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 people may not spend sufficient time on when and how to receive that money and how it affects their taxes.
Deferred comp and you
Explore our 3-part series on making the most of nonqualified deferred compensation plans.
That job can be confusing. It involves assessing potential cash flow needs and tax liabilities many years—or even decades—into the future. 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. Based upon your plan options, generally, you may choose 1 of 2 ways to receive your deferred compensation: as a lump-sum payment or in installments. Here are a few considerations:
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 is a strategy for scheduling preretirement distributions:
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. 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. A subsequent distribution election, if allowed by the plan, cannot permit the payment to be paid earlier than originally elected except in cases of extreme hardship, 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.
Tip: 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 5 additional years beyond the original distribution date.
For example, say you scheduled a distribution for May 2023 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 2022, and you can't receive the money until May 2028 or later.
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.
Next steps to consider
See how an advisor can help you grow and protect your wealth.
Learn ways to invest your money and create a plan of action.
Learn more about wealth planning strategies and related topics.