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JOURNAL OFDEFERREDCOMPENSATIONNonqualified Plans and Executive Compensation

Editor-in-Chief: Bruce J. McNeil, Esq.

To start your subscription to Journal of Deferred Compensation, call 1-800-638-8437

Volume 26, Number 2 WINTER 2021

• Editor’s NotE

Bruce J. McNeil ................................ iii

• thE BEst Ways to Pay for CollEgE

John Sanford and Timothy Drake ..... 1

• Part ii of NoNqualifiEd dEfErrEd ComPENsatioN PlaNs

Bruce J. McNeil ............................... 16

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1

The Best Ways to Pay for College

The 529 Plan or the 409A Plan

BY JOHN SANFORD AND TIMOTHY DRAKEJohn Sanford, Principal at Mullin Barens Sanford Financial & Insurance Services, LLC., Los Angeles CA

Email Address: [email protected] Office Phone: (805) 300 3161

Timothy Drake, Director of Wealth Management at Chamberlin Group, Irvine CA

Email Address: [email protected] Office Phone: (949) 553-0313

Yes, you want to save for your children’s education. Yes, you want to do that efficiently but with the most options and flexibility. What now? Two industry experts make the best case for 409A and 529 plans, their areas of expertise, as

tax-advantaged savings options for college expenses.There are many articles comparing various ways to effectively

save for college education (or any other educational pursuits). But this article compares the top educational savings plan, the 529 Plan, to the nonqualified deferred compensation plan, the 409A Plan.

WHAT IS A 409A NONQUALIFIED DEFERRED COMPENSATION PLAN (409A DCP)?

A 409A DCP is a company sponsored program that allows key employees to defer pre-tax cash compensation, have the money grow tax-deferred, and then receive the taxed balance at a defined later date. There are no dollar limits on the amount that can be deferred. These plans are designed to provide tax-advantaged, supplemental retirement savings opportunities. Employees are limited to what they can save in qualified 401(k) plans, so a 409A DCP provides additional pre-tax deferral opportunities for key employees.

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2 / JOURNAL OF DEFERRED COMPENSATION

There are significant tax-advantages of a 409A DCP. The graphic below illustrates the advantages of pre-tax savings and tax-deferred compounding.

HOW CAN A 409A DCP BE USED TO FUND COLLEGE EDUCATION?

409A DCPs are not just for retirement. They can meet both short-term and mid-term future cash needs as well. There is no minimum deferral period in the regulations, but typical plan designs require a minimum of 2–3 years after the year of deferral. However, payment commencing at a specified future date, like the year after a child’s high school graduation, and paid over a 5-year period is allowed.

For example, a 40-year-old eligible executive employee earning $150,000 in salary and $50,000 in bonus. The employee could elect to defer $10,000 of salary and $30,000 of bonus. Distribution can be set up for a future year, like 2030, and be paid over 5 years; or a future event, like termination of employment, and be paid over 15 years. As a comparison, the key employee’s maximum 401k contribution would be limited to $19,500 in 2020 and could be further restricted due to qualified plan rules. Because 401k account balances are generally only available without penalty starting at age 59.5, they are rarely advertised as college education savings vehicles.

HOW DOES A 409A DCP WORK?

An enrollment takes place each year, usually around October/November, for calendar year plans. The election to defer salary and/

ThE BEST WAyS TO PAy FOR COLLEgE / 3

or bonus is generally made prior to the compensation being earned. During enrollment, the key employee decides how much to defer and for how long. Deferral periods range from 2 years to 30+ years. Distributions are usually paid in a lump sum or in annual installments of up to 15 years.

Each annual enrollment can have a different election and may allocate deferrals to different distribution events, or “accounts.”

For example, the same key employee from the above example has two kids, a 5-year-old daughter and a 2-year-old son. This employee decides to set up an account/distribution event for each child. The daughter’s account will start payments in 13 years (age 18 is a typical college entry age), and the son’s account will start payments in 16 years. Both accounts will be paid over a 5-year period, as elected.

Each year, the key employee can redetermine how much to defer into each account. Since the daughter’s account has fewer years to grow, the employee may allocate an additional amount into that account.

For example, a few years later, the key employee is now earning $160,000 and expecting a $60,000 bonus. Bonus deferral elections can be $25,000 into the daughter’s account and $20,000 into the son’s account. See below for a visual example of how this 409A DCP distribution would work.


