CAPTRUST Senior Director | Consulting Research Group
When addressing the audience at a recent TED Talk (one of a series of nonprofit forums for industry leaders to share ideas on technology, entertainment, and design), behavioral researcher Sheena Iyengar suggested that the typical American reports making around seventy decisions per day.1 Logic, intuition, and experience help us make most of these decisions quickly and easily, but sometimes we are confronted with complicated choices that require a heavier dose of critical thinking. Such is likely the case for executives when it comes time to make annual deferred compensation election decisions.
On one hand, nonqualified plan participation can help executives by allowing them to save meaningfully in addition to their qualified plan deferrals. On the other hand, nonqualified plan deferrals are subject to a number of requirements and restrictions that can be confusing. How much should I defer? How should I invest? These questions carry long-term retirement planning implications, but probably the most difficult decisions relate to benefit distribution election options.
Under Internal Revenue Code 409A, which broadly governs nonqualified plan arrangements, participants must make distribution elections prior to deferral to prevent them from manipulating benefit receipt and taxation. Benefits can also be distributed for reasons including separation of service, disability, death, change of control, unforeseeable emergency, or plan termination. Many plans are designed to pay benefits in the event of a separation from service, even if the participant had previously chosen another option.
The predominant distribution decision controlled by the participant include the choice of a lump-sum distribution or a series of installments.2 These election decisions dictate at what point deferred income becomes taxable. Spreading payments out, or planning them for years in which they can be offset by other anticipated tax-related events, can have significant financial impact. Once elected, participants have limited ability to modify both the time and form of their distribution elections under 409A if enabled by the plan.
While some participants may be intimidated by the prospect of predicting their tax circumstances or retirement income needs years in advance, doing so is not without its rewards. For example, unlike individual retirement accounts or qualified plan distributions, nonqualified plan distributions are not subject to tax penalty prior to age fifty-nine and a half. As such, they may play an important role for early retirees by filling a gap prior to Social Security and Medicare eligibility.
In addition, many plans offer plan design features intended to provide benefit distribution flexibility as a way to help participants get comfortable with their plan and nonqualified deferrals, including:
• Class year accounting. Many nonqualified plan administrators accommodate class year accounting which, if offered by the plan, allows participants to apply different distribution elections to each annual contribution made into the plan. By allowing this annual flexibility — rather than an all-or-none approach to distribution election — class year accounting reduces a potential intimidation factor.
• In-service distribution options. Some nonqualified plans allow in-service distribution options, which permit participants to plan for the payment of their accounts’ value during employment. Utilizing the in-service option provides participants the most flexibility for payout timing and can make nonqualified plans a useful tool for achieving intermediate-term financial objectives. For example, this feature is extremely valuable for individuals who have known savings needs such as college education costs for their children, or other planned purchases like vacation homes, cars,
•Distribution election modifications — changes to time or form of payment. While plans are not required to allow for distribution modification options, once a distribution election is in place, technically, election modifications can be made by the participant. Any change to timing or form of an existing distribution election must be initiated at least twelve months prior to when the benefit would have otherwise been paid (i.e., separation from service), and the commencement of the benefit payment must be delayed for at least five years. Utilizing class year elections combined with an in-service distribution option provides the highest level of adaptability for nonqualified deferrals and subjects the least amount of benefits to a five-year postponement if modifications are made.
It’s important for participants to understand their distribution options during the enrollment process, especially when it comes to the impact of state income taxes on distribution. For participants who retire in a state with no income tax, regardless of where the income was earned, federal law permits distributions to be taken state-income-tax free. The participant is required, however, to establish residency in the new state and elect to receive the payments over a minimum of ten annual installments.
Nonqualified plans should be designed with maximum flexibility in order to cover the needs of a company’s highly compensated employees. Eligible nonqualified plan participants, who are asked to make numerous difficult decisions every day, should be armed with a keen understanding of the choices and their consequences, and plan sponsors should take this opportunity to educate them about plan design features and the decision making processes during the initial and annual enrollment phase.
1 Sheena Iyengar, “How to make choosing easier,” TED, June 2012, accessed June 24, 2014, http://www.ted.com/talks/sheena_iyengar_choosing_what_to_choose/transcript
2 Boston Research/PSCA, “A Study of Non-Qualified Plan Sponsor Attitudes and Behavior: Final Report,” June 2011, p. 30