The Essentials of Nonqualified Deferred Compensation

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1 These plans are nonqualified because they do not meet the rules of Section 401(a) of the Internal Revenue Code (IRC), which governs tax-qualified plans [e.g., 401(k) plans]. An NQDC plan is also typically exempt from most of ERISA. This Point of View (POV) focuses primarily on NQDC plans that provide for elective deferrals of compensation, such as salary and bonus. An NQDC plan could, however, provide for no elective deferrals of compensation, and instead provide deferred compensaleadership series market research October 2013 The Essentials of Nonqualified Deferred Compensation For executives and other highly compensated employees, nonqualified deferred compensation (NQDC) offers the potential for tax deferral. NQDC plans provide a financial planning opportunity to defer taxable income beyond the Internal Revenue Service (IRS) limits for qualified plans. In favorable circumstances, use of an NQDC plan may increase net after-tax income. The decision regarding whether to defer compensation with an NQDC plan is complex, and the potential for increased net income must be weighed against the inherent risks in an NQDC plan. Our position is that participation in an NQDC plan can be appropriate if all the following criteria are met: Steven Feinschreiber Senior Vice President Financial Solutions Fidelity Strategic Advisers Income deferred does not reduce any other employer-provided benefits, such as employer matching contributions to a 401(k) plan or benefits under a qualified defined benefit plan. Generally, this means compensation used in determining benefits under the qualified plans should not be reduced below the qualified plan annual compensation limit ($255,000 for 2013). An NQDC plan participant is an accredited investor, as defined in Rule 501 of Regulation D of the federal securities laws. This definition is provided in the Appendix. Income deferred under an NQDC plan is not relied on for retirement or other goal satisfaction. That is, all goals should have a sufficiently high probability of success excluding any payments expected under NQDC plans. Typically, a goal probability of 90% is considered satisfactory. An NQDC plan participant affirms that he or she is aware of and understands the risks of an NQDC plan, including, but not limited to, changes in tax policy, challenges in estimating taxable income over long time periods, risk of company default due to bankruptcy or other reasons, investment risk of deferred compensation, and other risks as may be applicable. In essence, NQDC is a contractual arrangement between a company and a participant, nearly always an executive or other highly compensated employee, to defer a portion of current compensation and thus the related income taxes. Typically, distributions are received in the future according to the participant s elections and the plan s provisions. The participant receives the compensation and pays the related income taxes at the time of distribution. FICA taxes (i.e., Social Security and Medicare) are paid at the time of deferral (or vesting, if later). In addition to the potential benefits of tax deferral, the deferred compensation could achieve tax-deferred growth through notional investment during the deferral period. Nothing in this paper constitutes, or is intended to constitute, tax, legal, or investment advice or opinions. This document was created in Q and is based on information available at that time. Neither Pyramis nor Fidelity assumes any duty to update any of the information presented.

2 tion without an elective deferral, e.g., a profit sharing contribution under an NQDC plan or a nonqualified deferred benefit plan (NQDB) plan that is a defined benefit plan providing for deferred compensation in excess of the limits the Internal Revenue Code imposes on qualified defined benefit plans. An example of an NQDB plan is a supplemental executive retirement plan (SERP). 1 Participants and their advisors have limited decisions to make with NQDB SERPs, which are discussed beginning on page 16. I. NQDC plans: what they are Crucially, nonqualified deferred compensation allows plan participants to save much more money than they could under a qualified plan, such as a 401(k) plan, while still providing for the possibility of tax-deferred investment growth during the deferral period. NQDC is, however, subject to the rules of Internal Revenue Code Section 409A, which the participant and company must follow carefully if the participant is to avoid potentially expensive additional federal (and, in some cases, state) income taxation. See the Appendix for an overview of the application of Section 409A to nonqualified deferred compensation. Qualified vs. Nonqualified Qualified plans, e.g., Section 401(k) plans, are subject to specific tax laws and sections of the Internal Revenue Code, which impose limits on the amount that the participant can defer during a given tax year. The statutory limitation on annual contributions to qualified plans is the major reason companies offer NQDC plans. Nonqualified deferred compensation plans have fewer limits (if any) on deferral amounts, though they more narrowly restrict the timing of enrollment and distributions and the ability to make changes in distributions. Depending on their provisions, NQDC plans may also allow the deferral of income to specific times in the future for various life goals other than just retirement. These are called in-service distributions or specified date distributions. Because it doesn t neatly fit into a tax code provision that allows it to escape immediate taxation, NQDC must meet interpretations of various tax code sections and IRS regulations that allow tax deferral until a future date of distribution, as discussed throughout this POV. Section 401(k) plans are formally funded. Money from the company is put into a specific account for each participant within a For qualified plans, the yearly limits on benefits and contributions are published annually by the IRS, usually toward the end of each year. With a 401(k) plan, a participant can defer a maximum of $17,500 in 2013, plus an additional $5,500 if catch-up eligible (that is, will attain at least age 50 within the calendar year). The yearly total contribution (employee contribution plus any match and/or profit sharing amount from the company) is limited to $51,000 in 2013 plus an additional employee contribution of $5,500 if the participant is catch-up eligible. The maximum amount