The January delivery of the American Taxpayer Relief Act of 2012 finally brought certainty – as well as new concerns – to higher-income Americans. As analysts explore the impact on the economy and federal budget discussions continue, financial professionals are supporting their clients with planning ideas to help meet the challenges of this new tax environment.
With higher marginal tax rates on high-income individuals and increases in capital gains taxes, non-qualified deferred compensation has emerged as a highly effective planning tool for coping with the new tax environment. In addition, the improving economy has renewed employers’ interest in attracting and retaining the best talent to insure success. These factors are providing financial professionals new opportunities to present NQDC to clients and prospects with new reasons to move forward.
What employers believe about offering NQDC plans
Each year the Principal Financial Group works with Boston Research Group to survey non-qualified plan sponsors and plan participants. (A complete report of the 2012 findings can be found at www.principal.com/nqresearch.) The findings suggest that even before the tax changes for highly compensated employees – which occurred four months after our survey – employers already perceived more value in NQDC plans in the improving economy.
The main reasons for plan sponsors offering NQDC plans to their key employees continue to be retirement, recruiting and retention. The top three:
Allow participants to save for retirement in excess of qualified plan limits (93 percent of respondents).
Provide a competitive benefit package for recruited employees (91 percent of respondents). [Note this showed a significant increase over the 2011 results of 84 percent.]
As a retention tool for current key employees (86 percent of respondents). [Note this also showed a significant increase over the 2011 results of 78 percent. Could both of these be a sign that NQDC is important to attract and retain key employees during an improving economy?]
The trend towards employers packaging their NQDC and qualified retirement plans with the same record-keeper continues to grow. In 2012, 79 percent of plan sponsors reported using the same record-keeper for both non-qualified and qualified plans, an increase from the 68 percent reported in 2011.
Reflecting a trend across the retirement plan industry, nearly three in five NQDC plan sponsors (58 percent) are concerned about their key employees having sufficient income to sustain them in retirement. Nearly two-in-five (38 percent) are more concerned than they were five years ago.
The importance of investment choice and information for plan sponsors AND participants
Investment resources are becoming more important to plan sponsors: Investment performance information is quoted as the top resource to help plan participants make decisions about their benefits; and offering different investment options is the most likely plan change mentioned by plan sponsors.
Investments are important to participants too. This year’s study also showed investments were the leading driver of overall satisfaction for participants, and were the leading factor in participant opinions about statements, plan communications and education. This is an area where financial advisors can add value to their client relationships. Participants factors when deciding on NQDC deferrals
Most NQDC plan participants have some level of confidence in their retirement readiness, although just over one-third are ‘very confident.’ More than one in three (35 percent) participants plan to increase their contributions in the NQDC plan over the next year, while nearly all of the remainder plan to maintain their current level of contributions.
The graphic shows the four primary factors that plan participants indicate they use in determining deferral amounts into the plan. While personal tax rates ranked as the fourth factor, the tax changes at the start of 2013 will almost certainly have an impact on this metric.
Income tax changes create NQDC leverage opportunities
It’s true that the American Taxpayer Relief Act of 2012 has no direct impact on the tax treatment of NQDC plans. But, the individual tax provisions have created a new environment with broad implications for employers and their highly compensated employees. These include:
Higher marginal income tax rates for highly compensated individuals may encourage more deferrals into NQDC plans.
Deferrals into a NQDC plan offer the potential to reduce or eliminate the impact of the tax increases for participants who are close to certain income thresholds.
Higher marginal income tax rates and higher capital gains rates make the tax-deferred earnings in NQDC plans more attractive vs. after-tax investing.
The “permanency” of the new tax rates gives plan participants more certainty over the taxation treatment of future NQDC plan distributions. This, combined with distribution planning in retirement, offers the potential for receiving benefits at lower tax rates after retirement.
NQDC plans offer participants potential opportunities for managing taxable income both today and in the future. By reducing current taxable income, deferrals into an NQDC plan reduce a participant’s current tax year income at their highest marginal rate. Then, they can elect when to receive plan distributions and potentially reduce their tax burden by spreading out distributions at retirement (as allowed by plan design) and coordinating with qualified plan distributions and Social Security.
With the improving economy causing significant changes in employer attitudes and participant behaviors, and the new higher tax environment causing many highly compensated individuals to take a fresh look at NQDC deferrals, all signs suggest a renewed interest in NQDC plans. For advisors this also suggests looking at both new and existing NQDC plan sales opportunities. With all the interest being generated, advisors should consider how – not whether – to integrate non-qualified deferred compensation into their business plans.