If Congress does not extend, the individual tax provisions will sunset and the tax law will revert to 2017 rates. In light of these recent changes, it’s important to note that a well-designed Nonqualified Deferred Compensation Plan could be a winning strategy for both employers and employees.
Advantages of Nonqualified Deferred Compensation
From the Employee’s Perspective
The Act includes seven personal tax brackets and lowers the tax rates for most. It roughly doubles the standard deduction, but eliminates personal exemptions and most itemized deductions.
A few of the changes for individuals include:
- In 2017, taxpayers could claim a personal exemption for themselves, their spouse (if married and filing jointly) and each qualifying child or qualifying relative. Each exemption reduced taxable income by over $4,000 in 2017. Under the Act, personal and dependent exemptions are eliminated.
- Married couples filing joint returns can only deduct up to $10,000 ($5,000 for married taxpayers filing separately) in state and local income or property taxes. Many have expressed concern regarding this limit (especially those in high-tax states) and feel their marginal tax rates could actually increase.
- For mortgages incurred after December 14, 2017, married couples filing jointly may deduct interest on up to $750,000 of principal (down from a previous $1 million limit).
- Taxpayers will no longer be permitted to deduct home equity interest.
- Miscellaneous itemized deductions subject to the 2% floor including employee business expenses, tax preparation fees, investment interest expenses and personal casualty and theft losses (except for certain losses in federally declared disaster areas) are fully eliminated.
From the employee’s perspective, many high income earners or those who own significant real property (particularly in high income and / or high property tax states) may not see substantial tax reductions. With fewer tax deductions, it is possible that some will find themselves in similar, or possibly higher, tax brackets resulting in a higher tax burden.
Because amounts deferred into an NQDCP and any earnings credited are not subject to federal or state income taxes until distribution, nonqualified deferred compensation will remain an attractive tax deferral option. Plan participants can use these plans to reduce current tax liability in addition to supplementing retirement income.
From the Employer’s Perspective
The Act lowers the maximum corporate tax rate from 35% to 21%. This reduction is permanent. It also provides a 20% tax deduction for owners of some pass-through businesses, but this deduction expires after 2025. Pass-through businesses include sole proprietorships, partnerships, limited liability companies and S corporations.
For employers, contributions to NQDCPs are only tax deductible when the distribution occurs (usually at separation from service or the death of a participant). The delayed tax deduction remains unchanged and is the employer’s cost of an NQDCP. Because of lower corporate tax rates, the cash flow required to support the delayed tax deduction will be much lower than it was prior to 2018. Therefore, the cost of sponsoring an NQDCP will be significantly less.
Planning for Success
The Act will impact individuals and businesses at all income levels and create changes in tax planning. At this time, it is not clear whether most individuals will see a reduced tax bill, as the Act appears to complicate an already complex tax code. Individuals concerned about the tax implications are encouraged to meet with their tax and financial planning professionals.
Many individuals will likely continue to pay high tax rates, resulting in a tremendous advantage to deferring compensation. Combine that with the decrease in corporate tax rates (which will ultimately reduce the cost for employers providing Nonqualified Deferred Compensation Plans), and it is clear that nonqualified deferred compensation is an appealing strategy.
This article originally appeared in the 2018 | ISSUE ONE of the SilverLink magazine, under the title “Tax Cuts & Jobs Act’s Effect on Nonqualified Deferred Compensation” To receive a complimentary subscription to the SilverLink magazine, sign up here.