Author: Paul A. Carl, CHSA, CPFA™ Vice President, Retirement Plan Consulting, Registered Representative
A 15-year veteran not-for-profit Executive Director announced her intent to retire in six months, at the end of the organization’s November 30 fiscal year. The Board, while disappointed, expressed sincere appreciation for her extraordinary service. The day after the Board meeting, the Executive Director notified her financial advisor of her announcement. The financial advisor, instead of congratulating her, got very quiet. After a few long seconds, the financial advisor informed the Executive Director that he thought it was a bad decision to retire during the current calendar year. His reason: Her non-qualified deferred compensation plan called for one lump sum payment to be made within fifteen days following her termination. This meant that she would be adding more than $700,000 as ordinary income to her current year’s earnings. The Executive Director delayed her retirement.
A non-qualified deferred compensation (NQDC) plan can be a wonderful benefit to attract, retain, and reward key talent for nearly any organization. In a recent study (The 2022 Principal® Trends in Nonqualified Deferred Compensation report), Principal® reported 59% of employers view a NQDC plan as a valuable recruiting tool and 66% as a valuable retention tool. In that same Principal® study, 60% of participants considered the NQDC plan as important when deciding to take a new job and 53% when deciding to stay with their current employer. Further, 63% of participants reported saving for retirement as the main reason for participating in a NQDC plan while 21% use the NQDC plan to reduce current taxable income.
One of the main reasons that highly paid professionals use the NQDC plan for retirement savings is the limitations the Internal Revenue Service imposes on qualified retirement plans. Annually, the IRS publishes its Internal Revenue Code Section 415 limitations. These limitations address items ranging from the maximum amount of compensation to be considered to how much someone can defer from a paycheck into a 401(k) or 403(b) plan. Because of these limitations, often highly paid executives can face a retirement savings shortfall that is disproportionate or even discriminatory as compared to their lower-paid staff, on a percentage of compensation-replacement basis. As an example, one general rule of saving for retirement is to focus on replacing 75% of an individual’s annual compensation. For a $500,000 per year executive, the 75% savings rule translates into income replacement of $375,000 per year. This level can be difficult to attain when the executive is limited to qualified plan contributions based on a maximum compensation of $305,000 (2022). The introduction and use of a NQDC plan can help close that savings gap for the executive.
Do the employees you value the most have a retirement savings shortfall?
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