On December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act of 2017 (TCJA), bringing about the most sweeping changes to the Internal Revenue Code since 1986. Total rewards professionals are now reconsidering the value of various compensation vehicles and employee benefits programs. In the wake of President Trump’s signature tax reform, nonqualified deferred compensation (NQDC) plans, which have long provided businesses a competitive advantage in attracting and retaining high-level performers, look even more attractive for many businesses. Savvy business leaders are increasingly taking advantage of the new tax landscape and making NQDC plans a part of their total rewards strategy.
What is an NQDC Plan and What is the Tax Treatment?
Like a more traditional qualified retirement plan (e.g., a 401(k) plan), an NQDC plan is a program that allows employees to earn compensation in one year but not recognize the income – and not pay income tax – until a designated time in the future when the compensation is distributed from the plan. Similar to a qualified retirement plan, an NQDC plan allows deferred compensation to grow, tax-deferred, until the compensation is later paid to the participant.
Qualified Retirement Plan vs. NQDC Plan
Qualified retirement plans provide sponsoring employers and participating employees with very beneficial tax treatment. Employees that defer compensation to an employer-sponsored qualified plan do not pay income taxes on their contributions and are generally only taxed later when they receive a distribution. Additionally, employers can take an immediate tax deduction at the time the employees make their deferrals. To receive this beneficial treatment, qualified retirement plans must comply with a litany of rules that, among other things, require the plan to benefit a large portion of the employee population and limit the amount that employees can defer into the plan in a given year.
NQDC plans, on the other hand, are a valuable tax planning tool that is reserved for top executives and other highly-compensated key employees. Like qualified plans, employees that defer income into NQDC plans do not have to pay income taxes on the deferred amount until the money is later distributed. Employers, however, cannot deduct the deferred amounts at the time of deferral. Instead, the employer takes the deduction on the deferred compensation when the income is recognized by the participant (i.e., upon distribution). As such, the employer and the employee have counterbalanced interests, in that the employer won’t get a deduction until the employee recognizes the income. Prior to the passage of the TCJA, these interests were roughly equal in value, as the corporate tax rate and top marginal individual tax rate were within a few percentage points (i.e., 35 percent vs. 39.6 percent).
Another key distinction between qualified plans and NQDC plans is that NQDC plans are not subject to the deferral limits of qualified plans. In 2018, the employee deferral limit for a 401(k) plan is $18,500, an amount that is generally inadequate for a highly-compensated employee’s retirement goals. For example, a key employee who earns $1,000,000 in 2018 can only defer $18,500, less than 2 percent of their income. On the other hand, depending on the specific NQDC plan terms, the same participant could choose to defer a much larger percentage of compensation into an NQDC plan (often times up to 100 percent).
The Effect of the TCJA on NQDC Plans
Since the passage of the TCJA, NQDC plans continue to provide valuable benefits to businesses and their key employees. While tax reform did not significantly impact the overarching rules and structure of NQDC plans, changes to the corporate tax rate have made NQDC plans more attractive to many businesses.
Congress designed the TCJA to keep money in the hands of businesses. Congress accomplished this goal, in part, by slashing the top corporate tax rate from 35 percent to 21 percent. First, the lowered corporate tax rate should generally free up more cash for companies to meet their planning needs and those of their key employees. Second, when an employee defers compensation into an NQDC plan, the lower corporate tax rate means that employers forgo a deduction at a 21 percent tax rate in the current year (down from 35 percent), while employees get to defer income recognition at a tax rate of up to 37 percent, creating more overall value in the deferral.
For example, if an employee at the top marginal rate defers $100,000 to an NQDC plan while working for a corporation that is being taxed at the 21 percent rate, the employee would defer the payment of $37,000 worth of taxes until the NQDC plan distribution (depending upon the tax rates at the time of distribution), while the company’s lost deduction would only result in $21,000 worth of current taxes owed.
Because of this disconnect in rates, companies are realizing the additional value in NQDC plans, and are evaluating whether they make sense for their top employees.
Alvarez & Marsal Says:
In this ultra-competitive labor market, employers need to offer competitive total reward packages to attract and retain top talent. NQDC plans, which have always been valuable perks for employees, can be a low-cost benefit that are even more attractive to employers following the adoption of the TCJA due to reduced corporate tax.
Please feel free to contact the executive compensation experts at Alvarez & Marsal Taxand, LLC if you have any questions or are interested in implementing an NQDC plan at your company.