In addition to myStockOptions.com, we publish a separate website: myNQDC.com, all about nonqualified deferred compensation (NQDC). It was therefore with interest that we noticed a recent article about NQDC in The New York Times. While, given the current economic climate, the article's title does not necessarily flatter the topic of NQDC ("For Top Executives, Richer Retirement Plans" by Fran Hawthorne, Sept. 11), the text does in fact present an informative summary of nonqualified deferred compensation and the related issues and risks for participants in NQDC plans.
We particularly appreciate the author's balanced coverage about the value of NQDC deferrals in the current environment of rising tax rates. Illustrating one opinion, the article presents the views of a wealth manager who claims that higher future tax rates, as expected for high earners in the next few years, "make these plans less desirable, because participants are basically delaying paying taxes until they withdraw the assets." While that advisor recommends reducing NQDC deferrals, other expert opinions expressed in the article take the opposite view: "If an executive's income is significantly less in retirement, or he or she moves to a low-tax state from a high-tax one, the tax bill might still be smaller in the future than today, even if rates go up. High and compounded investment returns could also outpace tax increases."
Why NQDC Deferrals Can Make Sense Even With Higher Tax Rates Ahead
That reasoning is, in fact, strongly supported by the NQDC experts that have contributed articles and FAQs to myNQDC.com. In particular, two articles we have published demonstrate the value of NQDC deferrals even when tax rates are expected to rise in the future. (See The Growing Importance Of Nonqualified Deferred Compensation Amid Rising Tax Rates by Andy Shourds and Advantages To Deferring Income In An Uncertain Tax Environment by Steve Broadbent and Chris Nyland.) As these authors indicate, the power of tax-deferred saving and investing through NQDC plans often persists even if the participant's income tax rate is expected to be higher at the time of payout than it is at the time of deferral.
How can that be? Even with rising tax rates, remember that the basic tenet of NQDC plans still applies. Participants defer taxes twice: first, when they would have received their salary or bonus and would have paid ordinary income tax on it at that time; second, on their investment income as it accumulates. While income such as interest, dividends, and realized capital gains from traditional after-tax savings in a taxable brokerage account is subject to income tax each year, earnings and the amount deferred in a nonqualified deferred compensation plan are not subject to income tax until the benefit is actually distributed. The out-of-pocket tax cost each year to after-tax investors in a regular brokerage account reduces their annual rate of return.
Assuming a pre-tax deferral is attractive, what about NQDC participation in light of expected tax-rate increases? Is it better to take the compensation now, pay current taxes at lower ordinary income rates than those expected in the future, reinvest the net amount, and then sell it later at capital gains rates? Or is it better to defer the income and taxes on it today and pay a greater total amount of taxes when it is distributed in the future? The answer depends on three factors:
- the calculation of current and future tax rates for both ordinary income and capital gains
- the investment return on the compensation deferred
- the growth of the alternative investment(s) for the after-tax amount of the compensation without deferral
Most of the time, the future value from the tax-deferred growth of the compensation, including investment earnings, will exceed the future value of that compensation without deferral. In short, participants are starting with a much bigger pre-tax sum that grows in a tax-deferred way, instead of paying taxes on their compensation earlier by forgoing deferral and then investing the smaller net after-tax amount. Even though participants may owe more taxes in the end, the net after-tax value of the deferred amount is larger.
NQDC Calculator: Fun, Informative, Free
The power of tax-deferred saving and investing through NQDC plans is also shown by our Deferral Choices Comparison Calculator at myNQDC.com. Of course, everybody's situation is different. This tool can help you decide the best course for your circumstances. You can see the difference between:
- deferring the compensation, putting it into investments available to you in an NQDC account, and receiving taxable distributions in the future
- taking the compensation now, paying taxes on it, and putting the net into your own investments or brokerage account
While this tool is a great starting point, consult a financial advisor and read our content on myNQDC.com before making any decisions about how much income to defer or about investment choices.
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