Nonqualified Deferred Compensation (NQDC) Plans are an exceptionally powerful tool for highly compensated executives, offering a unique opportunity to defer a large portion of their income and the taxes associated with that income. As with any powerful tool or financial instrument, its true value is unlocked only when it is used correctly.
A Guide to Nonqualified Deferred Compensation Plans
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What is a Nonqualified Deferred Compensation Plan?
At its core, an NQDC plan is a contractual agreement between an employer and an employee, allowing the employee to defer a portion of their current income, such as salary, bonus, or stock-based compensation, to a future date. This allows the executive to delay paying taxes on that income until it is actually paid out to them, ideally at a later date when they are in a lower marginal tax bracket.
Why do companies offer Nonqualified Deferred Compensation Plans?
Employers establish NQDC plans to provide benefits to a select group of employees, without having to deal with the restrictions and rules associated with qualified plans. Employers typically offer NQDC plans for one of the following reasons:
- To increase the wage replacement ration
- Helping highly compensated employees replace a larger portion of their pre-retirement income while in retirement.
- To defer the executive's compensation
- Providing a tax-efficient way for executives to delay receiving income while in a higher marginal tax bracket.
- In lieu of a qualified plan
- As an alternative or supplement to traditional retirement plans, often used when qualifies plan contributions are maxed out
Essential Decisions: Allocation and Distribution
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Two of the most important points to consider when participating in your company's NQDC plan are your investment allocation decisions and your distribution elections.
Allocation
NQDC plans typically allow participants to select an investment allocation from a menu of options provided by the plan. Similar to choosing your investment allocation for an employer-sponsored retirement plan, you should be sure to choose an allocation based on your time horizon, risk tolerance, and financial goals.
Unlike your retirement accounts, the money in your deferred compensation plan will not remain in the account for the remainder of your life. Instead, it will be paid out after a triggering event, such as separation from service or retirement, so it is important to consider your liquidity needs when selecting your allocation. Consider if you will be relying on this money for cash flow at any point, perhaps before your pension begins to pay out or before you draw Social Security? If so, you may want to choose a more conservative allocation and take a step down the risk ladder. This may be more appropriate to ensure the account value can support your lifestyle and cash flow needs. Conversely, if your pension and Social Security income will cover your cash flow needs, you may want to consider choosing a more aggressive investment allocation.
The decision is best guided by a comprehensive financial plan. This plan gives you a clear idea of what your cash flow might look like in retirement, which in turn helps you determine how conservative or aggressive you can afford to be with your allocation within the NQDC plan. By choosing the right allocation and periodically rebalancing the portfolio, one can ensure that his or her deferred compensation is not merely a deferred paycheck, but a powerful tool for building wealth.
Distributions
NQDC plans must provide for when and how you will receive the compensation you have deferred, as well as any applicable earnings. Unlike distributions from qualified retirement plans, NQDC plans do not have age restrictions on distributions and do not have required minimum distributions (RMDs). Based upon your plan options, you may generally choose one of two ways to receive your deferred compensation: as a lump-sum payment or in installments.
Lump-sum
Choosing a lump-sum distribution gives you immediate access to all your deferred compensation upon the distributable or triggering event, which is most commonly your retirement or separation from service. Here are some of the reasons one may consider taking a lump-sum distribution option
- Immediate Access
- If you need immediate access to all of your deferred compensation funds for cash flow purposes, perhaps to make a large purchase such as a home or a vacation property.
- Limited Investment Options
- NQDC plans typically offer a pre-selected menu of investment choices, which can sometimes be limited in scope. These options often consist of mutual funds or pre-mixed portfolios managed by a third-party firm. By taking a lump-sum distribution, you gain full control over your funds and can invest them in a broader universe of options that may better align with your specific financial strategy, such as individual stocks, bonds, real estate, or other alternative investments not available within the plan.
- Idiosyncratic Risk
- Idiosyncratic risk, also known as company-specific or unsystematic risk, is the inherent risk associated with a particular company or asset. These are called "nonqualified" deferred compensation plans for a reason; they are not subject to the same rules and regulations under the Employee Retirement Income Security Act of 1974 (ERISA) that protect qualified plans like your 401(k). The NQDC assets may be subject to the creditors of your employer. If the company were to go bankrupt, your NQDC account balance could be in jeopardy. A lump-sum distribution eliminates this risk by moving the funds out of the company's control entirely.
