Citing a recently issued government report, presidential contender Sen. Bernie Sanders (I-VT) said stronger regulations are necessary to rein in executive deferred compensation plans, potentially taking away their beneficial tax structure.
The benefits of nonqualified deferred compensation (NQDC) plans
Similar to 401(k) plans, NQDC plans allow participants to defer taxes on compensation and associated earnings until they take withdrawals in the future. Unlike 401(k) plans, there are no annual limits on how much income an eligible executive can defer. In addition, NQDC compensation elections are irrevocable until the following year and must be made before the executive earns the income. This allows high-income earners to defer compensation now and receive it at a later date when they expect to be in a lower tax bracket.
NQDC plans are not subject to sections 2, 3 and 4 of ERISA and allow virtually unlimited contribution amounts and payout structures. They can, however, carry a significant risk. While participants’ assets in a 401(k) plan are segregated from company assets, NQDC plan assets are subject to forfeiture risk. If the company fails, the NQDC assets could be subject to its creditors. The Internal Revenue Service (IRS) allows unlimited contributions, believing that these type of plans help align both executive and corporate goals.
Regulation of NQDC plans
Internal Revenue Code Section 409A has regulated NQDC plans since 2005. These plans have taken off significantly, and today more than 400 of the 500 largest U.S. public companies provide NQDC plans to almost 2,300 executives. These total about $13 billion in accumulated plan benefits. However, some feel that the proliferation of these arrangements demands more stringent regulation.
At the request of Sanders and two other Democratic senators, the Government Accountability Office (GAO) recently conducted a study of executive retirement plans and urged the IRS and the Department of Labor to increase oversight of them.
Proposed legislation
Citing the GAO report, Sanders introduced the “CEO and Worker Pension Fairness Act.” It would limit the NQDC plan tax deferral by making compensation deferred into the plans includable in taxable income when the money vests rather than when it is distributed. To achieve this, the bill would:
Amend Code Section 409A to tax NQDC and equity-based compensation when there is “no substantial risk of forfeiture.”
Workers who are not considered highly compensated employees under the IRC would be taxed on equity-based compensation when benefits are received.
Individuals with existing deferrals would include the amounts in gross income before 2029 or by the tax year in which there is no substantial risk of forfeiture.
Mandate disclosing NQDC on Form W-2, rather than voluntarily, as under current regulations.
Sanders hopes that the bill would raise $15 billion in federal tax revenue. He proposes helping to address multiemployer defined benefit plan underfunding by transferring the revenue raised to the Pension Benefit Guaranty Corporation.
Lockton’s take
There is little chance that this bill would be enacted this year, much less down the road under the current Senate makeup. But this proposal is indicative of Congress’ reoccurring misunderstanding that qualified and nonqualified plans are just a tax shelter for the 1%. Original drafts of the Tax Cuts and Jobs Act of 2017 also contained NQDC reforms, but these were eventually removed. In addition, several financial transaction taxes have been proposed that would impose penalties each time qualified plan participants make contributions to their retirement plans or take distributions in an effort to raise revenue for single-payer health plans, higher education tuition and student loan forgiveness.
These ideas indicate that there is a fundamental misunderstanding of how these plans benefit employers and employees. NQDC has become a valued benefit offering for employers of all sizes. While most of these plans benefit highly paid employees (HCEs), that group includes doctors, engineers, lawyers and other professionals whose talent is highly competitive. Because these individuals usually max out their 401(k) contributions quickly, offering an NQDC plan can be an attractive benefit in the talent war, not just something for the Fortune 100 CEOs. For 2020, the maximum employee contribution to a 401(k) is $19,500, plus an extra $6,500 for those over 50. Most of these professionals leverage their NQDC as a part of their retirement planning. If an engineer wants to retire at 62, they are not required to start withdrawing money from their 401(k) until they turn 72 and can maximize Social Security payouts by delaying receipt of benefits. Instead, they can time distributions from their NQDC plans to provide income in those early retirement years, letting their other savings and investments grow.
The communication is offered solely for discussion purposes. Lockton does not provide legal or tax advice. The services referenced are not a comprehensive list of all necessary components for consideration. You are encouraged to seek qualified legal and tax counsel to assist in considering all the unique facts and circumstances. Additionally, this communication is not intended to constitute US federal tax advice, and is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code or promoting, marketing, or recommending any transaction or matter addressed herein to another party.
This document contains the proprietary work product of Lockton Investment Advisors, LLC, and is provided on a confidential basis. Any reproduction, disclosure, or distribution to any third party without first securing written permission is expressly prohibited.
Investment advisory services offered through Lockton Investment Advisors, LLC, an SEC-registered investment advisor.
View alert (opens a new window)