of compensation that can be considered in the deferral calculation is limited to $255,000 in These amounts are subject to adjustment for inflation each year. These limits are known as 402(g) and 415 statutory limitations on qualified plan contributions. trust, and these contributions along with any associated earnings are protected from the company s creditors. By contrast, NQDC plans are not formally funded. The deferred amounts are considered among other company assets in a corporate bankruptcy, and thus they can be accessed by creditors. While both qualified and nonqualified plan distributions generally do not occur until sometime after the end of employment, there is another difference between them. Under the Internal Revenue Code sections on 401(k) and other qualified plans, with limited exceptions, participants can take a penalty-free distribution only after turning 59½ (almost all plans allow this). Participants should remember that although penalty free, the distribution will be subject to taxes. Before that time, participants may still be permitted to take out money, but they must pay an additional tax of 10% unless they are at least age 55 in the year when employment with the plan sponsor ends. There are, however, a few exceptions to this rule. With NQDC, while there are limited exceptions (e.g., the rules applicable to unforeseeable emergencies), participants must adhere to the distribution dates that they select up front. The major differences between 401(k) and nonqualified plans are summarized in the table on the next page. 2

3 Feature 401(k) NQDC Yearly limit on amount participant can defer Yes, IRC limits apply. No IRC limits, but plan limits are possible from income Can schedule in-service distributions for dates Yes, if the plan allows. Some sources of money, Yes, if the plan allows. in life before job separation such as profit sharing and match, may be taken Note: No penalty applies before age 59½ (if the plan allows), but a 10% Ability to take early withdrawal (withdrawals penalty will apply. Otherwise, all funds may be before age 59½) at any time, paying taxes and taken without penalty (if the plan allows). a penalty on it Must start taking out money at age 70½ Yes, by IRC mandate, unless still working at company where the 401(k) plan is subject to 5% owner rule. No IRC requirements, but plan rules possible. Ability to take early withdrawal (withdrawal before age 59½) at any time, paying taxes and a penalty on it Funds protected from creditors in the event of bankruptcy of employer Must get distribution upon employment termination Upon employment termination, participant can roll money over to an IRA or transfer to new employer s qualified plan Flexibility in when and how the participant can withdraw money in retirement Yes, if separated from service. 10% penalty does not apply if separated from service after age 55. See above for in-service distributions. Yes No. If balance is not more than $5,000, the plan could provide that the balance is cashed out, but is not required to do so. Also, participants may keep balances in plan well after normal retirement age, depending on plan rules. Yes, if the termination is a distributable event under the terms of the plan. Usually, but not required. No, with the possible exception of amounts deferred and vested before Note: No penalty applies No No. Sometimes employment termination will trigger a lump sum distribution, but this is not a general rule. No Limited by up-front elections, plan provisions, and redeferral rules. Participant can take loans from the plan Yes, if plan allows. No Tax deduction for the participant s company At time of deferral. At time of distribution or when the participant recognizes it as taxable income. NQDC benefits in brief As mentioned above, the statutory limitation of the amounts that can be contributed to qualified retirement plans is the prime reason companies offer NQDC plans. NQDC plans offer additional tax-deferred retirement savings opportunities for participants. The annual amounts they can contribute to a qualified plan may represent a much smaller percentage of their compensation than they would like to defer and put away for retirement. Using the 401(k) contribution limits for 2013, the chart below shows the yearly percentage that these maximum contributions represent of an executive s income. Income $17,500 $23,000 (age 50+ only) $200, % 11.5% $250, % 9.2% $300, % 7.7% $500, % 4.6% $1,000, % 2.3% Executives and other highly compensated employees can expect only a fraction of retirement income to come from a 401(k) plus Social Security. This savings gap can potentially be covered by nonqualified plans, IRAs, health savings accounts, tax-deferred annuities, taxable savings accounts, and many other investments. Nonqualified deferred compensation offers other strong benefits that prospective participants should understand, especially if they are uncertain about whether to enroll in an NQDC plan: NQDC plans are commonly used in most industries and across the full range of organizations, from publicly traded companies to privately held firms to tax-exempt employers. Plans can be structured to have tax advantages for participants similar to those available with respect to qualified plans, and can thus be very tax efficient from the participant s perspective. In addition to allowing participants to defer compensation and receive employer contributions in excess of the 402(g) and 415 statutory limitations on qualified plan contributions, an NQDC plan can be designed in a way that enables participants to defer compensation and receive employer contributions in excess of limits imposed by ADP and ACP nondiscrimination testing. 2 Unlike qualified plans, nonqualified plans do not have to limit their coverage to individuals who are employed by the employer. For example, independent contractors or non-employee members of the Board of Directors could be covered. 3

