Several studies continue to show the importance of nonqualified deferred compensation (NQDC) plans to attract and retain executive level talent for employers. See Study Shows The Need For Nonqualified Plans To Attract And Retain Talent. SECURE 2.0 also contains a provision that may encourage the use of NQDC plans. It provides that after 2023, catch-up contributions under 401(k), 403(b) or governmental 457(b) plans by employees (over the age of 50) whose wages exceed $145,000 must be made on an after-tax Roth basis. The earnings on such catch-up contributions are then tax-free when paid.
This “Rothification” of catch-up contributions was a revenue raiser to help balance other provisions within the budget bill containing SECURE 2.0. What this means is that older highly-paid executives who desire to save more for retirement would have to do so with after-tax contributions under the above plans. However, an NQDC plan can allow some or all of those executives to defer salary on a tax-deferred basis instead of through catch-up contributions under the 401(k), 403(b) or 457(b) plan. Additionally, the NQDC plan does not have to limit deferrals to the catch-up amount ($7,500 in 2023). Of course, the contributions and earnings on the NQDC plan contributions will be taxed as ordinary income upon distribution. Additionally, the employer does not get a tax deduction until the employee recognizes the income.
$145,000 May Not Be Enough.
Of course, an NQDC plan must be a top hat plan designed for a select group of management or highly compensated employees to avoid Title I of ERISA. The fact that an employee earns more than $145,000 annually will not necessarily make her or him a member of the top hat group. In this context “highly compensated employee” does not have the same meaning as under Code section 414(q) for qualified plans. A legal analysis comparing each proposed employee’s compensation to others in the organization as well as the duties of such employees should be undertaken to ensure they are considered to be in the top hat group.
A 401(k), 403(b), or governmental 457(b) plan has a definite advantage over an NQDC plan. The assets are set aside from the employer to be used for the exclusive benefit of the participants. On the other hand, assets in an NQDC plan must remain subject to the employer’s creditors to avoid the employees being subject to current income taxation. However, a “rabbi” trust could be used to hold the deferrals and earnings. Under such a trust the trustee can only use the assets to: pay benefits when due under the NQDC plan; or to pay the employer’s creditors when the employer is insolvent. Thus, as long as the employer is solvent, the employee-participants will be paid their benefits.
Another disadvantage would be that the NQDC plan is subject to Code section 409A and running afoul of its provisions would cause the executive to be subject to income tax to the extent vested (and elective deferrals are always 100% vested) and also subject to an additional 20% federal tax. California residents would also be subject to an additional 5% state tax. However, properly drafted and operated, an NQDC plan shouldn’t violated Code section 409A.
With Congress mandating catch-up contributions for higher paid employees to be Roth contributions beginning next year, employers should consider whether such employees would use an NQDC plan as a reasonable substitute for pre-tax catch-up contributions. Of course, if the employer already has an NQDC plan allowing elective deferrals, the executive may just want to increase her or his deferrals under that plan.