Nonqualified Deferred Compensation Plan - do it?

[M]

For 2017, the larger company that has bought my organization is offering a NQDC plan through Fidelity.  My wife (also a physician in the same group) and I are trying to figure out if it makes sense to enroll.  Hopefully the information I provide below will be sufficient for those smarter than I to offer some advice.  Thanks in advance:

• We currently max out all tax-advantaged space (401k, Backdoor Roth, HSA) and save an additional 20k/month in a taxable account using low-cost index funds.


• We are financially independent (and financially free, as defined by PoF).


• Our retirement horizon is no more than 10 years, no less than 2.5 years.


• If we enroll in the plan, we would use 50-75% of our monthly 20k taxable account investment, and put that into the NQDC Plan.


• The Plan funds are put into a "rabbi trust," so it would appear that the risk of loss of funds should be quite low.  However, if our parent company declares bankruptcy or otherwise becomes insolvent, I am not sure where on the list of creditors we would be, for purposes of which creditors get paid first before the account is depleted.


• Because of our relatively young ages and short retirement horizon, Plan rules state that we will have to take the entire disbursement of funds upon "separation" from the company.  So we can assume a fairly large tax bill in 2.5-10 years.

Has anyone had experience using this type of plan or advising their clients about its use?  Thank you!

[Raddoc123]

I would check the financial status of your organization.  Look at the bond rating, for example.  Do you work for podunk regional clinic or national highly regarded med center?  Highly rated tax exempt organizations have a negligible 10 yr risk of failure. Delaying paying tax and than having tax deferred growth is very valuable at your bracket.  Check out the distribution options, my organization offers 20 yr options which would let your money grow.  Good luck, should not matter much either way in your case.

[jfoxcpacfp]

M wrote:

For 2017, the larger company that has bought my organization is offering a NQDC plan through Fidelity.  My wife (also a physician in the same group) and I are trying to figure out if it makes sense to enroll.  Hopefully the information I provide below will be sufficient for those smarter than I to offer some advice.  Thanks in advance:

• We currently max out all tax-advantaged space (401k, Backdoor Roth, HSA) and save an additional 20k/month in a taxable account using low-cost index funds.


• We are financially independent (and financially free, as defined by PoF).


• Our retirement horizon is no more than 10 years, no less than 2.5 years.


• If we enroll in the plan, we would use 50-75% of our monthly 20k taxable account investment, and put that into the NQDC Plan.


• The Plan funds are put into a “rabbi trust,” so it would appear that the risk of loss of funds should be quite low.  However, if our parent company declares bankruptcy or otherwise becomes insolvent, I am not sure where on the list of creditors we would be, for purposes of which creditors get paid first before the account is depleted.


• Because of our relatively young ages and short retirement horizon, Plan rules state that we will have to take the entire disbursement of funds upon “separation” from the company.  So we can assume a fairly large tax bill in 2.5-10 years.

Has anyone had experience using this type of plan or advising their clients about its use?  Thank you!

Click to expand...

I think there may be some misunderstanding here. A rabbi trust is funded by the employer, not the employee. The employer pays income taxes on the income of the trust and cannot deduct contributions to it until the assets are paid out to the employee. You are taxed on the distributions as you received them. The rabbi trust assets can go into either a revocable or irrevocable trust. If revocable, the employer can use the funds if it wants, so I recommend the trust should be irrevocable for maximum protection.

In the event of bankruptcy or insolvency, your trust would stand in line after secured creditors. That is the only risk with an irrevocable rabbi trust.

Please read your benefits document again and ask for advice from your CPA or CFP. I see no reason not to accept the offer of a properly-drafted rabbi trust. It is a special benefit offered to HIPs.

[M]

Raddoc123, thanks for the suggestion to check my parent company's financials.  Morningstar gives my company 4 stars and says its credit rating is BB+ with a debt/asset ratio of 48%.  Apparently, the D/A ratio average for the industry is 57%, but I'd be freaking out if that was my personal balance sheet.  I also notice that there are some huge bond obligations coming due within the next 6-9 years; that makes me nervous.  Should it?

