A deferred compensation plan is a retirement plan that allows employees to defer some of their compensation to a later date. Common types you may already be familiar with are 401(k) and 403(b) plans. If you are a key employee, however, your employer may offer one or more nonqualified deferred compensation plans (NQDC’s).
NQDC plans are governed by section 409A of the U.S. tax code and differ from most other employer-sponsored retirement plans. Whether or not you should participate in an NQDC requires some careful consideration. In this article, we explain nonqualified deferred compensation plans and whether one is right for you.
What are Deferred Compensation Plans?
First, it’s important to understand the differences between qualified and nonqualified deferred compensation plans. The Employee Retirement Income Security Act (ERISA) governs qualified plans. This legislation sets standards for health and retirement plans offered by employers to protect employees.
An NQDC plan is exempt from ERISA law’s strict rules, making them more flexible and customizable for employees. The primary purpose is to attract and retain highly compensated key employees and executives.
Qualified Deferred Compensation Plans
ERISA law ensures that qualified plans have minimum standards for vesting, eligibility, benefit accrual, funding, and the overall administration of plans. It also guarantees certain benefits for participants through the Pension Benefit Guaranty Corporation (PBGC).
Participants in a qualified plan are also subject to strict parameters that govern the plan. Required minimum distributions, annual contribution limits, and penalties for early withdrawal apply in most scenarios. The complex rules of qualified plans position the employer as a fiduciary on behalf of the plan participants.
The table below lists other common characteristics along with the different types of qualified plans.
The single most important trait of qualified plans is that employee and vested employer contributions are assets belonging to the participant. This is the significant distinguishing characteristic between qualified and nonqualified deferred compensation plans.
Nonqualified Deferred Compensation Plans
A nonqualified deferred compensation plan or 409A plan, allows participants to defer some of their compensation into the future. For key employees and executives, this can be a very attractive benefit. Top-heavy and non-discrimination requirements limit key employees’ participation in qualified plans.
Additionally, highly compensated employees are subject to annual contribution limits of only $19,500 in a qualified plan. The ability to defer larger amounts of compensation into a nonqualified plan is a very attractive benefit to high-income earners.
Like most endeavors involving money, these plans do not come without risk. The compensation you defer into future years is considered an asset of the employer. This means that your NQDC plan would be at substantial risk if the company you work for becomes financially unstable.
The Benefits of Nonqualified Deferred Compensation Plans
As we just mentioned, the primary reason to participate in an NQDC is to minimize tax liabilities. Reducing compensation in the current year helps keep you out of higher marginal tax brackets.
And taking distributions in retirement years when tax rates are lower is the objective with retirement planning.
A Great Tool to Retain and Attract Key Employees
Employers want to attract and retain highly skilled executive talent. A nonqualified deferred compensation plan can be a key component of an executive benefits package. Even when the company has a qualified plan in place like a 401(k), an executive’s contribution amount faces more hurdles.
The annual contribution limit for employee deferrals to a qualified deferred compensation plan is $19,500 in 2021.
There are rules in place to prevent a plan from benefiting higher-income employees over rank and file employees.
These rules limit contributions of high-income earning employees to a lesser amount.
The qualified annual contribution limit of $19,500 is less than ideal for top earners. NQDC plans don’t have contribution limits, allowing employees the option to defer a large percentage of their salary.
For example, let’s say you accept a job offer that pays a salary of $450,000. Even without any other household income, this would place you in a 32% federal marginal tax bracket.
In reviewing your benefits package, you find out that you can defer $100,000 of your salary every year. This would save you $32,000 of tax liability!
Tax-advantaged Compound Growth
There are different types of nonqualified deferred compensation plans offering various investment options (more on that later). Most plans offer stocks, bonds, and mutual funds. This can provide substantial long-term growth in addition to tax savings.
Let’s look at an example of how powerful compound tax-deferred growth is in accumulating wealth. Following our previous example, let’s assume an employee in a 32% marginal tax bracket defers $100,000 into their NQDC. The tax savings in year one would be $32,000.
Assuming the plan’s investments grow at a rate of 7% over 10 years, the $32,000 grows into $62,949! So instead of paying $32,000 to the IRS, you created nearly $100,000 of additional wealth in retirement.
Spreading Income Tax Liability into Retirement Years
Once retirement begins, household income usually decreases, which means that tax liabilities decrease as well. So it’s extremely important to have a good idea of what your income tax situation looks like upon retirement.
Coordinating distributions with other sources of retirement income is crucial for achieving tax efficiency. Deciding when to take Social Security and pension benefits should be coordinated with scheduled distributions.
The same goes for coordinating retirement dates with your spouse and accounting for Required Minimum Distributions (RMD’s). Most of us are in the highest tax brackets in our working years. So deferring taxable income to your retirement years can make a ton of sense.
The Risks of Nonqualified Deferred Compensation Plans
Funds are Assets of the Employer
Unlike ERISA plans, salary deferrals into an NQDC plan are not assets of the employee, but assets of the company. In a nutshell, your deferrals become a promissory note between you (the borrower) and your company (the lender).
