When you sign up for a nonqualified deferred compensation (NQDC) plan you agree to set aside a portion of your annual income until retirement or another future date. But not enough people spend sufficient time on when and how to receive that money and how it affects their taxes.
That job can be confusing. Developing a distribution strategy involves assessing potential cash flow needs and tax liabilities many years—or even decades—into the future. And you need a clear picture of the role deferred compensation will play in achieving a comfortable retirement or other financial goals. So before you enroll in an NQDC plan, consider these factors to help you make the most of your distributions—whenever you decide to take them.
Planning retirement distributions
NQDC plans must provide for when and how you will receive the compensation you have deferred, as well as any applicable earnings. Still, distribution rules for deferred compensation are considerably different from those governing distributions from other retirement plans, such as 401(k)s or IRAs.
For example, the Internal Revenue Code (IRC) allows for 401(k) withdrawals to begin penalty-free after age 59½—but the IRC also requires that you start taking distributions at age 70½.1 By contrast, there are no IRC age restrictions on distributions from a deferred compensation plan.
Deferred compensation plans don’t have required minimum distributions, either. Instead, you choose one of two ways to receive your deferred compensation: as a lump-sum payment or in installments. Here are the pros and cons of each:
- Lump-sum distributions: Choosing a lump-sum distribution gives you immediate access to all your deferred compensation upon the distributable event (often at retirement). That may be important if you’re not comfortable with your former employer controlling your previously deferred compensation. Once you decide on a lump sum, you’re also free to reinvest it how you see fit, free from the restrictions of your company’s NQDC plan.
However, you will owe regular income tax on the entire lump sum upon distribution. That can result in a larger tax bill than if you were to choose installment distributions (see below), in part because it may push you into a higher tax bracket. You also lose the benefit of tax-deferred compounding when you withdraw money from the plan.
- Installment distributions: With an installment plan you take smaller distributions over time—typically on a yearly, quarterly, or monthly schedule. The remainder of your deferred compensation remains in the account, where it can continue to grow tax deferred. Spacing distributions over several years may reduce your overall tax bill, especially if your personal income tax rate declines. However, if you choose an installment plan you must be comfortable remaining as one of the company’s unsecured creditors.
You also may have the option of taking a special state tax benefit when payments are made over 10 years or more. Payments are taxed in the state of residence when paid, not in the state in which the income was earned. This is a tax benefit for those planning to move to a state with lower income tax rates. You also must plan your distributions around other sources of income, such as mandatory minimum IRA withdrawals, to accommodate your cash-flow needs and tax situation.
Whatever form of distribution you choose, be sure to consider the timing of those distributions relative to other company benefits, such as the vesting of restricted stock and the exercise of stock options, as well as income from other retirement plans.
Planning preretirement distributions
Some NQDC plans allow you to schedule distributions based on a specific date—also known as an “in-service” distribution. For some participants, this flexibility is one of the biggest benefits of a deferred compensation plan. It offers a tax-advantaged way to save for a child’s education, a new house, or other short- and mid-term goals.
In-service distributions also can help you partially mitigate the risk that your company could default on its obligations. If you’re not comfortable leaving deferred compensation in the hands of your employer, consider shorter deferral periods.
Scheduling in-service distributions requires more up-front work than simply deferring all compensation until retirement. Here are two strategies for scheduling preretirement distributions:
- The class-year approach: This strategy—also known as “laddering”—involves scheduling distributions for specific years and establishing separate accounts and investment portfolios for each one. For example, if you have a child starting college in 2016, you could schedule distributions for 2016, 2017, 2018, and 2019 (the years you’ll need to pay tuition). You also can schedule a distribution for your anticipated retirement date.
If you defer $100,000 worth of salary each year, you can “ladder” 15% of your assets as distributions in each of the four years your child will be in college. Then, the remaining 40% can be earmarked for distribution upon retirement.
You might choose class-year distributions to help manage your cash flow or tax bills even if you don’t know exactly when your income needs will spike. For example, you may decide to defer income for 10 years, and then schedule small distributions each year after that to boost your annual take-home pay.
- The account-based approach: This strategy—also known as the “bucket” approach—entails setting up multiple accounts, each for a specific goal. You assign a distribution year to each bucket, and choose an appropriate investment strategy based on your goal and time horizon.
For example, when you enroll in an NQDC plan you can create a college tuition bucket and a retirement bucket. If you defer $100,000 worth of salary each year, you can elect to place 40% of the money in your college tuition bucket and 60% in your retirement bucket.
Depending on your plan’s rules, each year that you make a deferral you can change the amount you defer into each bucket, or even create a bucket for a new goal with a new distribution year.
Distribution strategies and tax planning
In addition to the tax-efficient strategies outlined above, you should keep in mind that there is always the potential that federal law or your income may affect your tax rate down the line. For example, your income when you retire may be lower or higher 10 or 15 years later. Also, the state you live in may make a difference in how you want to schedule your distributions, because certain states may have lower or higher income tax rates than others.
One important note: No matter which distribution strategies you choose, it’s difficult to change the schedule once you’ve created it. Early distributions are prohibited except in cases of extreme hardship, such as death or disability—so you can’t simply change your mind and ask for your deferred compensation a year or two earlier than your scheduled distribution date.
You can postpone a distribution as long as you follow strict “redeferral” rules: The request to push back a distribution must be made at least 12 months before the planned date, and you must defer the compensation for at least five additional years beyond the original distribution date.
For example, say you scheduled a distribution for May 2014 to help pay for a second home. Then your plans change and you decide you’d rather put the money toward retirement. You must make the change before May 2013, and you can’t receive the money until May 2019 without paying taxes and penalties.
These restrictions on changing your distribution schedule are another reason why careful, up-front planning is essential to get the most out of your NQDC plan.