As far as the distribution options, unfortunately the only option I will qualify for is to take a lump sum after separation from the company, given that I won't be employed long enough (before my early retirement) to qualify for a longer-term distribution.

Johanna, thanks for your (always) sensible and thorough explanation.  I realize now that I explained my investment plan poorly in the post; I do understand that the rabbi trust (which is irrevocable) is funded by my employer.  I suppose the main question I need to ask myself is, can I stomach the (admittedly low) risk of losing the funds, in the event of my company's bankruptcy/insolvency.  Knowing what I do about healthcare reimbursements declining, expenses rising, and the company's seemingly insatiable appetite for expansion, I do worry that they are biting off more than they can chew and it could all end horribly.  But I'm a glass half-empty and leaking kind of guy.

[Hatton]

I would not want the risk of a BB+ company.  The tax deferred growth for 2.5 - 10 years is not worth the risk.  Having money in a taxable account is very useful for someone contemplating early retirement.

[Raddoc123]

Risk of cumulative default for BB+ is still less than 3% so risk of failure is small.  Invest a percentage of your money that you are ok with losing in the worst of cases.  I think there are bigger risks out there than losing your money in this plan.  I would still invest up to 10% of investable assets because of the benefits.

[M]

Thanks to all for the comments.  After further consideration, I'm leaning against participation in the NQDC Plan.  The risk of loss of funds is small, but I don't like the fact that I can't diversify this particular risk.  I can deal with investment risk by holding stock in hundreds/thousands of companies.  But if my parent corporation has a catastrophic event, I'm potentially buggered by the failure of just one company.

Having won the game already, I don't think I should get greedy at this point.  So I will take my compensation now and invest in my taxable account per usual.

[PenguinMD]

Opps, I meant to post my comment in this thread instead.

Anyways, the short summary is I'm also trying to evaluate participating in a non-qualified deferred comp plan too. This one is administrated by Fidelity.

I double-checked some details and found out that it actually offers a multitude of investment options (originally thought it was just low yield bonds) but they have a large range from conservative to aggressive with access to the Fido Target Freedom Funds. I still need to review all the fees but think there's something that could work.

Additionally, have various distribution options which essentially boils down to picking a date where you get the lump sum for contributions that year, or when you separate (in which point it's a lump sum across ALL contribution years). If can make it to 55 with the company (16 years out, hurts to even think that) then can do monthly distribution spread out either 5yrs or 10yrs.

The catch of course is you need to elect how much you want to contribute and what's the distribution in advance.

For distribution could try to employ a ladder system where I just pick a date X years out say 10 and do that each year so it spreads things out. Of course if I separate earlier then get everything at once so if I do plan to separate seems better to do it earlier in the year.

The other strategy is just to go for retirement distribution so betting I'll still be around doing the same old same old for the next 16 years (ack! Isn't the whole point is to try to quit early!?). With this option I can spread my distributions monthly across 5 years or 10 years.

Of all the distribution choices seems the most tax advantage is the retirement but this only really works if you're thinking traditional retirement but my whole goal is to try to reach FI in 10 yrs (before the next board cycle ).

So trying to figure what makes sense. One way is to pick a future date where I foresee I'd be cutting back my hours, this way I get "early access" to the money (before hitting retirement age) and also some tax advantages. I also have the option to make a distribution change ONCE but it needs to be before a year of the scheduled distribution and you must push the new distribution date at least 5 years.

So maybe go that route, the trick is "when" do I think I'll cut back, also there's risk as if I end up not cutting back any hours then I'd be getting the money back which will add to my tax base. But I could also do the one time change and push the date further out which essentially gets me to the retirement target window anyways.

The other important choice is the amount of deferral. They allow a 85% base to a max of $130k/year. That is doable but the illiquidity concerns me although there are special hardship clauses if I really really really needed access to the money.

I'm somewhat leaning toward doing a modest amount of $35k-$50k to defer and selecting a date of 10 years out, the idea is that by then hopefully will be cutting back hours. Plus have the option to change the distribution and push the date another 5 years if needed.

I'm thinking to start there and see how it goes and make adjustments the next go around.