Each year, a decision can be made as to how much is needed to go into each account to meet the goal. The employee may also establish additional accounts, like a retirement account or accounts for a future trip or second home purchase. Let’s say that this employee is doing well and elects to defer $10,000 of next year’s salary into a retirement account.

Now, there are three accounts: daughter’s college account, son’s college account, and employee’s retirement account. Because there are different time periods, each account can have its own investment allocation. The retirement account is longer term and may have a portfolio mix of a higher percentage of equities versus fixed income. Investment changes are usually available on a daily basis in most 409A DCPs. Investment changes are not taxable because the account grows tax-deferred. So, rebalancing, dollar-cost averaging, and adjusting the portfolio mix as the event gets closer are simple processes.

Deferrals into a 409A DCP can also lower current income taxes. The employee in our example is now earning $220,000 ($160k salary + $60k bonus). After deferrals into all three accounts and maximizing the 401(k), the employee’s taxable income is only $145,500 [$220k (salary + bonus) − $19.5 (401k) − $25k (daughter’s college account) − $20k (son’s college account) − $10k (employee’s retirement account)]

2020 Federal Income Tax Brackets[1]

Married Filing Jointly10% $0–19,750

12% $19,751–$80,250

22% $80,251–$171,050

24% $171,051–$326,600

32% $326,601–$414,700

35% $414,701–$622,050

37% $622,051 or more[1] Add State Income Tax Rates as applicable

In this example, the key employee reduced current federal and state income tax and saved for future events on a pre-tax basis. This is very efficient savings for future needs. Deferring current income can also help with your future college student qualifying for financial aid, since current income plays an important role in determining financial aid eligibility. Financial aid applications usually request retirement/


savings account information, but those accounts may be less important than current income.

CONTINGENCIES! WHAT HAPPENS IF PLANS CHANGE?

Let’s talk about flexibility and contingencies. You are going to hear a lot about qualified and nonqualified educational expenses under the 529 plan. None of that applies here. The future distributions of a 409A DCP can be used however is needed—there are no restrictions. The money can be used to pay for tuition at any college or educational system anywhere in the world. It can be used for room and board, or to pay for expenses associated with commuting, grocery shopping, technology, vocational education, gap year travel, starting a new business, or buying a car. And, there is much less paperwork. With a 409A DCP, there is no need to track receipts to prove that the expenses “qualify” as deductible and penalty free expenses as you will see in 529 Plan regulations.

Let’s fast forward in our example: the key employee has been deferring, the balance has been invested and earning tax-deferred gains, and now all three accounts have the following balances:

$400k (daughter’s college), $300k (son’s college), and $250k (retirement).The daughter is now 18 and ready to attend college this fall. The account has grown to $400k and distributions of about $80k per year have begun. Remember, none of this money has been taxed—yet. It was deferred pre-tax and has grown tax-deferred. But now, ordinary income tax will become due upon receipt of each payment. So, in a 35% tax bracket (combined federal and state tax rates), the key employee will have an additional $56k after-tax to supplement income and help with college expenses ($80k (distribution) − $28k (taxes @35%) = $52k).

In the same year, the son is now 15 and is a nationally ranked tennis player. The son’s account has grown to $300k. Colleges are already making overtures, and a scholarship seems to be on the horizon. In this case, the distributions may not be needed. The account distribution date can be changed to a later future date, or the account be combined with the retirement account.

The $300k from the son’s account can be added to the retirement account of $250k and enhance that account balance to $550k, as seen in the graphic above. Simple and easy. There is no reason to find another relative to use the leftover balance. Instead, redeploying the balance towards retirement provides ultimate flexibility. There, however, is a


rule here that must be mentioned. The distribution has to be changed at least one year prior to payments commencing in that account. If not combining with the retirement account, the payment has to be pushed out at least 5 years. But the employee can decide to postpone the scheduled distribution now (3 years until the son reaches 18), or wait a couple more years to see what transpires with the tennis career. Even if things change last minute and the one-year advanced notice is not achieved, the employee may be able to just increase deferrals to offset the additional income that is not needed, as the graphic below illustrates.

EXAMPLE:

The employee distributions are scheduled to start in 6 months which is too late to postpone. The son waited for his preferred college, and now, at last, has a 75% scholarship offer. At this time, the son’s account is now worth $450k and 5 annual distributions of about $90k pre-tax will commence. But, what if only $50k pre-tax is needed to supplement what the scholarship doesn’t cover. So, the key employee can increase deferrals by $40k for each of the next 5 years and apply that money to the retirement account.

