A nonqualified deferred compensation plan (NQDC) allows executives to defer income until a later date, therefore avoiding paying income tax until the money is paid out. While the cash is in "deferral mode," you can select from a plan-specific menu of investment choices to capitalize on tax-deferred growth. Sounds a lot like a 401(k) so far - but here's where they diverge.
A deferred compensation plan is much more restrictive than a 401(k) plan. There are specific rules about the timing and nature of your future withdrawals, and most significantly, the funds are not secured from your or your company's creditors in bankruptcy. If you're wondering if you should participate in a deferred compensation plan, consider whether the risks are worth the potential rewards.
Why use a nonqualified deferred compensation plan?
At a very high level, NQDC plans combine certain key benefits of a 401(k) plan and a Roth IRA: participants are able to reduce taxable income in the current year, enjoy the compounding effects of tax-deferred growth, and may be able to bypass required minimum distributions at age 70 1/2 by agreeing to the distribution schedule set forth in the plan description.
Essentially, in order for participation in a deferred compensation plan to make sense financially, employees should expect to be in a lower tax bracket in the future than they are today, which combined with the additional years of tax-deferred growth, may make this reward seem worth the risk associated with locking up the funds with their employer.
How deferred compensation plans work
Nonqualified deferred compensation plans are often offered to high-earning employees and executives, as a way to defer additional income on a pre-tax basis. Since 401(k) plans limit your annual contributions, NQDC plans can help supplement savings, as there is no annual contribution limit.
When you choose to participate in a deferred compensation plan, the portion of your compensation that you've elected to defer will be made available to you at a future date, as specified in the plan documents. Sometimes the plan may allow deferral for short periods of time, perhaps a few years, while others may stipulate that funds will be locked up until retirement.
Further, once you're eligible to withdraw the funds, the plan provisions may include specific language about when and how you may take distributions. Some plans don't allow distributions or rollovers if you change jobs, which is why these plans are sometimes referred to as "golden handcuffs." Others may force you out over a period of years once you terminate, with taxes due on the distributions.
The rules governing nonqualified deferred compensation plans are very plan-specific, so be sure to read your plan description entirely before deciding whether to participate or not. NQDC plans can be very restrictive, severely limiting your ability to access your money once the irrevocable election is made.
Key facts about deferred compensation plans
- What if you want to access the money early? Generally, deferred compensation plans don't allow flexibility in this regard, as you made an irrevocable election when signing up to participate in the plan. Unlike a 401(k) plan, you cannot take a loan. Depending on the type of institution you worked for, you may or may not be able to request a rollover to another tax-deferred account. In some plans, job separation may trigger a disbursement.
- Is there an annual limit on how much you can contribute? There is no IRC limit on annual additions to a NQDC plan, but there may be limits at the plan level.
- What are the investment options? The investment choices will be plan-specific. NQDC plans may offer the same fund lineup as the company 401(k) plan or another menu. This is another restriction of deferred compensation plans, as you are limited to the choices offered through the plan which could be mostly actively managed mutual funds with few low-cost options.
- Is my deferred pay secure? In short: no. NQDC plans allow for deferred taxation as long as the money is considered at a "substantial risk of forfeiture." Deferred compensation is not protected from creditors in the event your employer files for bankruptcy. The funds are also not protected in the event the employee files for bankruptcy.
- Do deferred compensation plans have required minimum distributions (RMDs)? There are no IRC rules about distributions at age 70 1/2, but plan rules are possible.
- Can you take the money with you if you change jobs? Maybe. It will depend on a number of factors, such as whether your plan allows distributions upon separation of service, how long it's been since your last contribution, the reason for your job transition (layoffs, merger or acquisition, disability, reduction of hours, termination, and so on), as well as the financial health of the company. Review the plan documents to see if deferred compensation assets may be paid out if you voluntarily leave the company. NQDC plans can become very complex in certain situations, many of which may be out of your control.
- What if my employer files for bankruptcy? In the event of bankruptcy, there is a very real chance that some or all of your deferred compensation will be lost. Even if you manage to leave the company with your cash before it files for bankruptcy, in certain circumstances, the court can claw back these funds if you had prior knowledge that your employer was no longer a going concern. Each situation will be unique to the facts and circumstances of that particular case - consulting an attorney is highly recommended in this situation.
