Are You Taking Full Advantage of Your Company Benefit Plan? Fundamentals of Investing

One of Left Brain's specialties is working with corporate executives. What are some of the deferred compensation and retirement account opportunities available to these executives, and how can you take advantage? We answer this question and much more in this week's Fundamentals of Investing. I'm Brian Dress, Director of Research and an investment advisor here at Left Brain, joined as always by our CEO and Chief Investment Officer, Nolan Langford. Noland's been a specialist in working with corporate executives over the years, and so we wanted to bring him in to get his thoughts on this important topic. Noland.

Hey, Brian. Glad to be here talking about this important topic with very important people.

Exactly. The VIPs are here watching. So we want to give some great information around deferred compensation and other non-stock compensation in your compensation packages. Quick preview for you. In today's video, we're going to cover wealth-building strategies often available to corporate executives beyond just direct stock compensation. The number one is deferred compensation. Number two is after-tax contribution to your retirement plan. And number three is what's called net unrealized appreciation or NUA. If you want to know more about equity compensation, we do also have a video for that and you can access that by clicking the link on the screen right here or right here. I'm not sure where it's going to be, but somewhere over here. With that being said, a quick intro. Nolan, can you discuss how important it is for corporate executives to take advantage of all aspects of their employee benefit package.

Yeah, sure, Brian. That's a great lead-in. You know, there's many forms of comp that executives get when they're recruited or when they sign on to these corporations. And the cash component is just one. Most people think in terms of, you know, I get my cash and then I get a target bonus if I hit plan. But then there's all these other little cookie jars that corp— that corporate executives could avail themselves of. And that's what we're going to talk about now. But if done right, these things can be very, very lucrative, particularly if you optimize your participation and if you're working for a company with a stock that's a winner.

Tons of information around employee benefit packages. Nolan, we're going to jump right into topic 1. So topic 1 is deferred compensation. Nolan, should people participate in deferred compensation? What is it and how much should they participate?

Yeah, so this is a very nuanced question. I think the answer is going to be different for every executive, so we're happy to talk you through it. But in general, a deferred comp plan is a plan that the company offers that allows high-paid executives to put money away pre-tax through their paycheck and to save money for the future.

Okay. And then talk about some of the criteria or decision-making that goes around with should people participate in these plans. With the company with which they work?

So I think a lot of times, or it used to be that these plans were referred to as 401(k) overlay plans. You know, typically I think how they originally came into being or a big use case, you know, you have Executive One, that executive earns $500,000 a year. You know, the 401(k) they'll be participating in, but they may be cut off from contributing the maximum amount. You know, it could be because of the testing, the highly comp versus non-highly comp discretionary testing. So, you know, it may be, for example, a $20,000 401(k) limit. They may only, only be eligible for 10, or if the 401(k) limit is $20,000 as an example, and they'd like to put in 50, there's no way that they can do it in a 401(k). So there's this deferred comp plan that is similar to a 401(k) in that you take the money out of your paycheck and it goes in pretax, which means I'm not taxed on the money today. The money grows deferred and then it comes out and I pay taxes at some point in the future. So that's typically the use case. Executives want to put away more money on a pretaxed basis and a deferred comp plan is a way for them to do so.

Okay. And then that sort of Sparks my thought about liquidity. Again, liquidity is obviously important in almost any investment that you have. What, what usually— how does liquidity usually work on these deferred comp plans?

So I would say they're not very liquid. They're a little bit more liquid than the 401(k) because for most people you can get the money out sooner. But for any executive that's thinking about participating in a deferred comp plan, this should be money that you don't want to touch for many, many years. So when you go into the plan, HR will ask you at the day that you enroll what day you want your money back. And the minimum time that Congress has set the IRS for these plans is 5 years. So the minimum time you're going to be away from your money is 5 years.

One very high-profile use of deferred comp, Nolan. Shohei Ohtani with the Los Angeles Dodgers. $700 million contract, but he's only getting paid $20 million in the next 10 years. So it's all getting paid in the back end after 10 years. So that's deferred compensation in a high-profile example, not necessarily in a corporate setting, but interesting. And for our viewers who know a little bit about baseball, Bobby Bonilla has been getting paid $1 million every year for the last 30. So just some high-profile examples of deferred comp.

Yeah, nice cash if you can get it.

Nolan, we were talking about deferred comp yesterday and you were talking about a case study, which was you had a client who was looking to pay for college for, for his kids and used deferred comp as kind of the vehicle for that. You want to talk a little bit about how that played out?

Yes. So we've used these before. I have a client. His son was in college. He was funding a 529, but he wasn't sure if the 529, the money was in there was going to be enough. Or if his son was going to go to grad school, he knew the $529,000 would not be enough. So what we ended up doing is we did an annual enrollment into the deferred comp plan, and then each year he enrolled, we staggered the date he was going to get his money back to line up with the, the college years for his son. So in those years where his college— his son needed the money for college tuition, we had a distribution coming, he could pay it, and if the son didn't need the distribution, he could use it for other purposes.

