When it comes to compensation for highly paid employees, various tax-deferral strategies can offer significant savings over the long run. In the process, nest eggs can accumulate more meaningfully without being reduced by taxes, and sponsoring companies can also receive important benefits along the way. While typical retirement plans exist to help all employees, their strict contribution limitations often prove insufficient in the overall planning of higher paid employees. A potential strategy for highly paid employees is a Non-Qualified Deferred Compensation (NQDC) plan, which allows participants to defer income from immediate taxation by placing such pre-tax dollars (from salary, annual bonus, commissions, or equity awards like RSUs) into investment pools held in trust by the company, in turn taking advantage of compounded growth over time on those pre-tax balances. In particular, increasingly popular restricted stock units (RSUs) offer attractive tax-advantageous strategies for managing additional deferred compensation.

Regular qualified retirement plans, such as 401(k)s, enable employees to put away up to $19,000 per year (for 2019). Moreover, the current catch-up contribution limit for employees age 50 and older is $6,000, and thus, older workers can now contribute a maximum of $25,000 to 401(k) plans in 2019.¹ For highly paid executives, though, these limits likely represent a much smaller than desirable share of their annual earnings to earmark for retirement. Plus, the high level of their current compensation also pushes them into the highest tax brackets. But through some sensible corporate planning at the executive level, there is an opportunity to either:

1. Save more for retirement when they expect their income tax bracket to be lower and a regular cash flow will cease; or,
2. Defer cash flow and hence the tax burden to a year when they anticipate needing greater cash flow, for example, a child heading off to college, or the planned purchase of a second home.

It is important to keep in mind that distributions from NQDC plans are eventually taxed as ordinary income and typically cannot occur until retirement, termination from the company, or per the agreed-upon distribution schedule established at enrollment (typically over a 10-year period). The key for highly paid executives is that NQDC plans have no contribution limits. Of course, it is critical that proper wealth planning is done to prepare executives for the inevitable tax cost when they start to collect the deferred compensation.

For the issuing company, using RSUs in an NQDC can enhance retention while simultaneously reducing, or at least smoothing out, the often-unexpected impact of tax consequences for such key personnel. Perhaps more importantly, the company will benefit from the deductibility of contributions made when the employee ultimately withdraws the deferred compensation. New rules put in place by the recent federal tax law limit the company to deducting no more than $1 million in total compensation (cash, equity, etc.) per year per “covered employee”, which, in the case of deferred compensation, occurs once a covered employee retires or is otherwise terminated from employment and the deferred compensation is paid.² Despite these new limitations, many, if not most, companies will likely fall below the $1 million threshold and can take full advantage of this deductibility feature. Since cash flow is such a critical component for smooth business operations, deferred compensation may be a “win-win” for employer and employee alike.

Bottom line, NQDC plans may enable key executives to proactively plan for many important life events and sensibly defer resources to help meet such goals; the resulting benefit to the company is icing on the cake. The opportunity to include regularly vesting RSUs in an NQDC plan is a potentially meaningful avenue for significant tax deferral.

¹ United States, Internal Revenue Service. “401(k) Contribution Limit Increases to $19,000 for 2019; IRA Limit Increases to $6,000.” www.irs.gov/newsroom/401k-contribution-limit-increases-to-19000-for-2019-ira-limit-increases-to-6000.

² United States, Internal Revenue Service. “Guidance on the Application of Section 162(m).” www.irs.gov/pub/irs-drop/n-18-68.pdf.