A nonqualified deferred compensation (NQDC) plan can be a tax-efficient way to save for specific goals, particularly retirement. But like any financial tool, an NQDC plan is effective only when it is used properly.
Two of the most important decisions to be made are how to fund your NQDC plan and how to invest the money within it. You first need to determine whether to defer a portion of your salary, bonuses, or other forms of compensation. Then you need to implement an investing strategy that complements your other assets, including existing retirement accounts, and works within the unique limitations imposed by NQDC investing rules.
Making deferral elections
When you are first offered an NQDC plan, you typically have just 30 days to enroll. Depending on plan rules, you may be able to defer part of your salary, bonuses, and cash payments under long-term incentive plans or grants of restricted stock units. If your plan allows preretirement distributions, you also must specify on the enrollment form when you wish to receive the money. (We discuss options for your distribution strategy in detail in Part 3 of this series on NQDC plans.)
Adding to the pressure, you have to decide how much income to defer the year before you receive it—and you generally can’t change your mind midyear if your circumstances change. So when making a deferral election, it’s essential to first examine the following factors:
- Your income picture for the coming year: Some plans let you set up an “evergreen” deferral election that rolls over every year. Going that route might make sense if you have a very stable annual income. Alternatively, you might want to adjust your deferral elections year to year based on the ways you expect your compensation to change. For example, if you’re expecting a large bonus payout, you may want to defer the entire bonus and not defer any salary that year.
- How deferrals affect your taxes: Deferred compensation doesn’t count as taxable income until you begin to take distributions (except that FICA taxes are still immediately due on the deferred income). For some executives, deferring income may keep them out of the highest tax bracket.
- Deferral time period: Decide for how many years you want to defer income. Do you want payments to begin when you retire? In five years? In 10 years? In 20 years?
- Re-deferrals: Does your plan allow you to make future changes in your distributions? If so, what is the time frame for making changes?
- Investment buckets: Consider splitting deferred amounts for different goals, e.g., 30% for college in 10 years and 70% for retirement in 30 years.
Investing your deferred compensation
In an NQDC plan, bear in mind that the money in the plan is not really invested; rather, your employer promises—not guarantees—to pay you the compensation you defer at a later date, along with the earnings you would have received if your assets had matched the return of a particular investment or index. In actuality, you make notional investment selections, which are simply for accounting purposes.
Your plan might offer you several options for the benchmark—commonly, major stock and bond indexes, the 10-year U.S. Treasury note, the company’s stock price, or the mutual fund choices in the company 401(k) plan. Consider the following factors to ensure that your NQDC investment strategy complements your overall financial plan:
- Your financial goals and time horizon: When are you planning to receive your deferred compensation? If you have decades until you’ll draw on the money, you may opt for growth-oriented investments to increase your potential returns. If you choose preretirement distributions that will begin relatively soon, you might select less volatile investments.
- Your diversification needs: Look for opportunities to use your NQDC plan to diversify your overall portfolio, paying close attention to special investments available only through such plans. For example, your plan may offer access to non-mutual fund investment options, or a more attractive fixed-income fund than you can get through your 401(k) plan. If you take advantage of options like these, remember to adjust your other portfolio allocations accordingly.
- Your risk tolerance: Ask yourself how much investment risk you’re willing to take with your deferred compensation. You may wish to review how different investments—different asset allocations—have performed historically.
- Remember that market volatility isn’t the only risk posed by an NQDC plan: These accounts are not guaranteed or protected from creditors in the case of a company bankruptcy. So if you’re concerned about the company’s long-term health, you may want to choose relatively short deferral periods, limit the amount deferred to a small percentage of your compensation, or simply not participate.
A final note on investing deferred compensation: IRS rules limit the control employees can have over the assets, and your company is likely to have its own restrictions on changing investment elections. So while you can make changes to the investments in your NQDC plan, don’t think of it as an account to tinker with continually.
Your investment strategies, and how you plan for them, are an essential part of your decision-making process when it comes to NQDC plans—all the more reason to think carefully and strategically about your deferral and investing strategy before you enroll.