Simply mention the word “taxes” and the reaction that you will get from most individuals, plan sponsors and employees alike, is one of disgust, frustration and/or irritation. The fact is that, in the United States, taxes have been and more than likely will always be a part of your personal and business financial picture; therefore, you have to be creative in your approach to how you manage your taxable assets.

Take, for instance, our client, James. As a successful business owner of a closely held corporation, he, like many of our plan sponsor clients, expressed to us an interest in ways to use a retirement plan to defer income from taxation. After telling him about two types of plans that could possibly help him accomplish this goal—nonqualified deferred compensation plans and cash balance plans—he realized that he and his company’s highly compensated employees were missing out on an opportunity to defer additional retirement dollars. 

Nonqualified Deferred Compensation Plan Overview

A nonqualified deferred compensation (NQDC) plan can be an effective retirement planning tool, especially for owners of closely held corporations. The NQDC plan is a contract between the employer and the employee to provide compensation to the employee at some time in the future in lieu of compensation paid today. The plans are nonqualified for two reasons; first the plan does not fall under the protection of the Employee Retirement Income Security Act (ERISA) and second, the same tax benefits are not applied to NQDC plans as they are to qualified retirement plans, such as a 401(k).

Due to the plan’s lack of qualification, the employer can discriminate freely amongst employees. To clarify, the nondiscrimination rules that apply to qualified plans do not apply to NQDC plans. Thereby, an employer can choose to benefit a select group of employees, regardless of their classification as highly compensated or non-highly compensated. There is also no limit to contribution amounts to the NQDC plan unlike the 415 limits that apply to qualified plans, nor is there a vesting schedule requirement.

The second major feature of NQDC plans concerns taxation. Unlike a qualified plan, the employer is not entitled to a tax deduction until the promised benefits are actually paid to the employee. This is where the tax doctrine of constructive receipt comes into play with a NQDC plan. This concept states the nonqualified plan benefits are taxable to the employee at the time the employee has the right to receive benefits regardless of when the benefits are actually paid, unless the employer’s promise to pay remains unfunded or unsecured. Note that it is typically preferred that the promise to pay remain unfunded in order to meet the goal of tax deferral. Finally, because the plan is not qualified, it is important to remember that these assets remain a liability to the corporation and are subject to the liens of general creditors.

Cash Balance Plan Overview  

A cash balance plan is a type of pension plan that has many of the features of a traditional qualified plan. One feature of cash balance plans is that, with the right plan design and demographics, owners of a company have the opportunity to put away up to $245,000 for retirement. However, because a cash balance plan is a qualified defined benefit pension plan, it falls under the laws of ERISA which means that there are plan design rules that must be followed in order to ensure that the plan does not discriminate in favor of the highly compensated employees. Simply stated, in order for the owners and highly compensated employees to benefit, the company must be willing to contribute employer dollars to the non-highly compensated employees as well. Furthermore, much like a profit sharing or non-elective contribution feature in a traditional 401(k) plan, employee deferrals are not a requirement to receive cash balance benefits.  

Another feature of a cash balance plan is that investment decisions are made by the employer or an investment manager appointed by the employer, not the individual participants. Investments are typically managed to a set investment crediting rate and increases and decreases in the value of the account do not directly affect the benefit amounts promised to participants. Finally, a cash balance plan is a pension plan which means that the benefits promised are usually insured by a federal agency, the Pension Benefit Guaranty Corporation (PBGC). If a cash balance plan terminates or does not have sufficient assets to cover its liabilities, the PBGC may step in and pay all promised benefits.   

Weighing Your Options  

Keep in mind that plan sponsor goals can vary greatly from company to company. Our belief is that careful consideration of your company's tax situation, long-term goals, employee demographics and funding obligations must be given before determining which plan type is right for you. However, in James’ situation, he opted for the nonqualified deferred compensation plan design. He ultimately felt like this choice would give him more options for recruiting and retaining more valuable employees while, at the same time, lowering his own taxable income through significantly increased deferrals.  

Comedian Will Rogers put his own spin on Ben Franklin’s classic quote about the certainty of death and taxes saying, "The only difference between death and taxes is that death doesn't get worse every time Congress meets."  Good comedy always showcases a hint of truth and while taxes seemingly are getting worse, a qualified financial professional may be able to help you design a creative solution to managing your tax liability so that you can be the one with the last laugh.

Trent A. Grinkmeyer, AIF, CRPC; Valerie R. Leonard, AIF; and Jamie Kertis, QKA, AIF  

Trent Grinkmeyer, Valerie Leonard, and Jamie Kertis are Registered Representatives and Investment Adviser Representatives with/and offer securities and advisory services through Commonwealth Financial Network, Member FINRA/SIPC, a Registered Investment Adviser. Fixed insurance products and services offered through Grinkmeyer Leonard Financial or CES Insurance Agency. Grinkmeyer Leonard Financial, 1950 Stonegate Drive, Suite 275, Birmingham, AL 35242. (205) 970-9088.   

This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the authors do not necessarily reflect the stance of Asset International or its affiliates. The persons portrayed in this example are fictional. This material does not constitute a recommendation as to the suitability of any investment for any person or persons having circumstances similar to those portrayed, and a financial adviser should be consulted.