Distributions (contributions plus earnings) are tax-deductible to the company when paid
Taxation: Assets (Funding)
  • Assets accumulate in a tax-qualified trust tax-free
  • Asset accumulation is taxable to the corporation unless a tax-favored asset such as corporate-owned life insurance (COLI) is used, which accumulates tax-deferred (tax-free if held until death)
Accounting: Liabilities (Plan)
  • Deferral results in compensation expense, just as salary payment would if there were no deferrals made by the employee
  • Any employer contribution (e.g., company match) creates an additional charge
  • There is no charge for investment gains in participant accounts
  • Liability is “off-balance-sheet”
  • Deferral results in compensation expense, just as salary payment would if there were no deferral made by the employee
  • Any employer contribution (e.g., company match) creates an additional charge
  • Investment gains/losses credited to participant accounts create an additional charge/gain
  • Company liability is carried equal to the participant’s account balance
Accounting: Assets (Funding)
  • Once funded, assets and liabilities are off the balance sheet
  • Assets are accounted as they would be under any other investment strategy
  • Assets do not directly offset liabilities, instead, they are presented as separate balance sheet line items
Tax Compliance
  • IRS Section 401(k)
  • ERISA
  • IRS Section 409A
  • Exempt from most ERISA requirements
Legal/Reporting
  • Annual DOL form 5500 filing
  • One-time DOL “Top-Hat Plan” filing Possible SEC reporting (Proxy, S-8, Form 4)

Participant Perspective

401(k) Qualified Plan 409A Nonqualified Plan
Taxation: Contributions
  • Income-tax deferred (traditional pre-tax) or Roth (pay income tax now)
  • Subject to FICA/Medicare
  • Income-tax deferred
  • Subject to FICA/Medicare
Taxation: Distributions
  • Pre-tax contributions subject to income tax
  • No FICA/Medicare (already paid)
  • Subject to income tax
  • No FICA/Medicare (already paid)
Contribution Limits
  • Subject to various restrictions. E.g., 2020 maximum 401(k) deferral under 402(g) is $19,500 + $6,500 catch-up contributions for participants over age 50
  • None, except as mandated by the plan
Timing of Elections: Contributions
  • Deferral election can be changed at any time, subject to rules of the plan
  • Must be made prior to the beginning of the calendar year in which the compensation to be deferred is earned
  • Changes are not permitted.
Timing of Elections: Distributions
  • Form of distribution is elected at the point of distribution
  • Form and timing of distribution must be elected at the time of the deferral election
Election Changes
  • Deferral election can be changed at any time, subject to rules of the plan
  • Deferral election can be changed only for subsequent calendar years
  • Distribution election may be modified with advance notice, subject to plan terms and Internal Revenue Code restriction
Timing of Distributions
  • Limited distribution options
  • Payments made before age 59-1/2 subject to penalty
  • Required minimum distributions commence at age 70-1/2
  • Flexible
  • Election must be made prior to beginning of earnings period
  • No penalty for distributions payable before age 59-1/2
  • Separation from service (retirement, termination, etc.) generally triggers payment
Hardship Distributions
  • Available at any age without penalty
  • If included in the plan design, available anytime without penalty
  • Stricter qualifications for meeting definition of “hardship”
Loans
  • Allowed
  • Not allowed
  • However, shorter-term cash needs may be satisfied from scheduled in-service distributions, if allowed by plan design
Tax-Free Rollovers
  • Allowed without penalty
  • Not allowed
  • Distributions typically commence upon separation of service.
Benefit Security
  • Plan balances are secured; contributions plus earnings are held in trust and owned by the participant
  • Plan balances are unsecured; payments are a contractual obligation of the employer to the employee (“promise to pay”)

Questions to ask yourself when considering a Nonqualified Deferred Compensation program for your organization:

  1. Are your key highly compensated employees concerned about having enough savings from a 401(k) or 403(b) plan and Social Security benefits to retire comfortably?
  2. Are contributions by you or your key employees limited by the deferral maximums on your 401(k) plan?
  3. Are your highly compensated employees getting refunds on their qualified plan contributions and you aren’t ready to bite the bullet and become a safe harbor plan?
  4. Do you and your key employees receive less match and profit-sharing benefits in your qualified plan than other employees?
  5. Are you concerned about recruiting, retaining and rewarding high-performing key employees?
  6. Are you interested in developing special incentives to connect your key employees to your organization for the long term?

If you answered “yes” to any of these questions, a Nonqualified plan may be a good solution for you. Contact LoVasco to learn more about how a Nonqualified plan would benefit your organization.

[1] Chart Assumptions: Data assumes a 25 year old begins contributing 10% of their income, increasing 3.0% annually, to their qualified retirement program with a 4.0% employer matching contribution. Each year's income is calculated by multiplying the income at the current age, 45, by the natural log of the ratio of the calculated age multiplied by Euler's number, e, divided by the current age, 45. This models an increasing income at an increasing rate.

Contributions are limited by historical and projected IRS 402(g) limits and qualified catch-up, employee and total contribution limits. For years beyond 2020, all aforementioned limits are modeled to increase annually by a rate equal to the 15 year average annual growth rate since 2020. IRS 402(g) limits modeled to grow by 2.1% annually; employee contribution limits modeled to grow by 2.3% annually; total contribution limit modeled to grow by 2.1% annually; catch-up contribution limited modeled to grow by 3.5% annually.

Investment balance is assumed to grow annually at 5.0% before age 65. Annual potential income in retirement is estimated by using the investment balance at retirement as the present value of the future cashflows to calculate each installment of a series of annual cash flows over a 20 year period starting at age 65 with a 2.0% post-retirement investment rate of return.

Insight By
Retirement Plan Consulting
Mike Iley
Vice President & Managing Director
File Number

3268659.1

Topic
Executive Benefits
Published on

October 15, 2020

updated on

October 15, 2020

Disclosure

This information was developed as a general guide to educate plan sponsors and is not intended as authoritative guidance or tax/legal advice. Each plan has unique requirements, and you should consult your attorney or tax advisor for guidance on your specific situation.

Securities and Investment Advisory Services offered through M Holdings Securities, Inc., a registered Broker/Dealer and Investment Advisor, member FINRA/SIPC. LoVasco Consulting Group is independently owned and operated.

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