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Deferred Compensation Plan

Deferred compensation usually is classified into Qualified Deferred Compensation and Non-Qualified Deferred Compensation.

A deferred compensation plan withholds a portion of an employee’s pay until a specified date, usually retirement.
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What is a Deferred Compensation Plan?

Deferred compensation refers to that part of the contribution that is withheld and paid at a future date.

This leads to a reduction in the executive’s taxable income for the current period and hence many business owners consider this as a viable tax saving option.

Depending on the current tax treatment that the sponsoring employer gets, these plans can be classified into two types

Qualified Deferred Compensation Plan and Non-Qualified Deferred Compensation Plans.

 

Differences between
Non-Qualified vs. Qualified Deferred Compensation Plans

A Non-Qualified Deferred Compensation is nothing but a mere agreement between the employer and the employee to pay the employee a certain amount of current compensation in the future. Qualified plans, on the other hand, are subject to IRS rules and regulations, which can be both a good and a bad thing.

In the case of a Non-Qualified Deferred Compensation Plan, the employer does not get to deduct the ‘future compensation’ and the employee does not need to pay income taxes on it currently (except social security and Medicare taxes). Thus, the employer does not get any tax benefit. However, the contribution made to a Qualified Deferred Compensation Plan is deductible on the company tax returns and leads to significant tax savings each year.

For a Non-Qualified Deferred Compensation Plan there are no IRS specified contribution limits or non-discriminatory requirements. More importantly, the ‘future compensation’ of the employee may reside with the regular business funds. Therefore, these funds do not receive any protection in the case of bankruptcy or fraud. Contributions to a qualified plan are capped based on the age of the individuals.

Non-Qualified Deferred Compensation plans are not suitable for small business owners with just a few employees. They require significant legal paperwork and should be considered as the last resort only after exhausting the Qualified Deferred Compensation Plans.

Advantages of Qualified Deferred Compensation Plans over Non-Qualified Deferred Compensation Plans

There are multiple reasons why Qualified Deferred Compensation Plans are a much-preferred choice for small business owners than Non-Qualified Deferred Compensation Plans.

Tax Deductions for Employers

In a Qualified Deferred Compensation plan, a contribution is made based on the age and the compensation of the individual participants. This amount is deducted on the employer’s tax returns, but the employee does not need to recognize it as income thereby deferring taxes on it.

Asset Protection from Credits

When a QDC plan is set up, the funds are deposited in a trust account. This accords protection from likely fraud or bankruptcy by the employer.

Standardization of rules through ERISA

Most Non-Qualified Deferred Compensation Plans are merely ‘agreements’ between the employers and the executives. Though these can be comprehensive, most executives lack the legal knowledge and understanding to comprehend these agreements and make an informed decision. In comparison, Qualified Deferred Compensation Plans are subject to a lot of regulatory requirements which leads to standardization of most aspects of the plan. This eliminates arbitrary decision-making by the employer and protects the interests of the employees and the executives.

The ability to postpone taxes further

When the employee terminates employment the contribution made under Qualified Deferred Plans can be rolled tax-free into an IRA. This money can sit in the IRA until the employee is 70 ½ and can further benefit the employee through the power of compounding.

Non-Qualified Deferred Compensation Plans are not actually funded

When the Non-Qualified plan is set up, a mere agreement is made to pay the compensation at a future date. The plan is not actually funded as the amount might become taxable because of the IRS’s economic benefit rule. Since the plan is unfunded, the employee must accept the risk that the company will remain solvent and will make good on its promise.

Loans not permitted in NQDC’s

Participants can take a loan up to the lesser of their vested interests or $50,000 from a Qualified Deferred Compensation Plan. This option is not available in NQDC plans.
Types of Qualified Deferred Compensation Plans
A typical alternative to a Non-Qualified Deferred Compensation Plan is a cash balance plan or a defined benefit plan that serves the needs of the business owners to contribute amounts significantly higher than a 401(k) plan. Both these plans are regulated by the IRS through laws like ERISA and afford a level of protection to the executives in a small to the medium-sized entity.

