It’s common for employees that earn considerable income to be offered a non-qualified deferred compensation plan (NQDC). Simply put, an NQDC plan allows a plan participant to defer receiving a portion of income in the year it is earned, to later receive this income in the future. The deferral of income is also, in effect, a deferral of federal income tax, which is a potentially attractive feature to many plan participants.
This tax deferral feature is particularly attractive to clients that find themselves receiving a six-figure salary along with long-term incentives, stock options, and a bonus. The big question for this particular demographic is, how can I pay less in taxes?
A non-qualified deferred compensation plan can allow for tax deferred income that is above and beyond the $18,500 (in 2018) per year contribution limit that is offered by a 401(k) plan.
But the decision to defer taxes via a non-qualified plan presents an interesting question. Just how valuable is an NQDC plan after you evaluate and compare your present and future after-tax account balance and compare that to the available alternatives?
For our example today, the alternative is a non-IRA investment account.
While many see the tax deferral mechanism as an instant win, further evaluation may prove that the winner isn’t as clear as it first seems.
Let’s see why.
Calculating the Value of the Tax Savings
The first step in understanding the value of an NQDC plan is understanding a simple example. To do this, let’s explore the math behind a non-qualified deferred compensation plan using a hypothetical example:
- A 50-year-old employee
- Current (and future) income of $300,000 per year
- 5% deferral into an NQDC plan
- 25% tax bracket
From this information, we can develop a simple illustration of annual income and annual cash flow for the employee, as illustrated below:
|NQDC contribution (5%)||($15,000)|
|Gross income less contribution||$285,000|
The chart illustrates that this employee has a gross income of $300,000. They will then contribute $15,000 into the NQDC plan. As part of the rules of a non-qualified plan, the $15,000 is not taxed as federal income in the year of deferral, although it is still taxed for Medicare and Social Security wages in the year of deferral.
Because it is not taxed, we can subtract the $15,000 deferral from gross income and calculate taxable income to be $285,000. Assuming a flat 25% tax bracket, the annual federal taxes due will be $71,250.
If we then subtract the tax due from the taxable income, we can calculate a net income of $213,750. We can think of this net income in our example as the amount that is available for this employee to either spend, save, or consume.
For comparison purposes, we can follow this example by assuming the employee did not contribute to a non-qualified deferred compensation plan. To do so, we simply remove the 5% contribution.
From the chart, we can see there is no deduction for a contribution to the plan, so the taxable income for this person is $300,000. Assuming the same 25% tax bracket, we can calculate a tax bill of $75,000.
(We can also see a net income of $225,000, which is $11,250 higher than the previous scenario. This is a key point that we will come back to later on in the discussion.)
If we evaluate the value of the non-qualified contribution solely in tax savings, the argument to participate in a plan is the clear winner. By participating, the employee paid $3,750 less in income tax. If the goal is to save tax, this may be a good option.
The Future Value of the Non-Qualified Deferred Compensation Plan
As you can imagine, the annual tax opportunity is only one piece of the non-qualified plan puzzle. A second piece is the future value of the deferred income (in our example, $15,000 per year).
When you contribute to a non-qualified deferred compensation plan, the contributions are directed into an account that often offers a variety of mutual fund investments from which you can choose to invest. Much like a 401(k) plan, you can invest your NQDC account in hopes of achieving tax deferred capital appreciation. This is money that will later be used to supplement your retirement income or other needs.
If we continue our example above, we can illustrate the potential long-term value of the NQDC account. To do this, we can calculate future values of the NQDC account using various annual rates of return.
If we assume that $15,000 is deferred for 10 years, we can calculate the future values to be as follows:
|3% rate of return||$177,117|
|5% rate of return||$198,101|
|7% rate of return||$221,754|
Depending on which average rate of return is used, you can see that the value of the NQDC plan can be substantial. Furthermore, one could suggest that not only have you accumulated a decent asset to supplement your retirement income but you have “saved” $3,750 per year for 10 years in income tax. That’s $37,500.
No Non-Qualified Deferred Compensation Plan but Instead Save
Before getting excited about the above numbers and diving head first into a NQDC plan, it’s important to consider the alternative option. The alternative option may be to NOT participate in the plan but instead save a portion of your annual earned income.
How much should you save? That depends. But in an effort to equalize the comparison, we will make an assumption.