$90k pre-tax distribution − $50k ($32.5k after-tax @35% combined tax rate) = $40k additional deferral out of salary/ bonus to


offset the income taxes on some of the distribution. Leaving only what is needed and redeferring the rest.

409A DCPs are usually described as supplemental retirement plans, and only groups of highly compensated employees or a select group of management are eligible. Your employer has to offer such a plan, but 409A DCPs are usually considered to be shareholder/owner friendly. Since the plan balance is subject to general creditor status during an employer bankruptcy, a shorter timeframe may be a wise choice. If the plan is managed correctly and has assets set aside to pay the benefits down the road, adverse consequences can be mitigated but not eliminated.

These plans sometimes offer minimum rates of return ranging from 1% to 4%; check with your employer for a list of available fund options.

CONCLUSION

Planning and saving for college expenses as early as possible is key to meeting future needs. The tax advantages of either a 409A DCP or a 529 Plan far outweigh the economics of taxable alternatives.

A 409A DCP is a pre-tax contribution with tax-deferred growth and ordinary income taxes being paid upon distribution, so there is more focus on future income tax rates.


The 409A DCP has no restriction on contributions and total flexibility over how distributions are used. And if needs change, the distribution can be postponed and/or redirected into another account. This flexibility can facilitate saving for retirement with unused college education accounts.

The main drawbacks to a 409A DCP is that your employer must offer it, and you must be eligible for the plan. Companies of all sizes may offer a 409A DCP, but be aware that your account balance is secured the company sponsoring your plan and you will be a general creditor of that company.

There are other benefits of 409A DCPs such as attracting, retaining and motivating key employees. Additional benefits include aligning participant incentives with meeting specific goals and the ability for participants to arrange distributions in order to reduce or avoid paying state income tax.

For help improving an existing 409A DCP, to establish a new plan or for more general information, please contact the author, John Sanford.

529 PLANS

With the cost of education rising at an unprecedented rate, families need to start planning as early as possible. Since Congress passed the Small Business Job Protection Act in 1996, the 529 Plan has become a staple for American families to save for their children’s education. 529 Plans have changed over the years and are even more flexible post the 2017 Tax Reform. Not only can 529 Plans be used for college education, they can also be used for K-12 education. In this portion of the article, we layout the benefits of a 529 Plan and why we think they are an effective solution for our clients.

529 Plans were designed for the sole purpose of educational savings and, due to this, they have several advantages that other savings plans do not.

529 PLAN BENEFITS

One of the greatest advantages of a 529 Plan is its accessibility. A 529 Plan can be established for almost anyone. For example, a grandparent, aunt, cousin, friend, or even a neighbor can open a 529 Plan for the benefit of another. 529 Plans allow an individual to gift $15,000 (indexed to inflation) to as many individuals as they choose each year, free from federal gift taxes if no additional taxable gifts to the beneficiary in that year were made. You can also accelerate


your gifting schedule by electing to make a lump-sum contribution of $75,000 to a 529 Plan in the first year of a five-year period ($150,000 for a married couple). At our firm, we see in most cases these plans being set up by grandparents, because they want to make sure their grandchildren never have to worry about education. Grandparents like 529 Plans because of the plan’s simplicity, purpose, and ability to reduce estate asset tax liability. A contribution to a 529 Plan is considered a completed gift (thereby, reducing estate assets), even though the account owner, not the beneficiary, maintains control over the money while it is in the account. Grandparents with many grandchildren can move a significant amount of their assets out of their estate to fund the education of future generations. For example, grandparents with four grandchildren can contribute the maximum to a 529 Plan for each child and move $1.2 million out of their estate. In our current climate, estate taxes are constantly being evaluated by Congress. Currently, the estate tax exemption is roughly $23.1M per couple. Depending on the upcoming election, the estate tax exemption might be lowered to $6M. 529 Plans are an effective and easy way to move money out of your estate and still have the money under your control and benefit your family.

HOW DOES A 529 PLAN WORK?

Now that we have discussed who can open a 529 Plan and the basic benefits, allow us to expand on the details. A 529 Plan is funded with after-tax dollars. In most cases, depending on your state of residency, these plans have no income or age restrictions. Each state-sponsored plan has varying maximum contribution standards, but the majority allow up to $300,000. Unlike other savings accounts, such as a custodial account, an unusual advantage of 529 Plans is that the owner of the account is always the controller. This means not only does the owner make the decision on how the money is invested and what strategy to use, they also have all the decision power when it comes to how the money is spent.