- What can happen if the company is acquired by another firm? There are a number of different possible outcomes in this situation. Unfortunately, although the question may be simple, the underlying rules are very detailed and outside the scope of this article. At a high level, depending on the nature of the transaction (IPO, stock sale, asset sale, or change in control) and whether the employee continues employment, the NQDC may be continued, accelerated and paid, or terminated. If the plan is terminated, the employee will likely receive the entire amount of their deferred compensation in a lump sum, triggering a massive unforeseen taxable event.
What are the pros and cons of nonqualified deferred compensation plans?
Although there a number of risks associated with NQDC plans, in certain situations they may present planning opportunities. Keep in mind, there are many elements in the analysis that are not controllable by any one individual, so there will always be an added risk in making an irrevocable election to defer a portion of your pay.
- Deferred compensation plans can provide forced savings. Saving can be a challenge at any income. For highly paid workers who frequently engage in "lifestyle inflation" as their income increases, a NQDC plan can help them keep spending under control.
- Planning opportunity: as an alternative to a NQDC plan, try automating your savings each month. Set up a bank or brokerage account at a financial institution you don't regularly use, and schedule automatic transfers to match your pay periods. This simple strategy is highly effective - even some pro athletes with multi-million dollar deals save this way.
- Gaining extra tax-deferred growth through a NQDC. Deferred compensation plans are popular among highly paid executives because relative to their income, the maximum annual contribution to a 401(k) qualified retirement plan ($19,500 in 2020, if under age 50), is quite low. It will be nearly impossible to maintain the same lifestyle in retirement without saving aggressively outside of your 401(k). Through the benefits of compounding, investing with pre-tax dollars can produce greater returns than after-tax over time. Assuming you fall into a lower tax bracket in retirement, using a NQDC plan can look very attractive.
- Consider the trade-offs: there's no doubting the benefits of tax-deferred growth; however, don't discount the value of liquidity and flexibility. By paying taxes on your income today, and investing the rest in a brokerage account, you can benefit from exposure to the market as well as flexibility in case you have unexpected cash needs.
- Plans to retire in a "tax friendly" state. If you're currently working in a high-tax state but planning to retire in a state with lower income taxes, a nonqualified deferred compensation plan may provide an added benefit. Focus on what you can control: there's no way to tell what the tax code may be in the future.
- The federal Tax Cuts and Jobs Act just provided individuals with sweeping tax cuts until 2025. Executives who elected to participate in a deferred compensation plan may be frustrated if they're missing out on realizing this income while the tax rates are lower. Tax savings should be a component of the decision to participate in a NQDC plan, but not the main driver.
- Avoid required minimum distributions. At age 70 1/2, investors with money in tax-deferred accounts like a 401(k) or a traditional IRA must begin required minimum distributions (RMDs). Since withdrawals will be taxed as ordinary income, RMDs can push individuals with large portfolios into higher tax brackets. If a NQDC plan does not require distributions at age 70 1/2, this could be a way to continue tax-deferred growth or provide supplemental income before RMDs begin.
- Treat the cause not the symptom: keep in mind that funds from a nonqualified deferred compensation plan will also be taxed as ordinary income when withdrawn. Since RMDs will never stop once they've started, the overlap will likely have a negative impact on your tax situation. Instead, consider using different types of accounts to gain tax diversification. A brokerage account has no RMD requirement, and although you'll pay tax each year at more favorable capital gains rates, assets left to your heirs will receive a "stepped up" cost basis - making it a very tax-friendly way to leave a legacy. Also, by drawing from both tax-deferred and taxable assets in retirement, it can help provide flexibility to manage your tax situation in retirement and even harvest losses to offset gains.
Diversification plays a big role in a successful strategy
Whether or not a nonqualified deferred compensation plan makes sense for your individual situation will depend on many factors. One of those key determinants is how diversified your assets are in general, and how much financial exposure you have to your employer. In general, no more than 10% of your net worth should be concentrated in one thing, whether it is your home, an asset class or stock, or ownership interests in a business.
Executives may unknowingly hold a great deal of financial risk by being over-exposed to their employer. Aside from the salary, benefits, and other perks provided by the company, employees are also exposed through stock options and equity compensation, having company stock in their 401(k), and participating in an employee stock purchase plan.
Depending on your situation, choosing to lock up a portion of your cash compensation for an "unguaranteed" payment later can represent a significant additional risk. Rather than prioritize tax savings, consider the opportunity to diversify in a low-cost tax-efficient investment strategy, with achieving your personal goals as the central priority.