4 While some companies set up NQDC plans solely to provide opportunities for executives to voluntarily defer compensation, other companies may find it advantageous to provide a profit sharing contribution and/or a match, including incentive-based matches, along with various vesting schedules. NQDC plans do not require company financing to set aside money to pay future distributions. However, some companies opt to set aside money to satisfy the liabilities created by their NQDC plans. Under the rules for nonqualified plans, companies cannot directly fund a plan and still retain their tax-deferral advantages for participants, so the funding must be indirect (called informal financing). This can be accomplished, for example, through a so-called rabbi trust. Even with a rabbi trust, however, participants would remain unsecured general creditors of the company in a corporate bankruptcy or other insolvency. NQDC plans often have flexible distribution options. Once elected, though, the distribution is locked in, with few exceptions. Although under some company plans, distributions mirror the provisions and requirements of qualified plans (e.g., no distributions until age 59½), many plans take advantage of the greater distribution flexibility available with NQDC. Plans can be structured to provide preretirement distributions, or in-service distributions, at specific dates. The intricacies of IRC 409A rules and the additional taxes they impose in the event of a violation make it important that companies either have expert in-house advisors and sophisticated administrative systems or use outside providers and advisors with expertise in nonqualified plan design and administration. Risks When representatives provide guidance to executives, it is also important for them to communicate the risks that are inherent in NQDC. NQDC plans can be only informally funded, not formally funded and protected. Although NQDC represents a contractual obligation of the company, if it were funded directly by the company in any way (i.e., protected in the event of employer insolvency), it would not defer taxes for the plan participants. This means that money deferred under NQDC plans is subject to claims by creditors if the company enters bankruptcy proceedings or becomes insolvent. Deferrals are also vulnerable to changes of corporate ownership, management, or philosophy that may lead the company to discontinue or freeze the NQDC plan. If the company were to be acquired and the new company refused to continue the plan, the end of the plan could trigger an early distribution and taxes. Understand the constructive receipt and economic benefit doctrines Along with knowing the Section 409A rules, understanding NQDC requires a basic understanding of the constructive receipt and economic benefit doctrines in US tax law, as these concepts underpin the ability of an executive to defer income taxation on deferred compensation. Under these doctrines, income tax is deferred so long as (1) participants have no rights in any specific assets of the company, (2) the deferred amounts are subject to the company s creditors in corporate bankruptcy or other insolvency, and (3) participants cannot assign their rights, among other requirements. While the company can invest the deferrals and internally allocate them for payouts, the deferred amounts must remain general assets of the company, not of the plan participant. These tax doctrines are a large part of the reason NQDC plans can be only informally funded, and why NQDC is merely an unsecured promise to pay deferred compensation to participants at a specified later time. So long as these doctrines are observed, and the plan complies with Section 409A (as applicable), ordinary income taxes are delayed until the participant actually receives the payment of deferred compensation under the NQDC plan. NQDC: What it all adds up to Nonqualified deferred compensation is all about tax-efficient saving for life goals, beyond the limitations applicable to qualified plans. In the ideal situation, participants will have more money, net of taxes, in the future for those goals. Executives and highly compensated employees can expect only a fraction of retirement income to come from 401(k) distributions and Social Security payments. One option for closing this funding gap is to use NQDC plans. II. FACTORS TO CONSIDER IN NQDC PLAN PARTICIPATION NQDC involves many decisions that must be made by the participant. The first of these is, of course, whether it makes sense to participate in the NQDC plan to begin with. For nonqualified savings and pension plans in which eligible executives and employees are automatically enrolled, the decisions instead involve elections for distributions and investments, to the extent available. Below and on the next page are three factors to consider when assisting executives and other highly compensated employees who are trying to decide whether to participate in their company s NQDC plan. 1. Is the participant maxed out on contributions under qualified plans? Executives should not participate in the NQDC plan if they currently cannot afford the maximum annual contributions to their qualified deferral plans, as these are fully funded and protected by ERISA. 2. Can the participant afford to put aside current compensation that instead would be deferred until distribution? Cash-flow projections that look at all sources of income against spending needs in the near future are a good starting point for this conversation. Alert: An NQDC plan is not like a 401(k), in which participants are usually permitted to decide how much to defer during the year when they are earning the money, and can usually increase or decrease contributions. An executive cannot adjust nonqualified salary deferrals during the calendar year. There are a few narrow exceptions to this rule, including an exception applicable to performance-based compensation (see The mechanics of deferral elections, page 10). Because of the 4

5 restrictions applicable to NQDC deferral elections, the executive must attempt to predict cash-flow needs and tax brackets for the year ahead. Making changes is almost impossible. 3. Is the company financially secure? It is important for the executive to consider the fact that in the event of the company s bankruptcy or other insolvency, any NQDC would not be protected from creditors. In that event, the participant would be an unsecured general creditor. This is the case regardless of whether the employer established a rabbi trust with respect to the NQDC plan. Therefore, it is important to fully understand the company s financial situation. Participants and advisors should carefully review SEC filings, public announcements, analyst reports, and financial statements to assess the risk to their company. Deferring compensation through an NQDC plan is similar to investing in a single long-term corporate bond with no liquidity. A company s bond credit rating can help give an indication of default risk, but also keep in mind that over long time periods, such as 30 years, pretty much anything can happen. Executives concerned about the risk of corporate bankruptcy have various strategies open to them, in addition to the option of choosing to not defer compensation. For example, they can shorten the period of risk exposure by delaying the deferral of compensation until later in their careers, after they have saved a sufficient amount for retirement. Other ideas include electing a relatively short payout period for distributions and setting a reasonable limit on the percentage of total assets deferred under the NQDC plan. Other questions on whether to participate (below) are about tax rates and the features of the company s NQDC plan. Some of these considerations are discussed in more detail elsewhere in this paper. 