Four Lessons Learned In the COVID-19 Era:

Yes, You Can Freeze Deferrals Or Take Cash
from Your Deferred Comp Plan

covid-19

Thirty years ago, I discovered and set out to master the nonqualified deferred compensation field.

I designed and placed several hundred plans prior to the 1986 Tax Reform Act, which caused dramatic changes in how these arrangements were funding. Prior to the Act, we could credit participant accounts with 18 to 22 percent guaranteed interest with no cost to the corporate sponsor.

Think about that. If you deferred $100,000 each year for ten years, you could take $592,000 out for 15 years (totaling over $8.8 million). No wonder I was so successful and had so many friends.

I also placed in operation, post-1968, hundreds of programs with a different funding vehicle and more investment flexibility. In the 1990s, tax rates were high. The top Federal rate jumped to 39.6 percent, plus added state income taxes. Notably, very little risk ever arose from one of these plans.

While Founder/CEO at Compensation Resource Group, Inc., I worked with fellow colleagues and we created a concept known as the “haircut provision.” This provision allows a participant to take—at any time and for any reason—a 10 percent haircut and withdraw his or her entire deferred compensation balance. Also, a company could simply terminate its plan, payout everyone, and begin a new plan.

Even though the Economic Growth and Tax Relief and Reconciliation Act of 2001 dropped the highest income tax rate down to 35 percent from 2003 to 2010, people continued to defer at a higher total tax rate due to state taxes.

Then Along Came 409A

Effective January 1, 2005, 409A kicked in and took major advantages away, in part, the haircut provision, how companies terminated plans, and how participants re-deferred dollars.

These provisions made nonqualified deferred compensation plans less flexible. Over four hundred pages of regulations have been issued under Section 409A. The following offers a summary of ten principles that are central to understanding the scope and impact of Section 409A:

Elections of time and form of payments
Limited distribution events
Acceleration of NQDC generally prohibited
Established unique definitions for common terms
Plans of the same type treated as a single plan
New rules on short-term deferrals
Separation of service rules
Six-month delay for publicly traded companies
Substitutions scrutinized and must follow rules

COVID-19 and the Need for Cash

Over the last few months, our firm has received many panic calls from individuals who participate in nonqualified deferred compensation plans. They needed input on how to either postpone existing deferral elections or access cash from their plans.

Many individuals are going through hardships caused by salary reductions or work layoffs. Unfortunately, 409A has placed many restrictions on their ability to qualify for a hardship withdrawal or even to freeze existing elections. For many who called, these restrictions keep them from helping themselves.

However, three ways exist to access limited amounts of cash from a nonqualified plan:

unforeseeable emergency request
small balance cash out
payments from pre-409A, grandfathered accounts

Unforeseeable Emergency

Under current Dept. of Treasury regulations, 409A plans may be designed to permit distributions, based on an unforeseeable emergency for the following incidences:

An illness or accident of the participant, the participant’s beneficiary, or the participant’s or beneficiary’s spouse or dependents;

Property loss caused by casualty (for example, damage from a natural disaster not covered by homeowner’s insurance) of the participant or beneficiary;

Funeral expenses of the participant’s spouse or dependent;

Other similar extraordinary and unforeseeable circumstances resulting from events beyond the control of the participant or his or her beneficiary (for example, to avoid imminent foreclosure or eviction from a primary residence or to pay for medical expenses or prescription drug medication);

Job loss or reduction in pay, by itself, will generally not qualify as an unforeseeable emergency. The participant seeking the distribution must show that the emergency expenses could not otherwise be met by insurance, liquidation of the participant’s assets (to the extent that the liquidation would not, itself, create severe financial hardship), or cessation of deferrals under the deferred compensation plan. Further, the amount of the distribution must be limited to the amount needed to satisfy the emergency, plus applicable taxes.

Small Balance Cash Out

A plan may provide, or be amended to provide, the employer with discretion to distribute a small balance to a participant at any time. The participant’s combined accounts under all other nonqualified plans maintained by the employer’s controlled group of organizations must not exceed $19,500 and the distribution must be a complete liquidation of the accounts. For this purpose, elective deferrals and company contributions (e.g., a matching account) are treated as separate plans, each having their own $19,500 limit.

Those elective deferrals you expect to make for the remainder of the year should be factored into the determination of the account balance. For example, a plan could not cash out a balance today and then cash out the deferrals for each subsequent payroll if the combined plan deferrals at year-end would exceed $19,500.

Pre-409A, “Grandfathered” Accounts

Amounts deferred and vested under nonqualified arrangements on or before December 31, 2004, may continue to be paid under the terms of the pre-409A arrangement. Many of these arrangements provided for “haircut provisions” which are discretionary withdrawals, with a reduction in the requested withdrawal, typically 10 percent.

Generally, pre-409A plans may be terminated and accounts paid without the need to terminate any of the employer’s plans that are subject to 409A.

Plan Terminations

Nonqualified plans other than pre-409A “grandfathered” plans may be terminated only for business reasons and not with a purpose to accelerate payments from the plan. To separate “business-driven” terminations from “acceleration-driven” terminations, the 409A regulations require liquidating payments to be delayed a minimum of 12 months after the board of directors takes final action to terminate the plan.