Since your deferrals are assets of the company, should they become financially insolvent, your funds would be at risk. This is by far the most important consideration when choosing how much to defer into your deferred compensation NQDC plan.
There May Be Limitations of Investment Options
Aside from stock option plans, most nonqualified deferred compensation plans will have an approved list of mutual funds to choose from. This mutual fund lineup is often the same as in the company’s qualified plan like a 401k.
In the case of a stock option plan, your deferrals purchase stock in the company. This creates additional risk if your company encounters financial trouble. Even if they remain solvent, a concentrated position in the company stock could experience large declines.
Distribution Options are Limited
The year prior to deferring money into your plan, you need to decide when distributions will begin. Plans can offer a lump sum or multi-year payout options, but 5-10 years is a common election. Distributions don’t start until a triggering event occurs. There are six triggering events:
- A fixed date
- Separation from service (usually retirement)
- A change in ownership of control of the company
- An unforeseen emergency
Distributions are difficult to change once selected and require a five-year waiting period if allowed at all.
In some cases, the triggers for deferred comp distribution are beyond your control. For example, death or disability will force you (or your heirs) to take distributions.
Choosing a fixed date can be useful when anticipating future income needs as well. A good example is having a child enter college around the same time you retire. Scheduling distributions when the child begins school can alleviate pressure to draw funds from other sources.
No Loans in Nonqualified Deferred Compensation Plans
If you really needed to access money from your 401(k) plan, many plans offer loans. This is not the case with an NQDC plan. Section 409A of the U.S. tax code governs these plans, subjecting withdrawals only to the six triggering events above.
This means that you should consider deferrals into the plan to be irreversible. So making sure you don’t overcontribute to the plan is important. It’s helpful to create a budget including annual income tax liability to avoid an income shortfall at end of the year.
Is a Nonqualified Deferred Compensation Plan Right for Me?
Do I Need Another Retirement Savings Account?
The first place to maximize retirement contributions is qualified plans like 401k’s and IRA’s. But few options reduce taxes and provide tax-deferred growth like an NQDC. Also, there aren’t any other types of deferred compensation plans with unlimited contribution limits.
Thus the biggest advantage of deferred compensation plans is a tax-advantaged way to save annual income surplus.
How Financially Secure is the Company I Work For?
Again, since NQDC plans are assets of the employer, the financial strength of your employer is of paramount importance. Your company needs to be around in the long run for you to receive distributions from the plan. The longer you are away from your triggering event, the more risk you carry.
Another consideration you want to make is how much of your wealth you tie to your employer. Do you already have other types of nonqualified deferred compensation plans? Do you already own a high concentration in company stock?
Too much concentration can be dangerous, as we saw with big companies like Chrysler in 2008 and Hertz in 2020. Having a significant amount of your wealth AND income tied to your employer can be extremely risky. If you feel comfortable with a high concentration of company stock, there are ways to obtain third-party insurance.
How Will My Tax Rate Change in the Future?
Tax savings are amongst the primary benefits of a nonqualified plan. It’s important to weigh your future income needs and tax liability when electing to participate in your plan. Accounting for all your sources of income such as Social Security and RMD’s is vital upon retirement.
Remember that your contributions are invested into a portfolio with an expected rate of return. If you are ten years away from retirement, you should estimate your contributions’ value in year ten.
This is because all distributions are income taxable. You must be careful not to defer too much and create a future tax problem. It’s recommended to consult with a financial planner or tax advisor before you make your elections since they can’t be changed.
What are My Distribution Options?
We have discussed how important it is to coordinate your NQDC distributions with your other retirement income sources. The big challenge is choosing the distribution schedule at the same time as the deferral election.
Let’s go through an example of how this works. It’s September and you receive your enrollment package to make your deferral for the following year. Your salary is $300,000 and you anticipate your bonus will be $100,000 next year.
You can defer up to 50% of your salary and 100% of your bonus. You decide to defer 33% of salary and 100% of bonus to your retirement date 10 years down the road. Your distribution options are to take a lump sum or payment over 10 years.
You must decide on which distribution to take, even though it won’t start for 10 years. To make a good decision, you will need to coordinate distributions with your future income sources. This takes some serious financial planning.
The final step is to choose how your deferral will be invested. The performance of the investments you choose will determine what the final amount will be upon retirement. As you can see, there are a lot of variables to consider when making this decision.
Nonqualified deferred compensation NQDC plans are a great tool for both employers and employees. Employers have added ways to enhance benefits packages for employees. And employees have another way to save in addition to their qualified retirement plan.
Employees need to weigh the benefits, risks, and whether an NQDC fits into their financial plan. They are a great way to reduce taxes and boost tax-deferred growth for retirement. But remember that the funds in these plans belong to the employer until the employee actually receives them.
These plans are very complex and should be discussed with your financial advisor prior to participating.