Solving the Tax-Deferred Savings Gap for Highly Compensated Employees
Insight by
Mike Iley
December 7, 2022
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 $$22,500 per year (2023 limit) and a $7,500 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., 2021 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:
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?
Are contributions by you or your key employees limited by the deferral maximums on your 401(k) plan?
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?
Do you and your key employees receive less match and profit-sharing benefits in your qualified plan than other employees?
Are you concerned about recruiting, retaining and rewarding high-performing key employees?
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.