Okay. Just, it's good to get kind of a real-world example of how we put these things into practice. One last thing I wanted to talk about deferred compensation, and there are a couple of drawbacks with this. Aside from, obviously we mentioned it's not the most liquid investment. What are some other drawbacks that may occur with deferred comp?

There is a creditor risk. So deferred comp, the company's going to offer it. But this goes on the corporation balance sheet as a liability. So if something happens with the corporation where they don't make it or they find themselves in financial straits, the people that participated in the deferred comp become unsecured creditors. So you really want to be careful. You want to make sure that you do this with a well-established big company that you're comfortable is going to survive at least as long as your money is going to be in the plan.

Again, a great point, Nolan, and why you need to probably speak with somebody that has some expertise in the investment realm, because, you know, if you have a company that's potentially on the brink of not doing so well, you may not want to be so invested in a deferred compensation plan. So I would suspect you'd want to speak with someone that has at least an opinion on the company with which you work so that you can make a decision or maybe avoid this if it's you know, more of a risky decision or a risky proposition from your perspective. So, definitely want to look for help from, for professional help in this area. With that said, let's move on to topic 2. Topic 2 is after-tax contributions to retirement plans. So, a little bit different here, Nolan. Tell us what this is referring to in terms of after-tax contributions to retirement plans.

This one you don't run across very often, but it could potentially be very lucrative and helpful for people who participate. So in a 401(k) plan, there's going to be a maximum amount that you can contribute to a 401(k) plan. And a lot of plans will allow you to put in— if you put in above what they'll allow, they'll put it into a separate sidecar we call after-tax contributions. And a lot of companies will just flat out allow after-tax contributions. I won't say a lot, but some. I work with clients who have, and I've seen these. Imagine a client is putting in $5,000 a year on an after-tax basis. It goes into the plan, but it's in a segregated account on the 401(k) statement in an after-tax bucket. So that money's invested. The employee directs how it's invested. It's usually invested the same way they invest the 401(k) funds. But when the employee leaves, instead of having to roll over that money and put it into another restricted IRA account, that money can be withdrawn or it can be moved to a Roth IRA, which can be very tax advantageous. Roth IRA contributions are limited to $7,000 a year, but particularly you can have somebody with hundreds of thousands in an after-tax account in one of these 401(k) plans, and I can set them up nicely for moving that money into a tax-free Roth.

So, Nolan, the strategy you're referring to Now, what's interesting is sometimes accidentally people put more money into this after-tax bucket than they intended to because maybe they are putting in, say, 20% of their check and then they get a huge bonus check at the end of the year and it all goes into this bucket, which is maybe kind of a happy accident because they have money now that's unencumbered and that they can potentially get into a Roth vehicle. Let's talk about that, Nolan. You know, Roth, why it's important to try to get more money into Roth. And then this is what we call the mega backdoor Roth strategy. So can you mention that this mega backdoor Roth, this is a really powerful strategy for corporate executives that are on the higher end of the pay scale.

So I think given a choice, if we could have in door number A, $1 million in a normal IRA or a 401(k), or behind door number B, $1 million in a Roth IRA that's tax-free. I think just about everybody would choose door number B, the million dollars in the tax-free plan. The problem is we're gated and restricted from putting a lot of money in a Roth. If you're over that contribution limit, I think it's like 100— and I have to look up the numbers— $162,000 or something, then you're restricted from actually putting in an annual contribution into a Roth IRA. So it's really tough to get money into a Roth IRA. However, if you're a participant in one of these plans like Brian is mentioning and they're taking money out of my paycheck to put into the plan, then you won't have that $7,000 restriction. That number is much higher as far as the amount that you could put in there. And if you look at multiple years, if you're putting in $10,000 or $15,000 into one of these 401(k) or these after-tax accounts, then you could be looking at six figures particularly potentially that could go into a Roth when you leave the company. And what Brian's talking about, a backdoor Roth, that's typically where a high earner— you can earn $1,000,000 a year and still put $7,000 into a normal IRA. It would be nontaxable. And because it's nontaxable, you then could convert that $7,000 the next day to a Roth. It's what we call a backdoor Roth. The only limit is that $7,000 per year. So it's a nice strategy. I just can't get a lot of money in it all at once. However, if I'm contributing through my paycheck, through my payroll and the after-tax bucket of the retirement account, I could potentially get a lot more than $7,000 per year into one of these tax-free Roth accounts.

And no one will put on the screen the exact number of what the additional amount you can get into a Roth this through this mega backdoor Roth, but it is in excess of about $50,000 per year. So, as you can understand, do that for 10 years, you could have $500,000 to $1 million in a Roth in a way that you wouldn't be able to do without this strategy. So, these are the types of things, you know, just small little changes that you can make in the strategy that you're using for your employee benefit package that can really benefit you greatly in the long run. That's, that's the after-tax contribution in retirement plans. Let's go to topic 3. So topic 3, this is one of Nolan's favorites, net unrealized appreciation, NUA. I'm going to throw it out to you, Nolan. What's NUA? What's net unrealized appreciation?