4. What is the participant s current marginal tax rate and expected tax rate in retirement? When a participant defers compensation under an NQDC plan, the compensation is excluded from current taxable income. The value of the compensation is taxed as ordinary income when it is later distributed. (At the time of deferral, only Social Security and Medicare taxes are paid.) It is important for the executive to consider the estimated marginal tax rate applicable for the year in which the compensation would be paid, absent the deferral and the amount of taxable income that would result in an increase or decrease in the marginal rate. The participant should consider whether the tax rate at the time of distribution may be lower, the same, or higher than it is at the time of deferral. If the rate is estimated to be lower, then deferral could be advantageous purely from a tax perspective. When the rate will be the same or higher, various factors determine whether deferring the income is preferable to taking it now. The participant should keep in mind that estimation of a participant s marginal tax rate many years in the future is extremely challenging, if not impossible, given possible changes in tax policy, state and city of residence, and estimation of future taxable income. Alert: In 2013, the Medicare tax rate rose from 1.45% to 2.35% on earned income amounts over $200,000 for single filers and over $250,000 for married joint filers. Guidance issued by the IRS clarifies that for NQDC, the 0.9% additional Medicare tax is withheld at the same time as the regular 1.45% Medicare tax at deferral. In addition, individuals with income over these thresholds face a 3.8% Medicare surtax on net investment income, which includes amounts received from sales of securities, interest income, and dividends. Deferrals into NQDC plans can help keep participants under the investment income surtax limit, while NQDC distributions can push incomes over the investment income surtax limit. In addition, state income taxes apply. Depending on how the plan is structured, this tax may be in the state of residence at retirement or the state of employment when the income was deferred (for more details, see Tax treatment when the participant has relocated to a different state, page 14). Therefore, the executive should think about his or her intended state of residence at retirement. Hypothetical scenarios: Economic value of deferring income in an NQDC plan The scenarios beginning on the next page help illustrate the potential economic value of deferring income. In each scenario, four alternative strategies are examined: 1) defer income in an NQDC plan, 2) take the net income and invest in a tax-deferred annuity, 3 3) take the net income and invest in a taxable account, and 4) take the net income and invest in a tax-efficient investment in a taxable account. As illustrated here, in most cases, the NQDC plan provides the greatest economic benefit, even if taxes increase. 5. What is the impact of NQDC participation on a 401(k) plan or pension plan? Executives can participate in their 401(k) plan (if permitted by the plan), although the executive should understand how participating in the NQDC would affect the 401(k) contribution calculation. Example: An executive earns $200,000 annually and defers 25% into a nonqualified deferred compensation plan, leaving $150,000 available for his qualified plan. He annually defers 7% of compensation into a 401(k) and the company matches contributions up to 5%. This 7% participant contribution and 5% employer matching contribution is calculated from the $150,000 and not from the $200,000. Participant contributions would be reduced from $14,000 to $10,500 and employer matching contributions reduced from $10,000 to $7,500. While in the example above the participant may be able to increase the deferral contribution rate to 9% or 10% to maintain approximately the same deferral contribution amount, nothing can be done in this example to offset the loss of $2,500 in employer matching contributions. Furthermore, participants should not contribute to an NQDC plan until they have maxed out their qualified plan contributions. As already stated, income deferred should not reduce any other employer-provided benefits, such as employer matching contributions to 401(k) plans or accrued benefits under defined benefit plans. 5

6 Hypothetical illustration of potential value: 20-year deferral period, 7% assumed return Current Year Is 2013 Assumptions Taxable Account Tax-Efficient Taxable Account Income Amount $1,000,000 Dividends 2.00% 0.00% Current Tax Rate 39.6% Interest Income 2.00% 0.00% Deferral Period (Years) 20 Realized LTG 1.00% 0.00% Net Proceeds (After Taxes*) $604,000 Unrealized LTG 2.00% 7.00% Current Capital Gains Tax Rate 20.0% Gross Return 7.00% 7.00% Tax Change 10.0% Deferral Year of Tax Change 11 Medicare Investment Surtax 3.8% Net Amount After Taxes Investment Amount At 10% Lower Tax Rate At Same Tax Rate At 10% Higher Tax Rate NQDC Plan $1,000,000 $2,724,258 $2,337,289 $1,950,321 Tax-Deferred Annuity $604,000 $1,712,465 $1,546,029 $1,379,593 Taxable Account $604,000 $1,632,800 $1,515,220 $1,402,048 Tax-Efficient Taxable Account $604,000 $2,098,095 $1,924,767 $1,751,438 Hypothetical illustration of potential value: 10-year deferral period, 7% assumed return Current Year Is 2013 Assumptions Taxable Account Tax-Efficient Taxable Account Income Amount $1,000,000 Dividends 2.00% 0.00% Current Tax Rate 39.6% Interest Income 2.00% 0.00% Deferral Period (Years) 10 Realized LTG 1.00% 0.00% Net Proceeds (After Taxes*) $604,000 Unrealized LTG 2.00% 7.00% Current Capital Gains Tax Rate 20.0% Gross Return 7.00% 7.00% Tax Change 10.0% Deferral Year of Tax Change 6 Medicare Investment Surtax 3.8% Net Amount After Taxes Investment Amount At 10% Lower Tax Rate At Same Tax Rate At 10% Higher Tax Rate NQDC Plan $1,000,000 $1,384,875 $1,188,159 $991,444 Tax-Deferred Annuity $604,000 $976,929 $920,933 $864,938 Taxable Account $604,000 $988,882 $950,085 $911,905 Tax-Efficient Taxable Account $604,000 $1,107,545 $1,049,129 $990,714 *State and local taxes are not modeled. These hypothetical examples are for illustrative purposes only. They are not intended to predict or project investment results. An investor s rate of return may be higher or lower than that shown in these hypothetical illustrations. Tax-deferred earnings and taxable contributions will be taxed at the time of withdrawal at the federal income tax rate in effect at the time. State and local taxes may also apply. 6

