Do you max out your 401(k) (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.
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.
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," says Shailendra Kumar, director of Fidelity Financial Solutions. "Deferring this income provides one tax advantage: You don't pay federal or state 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 $540,000 a year. For 2022, the $27,000 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 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.
Important questions to ask
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 7 important questions to ask yourself when deciding whether an NQDC plan is right for you:
- Do I annually maximize my contributions to traditional retirement plans and other savings options?You should be making the maximum contribution to a 401(k) plan and HSA (if applicable) each year before you consider enrolling in an NQDC plan. IRS Section 401(k) plans are funded directly and are protected under the Employee Retirement Income Security Act, while an NQDC plan is not.
- Will my tax rate change in the future, and can I 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 1 year ahead), the decision is irrevocable.
- Is the company financially secure? 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 employers may force payments as a lump-sum distribution per plan rules, while others require you to defer compensation until a specified date, which could be during 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 or variable rate of return on deferred compensation, but that practice is less common. 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 a NQDC plan into your diversified investment strategy.
- Is NQDC plan participation appropriate for me? 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.
- Are you comfortable with not having access to this money for a number of years? NQDC money is generally not accessible until the distribution date or an other allowable event such as termination. Unlike a 401(k) plan, NQDC generally does not allow early distributions and/or loans.
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.
"The decision regarding whether to defer compensation with a NQDC plan is complex," says Shailendra Kumar, "and the potential for increased net income must be weighed against the inherent risks in a NQDC plan."
401(k) and NQDC plans: What's the difference?
|Yearly limit on amount participant can defer from income
|Yes, Internal Revenue Code (IRC) limits apply
|No IRC limits, but plan limits are possible
|Must start taking out money at age 72*
|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 are 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, but based upon plan rules
|No, but job separation and other events can trigger distributions before that age. In some cases, it may be possible to take an Unforeseeable Emergency withdrawal if the plan allows for it
|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
|Not generally. However, some plans allow you to choose a withdrawal upon a stated date or age. You would have to elect this option in advance or when the election is made to defer the compensation and the distribution would be subject to income tax.
|Funds protected from creditors in bankruptcy
|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
|Not generally. Most plans provide a distribution that begins upon separation from service. 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
|Flexibility in when and how the participant can withdraw money in retirement
|Usually, but not required
|Limited by up-front elections, plan provisions, and redeferral rules
|The participant can take loans from the plan
|Yes, if plan allows
|Tax deduction for the participant's company
|At time of deferral
|At time of distribution or when the participant recognizes it as taxable income