Have you maxed out on your 401(k) or 403(b) workplace savings plan, but still want to save more for retirement or other goals? If your employer offers a nonqualified deferred compensation (NQDC) plan, it may be an option to explore. NQDC plans allow executives to defer a much larger portion of their compensation, and to defer taxes on the money until the deferral is paid.
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 executives review their NQDC opportunity with their financial adviser.
NQDC plans vs. 401(k)s
NQDC plans aren’t like other workplace savings vehicles, which typically let employees defer a portion of their salaries into a segregated account held in trust, and then invest these funds in a selection of investment options. 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 five 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 that income provides two tax advantages: You don’t pay income tax on that portion of your compensation in the year you defer it (you pay only Social Security and Medicare taxes), and you can invest that money, 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. Take an executive earning $500,000 a year: The $17,000 limit on annual 401(k) contributions represents only 3.4% of his or her annual income. At that rate, the executive could never save enough to make up the typical 70%–90% replacement income goal for retirement. By contrast, the exec could choose to set aside a much larger percentage of his or her salary into an NQDC plan each year, creating an appropriate retirement cushion.
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).
The biggest difference involves the way the plans are funded. To comply with tax law, an NQDC plan must be “informally funded”—meaning the company sets aside no money for the employee, and the employee “owns” no account. Rather, the plan essentially represents a promise by the company to pay you back. At most, the company may set aside money in a trust (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, meaning they 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. Viewpoints: Non-qualified distribution investing and Distribution strategies delves 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 six important questions to ask yourself when deciding whether an NQDC plan is right for you:
- Have you maxed out contributions to traditional retirement plans? You should make the maximum contribution to a 401(k) or 403(b) plan each year before enrolling in an NQDC plan. IRS Section 401(k) and 403(b) plans are funded directly and are protected under the Employee Retirement Income Security Act, while an NQDC plan is not.
- Will your tax rate change in the future and can you afford to defer compensation? You don’t pay income taxes on deferred compensation until you receive those funds. Participation is more appealing if you expect to be in a lower tax bracket when you retire (or whenever you plan to receive a distribution from the plan). Look closely at your cash flow needs and upcoming expenses to estimate whether you can afford to forgo income you expect in the coming years. After you’ve selected a deferral amount (it must be a year ahead), the decision is irrevocable.
- Is the company financially secure or are the funds secured in some other way? You need to feel confident that your employer will be able to honor this commitment down the line.
- Does the plan allow a flexible distribution schedule? Some plans require you to defer compensation until a specified date, which could be after retirement. Other plans allow for earlier distributions. Depending on your personal situation and income needs, greater flexibility with distribution elections can be a significant advantage.
- What investment choices does the plan offer? Some plans promise a fixed rate of return on deferred compensation, but that practice is rare. Instead, most companies base the growth of deferred compensation on the returns of specific notional investments. For example, some NQDC plans offer the same investment choices as those in the company 401(k) plan. Others allow you to follow major stock and bond indexes. The more investment choices available to you, the easier it is to fit an NQDC plan into your diversified investment strategy.
- Is NQDC plan participation appropriate for you? Can you afford to lose the money? Do you have substantial wealth outside the NQDC plan? Do you understand the risks? If the answer to all these questions is yes, then NQDC plan participation may potentially be appropriate for you.
Giving thought to the preceding questions 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
|Yearly limit on amount participant can defer from income||Yes, Internal Revenue Code limits apply||No IRC limits, but plan limits are possible|
|Must start taking out money at age 70½||Yes, by IRC mandate, unless still working at company where the 401(k) plan is, subject to 5% owner rule||No IRC requirements, but plan rules possible|
|Can receive distributions of any amount and at any time for financial hardship, and, from age 59½ on, without a penalty tax||Yes, whether employed or not||No, but job separation and other events can trigger distributions before that age|
|Ability to take early withdrawal at any time, paying taxes and a penalty on the withdrawal amount||Yes, but only upon separation from service; a 10% additional tax may apply if under age 59½. Plan may permit in-service withdrawals without penalty after age 59½||No, with the possible exception of amounts deferred and vested before 2005|
|Funds protected from creditors in bankruptcy||Yes||No|
|Must get distribution upon job loss||No. If balance is under $5,000, the plan sponsor may cash out the balance but is not required to do so. Also, participants may keep balances in plan well after normal retirement age||No. Sometimes a job loss will trigger a lump-sum distribution, but this is not a general rule.|
|Upon job loss, the participant can roll money over to an IRA or transfer to a new employer's qualified plan||If the termination is a distributable event under the terms of the plan||No|
|Flexibility in when and how the participant can withdraw money in retirement||Usually, but not required||Limited by upfront elections, plan provisions, and redeferral rules|
|The participant can take loans from the plan||Yes, if plan allows||No|
|Tax deduction for the participant's company||At time of deferral||At time of distribution or when the participant recognizes it as taxable income|