7 Hypothetical illustration of potential value: 5-year deferral period, 7% assumed return Current Year Is 2013 Assumptions Taxable Account Tax-Efficient Taxable Account Income Amount $1,000,000 Dividends 2.00% 0.00% Current Tax Rate 39.6% Interest Income 2.00% 0.00% Deferral Period (Years) 5 Realized LTG 1.00% 0.00% Net Proceeds (After Taxes*) $604,000 Unrealized LTG 2.00% 7.00% Current Capital Gains Tax Rate 20.0% Gross Return 7.00% 7.00% Tax Change 10.0% Deferral Year of Tax Change 5 Medicare Investment Surtax 3.8% Net Amount After Taxes Investment Amount At 10% Lower Tax Rate At Same Tax Rate At 10% Higher Tax Rate NQDC Plan $1,000,000 $987,396 $847,141 $706,886 Tax-Deferred Annuity $604,000 $759,372 $736,043 $712,714 Taxable Account $604,000 $766,287 $755,934 $745,581 Tax-Efficient Taxable Account $604,000 $813,588 $789,274 $764,960 Hypothetical illustration of potential value: 10-year deferral period, 0% assumed return Current Year Is 2013 Assumptions Taxable Account Tax-Efficient Taxable Account Income Amount $1,000,000 Dividends 1.00% 0.00% Current Tax Rate 39.6% Interest Income 1.00% 0.00% Deferral Period (Years) 10 Realized LTG 1.00% 0.00% Net Proceeds (After Taxes*) $604,000 Unrealized LTG 2.00% 0.00% Current Capital Gains Tax Rate 20.0% Gross Return 1.00% 0.00% Tax Change 10.0% Deferral Year of Tax Change 6 Medicare Investment Surtax 3.8% Net Amount After Taxes Investment Amount At 10% Lower Tax Rate At Same Tax Rate At 10% Higher Tax Rate NQDC Plan $1,000,000 $704,000 $604,000 $504,000 Tax-Deferred Annuity $604,000 $594,056 $595,549 $597,042 Taxable Account $604,000 $575,246 $581,227 $587,207 Tax-Efficient Taxable Account $604,000 $604,000 $604,000 $604,000 Additional assumptions for all hypothetical illustrations The income amount is net of FICA taxes, including the 0.9% Medicare surtax on earned income. We assume the executive is subject to the 3.8% Medicare surtax on all investment income for the entire deferral period. Please read the details at Model assumes that no early withdrawal penalties are due on tax-deferred annuity. Penalties apply on withdrawals under age 59½. Annuity calculation includes an annual fee of 0.25% when balances are below $1,000,000, and 0.10% when balances are greater than or equal to $1,000,000. Lump-sum initial investment No additional investments or withdrawals All dividends and interest reinvested after taxes are paid Lump-sum payout Returns compounded annually No investment fees or expenses modeled *State and local taxes are not modeled. These hypothetical examples are for illustrative purposes only. They are not intended to predict or project investment results. An investor s rate of return may be higher or lower than that shown in these hypothetical illustrations. Tax-deferred earnings and taxable contributions will be taxed at the time of withdrawal at the federal income tax rate in effect at the time. State and local taxes may also apply. 7

8 So in this example, a contribution to the NQDC plan would not be recommended. Now, in some cases, companies match contributions to their NQDC plan. In these cases, the company match to the NQDC plan may make up for the lost match in the qualified plan. Still, the NQDC matching dollars are at risk (bankruptcy risk) along with all other NQDC balances, whereas qualified plan matching contributions are not at risk, assuming the participant is fully vested. 6. Is the NQDC secured in some way? As mentioned on pages 9 and 19, a rabbi trust can have some limited use. This mechanism lets an employer place assets into an irrevocable trust and can potentially provide protection against a future attempt by management to rescind these benefits ( change of heart ) for example, following a change in control. Even with a rabbi trust, however, participants remain unsecured general creditors of the employer in the event of the employer s bankruptcy or insolvency. (Note: Whether the rabbi trust provides any protection in the event of a management change of heart depends on the terms of the trust.) 7. Is there any company match or contribution? These are fairly common in NQDC plans, though not so common as in 401(k) plans. A match is usually based on a percentage of the deferral, up to a specified amount. A matching contribution can provide an incentive for the participant to contribute. It often makes sense to contribute at least enough to get the full match. A company can also make a contribution that does not depend on the participant s contribution, similar to a profit sharing contribution. Vesting provisions are common. A match or other employer contribution can also require that specific goals be reached, or can apply only to a bonus deferral, making NQDC a form of incentive compensation. 8. Is there any automatic crediting rate on deferrals? It used to be more common for companies to guarantee a single fixed rate of return on the deferred compensation. Now it is more common for earnings from deferred amounts to be tied to the performance of particular notional investments that the participant selects, such as mutual funds. 9. What are the notional investment choices when there is no automatic crediting rate on deferrals, and how do they fit with other investments? Notional investments can follow the choices in the company s 401(k) plan [common for excess 401(k) plans], or they may follow a stock index, the company s stock price, a corporate bond index rate, the 10-year Treasury note rate, the Consumer Price Index, or a combination of these or other factors. To help create a diversified portfolio, the notional investments can complement those in a 401(k) plan or taxable account. It is important to remember that these are phantom investments for accounting purposes only. NQDC participants have no actual rights in any of the notional investments (although the SEC believes that in many cases, an interest in the NQDC plan is an interest in a security). 