Participants February 24, 2021

Ways NQDC Plan Participants Use Their Accounts

Section 409A nonqualified plans allow for various payment dates so participants can save for children’s college expenses and other financial needs and wants.
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Art by Grace Park

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.

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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.”

Administration February 24, 2021

Differences Between NQDC Plans Subject to IRC 409A and 457

The nonqualified plans offered to top executives at for-profit companies are subject to different rules than those offered to executives at nonprofits.
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There are some differences between the types of nonqualified deferred compensation (NQDC) plans that can be sponsored by for-profit plan sponsors and by nonprofit or government plan sponsors.

An NQDC plan sponsored by for-profit plan sponsors is governed by Internal Revenue Code (IRC) Section 409A, while one sponsored by a nonprofit or governmental plan sponsor is governed under IRC Section 457(b) or 457(f). A 457(b) plan is a NQDC plan or eligible deferred compensation plan that can be sponsored by governments—states and political subdivisions of states. Tax-exempt organizations can sponsor 457(b)s in which only certain highly compensated employees (i.e., the top paid group) can participate. Governments and tax-exempt organizations may also sponsor a 457(f) top hat plan. These plans are established by a specific agreement, have specific payout options and have no contribution limits.

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William Fogleman, of counsel at Groom Law Group, Chartered, says the Employee Retirement Income Security Act (ERISA) subjects retirement plans to rules regarding vesting, participation, funding and nondiscrimination. However, under the “top hat” rule in ERISA, plans offered to a select group of management or highly compensated employees are not subject to ERISA’s strict provisions.

Section 409A Plans

Mark West, national vice president of business solutions at Principal, says 409A plans have no limit on contribution amounts, contributions can be a combination of employee deferrals and employer contributions—match or profit sharing type—and participants have the ability to schedule in-service distributions in addition to distributions at retirement. Section 409A also gives plan sponsors some flexibility in choosing vesting schedules for employer contributions—there are not the same kind of limitations a qualified plan has.

In Section 409A plans, participants make distribution elections at the time they make their deferral elections. However, participants can move the distribution to at least five years later if they change their mind about timing, West says. Participants cannot get distributions earlier than elected.

Fogleman explains that 409A rules generally restrict the timing and form of payments, which have to be set up before amounts are deferred. He warns that if a plan is not administered in accordance with 409A, participants could face tax consequences. The participant will have immediate taxation of the deferred amount in the year the right to the payment vests—even if it hasn’t been received yet by the employee. A 20% penalty tax is imposed on the amount involved, and an increased interest rate is imposed on the late payment of the income tax due on the participant’s benefit.

Section 457(b) Plans

With 457(b) plans, there is a cap on contributions, West says. It is the same amount as with 401(k) or 403(b) plans—$19,500 in 2021. Generally, employer contributions are 100% vested immediately, unlike with 409A plans in which employers have a choice of vesting schedules. Participants can roll over balances between eligible 457(b) plans, but assets can’t be rolled into an individual retirement account (IRA) or another type of plan. West adds that one key distinction between 457(b) plans and 409A plans is that 457(b) plans don’t permit scheduled in-service distributions for participants. “They’re really only saving for retirement,” he says.

A 457(b) plan has to be structured in way that limits amounts that can be deferred every year and limits distribution options, Fogleman says. “It has a strange hybrid of qualified and nonqualified rules,” he says.

Fogleman says a 457(b) plan has some preferential tax treatment that doesn’t apply to 457(f) plans. “One reason a plan sponsor would choose a 457(b) plan is participants can be vested in the amounts they defer without being subject to taxation,” he states. “In 457(f) plans, once benefit amounts are vested, participants cannot defer paying taxes, whether they get a distribution or not.”

Section 457(f) Plans

There is no contribution limit in 457(f) plans, West says. And, he adds, these plans almost always fully consist of employer contributions because there is vesting placed on assets by the plan sponsors. “When the vested date hits is when benefits become taxable, whether they are paid out or not,” he explains.

“Employees can defer into 457(f) plans, but it is uncommon because a participant would be reluctant to put some of his pay into the plan with the risk he could lose it,” West says. “There is a substantial risk of forfeiture in these plans. If a benefit doesn’t vest until 10 years and the participant is no longer with the company at that time, his account is forfeited.”

West says some 457(f) plans could be subject to Section 409A as well, but that doesn’t typically happen. If the plan sponsor determines the vesting date and, at that point, account amounts would be included in the participant’s income, the 457(f) plan would fall under the short-term deferral exemption from 409A, and is not subject to other 409A provisions, he notes. He adds that the vesting and pay design of 457(f) plans make them more likely to be used for recruiting and retention purposes than for participant retirement savings.

West says a primary difference between 457 plans for nonprofits and those for governments concerns ERISA top hat provisions. Governmental plans are not subject to ERISA, but nonprofits still need to follow the rules for only allowing NQDC plans to a select group of management or highly compensated employees.

Fogleman notes that Section 457(f) exists because nonprofits are tax-exempt; they don’t pay taxes so they don’t get the credits for-profit employers do. A for-profit employer will get a tax credit when a NQDC plan participant’s deferred compensation is paid. “They have to keep the amounts on their books because they don’t get the credit until amounts are paid to participants,” Fogleman says. “Tax-exempt employers don’t have to worry about it.”

One final issue Fogleman says nonprofit employers might want to consider is that tax-exempt organizations are now subject to IRC Section 4960 added by the Tax Cuts and Jobs Act (TCJA). “Tax-exempt organizations will be taxed on compensation paid over $1 million, which includes amounts in 457(f) plans,” he says. “Plan sponsors need to be cognizant of any large payments coming out of 457(f) plans that may be taxable to them.”

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