Fulcrum, an executive benefits consultancy, released “Advantages to Pre-Tax Deferral of Income in an Uncertain Tax Environment” last week. Authored by Steve Broadbent and Chris Nyland, the paper takes an analytical look at the common practice of deferring compensation and what that means financially to the individual given today’s tax environment.
The paper shows how employees can consider recent and future tax rate changes and investment returns when analyzing whether to participate in their employer’s nonqualified deferred compensation (NQDC) plan. Broadbent explained, “We continue to hear concerns from deferred compensation plan participants about the potential impact of higher taxes in the future. The objective of this analysis is to demonstrate that the pre-tax deferral of income continues to provide greater results as compared to after-tax investing if taxes continue to rise in the future.”
In the paper, the authors mention how the “new conventional wisdom reverses the time-honored thought that one should tuck away income in deferred accounts now to pay lower taxes in retirement later.” As to when and why this became the new wisdom, Broadbent told PLANSPONSOR, “In the fall of 2008, there was a fear of tax rates going up and deferrals were definitely going down. After that, we started to get feedback from the participants of these plans and the recent white paper is part of a continual update of those earlier studies. Plus many people believe that tax rates today are as good as they’re going to get.”
In the paper, Nyland observed, “The economy is beginning to recover, albeit a limited recovery. As this happens, new optimism arises in how nonqualified deferred compensation plan participants feel about their employers and their individual financial plans.”
Nyland told PLANSPONSOR, “There are people that have maxed out the contributions to their 401(k) plan and this type of plan (NQDC) works well when used as a supplement to their 401(k).”
According to the paper, research by Fulcrum suggests that “in all but a few scenarios, even if taxes do rise in the years ahead while working or during retirement, the accumulated savings that may be achieved over the long term through deferral of income and related taxes under a nonqualified deferred compensation plan are still greater than the amount that could be accumulated through after-tax investing in a personal investment account.”
The analysis compared the value of the personal investment account to the NQDC after capital gains or ordinary income taxes were paid. The personal investment account was taxed at the capital gains rate and the end of each calendar year (with the assumption of non-tax managed mutual funds with a high asset turnover) and the NQDC account was taxed at ordinary income rates when distributions were received from the plan.
In almost all scenarios, the NQDC provided superior results. The only scenarios favoring the personal investment account are based on the highest wage earners who are willing to settle a 3% pre-tax return and invest their income over a short 10-year period. In all other scenarios, a NQDC account provided an advantage—in terms of the total amount accumulated after taxes are paid—ranging from a low of 1.75% to 47.75%. The recent increase in capital gains rates from 15% to 20% provides an additional advantage to an NQDC ranging from 3% to 15% depending on the rate of return and the length of the investment.
As to when participating in a NQDC plan wouldn’t be a good idea, Nyland said to PLANSPONSOR, “They’re definitely not for everyone, but the information in white paper shows that the choice is very mathematically driven. When you ask questions like how long you will leave the money in the account or what the tax environment will be now and in the future, charts like the one on page 10 of the paper will give a good model that can answer these questions.”
Broadbent told PLANSPONSOR, “It also depends on the type of investor you are. If you are highly compensated but like to maintain low investment risk, then an NQDC plan is probably not for you and you should invest in CDs or money market accounts.”
The white paper can be downloaded here.