A distribution also will violate 409A if the board action to terminate occurs in connection with a “downturn” in the financial health of the employer. Because of the required delay in payment and the likely inability to terminate at all under current economic conditions, plan termination is not included as a viable payment source.

Suspending Deferrals

Several participants requested a suspension of their deferrals to increase their existing take home cash flow. Generally, once deferrals commence for the calendar year, they may not be suspended. Exceptions include suspension due to disability and unforeseeable emergencies. If an unforeseeable emergency exists, most plans will automatically require a suspension of deferrals as a condition for taking a withdrawal.

A disability includes a medical condition that precludes the participant from performing his or her job functions. Note that this is not the same as a disability payment event from a nonqualified plan which is defined as the inability to perform any remunerative work for a period of at least 12 months or under conditions likely to result in the death of the participant.

Lessons Learned from COVID-19

Now that you know these 409A limitations, place a clean sheet of paper before you and take pen in hand: What could you have done differently?

Most individuals seeking cash had incomes in the $150,000 to $250,000 range. The super high-earners held ample external resources from which to draw on.

The first lesson learned—to use and maximize all other deferral options first, before considering a 409A deferred compensation arrangement.
Maximize your 401(k) contributions first. Currently, you can defer up to $19,500 (2020), and with the catch-up contribution limit for employees aged 50 and over who participate in these plans, you can contribute another $6,500. For employees earning $200,000 per year, you can defer 19.5 percent to 26 percent of your income into a plan with more flexibility and with the ability to access cash. The Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) allows participants in tax-qualified retirement plans such as 401(k) plans and governmental 457(b) arrangements to take hardship withdrawals up to $100,000 without a 10 percent penalty; to spread the tax on the withdrawal over three years and; to repay the withdrawal to the plan within three years with the repayment treated the same as a tax-free rollover. The provision also permits plan loans up to $100,000. Unfortunately, there were no provisions specific to nonqualified plans.
Contribute to a Roth IRA, too. After you fill your 401(k) bucket, consider using a Roth plan to diversify the tax treatment at retirement. You can contribute to a Roth IRA and a 401(k) at the same time. Some 401(k) plans even allow you to make Roth Contribution which should be considered based on your current and future tax situation. As we mentioned above, you can contribute up to $19,500 in 2020 to a 401(k) plan, and if you’re 50 or older, the annual contribution maximum jumps to $26,000. You can also contribute up to $6,000 to a Roth IRA in 2020. This ability will give you some diversification and take future tax rate risk out of your distributions. There are also nonqualified Roth type strategies available, using insurance products, with no limits. The major advantage is non-taxable income at retirement and the ability to access cash at any time without penalty or taxation.
Short term “in-service” distributions in an NQDC with re-deferral option. Most NQDC plans offer short-term distributions. Typically, you could defer dollars in 2020, and take a distribution in 2022. However, because of the 409A re-deferral rules, you would have the ability to push out the payment.
- The subsequent deferral election must be made at least 12 months before the originally scheduled payment date;
- The subsequent deferral election may not go into effect until at least 12 months after the election is made;
- The new payment date must be at least five years after the originally scheduled payment date.

So, with our example, you could defer in 2020, and in 2021 (12 months prior to distribution) re-defer until 2027 (five years out). You could cascade these distributions by deferring in 2020 and selecting five distribution dates 2022, 2023, 2024, 2025, and 2026. Twelve months prior to each distribution, you could re-defer for five years.

Work with Unbiased Financial Advisor to help Plan Retirement

Based on the limitations and restrictions under 409A, you owe it to yourself to consider working with your financial and tax advisor to develop a clear picture of the role deferred compensation can play in achieving a comfortable retirement or other financial goals.

When you sign up for a nonqualified deferred compensation (NQDC) plan, you agree to set aside a portion of your annual income until retirement or another future date. But people may not spend sufficient time on when and how to receive that money and how it affects their taxes. Be wise and work with an advisor who can help you model out these scenarios.

My Financial Coach (www.myfinancialcoach) offers a precision platform to model these options forward and coordinate them with your corporate benefits and personal assets. My Financial Coach also matches you with a personal unbiased Certified Financial Planner™ (CFP®) professional with knowledge of these options and the tools to help you in the planning process. Retirement planning is critical, although one part of a far larger total financial plan. It is essential to your wellbeing that you coordinate all aspects of your financial profile with your lifelong goals. covid-19

That coordination effort can be complex and confusing because one must assess potential cash flow needs and tax liabilities many years—or even decades—into the future. That’s why you need a clear picture of the role deferred compensation will play in achieving a comfortable retirement or other financial goals.

What’s more, also we suggest you look into other retirement cash accumulation vehicles to work in concert with your 401(k) and NQDC plan.

Above all, before you enroll in an NQDC plan, consider the four factors shared above to help you make the most of your distributions, whenever you decide to take them.

In best regards,

Bill MacDonald

CEO