First off, what are Non-Qualified Deferred Compensation Plans?
Non-Qualified Deferred Compensation Plans (NQDCs) are an excellent way for executives to defer some of their salary and bonuses into retirement, deferring the tax liability until they receive the payout. However, as the executive approaches retirement, or key payout dates, it's essential to understand how to manage the tax impact of the payout.
The first solution is to spread out the Payout
One way to manage the tax impact of an NQDC payout is to spread it out over several years. The IRS allows for this option, which is called "elective deferral." The executive can choose to receive their payout in one lump sum, or they can elect to receive it in equal payments over a set number of years. This option helps spread the tax liability over several years, which can lower the impact of the payout on their tax bill.
A second idea is to Coordinate Payouts.
An executive may have multiple NQDC plans with different payout schedules. It's important to coordinate these payouts to minimize the tax impact. For example, suppose an executive has two NQDC plans, one paying out in the same year they receive a large bonus, and the other paying out a few years later. In that case, it may make sense to delay the first payout to the same year as the second payout, to lower the overall tax impact.
Another strategy is through Managing Investments.
Many NQDC plans allow the executive to choose how their deferred income is invested. Choosing a mix of stocks, bonds, and other investments can help reduce the overall tax impact of the payout. For example, suppose the investments are in stocks that have appreciated over the years. In that case, the executive may want to sell some of those stocks before the payout, realizing a lower capital gain tax rate.
Conversely, if the investments are in bonds, the executive may want to defer the payout to take advantage of lower interest rates. Sometimes these plans use life insurance which is a tax-deferred vehicle that, depending on the arrangement will altogether have different tax implications. We'll leave these specific situations for a different time.
Another good rule of thumb when it comes to managing the tax impact of an NQDC payout, is that it's crucial to understand the various tax rates involved. For example, the executive will likely pay federal and state income taxes on the payout, as well as Social Security and Medicare taxes. Understanding these rates and how they apply to the payout can help the executive plan better for the tax impact.
Lastly, considering charitable giving:
Another way to manage the tax impact of an NQDC payout is to donate some of the payout to charity. Charitable donations are tax-deductible, and the executive may be able to lower their overall tax bill by making a charitable donation, it just depends on that individuals tax situation. In addition, some charities offer charitable gift annuities, which can provide a lifetime income stream while also reducing the tax impact of the NQDC payout. You'll want to carefully work your financial planner, accountant and other professionals in a coordinated approach to make the most of these strategies.
Managing the tax impact of an NQDC payout requires careful planning and understanding of the various tax rates and investment options. Spreading out the payout, coordinating payouts, managing investments, understanding tax rates, and considering charitable giving are all excellent ways to lower the overall tax impact of an NQDC payout. With careful planning, executives can maximize the benefits of their NQDC plans and minimize the tax impact on their retirement income.
Brian Ruh Owner, Financial Adviser