The Money Mustache Community
General Discussion => Welcome and General Discussion => Topic started by: Vilgan on August 27, 2014, 12:57:38 AM
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One possibility I found out about recently are NQDC plans. This seems especially in line with people who are retiring early, but I haven't seen much discussion on these forums. While not all companies will offer them, it seems really awesome from an early retirement standpoint with the obvious downside of more risk.
Short explanation: you are limited to 17,500 of qualified deferrals which are protected by federal law (more if 50+). However, your company can refrain from paying you part of your salary now and instead pay it (along with appreciation) later. This apparently can be in a similar dashboard with companies like Fidelity to your 401k, it is just a separate fund and changing deferral amounts and exchanging stuff might be more restricted (I'm not super familiar yet with what restrictions might be). The upside is huge in that you can essentially set aside unlimited amounts of pretax money and then when you retire (no age restrictions btw, so you can do this at 30 or whatever) you can set up the paypack schedule to get that money (plus appreciation) back but while in a potentially much lower tax bracket. The downside is that the money is not protected so if your company goes bankrupt you have to get in line with the rest of the creditors to get money and you can potentially lose some or all of the money you've deferred in this manner.
For example, lets say I'm in the 28% tax bracket and set aside 50k a year for 10 years. That's 500k that you didn't pay a 28% tax on. Then, if you have that 500k + appreciation paid out to you over 20 years when you retire (at say.. 40 years of age) you will pay taxes on it at the much lower tax bracket. Just moving it from the 28% tax bracket to the 15% tax bracket is a pretty huge savings.
There are obvious downsides, but this seems like a strategy that would be discussed more amongst a group that likes to retire early. Does anyone have more experience with NQDC plans and have experience they can share from the inside?
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This sounds like a really terrible deferred comp plan.
Take the tax hit now and invest the money. Your gains will far outweigh the tax benefits of just deferring the pay.
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This sounds like a really terrible deferred comp plan.
Take the tax hit now and invest the money. Your gains will far outweigh the tax benefits of just deferring the pay.
Who said anything about losing gains? You define what funds it goes into just like a 401k and your comp appreciates along with the stock market and dividends. Maybe I needed to bold the + appreciation part.
Longer explanation:
Let's say someone makes 167,500. They can put 17,500 of that into their qualified 401k plan and get taxed as if they earned 150k. However, if they can take advantage of an NQDC plan and pull out another 50k (more if they wanted to but ALL eggs in one basket is a bit crazy). They do not pay income tax on that 50k for now.
The 17,500 and 50k both are invested into the stock market. You can see both in your dashboard at Fidelity. Let's say you retire 10 years later at 40 years old, your accounts might be at something like: 262k in your 401k, 750k in your NQDC, and 300k in other places. Now, you have your NQDC plan pay you back over 20 years (and it continues to appreciate during this time). When that money runs out, you are now 60 and can freely hit your 401k and Roth, other accounts, and potentially social security (if you want). Also, instead of paying 28% or 33% on that money you paid 15% since you spread out the compensation into retirement years and dropped into a lower income bracket. That's essentially an instant return of 13% or 18% while still getting all the appreciation you'd have gotten in a 401k.
There are 2 primary downsides as far as I can tell. 1) If you worked for Enron and it collapsed when you were looking to retire, if you didn't get the money out fast enough you'd have lost most or all of it. 2) If you want to rotate companies, it doesn't work as nicely since your employer will want payments to start immediately and that might be less than ideal.
I think the main target audiences who might consider this are:
1) Highly paid execs (the traditional target)
2) People who want to retire well ahead of the usual retirement age aka people on these forums
So in general, it seems definitely worth looking at but there doesn't seem to be much discussion of it here so was curious if people had experience with it.
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Nonqualified Deferred Compensation Plans are typically offered to upper management. There are a host of requirements that must be satisfied. It can be a good device to use to delay the tax hit, but that comes with some strings. First of all, the amounts must be subject to a substantial risk of forfeiture in order to get the delayed income inclusion/taxation. Two issues with this from the executive's standpoint: (i) it must be subject to a substantial risk of forfeiture; and (ii) upon bankruptcy, etc., the company doesn't have to pay it.
