Do you max out your 401(k) or 403(b) (along with other options including HSAs and IRAs) but still want to save more for retirement or other goals? If your employer offers a nonqualified deferred compensation (NQDC) plan, you might want to explore this option. NQDC plans (sometimes known as deferred compensation programs, or DCPs, or elective deferral programs, or EDPs) allow executives to defer a much larger portion of their compensation and to defer taxes on the money until the deferral is paid.
Deferred comp and you
Explore our 3-part series on making the most of nonqualified deferred compensation plans.
That said, NQDC plans aren't for everyone. Before you enroll, it's important to understand exactly how such plans work and how one might fit into your overall financial plan. NQDC plans have the potential for tax-deferred growth, but they also come with substantial risks, including the risk of complete loss of the assets in your NQDC plan. We strongly recommend that executives review their NQDC opportunity with their tax and financial advisors.
2017 tax law changes
The Tax Cut and Job Act of December 2017 (the Act) established new income tax rates, corporate tax rates, and modifications to many deductions. It also impacted nonqualified plans in several ways. The Act included a new deferral provision for certain types of broad-based employee equity, which may apply to certain private companies.
The Act also expanded the group of covered employees that are subject to the $1 million cap on deductible compensation to include the CFO as well as the CEO, and repealed the exception from this rule for performance-based compensation. Lastly, the Act grandfathered compensation vested prior to 2017 under existing contracts.
NQDC plans vs. 401(k)s
NQDC plans aren't like other workplace savings vehicles, which typically let employees defer a portion of their salary into a segregated account held in trust, and then invest these funds in a selection of investment options. Often used by employers as an attraction and retention vehicle, an NQDC plan is more like an agreement between you and your employer to defer a portion of your annual income until a specific date in the future. Depending on the plan, that date could be in 5 years, 10 years, or in retirement.
You can decide how much to defer each year from your salary, bonuses, or other forms of compensation. Deferring this income provides one tax advantage: You don't pay federal income tax on that portion of your compensation in the year you defer it (you pay only Social Security and Medicare taxes), so it has the potential to grow tax-deferred until you receive it.
Most companies provide NQDC plans as an executive retirement benefit, because 401(k) plans often are inadequate for high earners. For example, consider Susan. She's a tech executive earning $500,000 a year. For 2019, the $25,000 limit on annual 401(k) contributions (including catch-up contributions) represents only 5% of her annual income. At that rate, she could not easily save enough (pretax) to make up the typical 70%–90% replacement income goal for retirement. By contrast, Susan could choose to set aside a much larger percentage of her salary into an NQDC plan each year, creating an appropriate retirement cushion. Of course, many executives, like Susan, have after-tax savings opportunities as well, such as a taxable account, after-tax IRA, a Roth conversion and/or after-tax contribution option, and/or a tax-deferred annuity.
But there are downsides to NQDC plans. For example, unlike 401(k) plans, you can't take loans from NQDC plans, and you can't roll the money over into an IRA or other retirement account when the compensation is paid to you (see the graphic below).
Unlike a qualified plan, where benefits are segregated from the employer's general assets, your deferred compensation deferred into the NQDC remains in the employer's general assets and is subject to potential loss. The plan essentially represents a promise by the company to pay you back. At most, the company may set aside money in a trust (sometimes called a Rabbi trust) to pay future benefits when they become payable. The funds in this trust are still part of the company's general assets and would be subject to creditors' claims in a corporate bankruptcy.
NQDC plans aren't just for retirement savings. Many plans allow you to schedule distributions during the course of your career, not just when you retire, so you can defer compensation to cover shorter-term goals like paying a child's college tuition. You also can change your deferral amount from year to year.
Participating in an NQDC plan: key considerations
To get the most benefit out of an NQDC plan, you must give careful thought to your deferral strategy, investment options, and distribution plan. Read Viewpoints on Fidelity.com: Non-qualified distribution investing and Distribution strategies delve into how to approach those decisions. But before you tackle these issues, you must first decide whether to participate in your company's NQDC plan at all.
Here are 6 important questions to ask yourself when deciding whether an NQDC plan is right for you:
Giving thought to the preceding questions and working with your tax and financial advisors may help you decide whether an NQDC plan is a good fit for your financial needs.
At a glance: the differences between 401(k) and NQDC plans