10. Are there flexible choices for electing distributions (within the limits of IRC Section 409A), including the ability to elect both in-service and retirement distributions? This depends on the company s NQDC plan. If the timing is flexible, it is important for the participant to consider the financial goals of the NQDC distributions before deciding whether to receive them during employment or in retirement. Any flexibility is, of course, limited to the initial up-front election. Even if the plan allows distribution dates to be altered later (not all do), changes must follow the strict rules of IRC Section 409A, including a minimum five-year extension for a subsequent deferral election or redeferral, which is necessary to avoid immediate taxation and additional income tax (companies can use different names for redeferrals, including pushout distribution elections). 11. Will the participant have the ability to base distribution elections, including in-service distributions, on specific goals and schedule them for specific years? Will he or she be able to change elections within the limits of Section 409A? These are essential questions that can be answered only by referring to the NQDC plan documents. These types of provisions offer participants more flexibility in their financial planning and the potential uses of the distributions. As with all aspects of elections and distributions, Section 409A compliance is crucial. 12. How do NQDC deferrals compare with a tax-deferred annuity? Annuities can take various forms. With NQDC deferrals, taxes are deferred on the current compensation income plus the potential growth due to the notional investments. With a tax-deferred annuity, while any investment growth is tax deferred, the contributions to the annuity is on an after-tax basis. With a tax-deferred variable annuity, all gains are taxed as ordinary income upon withdrawal (the contributions constitute tax basis), and a 10% additional federal income tax applies to withdrawals taken before age 59½ unless the payments were annuitized according to specific IRC rules. By contrast, with NQDC plans, the full distribution is taxed, and the age 59½ rule applicable to annuities is not applicable to NQDC. In general, while the total tax paid on NQDC distributions may be higher, the net amount received will generally be greater than with a tax-deferred annuity, assuming the same investment returns given the up-front taxes paid. See the illustrations beginning on page Does the executive also have expected proceeds from stock compensation, e.g., from a stock option exercise, restricted stock/ restricted stock unit vesting, or performance share payout? In a year when income from equity compensation is expected, additional cash compensation may not be needed and thus may be available for deferral. In addition, deferring salary and/or bonuses under the NQDC plan may keep the executive out of the highest tax brackets. The funds will later be available for payment during retirement, when the executive may potentially be in a lower tax bracket. Alert: Some restricted or performance share unit plans allow the executive to defer the share delivery and thus the compensation. These are NQDC plans, and all the issues discussed in this POV apply. 8

9 14. What is the quality of the plan documentation and administration? Consider the NQDC track record of the company or plan provider and ascertain whether it has made any serious mistakes with its plans or 409A compliance in the past. 15. Does the plan comply with the rules of Section 409A? This is crucial. Even if only the company, not the participant, fails to comply with IRC Section 409A, the negative income tax consequences applicable in the event of noncompliance fall solely on the participant. In the absence of a timely correction under the IRS 409A correction program, all vested amounts under the plan covered by 409A would be immediately included in the participant s income. An additional tax of 20% would apply to the income, and the participant would owe an additional tax based on the interest rate applicable to underpayments of income tax plus one percentage point. Secular trusts As mentioned earlier, a rabbi trust is an IRS-approved mechanism letting a company place assets in a trust under state law to establish a reserve to satisfy the liability created by the NQDC plan. Even with a rabbi trust, however, participants remain unsecured general creditors of the company in a corporate bankruptcy or other insolvency. This risk is partly what permits the tax deferral of the NQDC even when the employer maintains a rabbi trust. An alternative arrangement, called a secular trust, involves a different approach to that of the rabbi trust. The amounts deferred each year are contributed to a trust that cannot be reached by the company s creditors in the event of bankruptcy. A secular trust thus protects deferred amounts from not only the risk posed by changes in corporate control or attitude but also the risks of corporate bankruptcy. However, a secular trust is, in most cases, not practical, as discussed on page 19. Does deferral make sense if tax increases are likely? Even though NQDC plans allow savings well beyond the limits of qualified plans, companies and plan participants have started to question the merits of using pretax savings plans in what they believe will be an environment of rising tax rates in the future. However, even with rising tax rates, the basic tenet of NQDC plans still applies: Participants defer taxes twice: first, when they would have received their salary or bonus and would have paid ordinary income tax on it at that time; second, on any investment income as it accumulates. While income such as interest, dividends, and realized capital gains from traditional after-tax savings in a taxable brokerage account is subject to income tax each year, earnings and the amount deferred in an NQDC plan are not subject to income tax until the benefit is actually distributed. The out-of-pocket tax cost each year to after-tax investors in a regular brokerage account can potentially reduce their annual rate of return. Assuming a pretax deferral is attractive, what about NQDC participation in light of expected tax-rate increases? Is it better to take the compensation now, pay current taxes at lower ordinary income rates than those expected in the future, reinvest the net amount, and then sell it later at capital gains rates? Or is it better to defer the income and taxes on it today and pay a greater total amount of