When a couple is getting divorced, what are the options when a significant amount of money is in one spouse’s non-qualified deferred compensation plan? And how do non-qualified deferred compensation plans differ from defined benefit plans?
By Ben Feldmeyer, CFP®, CDFA®, CLTC®
Before we get into the issues surrounding non-qualified deferred compensation plans and divorce, let’s define what non-qualified deferred compensation is. To do this, let’s start with qualified deferred compensation plans – which are called defined benefit plans, but most people refer to them as “pensions.”
Money is funded into the defined benefit plan by the employer, and sometimes the employee too. The money contributed to the plan is a tax deduction for the contributor, so it “qualifies” for a tax deduction.
Qualified plan accounts are taxed at the time of distribution as ordinary income, so the more you take out, the higher the marginal tax bracket.
Qualified Deferred Compensation Plans (a.k.a. Defined Benefit Plans): Formulas and Limits
Typically, the plan benefit is defined (that’s why it’s called a defined benefit!) The formula is typically a matrix that uses years of service on one axis and the person’s age on the other axis to provide a percentage of their income that will be paid at retirement. Sometimes the formula uses the highest 5 years of income, but some use lifetime average.
No matter what the formula is, there is a limit to how much of a person’s income can be counted toward the plan. The IRS provides this number, and for 2019 the code says: “The annual compensation limit under Sections 401(a)(17), 404(l), 408(k)(3)(C), and 408(k)(6)(D)(ii) is increased from $275,000 to $280,000.”
So if a person’s salary is $500,000, only $280,000 can be used toward the pension calculation. That leaves $220,000 of income that isn’t included in the calculation. To create a better executive-level benefit plan, a company may elect to provide an additional plan – a non-qualified deferred compensation plan – that takes the additional $220,000 into account.
Non-qualified deferred compensation plans differ from defined benefit plans in several ways.
|Defined Benefit Plan||Non-Qualified Compensation Plan|
|Subject to ERISA||Not subject to ERISA|
|No tax on dollars contributed||Dollars may or may not be contributed to the plan|
|Can be rolled to an IRA to continue tax deferral||Cannot be rolled into an IRA – subject to taxation when received|
|Trusteed plan||Non-trusteed plan|
|Account is funded||May be funded or not – Plan is a debt that is owed to the employee|
|PBGC insurance||No insurance on planned benefit|
This problem is even worse if a person’s income is higher. If the client is a high-income producer the non-qualified plan could end up being significantly bigger than the qualified plan. For example, if an executive’s salary is $1,000,000 and only $220,000 can be counted toward the pension, that’s only 22%. The other 78% of the benefit funding is a debt that may or may not be paid.
Excess Benefit Plans (EBP), Top-Hat Plans (THP), and Supplemental Executive Retirement Plans (SERP) are different types of non-qualified deferred compensation plans.
These plans can be either funded or unfunded.
- Funded means that there is some form of investment capital in the plan to pay the benefit in the future.
- The unfunded plan is a debt that the company owes the employee, so if the company goes into bankruptcy, the employee becomes a creditor and waits for a settlement from the bankruptcy court. The court may find that there is no money to pay the benefit.
What are the options when a significant amount of money is in the non-qualified deferred compensation plan?
Some non-qualified deferred compensation plans can be divided in divorce. If the non-qualified plan does not allow for division in a divorce, the divorcing couple may be looking at an “if, as, and when” agreement.
This is an agreement that identifies how the amounts will be divided at some point in the future – if, as, and when there are actually distributions from the plan.
If this is the case, there may be a coverture fraction calculation to determine the marital portion as well as a need for provisions regarding changes in value between the settlement date and the payout date. This is especially important if the payment is unlikely to be made for several years.
But typically there’s a trade-off, which I like to call a swap meet: “I’ll trade you my half of the marital portion of your pension for the house,” or “I’ll trade you my half of our art collection for your half of the marital portion of my pension.” Sometimes the simplest solution is the best, but you should evaluate all options with an experienced divorce financial expert before agreeing on any solution.
Ben Feldmeyer CFP®, CDFA®, CLTC® is a Private Wealth Advisor and President of Feldmeyer Financial Group, a private wealth advisory practice of Ameriprise Financial Services, Inc. He has 25 years of experience in the financial planning industry providing comprehensive financial planning and wealth management. Ben has been working as a divorce financial neutral and divorce financial advocate since 2014 and is located in the Dayton, OH area. www.ameripriseadvisors.com/team/feldmeyer-financial-group
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