Take another look at nonqualified deferred compensation plans

These plans are capable of generating significant wealth because they allow assets to compound tax-free over time.

For executives, taking advantage of their company-sponsored, nonqualified deferred compensation plan now could be one of the wiser moves to make for their future well-being.

Across the United States, companies have reduced or eliminated pension plans. Many executives, therefore, are putting away money now for their retirement years and making sure to give their assets every opportunity to grow.

When executives are not constrained by cash-flow concerns, they tend to contribute the maximum amount possible to deferred compensation plans.
Everyone else should evaluate:

1) The maximum amount of compensation they might comfortably defer.

2) Whether they might afford to borrow so as to defer a more substantial amount.

NQDC plans are capable of generating significant wealth because they allow assets to compound tax-free over time and frequently offer attractive investment options.

Our modeling found, for example, that $100,000 invested inside a deferred compensation plan for 10 years grew 3.30% more annually than the same amount invested for the same period receiving identical returns.

On the downside, there is, of course, the risk associated with investments, as well as the fact that taxes eventually need to be paid on the deferred amount.

But there is also this: In the event an executive’s company goes bankrupt, the balance in his or her deferred compensation plan is not protected from the company’s general creditors.

A KEY DECISION

Two times a year, corporate executives are asked to decide whether they want to defer a portion of their compensation:
• June 30 is the deadline for deferring variable or incentive compensation for that year.
• December 31 is the deadline for deferring fixed compensation for the following year.

We recommend asking these five questions to help you determine whether deferring compensation is a good choice:
1) How much and for how long can I afford to defer?
2) Does my company offer a match on my contributions?
3) Is the sole investment option company stock?
4) Do I plan to relocate to a lower-tax jurisdiction prior to receiving deferred compensation payments?
5) Do I feel comfortable accepting my company’s credit risk during the deferral period?

CONSIDERATIONS

As the decision is being made, we recommend considering:
• The benefit of deferring increases if you are able to defer for a longer period (usually at least seven years).
• There are no federal limits to contributions to NQDC plans; however, your particular plan may impose certain limits on the amount an executive can defer.
• Some executives borrow funds so they can put more into their deferred compensation plans — this is attractive given today’s low-interest-rate environment, coupled with the growth potential of tax-free compounding.

MECHANICS

How do executives actually defer?

First, their company should notify them of the upcoming election. Then, in filling out the company’s form, they will be given certain choices:
• How do you want to receive the compensation (when you do receive it at a later date): as a lump sum or in annual installments?
• When do you want to receive the deferred income: in a specific year, upon a specific event such as retirement, or after a number of years of deferral?

HOW DO THE TAXES WORK?

In the nondeferral scenario, compensation is taxed 100% as ordinary income (including Social Security and Medicare taxes). Similarly, interest and dividends are taxed upon receipt. Capital gains are taxed when realized.

When compensation is deferred, federal and state income taxes are not imposed, only Social Security and Medicare taxes. Investments then compound in a tax-free environment until the time of distribution, at which point the distribution (including capital appreciation) is subject to income taxes.

KEY CONSIDERATION: TAX RATES

The benefit of deferral is that deferred investments compound income and capital gains tax-free during the period of deferral. One risk is that tax rates may be higher at the time of distribution–offsetting the benefit of deferral. An individual considering deferral should weigh the benefit of deferring against the risk that tax rates may be higher when they receiving distributions.

KEY CONSIDERATION: RETURNS INSIDE VS. OUTSIDE DEFERRAL PLAN

Because of the effects of tax-free compounding, investments outside of a deferral plan must produce excess returns in order to have the same after-tax value of the deferral plan in various years.

Robert Barbetti is head of executive compensation advisory at J.P. Morgan Private Bank.