As explained above, the initial investment in a 529 Plan is made with after-tax dollars. This is a great advantage to the owner and the beneficiary. If the funds are used for “qualified education expenses,” then no federal income taxes are owed on the distributions, including the earnings from the investments. These qualified expenses include: tuition, fees, books, supplies, study equipment (computer), and room and board for a full-time student. Additionally, if the child does not go to a four-year university, these plans can be used for any vocational training program or junior college. Before the 2017 Tax Reform, a


529 Plan could only be used for college expenses. However, now these plans can be used for to pay for tuition and other expenses for grades K-12. For parents who want to send their children to private school, this is a wonderful additional feature of these plans.

CONTINGENCIES AND FLEXIBILITY

A question we often get, and what John pointed out above is: what happens if my child gets an athletic or academic scholarship and this money is not needed? The great news is that 529 Plans are highly flexible! The owner of the account can change a beneficiary at any time for no stated reason. This means that if one of your children gets a scholarship, the account can be transferred to the next child.

Let’s say you have very athletically gifted children and both of your children get full ride scholarships. The next question is: what happens to the account that has over $300,000 for both children? There are multiple ways around this situation. 529 Plans are very flexible with who the plans can be transferred to. The IRS has a list on their website explaining who these plans can be transferred to—even first cousins qualify. The owner of the plan can either keep it for the next generation of children, or they can transfer it to a distant family member.

However, just because the beneficiaries of the plan got a scholarship for their undergraduate studies, we advise our clients to not change anything on the plan for multiple years. Our reasoning is that these plans can be used for any graduate or vocational program. If the recipient of these plans decides to go to nursing school or get an MBA, then it would be a shame if the plan was surrendered too quickly and the student must take out loans for their graduate studies.

Lastly, 529 Plans can be used to pay off student debt. Keeping with this example of having a couple of the grandkids getting scholarships, let’s say that one of the four grandkids uses their entire 529 Plan balance and must take out additional student loans. Two of the other grandkids in the family received scholarships, and there are two untouched plans. The grandparents can transfer the beneficiary to the child who has student loans, and $10,000 out of each plan can


be used to pay back the loans. This is an underutilized option that most families do not take advantage of.

In some cases, there is a rare situation where there are no more educational needs, and the owners want to take the money out of the 529 Plan. Since the beneficiaries received scholarships, the owner of the 529 Plan can take out the equal amount of the scholarship from the plan with no penalty. For example, there is $150,000 in a plan, and one of the children gets a full ride to Notre Dame. The scholarship for four years at Notre Dame is going to be worth roughly $200,000. The amount in the current 529 Plan is less than the scholarship amount and the owners can take the entire amount back with no penalties.

Now for the worst-case scenario: every child gets a scholarship and there are no more educational needs in the immediate or extended family. What happens to these plans? Depending on what state you live in, the tax rules will be a little different. There, however, are some rules that are consistent through all states. The money you put in, you take out tax free. If you put $300,000 into a plan, you get that money out with no penalties and no tax. That initial investment was paid for with after tax dollars and it will not be taxed a second time. The gains, however, will be taxable as ordinary income by the federal government and in states that have a state income tax. In some cases, there can also be a 10% penalty for any gains that you take out. Again, this is the worst-case scenario, and because the plans are so flexible, it is one that we do not see often.

CONCLUSION

In conclusion, 529 Plans were created to give children the best education possible. Whether it is used as a vehicle for parents to fund a monthly amount over multiple years or for grandparents to fund the entire plan with one big check, these funds are used for the purpose of educating the next generation. The flexibility of these plans make it easy to change beneficiaries and to fit families’ needs. However, like any other tool, they are not perfect. We get to know our clients and their situations before recommending a 529 Plan or any other savings tool. Before any decision is made, we highly suggest that you talk to


your personal financial professional and decide what is best for your family.

The goal of this article was to examine and compare 409A DCPs to 529 Plans. In our mind, the one of the greatest advantages of a 529 Plan is that any person over the age of 18, who pays taxes in the United States can open one. As John mentioned above, only highly compensated individuals can participate in 409A DCPs, and only if their companies offer them. However, when it comes to most Americans, 529 Plans are not only the best and most tax-efficient way to save for college, they are the only vehicle to choose for that specific purpose. 529 Plans are an integral part of a comprehensive financial plan and, when appropriate, we use them with our clients.