Thoughts on this approach? Advice?

[fatlittlepig]

I'm contributing a large amount into a NQDCP (approx 180-190K/year), however my plan is more flexible than yours in that I can "ladder" my payments over a 5-15 year period, in fact each year's contributions can have a different year of distribution over a different period of time. Obviously I have been able to greatly reduce my adjusted gross income through this plan. It has worked very well for me so far. I may in the future increase contributions to the plan.

[pulmdoc]

If you are planning to do early retirement in only a few years AND the plan requires lump sum distribution on severance, I would probably pass. In this scenario, you are basically exchanging marginal income tax rates on today's income for having your investment gains be taxed at marginal rates instead of LTCG AND a high probability of being in the top tax bracket on that lump sum distribution. If you are already in the top tax bracket it's not as bad (especially if you can drop into a lower tax bracket by deferring compensation). The other part of the equation you haven't told us is your investment options for the deferred comp. If the choices are lousy, that's another reason not to pursue it.

[PenguinMD]

*Bump*

It’s open enrollment time again.

Curious if anyone is changing their NQDC strategy with all the tax reform discussion happening.

Of course the kicker is that by the time all the tax reform settles open enrollment will close. ...

Likely to still do a small NQDC election (5-10%) again this year.

What are others doing in regards to NQDC plans?

[VagabondMD]

PenguinMD wrote:

*Bump*

It’s open enrollment time again.

Curious if anyone is changing their NQDC strategy with all the tax reform discussion happening.

Of course the kicker is that by the time all the tax reform settles open enrollment will close. …

Likely to still do a small NQDC election (5-10%) again this year.

What are others doing in regards to NQDC plans?

Click to expand...

My wife has such a plan, and we plan to sign up for 5% of her salary and 10% of her annual bonus. As I plan for our joint not-so-early-but-earlier-than-some retirement (whew!) in a few years, I am finding that this growing asset bucket should provide a nice little income stream to help get us from the mid-50’s to the early 60’s.

[Dr P]

My fiance recently started a new job and has a situation similar to PenguinMD.  She can defer up to 75% of her income in a NQDC plan but must take it out as a lump sum if she separates before age 55.  At first it seemed like a great deal, but we're not sure we want to stay in the region, or work, that long.

My thoughts were along the line of pulmdoc's.  If she separates early, the majority of the lump sum will be taxed at the top tax bracket.  If she were to pay taxes on the income now, none of it would be in the top bracket.  I'm thinking that alone may be reason to avoid the plan.

 

 

[NoobNephron]

My employer offers a NQDC. Big box company felt healthy enough for Berkshire, and while not foolproof, passes litmus test for me.

As you know, fed/state income tax deferred, FICA not.

Plan is hosted by Prudential. Management/admin fee is 0.15% and has in its investment options a decent vanguard inst stock fund (s&p 500 indexed equivalent i believe) c ER of 0.04.

Ive maxed every tax deferred/advantaged (solo 401k, comp 401k to match amount, hsa, 529, dependent fsa, backdoor roth, no 457 option) account possible and am seeking more options as have a substantial amount of 1099 income at max marginal tax rate this year. So tax deferral savings would be substantial. To pulmdoc's point, im maybe 5 years to FI and 2 more after for early RE and plan on setting distribution dates to low earned income dates.

Distribution is similar to whats stated by above posters. You make distribution plans each year you contribute. So yeah, would need extremely cautious and meticulous planning. Mine has a seperation of service exit plan which you can choose 1 lumpsum (as pointed out, tax kill) or annuitize over 2-20 year. Not sure if undistributed funds remain vested if that was to happen or just sits there lazy and "unemployed."

In early RE, Id like to employ an individualized variation of early retirement withdrawal strategies brilliantly outlined in PoF's article "tax man leaveth" and experiment/dabble in some roth ira conversion ladders + capital gains/loss harvesting, etc. Currently crunching numbers and employing all sorts of differenet scenarios. Maybe time distributions to early RE during the 5 year roth conversion wait period and leave taxable brokerage index untouched?

Any thoughts would be helpful!