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The Real Cost of Nonqualified Deferred Compensation Plans

With the reduction in the 401 (a) (17) limit on compensation to $150,000 for 1994, many 401(k) plans are finding it difficult to pass their actual deferral percentage (ADP) tests, which are designed to spot discrimination in favor of highly compensated employees. One solution has been to enroll highly compensated employees in nonqualified plans, variously called top-hat plans or excess-only 401(k) plans. But there is a price to be paid for such a move, and Robert J. Dema, CPA, president of CPI Qualified Plan Consultants, Great Bend, Kansas, and Kyle C. Frazier, CPI's pension administration supervisor, discuss those costs below. A top-hat plan is a nonqualified deferred compensation plan that lets highly compensated employees defer taxes on pay and any employer-matching funds. Investments usually parallel those in the employer's 401(k) plan. Many pension advisers recommend that employers remove highly paid employees from their 401(k) plans to prevent the plans from failing the ADP test or to avoid the need for testing at all. But most companies don't realize that although this approach solves the test problem, it is expensive. The first four columns in exhibit 1, page 87, show what happens to the pension account of an employee who opts for a nonqualified plan rather than the company's 401(k) plan. So that the employee does not suffer financially, the account is credited with full earnings without any reduction for taxes. In this case, the employee defers $8,000 of compensation and a $2,000 employer matching contribution, which are invested to earn 8% a year. At the end of 20 years, the fund accumulates $457,620 and, considering the 8% return on the growing fund, will be paid out at the rate of $46,610 for 20 years for a total payout of $932,200. AN EXPENSIVE MOVE The fifth and sixth columns in exhibit 1 address the cash flow effect on the company, assuming the cost of money is 10% before taxes and 6% after taxes and the company is in a 40% top marginal federal and state tax bracket. The cumulative cost of the lost tax deduction over 40 years is $819,770, including tax on the investment account earnings. The last three columns in exhibit 1 show how much additional salary the employer could afford to pay an employee not participating in either plan. The employee could take full salary (without deferring anything) and receive a $12,977 raise ($2,000 for the match plus $10,977--or roughly 150% of the amount of deferral not made) and the employer would be no worse off. This model makes many assumptions about earnings growth and tax brackets and does not deal with the effect of additional Social Security taxes. However, no matter how the arrangement is looked at, the cost of nonqualified deferred compensation to the employer is staggering. RULING OVERTURNED Last December, the Ninth Circuit Court ruled, in Albertson's v. Commissioner, that interest appropriately credited to a nonqualified deferred compensation arrangement did not count as compensation and could be deducted currently as interest expense (see "Interest Component of Deferred Compensation Is Deductible," JofA, Feb. …