For more information on 529 Plans and how they can benefit you or your family, please contact the author, Tim Drake.

COMPARISON OF A 409A DCP AND 529 SAVINGS PLAN

409A DCP 529 Savings PlanObjectives Company provided benefit to

highly compensated employees or a select group of management. Many of which may be limited in other pre-tax savings plans, such as 401(k)s or Individual Retirement Accounts (IRA).

Highly flexible in design and can meet a variety of corporate retention and motivation objectives.

An education savings used by parents, grandparents, or friends that have many tax benefits to help pay for education starting as early as primary school and ending with a PHD or even medical school.

Eligibility Most company structures may offer a 409A plan. Eligibility must be reserved for highly compensated employees or select group of management. Generally less than 10% of domestic employee count.

Anyone over the age of 18 may open a 529 Savings Plan. Others may also contribute to the plan (parents, grandparents, etc.).

Contributions Pre-tax deferral of cash compensation from salary, bonus, and other incentives.

Company contributions to make up for match limits in a 401(k) or to motivate for achievement of specific actions are also popular.

After-tax. Some states may allow for a small amount of state income tax deduction.


409A DCP 529 Savings PlanEarnings Tax-deferred growth. Tax-deferred growth.

Investment Strategy

Many investment options are available. Typically a menu looks similar to what can be found in a 401(k). Fixed rates with minimum crediting amounts may also be available.

State-specific investment options. Some offer Enrollment year investment portolios that shift the investment mix as the child approaches college age.

Fees Some companies may pass along plan cost to participants; others do not. Many even offer a company match.

Typical fund management fees.

In state v. out of state;

Account maintenance fees;

Enrollment application fees;

Management fees;

Annual account fees;

Typical fund management fees.

Usability Company you work for must offer a plan.

Must also be employeed, so not beneficial for retirees.

Annual election in advance compensation being earned.

No compensation deferral limits except as provided in plan design.

Typical design allows deferrals of up to 50% of salary and 100% of bonus/cash incentives.

Easy-to-use modern websites v. extensive paperwork

Restrictions...

Retirees/Grandparents can set up plans for grandchildren.

Early Withdrawal

Permitted only upon unforeseeable emergency or penalties may apply. However, a short term defer is allowed so an early withdrawal is only if money is needed before it is scheduled to be paid.

10% penalty if funds are not used for Qualified Education Expenses


409A DCP 529 Savings PlanDistributions Several accounts can be set up to

meet a variety of short term, mid-term or long term needs.

Typically, distributions can be paid in a lump sum or over a period of years.

Specific future date or event (like separation from service, disability or death)

Taxed as ordinary income and no restriction on how the funds are utilized; even international transportation and travel whether education oriented or not.

Distributions may be postponed into the future (minimum of 5 years out) with advanced notice of the change at least 12 months before the original scheduled payment date.

Based on the above rule, future date distributions targeted for college education can be moved into another account including college for another child, home purchase, vacation, separation from service or retirement.

Tax free if used for Qualified Education Expense—tuition and fees

Security General credit risk of Company providing the 409A DCP

Risks

Financial Aid

Investment Risks—investment returns are not guaranteed; although fixed rates may be available.

Financial Risks—Company bankruptcy and insolvency, subject to claims of general creditors.

Distribution Limitations—not portable to another savings plan.

20% penalties for violations, such as unscheduled withdrawals.

Potential beneficial effects; such as reducing current income

Investment Risks—investment returns are not guaranteed.

Use of funds is restricted to list of educational expenses.

Beneficiary is easily changed with limitations.

Can be used in conjunction with finvancial aid.


This material is intended for informational purposes only and should not be construed as legal or tax advice and is not intended to replace the advice of a qualified attorney, tax advisor or plan provider.

Investments in securities involve risks, including the possible loss of principal. When redeemed, shares may be worth more or less than their original value.

The tax and legal references attached herein are designed to provide accurate and authoritative information with regard to the subject matter covered and are provided with the understanding that Mullin Barens Sanford Financial & Insurance Services, LLC is not engaged in rendering tax or legal services. If tax or legal advice is required, you should consult your accountant or attorney. Mullin Barens Sanford Financial & Insurance Services, LLC does not replace those advisors.

Securities offered through M Holdings Securities, Inc., a registered broker dealer, member FINRA / SIPC. Mullin Barens Sanford Financial & Insurance Services, LLC is independently owned and operated. #3222366.1

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