taxes when it is distributed in the future? The answer depends on three factors: Current and future tax rates for both ordinary income and capital gains The investment return on the compensation deferred The growth of the alternative investment(s) for the after-tax amount of the compensation without deferral The future value from the tax-deferred growth of the compensation, including investment earnings, may potentially exceed the future value of that compensation without deferral. In short, participants are starting with a much bigger pretax sum that can grow in a taxdeferred way, instead of paying taxes on their compensation earlier by forgoing deferral and then investing the smaller net after-tax amount. Even though participants may owe more taxes in the end, the net after-tax value of the deferred amount could be larger. See the illustrations beginning on page 6 for examples of how an NQDC plan can add value even in a rising tax environment. The longer the period until the participant takes distributions, the more likely that it could potentially make sense to defer compensation, particularly if the participant expects tax rates to rise. Also, consider state rates if the participant plans to move from a high-tax state (e.g., California) to retire in a low- or no-tax state (e.g., Florida) where he or she will receive distributions. Altering elections and distributions because of tax rate changes If executives are concerned about future tax rate increases, they may want to consider changing their deferral or distribution elections and instead receive the money in the current year. However, NQDC plan participants cannot change or cancel deferral elections for income earned in the current tax year. NQDC plans are not like 401(k) plans, where modifications of deferred amounts can typically be made during the year when they are earned. One of the core concepts of NQDC is the irrevocable election to defer income in the year before it is earned. Exceptions are made for participants who have just become eligible for the plan and for performance-based compensation. In addition, strict rules about redeferrals make it impossible to accelerate a scheduled distribution from a future year to the current year. It is also impossible to change the time of distributions to receive them earlier than the originally elected date without incurring immediate and additional taxation under Section 409A (unless something triggers an early distribution under the plan). As discussed on page 10, if participants want to reschedule a distribution, they must follow strict rules. Redeferrals to push out the distribution date cannot take effect until at least 12 months 9

10 after the date the redeferral election is made; have to be made at least 12 months before the originally scheduled distribution date, where there is a fixed date; and the new date of distribution must be at least five years beyond that original distribution date. An exception could apply for amounts deferred and vested before 2005, e.g., such amounts under a plan with a haircut provision. (See the discussion of this topic on page 13.) III. ENROLLMENT, DEFERRAL DECISIONS, AND INVESTMENT STRATEGIES Electing deferrals in an NQDC plan involves a number of decisions that may affect the participant s long-term financial situation. As already mentioned, changing deferral elections may not be allowed by the plan; even if they are permitted, redeferrals must follow the strict rules of IRC Section 409A to avoid immediate taxation on existing deferrals and additional income taxes. Therefore, the decisions participants make at election are difficult if not impossible to change. Alert: Section 409A immediate and additional taxation falls on the participant, not the company. To avoid these negative tax consequences, participants must have a basic understanding of 409A These rules severely limit the flexibility of NQDC deferral election timing and payment timing. Informed forethought about the participant s financial plan and other investments is therefore an important prerequisite to NQDC enrollment. The mechanics of deferral elections Deferral elections are made for compensation to be earned during the following year. The participant may be able to make an evergreen election that applies automatically every year unless it is modified, though any change must occur before the start of the following year. It is important that the participant looks at the election forms, the NQDC plan documents, and any related materials to determine what he or she can elect. Elections can include: The amount (usually the percentage) of compensation the participant wants to defer. The breakdown in the deferral percentage for salary and/or bonuses. The time when the participant wants to receive the distribution(s), e.g., all in one year of choice or in different years selected for various accounts. Alternatively, the plan may have mandatory provisions on timing and may not permit participant elections. Choices in the form of the distribution, e.g., a lump sum or installments, unless the plan has mandatory provisions (which can vary according to the distribution event). Notional investment alternatives for the amount being deferred or for each account, if choices are given (investment choices are the only feature the participant can change without triggering 409A issues). These can all be combined in one or two forms, or there may be separate election forms for: Salary deferral percentage Bonus deferral percentage Investment election Form of distribution Timing of distribution Redeferral (if the plan allows this) Beneficiary designations New participants must make deferral elections within the first 30 days after they become eligible to participate in the plan. An exception applies if the compensation is performance based: in this case, participants can make elections up to six months before the end of the performance period, so long as, among other requirements, the performance period is at least 12 months long and they don t know whether they have earned the compensation when making the election. ( Performance-based compensation is a term of art with a narrow meaning under 409A.) Depending on the plan provisions, the type of compensation eligible for deferral can be salary, bonuses, cash payments under long-term incentive plans, or grants of restricted stock units. For directors, it can include fees and retainers. Similarly, the amount of compensation that can be deferred depends on the plan and the type of compensation. For example, companies commonly