Remember, you will owe income tax on the entire lump sum in the year of the distribution. That can result in a larger tax bill than if you were to choose the other option, installment distributions, partly because a single large payment may push you into a higher tax bracket. You will also lose the benefit of tax-deferred growth on your plan's assets when you choose to take a lump-sum.
Here is an example of a lump-sum distribution for an individual filing Married Filing Joint, and with no other income:
Installment Distributions
Installment distributions will provide equal periodic distributions over a specified period, typically on a monthly, quarterly, or annual schedule. This can be a good way to spread out the federal taxes due on your deferred income. Installment distributions may also reduce your income tax bill at the state level, assuming you plan on moving to a state that has low or no income tax. Typically, your NQDC plan payout is subject to taxes in the state in which it is accrued. However, there is an exception to this rule, which comes into play if your plan allows you to choose to receive payments for a period of 10 years or more. With this election, payments are taxed in the state of residence when paid, not in the state in which the income was earned.
Another key benefit of choosing installment payments is that the remainder of your deferred compensation can continue to grow tax-deferred within the plan. Unlike a lump-sum distribution, where you lose the benefit of tax-deferred compounding, an installment plan allows the portion of your account that hasn't been distributed yet to continue accumulating earnings, which are not taxed until they are paid out to you. This can be a powerful way to enhance your long-term wealth accumulation.
While installment distributions offer significant tax advantages, they also prolong your idiosyncratic risk exposure. By leaving your funds in the company's plan for a longer period, you remain a general, unsecured creditor to your former employer. The solvency of your company should be considered when choosing this option.
Below is another example of the tax consequences of your distribution election. This is a 15-year installment distribution for an individual filing Married Filing Joint, and with no other income. As you can see, the total tax liability is lower using the installment election:
The Importance of a Financial Plan
It is important to note that the basic tax examples above illustrate the significance of choosing the right distribution schedule and the potential tax ramifications of your election. What these examples do not show is the impact this could have on your overall financial plan. Choosing the wrong distribution schedule could cause you to draw on other retirement funds earlier than expected to cover unexpected expenses or to take distributions from other retirement savings to fund living expenses in a down market.
It is impossible to predict the future, but a plan that can accommodate a wide range of outcomes improves the probability of success for your financial plan and the odds of a successful retirement. A comprehensive financial plan helps you determine when you can afford to retire, what year that might be, what your estimated income and expenses will be, and how to best manage your deferred compensation plan within that broader context. At the end of the day, a plan gives you more cards to play and ensures you aren't "hamstrung" by an inflexible or ill-suited distribution election. A thoughtful approach to your NQDC plan's distribution schedule gives you more flexibility and improves the probability of a successful retirement. It is crucial to seek advice from a qualified financial and tax professional to model different scenarios and understand the legal and tax implications of your choices. The decisions you make today will have a lasting impact on your future financial well-being.
Frequently Asked Questions
What's the difference between a Nonqualified Deferred Compensation (NQDC) plan and a 401(k)?
A nonqualified deferred compensation plan allows high earners to defer unlimited income for future payouts, but these funds are subject to company bankruptcy risk and have limited access before distribution. In contrast, a 401(k) is an ERISA-protected, employer-sponsored plan with contribution limits and some withdrawal flexibility, and funds are protected in the event of company bankruptcy.
Should I enroll in a deferred compensation plan?
Enrolling can be a powerful wealth-building tool, particularly if you are a highly compensated employee who has already maxed out other retirement plans. The decision should be made within the context of a comprehensive financial plan that considers your goals, cash flow needs, and risk tolerance.
What happens to deferred compensation if I quit?
Your deferred compensation is paid out based on the distribution schedule you elected, typically after a "separation from service" or retirement. The timing and method of the payout are determined by the plan's rules and your prior election, which is generally irrevocable.
How to avoid taxes on deferred compensation?
You cannot avoid taxes on deferred compensation, as it is a tax-deferral tool, not a tax-avoidance tool. The income is taxed as ordinary income in the year it is paid out to you. However, you can use a strategic distribution schedule to manage when you pay the taxes, potentially lowering your overall tax liability.
What is the tax rate on deferred compensation?
Deferred compensation is taxed as regular income at your ordinary income tax rate. The specific rate depends on your total taxable income in the year you receive the payout, which is why a thoughtful distribution schedule can be so important.
What deferred comp distribution choice is best?
There is no single "best" choice. The ideal distribution method (lump-sum or installments) depends entirely on your personal financial plan, liquidity needs, tax situation, and risk tolerance. A comprehensive financial plan is key to making the right decision for your unique situation.