Dealer Insights - January-February 2016 - NQDC Plans: Saving More for Retirement
January 28, 2016
Many dealership owners and executives would like to save more money for retirement than they're allowed to sock away in their 401(k) plan. For 2016, the annual elective deferral contribution limit for a 401(k) is just $18,000, or $24,000 if you're 50 years of age or older.
This represents a significantly lower percentage of the typical owner's or executive's salary than the percentage of the average employee's salary. Therefore, it can be difficult for highly compensated owners and executives to save enough money to maintain their current lifestyle in retirement. That's where a nonqualified deferred compensation (NQDC) plan comes in.
NQDC plans enable dealership owners and key executives to significantly boost their retirement savings without running afoul of the ERISA nondiscrimination rules that apply to qualified plans, such as 401(k)s. These rules ban highly compensated employees from benefiting disproportionately in comparison to rank-and-file employees.
NQDC plans are contracts between owners and executives and their dealerships that agree to pay out compensation at some future time, such as at retirement. Not only do they not have to comply with ERISA nondiscrimination rules, but they aren't subject to the IRS contribution limits and distribution rules that apply to qualified retirement plans. So, dealerships can tailor benefit amounts, payment terms and conditions to owners' and executives' specific needs.
There are several types of NQDCs. Among the most common are:
- Excess benefit plans,
- Wraparound 401(k) plans,
- Supplemental executive retirement plans (SERPs),
- Section 162 executive bonus plans, and
- Salary-reduction plans.
The key to an NQDC is this: Because the promised compensation hasn't been transferred to you or your executives, it's not yet counted as earned income — and therefore it isn't currently taxed. This reduces current taxes and allows the compensation to grow tax-deferred.
While NQDC plans aren't subject to many of the qualified plan requirements, they're subject to Internal Revenue Code Sections 409A and 451 — which don't apply to qualified plans. Sec. 451 sets the parameters for income taxation of nonqualified deferred compensation, and Sec. 409A imposes strict requirements on the timing and form of deferred compensation payments and of any subsequent change in their timing or form. Specifically:
- Employees must make the initial deferral election before the year they perform the services for which the compensation is earned. So, for instance, an employee who wishes to defer part of his or her 2016 compensation to 2017 or beyond must have made the election by the end of 2015. There are exceptions for new employees and certain performance-based compensation.
- Benefits must be paid on a permissible payment date specified at the time of the deferral, such as death, disability, separation from service, change in ownership or control of the employer, or unforeseeable emergency.
- The timing of benefits may subsequently be delayed subject to specific rules within Sec. 409A, but generally may not be accelerated except in special circumstances, such as plan termination or compliance with legal requirements. Elections to change the timing or form of a payment must be made at least 12 months in advance of a scheduled payment, and the election may be effective no earlier than 12 months after it's made. Also, the postponement must be at least five years. Distributions because of death, disability or unforeseeable emergency may be postponed for shorter periods.
Penalties for noncompliance are harsh for the executive: They include taxation of any vested benefits at the time of the deferral plus a 20% excise tax and a "bump-up" in the tax underpayment interest rate.
Right for your dealership?
Another potential drawback of NQDCs is that, unlike 401(k) plans, you and your executives can't take loans from your plan. Nor can you roll the money over into an IRA or other retirement account when you retire or otherwise depart the dealership.
While NQDC plans have some drawbacks, such as these, their benefits can far exceed them. Consult with a CPA or employee benefits professional for more details on NQDCs to determine whether one is right for your dealership.
Sidebar: Using a rabbi trust for funding
To be eligible for tax deferral and exemption from ERISA nondiscrimination requirements, NQDC plans must be "unfunded." However, there's no guarantee that the compensation will actually be paid in the future. Unlike the assets in a qualified retirement plan, NQDC compensation isn't segregated from the dealership's general assets and thus would be subject to creditors' claims in a corporate bankruptcy.
One possible solution: Your dealership could set aside the assets in a rabbi trust, which would require that deferred compensation payments be made from the trust in accordance with the terms of the deferred compensation agreement. This ensures that the dealership can't renege on its commitment to pay the compensation. Money in this grantor trust would remain a part of the dealership's general assets and still be reachable by creditors.
Dealer Insights - January/February 2016