Section 409A nonqualified deferred compensation (NQDC) plans aren’t just an extra retirement benefit for executives, the plans can help executives with other financial needs as well.
With Section 409A NQDC plans, participants have to make elections for deferrals and distributions ahead of when the deferrals will be made, and a plan sponsor can design the plan to either allow for in-service withdrawals or not, says Steve Marrow, senior vice president of plan sponsor strategy and analytics at Fidelity.
Participants can defer salary, annual or long-term incentives, restricted stock or restricted stock units, and there are different rules about the timing of those elections, Marrow adds. But with any type of deferral, the plan sponsor can design the plan to specify whether participants’ money is available to them before retirement or a separation of service.
The plan’s design can set plan sponsors apart if they use it to recruit top talent, Marrow notes, so plan sponsors might want to allow the plan to meet executives’ financial needs other than retirement.
Employer money—a match that participants aren’t able to get in qualified plans due to statutory limits or special retention contributions—could also be included in in-service withdrawals for purposes other than retirement, Marrow says. “If the plan is designed so that in-service distributions can be elected for employer money, any vesting schedule attached to that money would have to be considered for distribution timing,” he notes.
Karen Volo, senior vice president of executive services program at Fidelity, says plan design matters in how participants can use their NQDC plan assets. She says about 50% of plan sponsors allow a choice of either in-service or vesting-driven payments.
Mark West, national vice president of business solutions at Principal, says another type of NQDC arrangement, 457(f) plans, are used by plan sponsors more as a retention mechanism and do not offer the various payments dates that nonqualified plans subject to Internal Revenue Code (IRC) Section 409A plans do.
“I suppose if someone was offered a 457(f) plan, they could make a deal. They could say they have a child going to college in eight years so they want part of their payment at that time, but it’s not as clean as with a 409A plan,” he says.
The most common use of NQDC plan accounts is to bridge the gap for participants who want to retire early but don’t want to dip into other savings accounts, West says. For example, an executive might want to retire at age 60 but avoid taking money out of his qualified plan until later to get more tax deferred growth, West explains. He might use what’s in his NQDC plan to cover expenses from age 60 to whenever he wants to start drawing money from other assets. Likewise, a participant can use his NQDC funds to bridge the income gap until age 70 when Social Security is maximized.
According to Volo, the majority of plan participants are taking distributions after age 60 for retirement. The top uses are to create a ladder for payments to bridge the gap between that age and when they start taking distributions from other sources, to bridge the gap for health care expenses or to purchase long-term care insurance.
Using NQDC Plan Assets for Other Needs, and Wants
In addition to retirement, participants can use NQDC plan assets to cover their children’s education expenses. If an executive has a child who will be starting college in 2021, he could elect distributions for 2021, 2022, 2023 and 2024, West explains. He says the use of in-service distributions to pay for a child’s education is the one Principal sees the most.
West says he has also seen participants target buying a vacation home at age 50 or 55. They will elect to take a distribution at the age they need to purchase it or to make a down payment. “I’ve also seen it used for an extended vacation, when the participant plans to be gone for a couple of months,” he adds.
In addition, NQDC plan participants can schedule a distribution to be used for home remodeling. “They are generally thinking they want some things done before they retire,” he says. “I’ve even seen a participant use a distribution to buy a boat. Really, anything a participant is dreaming to do, they can set up a distribution for it.”
Volo says when Fidelity recently surveyed representatives that help with retirement planning, the reps mentioned a wide range of uses for NQDC plan assets—one participant used his plan assets to achieve his dream of buying a farm.
Marrow adds that another individual used his plan assets to buy a plane. “There’s a lot of flexibility,” he says.
“I think now, more than ever, there’s a desire to take advantage of potential tax diversification among retirement accounts, to defer money with no specific goal in mind, but to take out if they do need it for a big expenditure,” he says.
Taxes and when a person needs the assets are factors in the decision about when to take distributions, Marrow says.
Plan Design Considerations
Plan sponsors can allow participants to make a different distribution election each year if they want to, Marrow says. And, if a participant doesn’t want a distribution at the original time he elected it, the plan sponsor can allow him to re-defer it until at least five years beyond the time he was going to use it. Marrow says this is called the 409A push rule.
Although, more often, participants are given the ability to take in-service distributions, NQDC plan sponsors could design the plan to steer participants into certain uses for their accounts, West says. “If the plan sponsor wanted to steer participants to use their accounts just for retirement and didn’t like offering the chance for multiple in-service distributions, it could design it that way,” he says. “Still, the plan sponsor wouldn’t ultimately know what the participant uses the money for.”
He says there are also plans that will distinguish between a separation of service below a certain age or a service requirement before retirement. “For example, if a participant leaves the employer after age 50 with 10 years of service, the plan might allow him to get installment payments over 10 to 20 years,” Marrow explains. “If the participant doesn’t hit that age before leaving the employer, the plan would force him to receive a lump-sum payment.”
Fidelity has found that nonqualified plans can be difficult to understand for participants, so Volo says they should be coupled with financial planning.
“It is so important to have a planning component alongside the plan to help participants to understand the complexities of the plan and the opportunities it offers, and to consider the best use of assets,” Volo says. “That’s one thing Fidelity will focus on going forward.”
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