As noted above, I want to come back to the net income numbers produced at the beginning of this article. Specifically, the net income numbers for the two scenarios were as follows:
|Net Income – with NQDC||$213,750|
|Net Income – without NQDC||$225,000|
One way to view net income is to consider this to be the money you have available after taxes are paid. If we make this assumption, the calculations illustrate that the net income in the scenario when not participating in the NQDC is higher than when participating by $11,250.
(The higher net income is due to the fact that $15,000 is not being allocated to the NQDC plan in any given year.)
Therefore, it could be reasonable to assume that even though this money is not being allocated to the NQDC plan, it could be allocated elsewhere. For our purposes, we’ll use a non-IRA brokerage account.
If we assume this $11,250 is allocated to a brokerage account for the same 10 years and at the same rates of return, we can calculate the following future values.
|3% rate of return||$132,838|
|5% rate of return||$148,576|
|7% rate of return||$166,315|
Not surprisingly, these numbers are lower than the NQDC plan. You made a smaller annual contribution, and therefore the figures would be lower.
If we stop here, one would assume the NQDC plan is a clear winner, and I would agree. However, it’s important to consider taxes in the distribution phase in order to fully analyze the options.
Comparing the After-Tax Values of NQDC vs. the Investment Account
Ultimately, income that is deferred into an NQDC plan or income that is saved in a brokerage account may be used to supplement income in retirement. Whenever this money is used, taxes will need to be paid. The amount of tax is dependent, however, on which account the income is distributed from.
Distributions from a non-qualified deferred compensation plan are taxed as ordinary income in the year of distribution. If we apply a flat 25% tax to the gross value of the NQDC plan, we can calculate the after-tax value of the account.
|3% rate of return||$177,117||($44,279)||$132,838|
|5% rate of return||$198,101||($49,525)||$148,576|
|7% rate of return||$221,754||($55,439)||$166,316|
Applying the long-term capital gains rate to the investment account (for our purposes 15%), we can determine the after-tax value to be as follows:
|3% rate of return||$132,838||($3,051)||$129,787|
|5% rate of return||$148,576||($5,411)||$143,165|
|7% rate of return||$166,315||($8,072)||$158,243|
(I have assumed the basis in the investment account to be $112,500, or the value of 10 years of contributions. Therefore the amount subject to LTCG tax is the value over basis.)
If we illustrate the after-tax values next to one another, we can compare the values of the two accounts. One could argue that they nearly end up at the same spot. In addition, one could argue that the minimally higher account values in the NQDC plan are not worth the additional levels of risk and liquidity that are required to participate in the plan.
|3% rate of return||$132,838||$129,787|
|5% rate of return||$148,576||$143,165|
|7% rate of return||$166,316||$158,243|
(If we wanted to take this one step further, I wonder what would happen if this $11,250 was contributed to a Roth IRA via a backdoor Roth contribution. Would this make the decision to NOT participate in an NQDC plan the easy winner?)
Should You Contribute to a Non-Qualified Deferred Compensation Plan?
If you look at short-term tax savings, a NQDC plan may be seen as a fantastic strategy for saving and for deferring tax. However, further analysis can make an argument that contributing to a non-qualified plan may not provide enough after-tax value to substantiate the risk associated with the plan, specifically, the risk that you are an unsecured creditor of your company. Furthermore, there is also the liquidity risk regarding when and how you can access your money.
On the other hand, a non-qualified plan can make saving very easy. Similar to a 401(k), the money is taken directly from your pay and deposited into your plan account.
From experience, I can suggest that “forced savings” is often the easiest way to save and should not be overlooked or discounted in any way.
Said another way, if you don’t participate in the NQDC plan, will you actually contribute annually to a brokerage account? If the answer is no, then all math and reason goes out the window. Participating in the NQDC plan is the clear winner.
Finally, what is illustrated here is one simple example. Tax rates and rates of returns may change. Other factors may also impact your willingness and desire to contribute to a plan.
Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts.
The above figures are for illustrative purposes only and do not attempt to predict actual results of any particular investment.
Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.
None of the information in this document should be considered as tax advice. You should consult your tax advisor for information concerning your individual situation.
Contributions to a Roth IRA are not tax deductible and there is no mandatory distribution age. All earnings and principal are tax free if rules and regulations are followed. Eligibility for a Roth account depends on income. Principal contributions can be withdrawn any time without penalty (subject to some minimal conditions).