Retirement Meditation #39: When is a non-qualified deferred compensation plan not beneficial?

Insights | Retirement Meditation #39: When is a non-qualified deferred compensation plan not beneficial?

Author: Paul A. Carl, CHSA, CPFA Vice President, Retirement Plan Consulting, Registered Representative

“Howard” succeeded his father to become the fifth-generation owner of the family’s funeral parlor. Now 60 and seeking to retire himself and with no children interested in taking over the nearly 200-year-old business, Howard looked to outside purchasers. One offer particularly captured his attention. A Canadian-based enterprise offered a reduced cash price and an employment contract covering the next five years that would include a seven-figure deposit into a non-qualified deferred compensation plan established on Howard’s behalf. Less than nine months later, the Canadian company filed for bankruptcy protection. Howard became an unsecured creditor and was ultimately paid 17-cents on the dollar.

As mentioned in previous Retirement Meditations, a non-qualified deferred compensation plan (NQDC) can be an incredible tool to attract and retain talent. They are exempt from ERISA, possess unique features, and have certain tax rules they must follow. However, they are non-qualified which also means they are effectively an unsecured liability of the employer. In order to remain in the tax-preferred status, the assets of a NQDC plan must remain subject to a substantial risk of forfeiture. Any elimination of the substantial risk of forfeiture can create a taxable event for the covered individual. 

Risk-eliminating events can vary. Distribution of the NQDC funds is the most common elimination of the risk. The individual covered by the NQDC plan meets criteria, such as retirement, and payment begins based on the terms of a payout schedule. Any payment issued based on the payout schedule is taxable when distributed. The undistributed funds remaining in the NQDC plan remain subject to the risk of forfeiture until paid. 

Recognizing vesting prior to distribution may or may not trigger a taxable event. Vesting generally means ownership. In a funded NQDC plan, vesting could cause the loss of the substantial risk of forfeiture and trigger a taxable event. In a NQDC plan considered to be unfunded, vesting could simply mean that the covered individual has a right to a future benefit that may or may not be paid in the future. In other words, the employer’s ability and requirement to pay the liability to the covered individual is not guaranteed to happen. The benefit remains subject to a substantial risk of forfeiture and tax deferred. 

Whether you are an employer or employee, a best practice includes seeking counsel from trusted sources such as tax, legal, and investment professionals when evaluating a NQDC plan.

How might substantial risk of forfeiture impact you?

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