Yeah, net unrealized appreciation is a strategy that clients can use if they own publicly traded stock in their 401(k), and when they distribute that stock, they could get a favorable tax rate for owning company stock inside the plan.

And tell us how an executive can set themselves up properly to take, take advantage of NUA.

Yeah. So there's a couple of assumptions. One of them is not only that I work for a company with a publicly traded stock, but that it goes up over time. So let's use an example. Let's say Jane Doe works for Company A. And she contributes every payroll period to company stock in her plan. And let's say she does that for 10 years. Let's say at the end of 10 years, the amount that she owns in company stock is $100,000. But because she's been buying it and dollar-cost averaging in over the last 10 years, her average cost might only be $50,000. The market value of my stock is $100,000, but my cost basis is only $50,000. The difference, the $50,000, is what we call net unrealized appreciation. And that's the beginning of the tax strategy, the difference between what I paid for a stock and its current market value.

So let's talk about a little bit of the nuts and bolts here. What are the considerations around making the decision of whether to use NUA and that unrealized appreciation to build wealth? Because you got to have some foresight here, Nolan. You need some time to, to develop that appreciation so that you can put the strategy into place.

Yeah. So for this one, it's a little bit more complex than the other strategies that we've talked about, but potentially could be a lot more lucrative. I would encourage anybody thinking about this strategy, reach out to your advisor. Not a lot of people are familiar with it. We're here to help us as a resource. But there's a few considerations. And you're right, Brian. Brian, in regards to the planning of this, there's a couple of caveats. So let's just get to the why it's lucrative and why somebody would want to do it. In my example, I say we paid $50,000 for the stock. The stock's now worth $100,000. Well, if I am 55 or older and I leave the company, I don't have to roll my company stock over. The rest of the money in that retirement plan, I'm going to roll over to another deferred account, probably an IRA, and keep my deferral going until I start to take taxable withdrawals. But this separate bucket of money, this $100,000 in stock, I can actually just withdraw it. I don't have to move it to another deferred retirement account with restrictions. I can move it to my bank account or my brokerage account. And when I move it, the $50,000 is my cost basis. I have to pay taxes on the lower of market value or my cost basis. So in this example, I get to pull out $50,000 in stock. I'm sorry, I get to pull out $100,000 in stock, but I only have to pay taxes or ordinary income taxes on $50,000. There's a really big tax break there. The difference between the 50 and 100, the additional 50, I'm going to get capital gains tax on and not ordinary income tax. So if you're a high earner and you're in a high tax bracket, let's imagine you're in the 35% tax bracket, but your capital gain rate is 15%, then that can be a huge savings when you take a look at that transaction.

Right. And then you sort of juxtapose that against whether if you just left the money in a deferred vehicle, right, Nolan? If you're high net worth, even when you're in retirement, you're likely to be at a high tax bracket. So the strategy that you're describing is likely to generate quite a large tax savings relative to whether if you just left it in that tax-deferred vehicle. So this is kind of why we like NUA. Anything else you want to mention about net unrealized appreciation?

I would. Liquidity. So a lot of executives, they don't dream of working to age 65 or 62. So if you're one of these executives that, you know, the company comes by and offers you this early retirement program, interestingly, always seem to offer them between the age of like 50 and 58. That's kind of the sweet spot. You may be on the fence of whether you want to go back to work for another corporation or just retire a few years early. When I move that money, that net unrealized appreciation, to my brokerage account, it's now liquid. And what that means is if I have enough money there in that bucket, that could fund that gap between the day I retire and when I start getting Social Security. So it could really be a lifestyle changer as well.

Right. And not only that, Nolan, if we're talking about, say, someone who's 55, can't really touch the retirement money until 59 and a half as well. So, there's another consideration there as well. We'll close it there. We're going to ask you to like and share the video with your colleagues if you did find it useful, because as we've said before, there are a lot of executives out there with these wonderful benefit plans, but not necessarily all the expertise that they need to fully optimize those plans. So, we'd love it if you would share it with your colleagues. That way they can find it, and it's going to help them as well as it helps you. Also subscribe and hit the bell for notifications. That way you find out every time we're out with these types of videos and we're out every couple of weeks with these. And finally, we'll close it this way by saying it is difficult to find information on these benefit plans. Your human resources department is in charge of these plans. They're not in the business of giving advice on these plans. They can give you basic information. So if you need to find out more, try to develop a strategy on how to take full advantage of your employee benefit plan. Please do contact a professional. And this is something that we at Left Brain specialize in. So we'd love to be a resource for you if you're looking to find your best strategy for taking advantage of your employee benefit plans. With that being said, thank you for being with us. Thank you, Nolan. And we'll see you again on the next Fundamentals of Investing.