A business owner's guide to retirement savings, part 3: Guest view
Let's talk about where you've been.
You wanted to save for your own retirement in a tax-benefited way, so you took the advice of the professionals and started up a 401(k) plan. Then you listened to your advisers again when they told you that you should consider creative profit-share formulas to defer just a bit more income from taxation.
Here you are now, looking for more tax-benefited savings - and your 401(k) plan and other retirement-savings vehicles just aren’t enough to keep Uncle Sam’s grubby hands off your hard-earned wages.
What’s left to do?
401(k) plans can offer employees and business owners considerable opportunities for tax-deferred savings. But these plans are considered “qualified” by federal guidelines, which means that they must follow strict rules requiring that a large percentage of employees benefit from the plan. These requirements can make the targeted approach that some business owners prefer to use (offering the bulk of a benefit to key employees and themselves, for example) very difficult to achieve.
A non-qualified deferred compensation plan, or NQDC, may help to more directly target specific individuals in your company to help them defer compensation from taxation this year until some date in the future.
Tip of the top hat
You’ve got a favorite employee, just admit it.
It’s the person who always gets the work done on time or early, never complains, manages to mitigate risks within your workforce and helps to reason with clients who may be unhappy.
These people are your dream hires and you don’t ever want to lose them.
There’s a pretty high likelihood that the person you value most within the company falls into the “highly compensated” category as defined by government regulation, and that means you may have difficulty giving him or her all of the benefits toward retirement that you’d like to give. In many instances, this kind of employee is also a flight risk, because, let’s face it, your competitors are paying attention and will hire them away in a heartbeat if they can.
A “Top Hat” plan is an NQDC plan that can be your magic weapon.
The premise of the plan is simple: You offer a select group of employees the opportunity to take a portion of their income out of their wages each year with the promise that their money will be returned to them at some point in the future, oftentimes in retirement.
The tax impact
While the benefit of tax deferral will appeal to some of your higher-paid employees, business owners implementing these plans should know that the business cannot take the tax deduction on the benefit until it is paid out. In this way, the employee’s taxation will dictate the timing of the business’ tax deduction. In years of relatively low tax for some corporations after the 2017 tax cuts, this can appeal to some business owners.
Think of it as the business paying taxes at preferential rates (i.e. rates in accordance with the 2017 tax cuts) and getting a tax benefit at some point in the future when they may need it more (i.e. when Congress begins to realize that the taxpayers are going to have to pay down the federal debt).
What are the risks?
Typically, an “unfunded” NQDC plan is used to avoid federal regulations requiring a specifically “fair” distribution of benefits to employees. When a plan is “unfunded” it simply means that you, as the business owner, don’t formally set aside assets to pay the plan benefits in the future. This leaves you to pay plan benefits out of current cash flow or you can set aside assets to pay plan benefits in the future.
Employees need to worry about the risk of the business owner’s insolvency. Even if the assets funding the NQDC benefits have been set aside in a trust, they might still be subject to claims of general creditors. Employees who has chosen to set aside some of their income under a promise that the business owner will give it back to them at retirement have taken a leap of faith that the business owner will be able to support the benefit and won’t go insolvent in the meantime.
The proper trust arrangement will help protect employees against the business owner going back on his or her word. The risk of the impact of insolvency remains. But let’s leave that bit up to the attorneys.
The NQDC “golden handcuff” is most often applied in C Corporations, though some insurance policies will allow S Corporations and other pass-through entities the opportunity to benefit from the right strategy.
Remember, I’m not a CPA and I’m not an attorney, so get your tax and legal advice elsewhere. Still, a team of certified financial professionals should be able to assess whether these plans are a good fit for your firm and to help you get the ball rolling.
Registered Representative Securities offered through Cambridge Investment Research Inc., a broker/dealer, member FINRA/SIPC. Investment Advisor Representative Cambridge Investment Research Advisors Inc., a Registered Investment Advisor. Cambridge and Conte Wealth Advisors LLC are not affiliated.