Elections to make deferrals in accordance with the plan must be made no later than the year prior to the year in which the deferral becomes effective. Also, the deferred compensation can ONLY be paid out upon one of six specified distribution events.
If these plans are not properly drafted, the executive (not the company) could be subject to a very significant federal excise tax of 20% on top of federal income and employment tax. Some states have a similar state excise tax, on top of the state income tax. (For example, California.)
For a brief discussion of some of the 409A rules, I found an article (it's one of many). Link is here:
http://www.lindquist.com/files/Publication/2088c518-94f2-4a1f-b1cf-037f95397539/Presentation/PublicationAttachment/c13bd0c3-02d9-4064-9039-11dadbf0102e/Alert%20Summary%20and%20Checklist%20Code%20409A.pdf
As a general rule, if you are given the option of cash now or cash later with restrictions, you're better off taking the cash now. What makes deferred comp so valuable is that if you defer income, some plans will provide that you will be entitled to your deferral plus a matching component, for example 25%. Usually, though, the deferred comp is offered by companies to entice executives to employment. Deferred comp is not a current immediate expense for the company, but rather is a future liability and doesn't impact current cash flow.
It's a lot more complicated than your description would imply.
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I’m bumping this thread for more insight.
I have been eligible but have not participated in this in the past but now my income has risen quite a bit with a promotion and as a single person a fair portion of my income will be in the 28 & 33% tax bracket next year. I’m hoping to retire early in 2.5 to 3.5 years. Is there anything wrong with this picture?
Defer 50% of salary + 100% of bonus into the NQDC plan for my remaining years. My early retirement will be considered a ‘separation’ by which I will be required to start taking distributions, of which one allowed plan is 15 years of fairly even distributions. Money is allowed to stay in the Vangard fund choices. The mechanism behind this is trust owned life insurance and the company pays the insurance charges. Annual fees on the funds range from 0.08% and up.
The two main concerns are that there is additional risk if the company goes into bankruptcy and the money essentially gets locked into what I described above (although I could stop contributing or change the # of years of distribution as long as it’s done more than a year before separation). Bankruptcy risk is pretty low. Also, I’m not concerned about locking the money up. I have over 10 years of expenses saved in liquid, non-retirement accounts plus an apartment that I could rent for about $1000 per month income after all expenses.
So this will move the taxation from the 28-33% tax bracket now to 15%-25% over the 15 year payout and leave a nice annual income for the first 15 years of early retirement – a bridge to age 59.5 when the 401(k) can be accessed.
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JoJo-
What insight do you need? If you are comfortable with the risks inherent in nonqualified deferred compensation (i.e., the fact that it is subject to a substantial risk of forfeiture and/or that if the company goes bankrupt, you line up with other unsecured creditors) and cash flow is not a problem for you, then what is your question?
NQDC plans are relatively common for upper management. Just make sure that the plan/arrangement has been reviewed by someone knowledgeable with respect to IRC 409A. At the very least, make sure there is a 409A savings provision in there.
Other than the tax savings, is there another benefit, such as a matching contribution? If no matching, etc. are your deferrals subject to an additional vesting schedule? (If so, that's stupid, don't do it.)
The whole purpose of NQDC from the employer's standpoint is to keep the executive working. If there are no employer contributions, aside from your deferrals (whether from your salary or bonus), are there any other catch provisions? Make sure you fully understand the provisions and, if you're still comfortable going forward, then go ahead.
In summary, it's beneficial from a tax perspective, but it comes with a lot of strings. If you're comfortable with those strings, fine. Just make sure the cost of those strings is less than the tax benefit you expect to receive.
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Thanks for the reply. There's definitely not any employer matching unless the exec's income is very high (the # is something so high I don't plan on ever making that amount of money).
I'll look into the other provisions but it looks to me that I am immediately vested. It just feels like there should be some catch if I do what I'm planning - only pay in for a couple years and draw it out over 15 years of early retirement - but I haven't found a catch yet (other than those mentioned in my prior e-mail)
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@JoJo-
If you want, I'm happy to look at the plan document if you'd like. Employee benefits and executive compensation is my area of expertise. But, of course, I'm not agreeing to be your attorney/consultant/blah blah blah. But I'm happy to take a look and let you know if I see anything weird.