allow up to 100% deferral of bonuses. For salary, there is greater variety. Excess 401(k) plans generally allow only elective employee contributions to the same percentage of compensation as permitted under the 401(k) plan, use the same definition of eligible pay, or make up for the lost company match only in the 401(k). Notional investments and making choices NQDC account balances are usually credited with some type of interest or notional investment return (often called the crediting rate). This can be automatic or based on notional investment choices made available to the participant. It used to be more common for companies to guarantee a single fixed rate of return on deferred compensation. Now earnings credited on the deferred amounts are often tied to the performance of particular notional investments that the participant selects, such as mutual funds. Notional investments can follow the choices in the participant s 401(k) plan, a stock index, company stock, a corporate bond index rate, a Treasury note rate index, the Consumer Price 10

11 Index, a combination of these factors; or in special investments, such as hedge funds, which may be available only in the NQDC plan. Therefore, advisors and participants should be alert to unique investment opportunities in the NQDC account that will be a good fit for a participant s overall portfolio. The choices, along with any default option, for deferred and matching amounts will be specified by the plan and election forms, and will be made available through an account with the company s plan provider. Choices and changes in these are not directly affected by Section 409A rules so long as (with limited exceptions) the timing or form of distribution is not changed (the employer is also generally restricted from making such changes). Alert: Investments and return or interest credited to the account on the deferred amount are hypothetical (sometimes termed phantom or notional). To keep their tax-deferred status, the account balances must be bookkeeping entries, not actual funds, put outside the reach of the employer s creditors to pay the benefits. The executive cannot withdraw the money or directly control it. Even though these are hypothetical investments, they can affect the future value of the NQDC account balance and the size of the distributions eventually made. Notional investments are subject to standard risks, such as stock market volatility. As with any investment, participants will want to consider financial goals, time horizon, risk tolerance, and diversification (in the context of all assets and investments). As with a usual investment portfolio, total return and risk from an NQDC arrangement will probably be more a function of the asset classes than of the individual investments populating the asset classes, assuming a well-diversified portfolio. The distribution actually received is generally in cash for the value of these investments, not of the specific notional investment itself. Not all plans offer notional investment alternatives in all the important asset classes. In those cases, the participant will want to plan to complement his or her other investments with the most suitable NQDC asset classes for his or her overall allocation. Example: The employer s plan offers a fixed-income alternative with return based on relatively attractive interest rates. The executive can consider overweighting the NQDC allocation to that class, and underweighting the class in her 401(k) and other investments. This tactic can be particularly appealing if the fixed-income vehicle has a constant-dollar principal (i.e., it is not inversely related to the movement of interest rates, as is the case with traditional fixed-income investments). Alert: If the plan provides for a fixed interest rate on deferred compensation balances, the participant should not consider those balances identical to safe fixed-income investments in a 401(k) or brokerage account. They may offer a fixed income, but they aren t safe (e.g., from corporate bankruptcy). Some plans offer an employer-stock alternative, which can be used to satisfy share-ownership requirements for executives. In addition, participants may be allowed to have different investment allocations for distributions in different years; participants may allocate to fund different goals, such as a child s education or retirement (assuming they have preset payment dates). Usually, each of these account balances can have different investment allocations, which will be clear from deferral-election forms. The company determines whether it will allow this according to its goals for the plan, the administrative complexities, and the costs. Example: The NQDC account has elections to pay distributions from 2013 through 2016, which the participant has earmarked for college funding. Given this time frame, a conservative investment allocation may be appropriate. For another account, set up to pay a lump-sum distribution in 2023, the planned year of retirement, a more aggressive investment allocation may be considered. IV. GETTING MONEY: DISTRIBUTION RULES AND STRATEGIES Participants determine the time and form of distributions when they make deferral elections. In general, decision making about distributions has two aspects: (1) when the distribution will be received, and (2) in what form. Participants should be aware that NQDC plans may have mandatory provisions for these. Distribution timing At the time of deferral, the participant may be able to choose when distributions will occur. If the executive does not make elections, a default distribution election stipulated in the plan will probably apply. Apart from following the usual redeferral rules under Section 409A, there are only limited ways the elected timing of distributions can be changed without incurring 409A taxation: for example, the occurrence of an early payout trigger specified in the plan, such as termination of employment or an unforeseen emergency. These events trigger permissible early payout under the plan and 409A rules. Under Section 409A, a plan may have up to five distribution triggers other than the specific date as specified in the distribution election: Disability An unforeseeable emergency Separation from service A corporate change in control Death While these triggering events notionally accelerate payouts by bringing them forward from the originally elected or otherwise mandatory distribution date, they are not considered accelerations, which the 409A rules generally prohibit. Except in limited circumstances, 11