Since these plans are regulated, the maximum contribution amount is capped based on the age and the compensation of the individual participants. There might be a small minimum required contribution, but that can be reduced or eliminated by amending the plan.

The IRS also makes it mandatory to provide some basic benefits to the other employees. Since these employees might not be earning significantly, the employer will make some contributions for them. These amounts range from 5% to 7.5% of the employee’s gross compensation.
Example of a Qualified Deferred Compensation Plan
We have a small business that is structured as a partnership wherein the two partners own 50% each. There are three other employees in the firm with total compensation of $150,000. Both the partners draw a W-2 compensation of $150,000 each and the residual profits of the business flow for each of the partners as K-1 income which is also $150,000.

The partners don’t have an immediate need for the $150,000 of the additional K-1 income and would prefer to defer it to a future date. This will lead to lower personal taxes and the accumulation of a retirement fund in a tax deferred manner.

In this situation, the partners set up a cash balance plan for themselves and contribute $150,000 each to a trust account that is jointly managed. This contribution is deductible on the company tax returns and leads to lower taxes for the business. The partners have also not earned this income and it does not add to their personal income when filing their taxes.

The business will fund 7.5% of compensation to the employees as a profit-sharing contribution. This also acts as a retention bonus than just as a cost to the business. The employees need to work six years in order to be fully vested and the unvested portion becomes a part of the plan if they quit prior to completing six years. Therefore, the net cost of the employee contributions is much lesser over the longer term.

Both these plans are aggregated and tested together to satisfy all IRS and ERISA requirements.

Know more about Cash Balance plan

Theoretically speaking, a cash balance plan is only a type of defined benefit plan. The difference is in the manner in which the allocations are communicated to the clients or plan participants. The allocation is the deferred compensation for the executive or the owners.

For example, the cash balance plan document can state that the owner of the business receives an allocation/deferred compensation of $125,000 each year. This amount is typically referred to as the ‘hypothetical account balance’

In the first year, the company will deposit the $125,000 for the owner of the cash balance plan account and an account balance certificate will be provided that states the allocation amount.
Deferred Compensation Plans
For a company with only one participant, the cash balance or defined benefit plan will generate the same retirement benefits. This is an important point to note!

To get an approximate estimate of how much you can contribute to a cash balance plan, please use our cash balance plan calculator.

Why was the concept of a cash balance plan created?

Cash balance plans were created to easily determine and communicate the benefits to the participants.

Allocations to these qualified plans are based on the age and the compensation of the individual participants. Most companies will have more than one participant in the plan. Each participant will also be of different age and receive different compensation. Hence, each participant will accrue benefits at a different rate and such situations typically lead to a conflict if it is a small business.

Assume a situation where a company has three partners who are 40, 50 and 60 years old with different compensation amounts. It will be almost impossible to generate the same allocation for each of them year after year. Such situations are easily resolved by utilizing the cash balance plan design.

The partners in the above situation can agree to make a contribution of 80,000 for each so that the amount is the same for each irrespective of their age.

The other possible scenario is that the partners can agree to allocate $80,000 to the youngest partner, and $150,000 and $200,000 to the other two partners based on their proximity to retirement age.
All cash balance plans will have the following components
An allocation rate
A crediting rate
Allocation Rate
The allocation rate is the amount that has to be contributed for each participant each year. This could be stated as a fixed dollar amount, or as a percentage of salary. The $80,000, $150,000 and $200,000 stated in the above example were allocation rates.
Crediting Rate
The cash balance plan will credit fixed interest based on the hypothetical account balance each year. For example, the crediting rate could be 4%, so the participant’s account balance will grow at the rate of 4% each year in addition to the allocations that are made.

If you are interested in learning more about CB plans, read our Comprehensive Guide for Cash Balance Plan.

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