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A Non-Qualified Deferred Compensation (NQDC) plan is a great way for employers to attract and retain key talent. It also represents a potentially massive tax saving opportunity for highly paid employees. However, there is a lot you need to know about these plans before you decide to join one. So let’s get down to the basics.
A non-qualified deferred compensation (NQDC) plan allows employees to earn salary, potential bonuses and other forms of compensation during one year, but receive those earnings in a future year. This also postpones income tax on the compensation. It helps to provide income for the future and there is an opportunity for reduced income tax to be paid if the employee is in a lower tax bracket at the time of the deferred payment.
It is worth noting that tax law requires these NQDC plans to be in writing. There must be documentation of the amount paid, the payment plan and what the future triggering event will be for compensation to be paid. There must also be a claim from the employee that they intend to postpone the compensation beyond the year.
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An NQDC plan is a contractual fringe benefit that is often included as part of an overall compensation package for key managers. It can serve as an important supplement to traditional retirement savings tools, such as individual retirement accounts – IRAs and 401(k) plans.
Like a 401(k), you can defer compensation into the plan, defer taxes on any earnings until you make withdrawals in the future, and designate beneficiaries. Unlike a 401(k) plan or traditional IRA, there are no contribution limits for an NQDC — although your employer may set its own limits. Therefore, you can potentially defer up to all your annual bonuses to supplement your retirement. We’ve seen companies that let you defer as much as 25-50% of your base salary as well.
Employers: Take note
NQDC plans also have some benefits for employers. The plans are a reasonable effort. After initial legal and accounting fees, no annual payments are required. There are no unnecessary registrations with government agencies such as the Internal Revenue Service.
Since the plans are not qualified, they are not covered by the Employee Retirement Income Security Act (ERISA). This provides greater flexibility for both employers and employees. Employers can offer NQDC plans to select managers and employees who will benefit most from them.
Companies can tailor plans toward valued members of their workforce, creating incentives for these employees to remain with the company. For example, an employee’s deferred benefits may be lost if said employee decides to leave the company before retirement. We call this strategy a “golden handcuffs” approach.
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Employees: Please be aware
For highly compensated employees, Social Security and 401(k) can only replace so much of your income in retirement. You can potentially build up the bulk of your retirement savings with your NQDC plan. There is also the bonus of reducing the annual taxable income by deferring the compensation. This brings in the idea of being in a lower tax bracket, which reduces the amount of tax you have to pay. Many employers even encourage this, offering a match of some sort.
Time of payment
The timing of when you take NQDC distributions is important as you need to project your potential cash flow needs and tax liabilities far into the future.
Deferred compensation plans require you to make a pre-selection of when you want to receive the funds. For example, you can specify that the payments should come at retirement or when a child starts college. In addition, the funds can come all at once or in a series of payments. There is often enormous flexibility in these plans.
Taking a lump sum payment gives you immediate access to your money upon the distribution event (often retirement or separation from service). While you will be free to invest or spend the money as you wish, you will owe ordinary income tax on the entire lump sum and lose the benefit of tax-deferred compounding. If you choose to take the money in installments, the balance can continue to grow deferred, and you will spread your tax bill over several years.
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An NQDC plan comes with some risks. When you participate in a qualified plan, your assets are separate from the company’s assets and 100% of your contributions belong to you. Because a Section 409A plan is nonqualified, your assets are tied to your employer’s general assets. In the event of bankruptcy, employees with deferment become unsecured creditors of the company and must stand behind secured creditors in the hope of getting paid.
Therefore, you should consider how much of your wealth – including salary, bonus, stock options and restricted stock – is already tied to the future health and success of one company. Adding deferred compensation exposure may cause you to take on more risk than is appropriate for your personal situation.
Before choosing to participate in an NQDC plan, you should speak to both your financial advisor and your tax professional. You really want to model out how and when you will receive these payouts. Ideally, you plan with enough foresight that you will offset this income tax event in retirement with withdrawals from a brokerage account or a Roth IRA or 401(k). You’ll also want to be aware of the impact of high income with the taxation of Medicare Part B – if you think there are a lot of moving parts here, you’re right! When executed correctly, you can truly develop a unique plan that is tailored to your exact life situation and future goals.
Any discussion of taxes is for general information purposes only, does not purport to be complete or cover every situation, and should not be construed as legal, tax or accounting advice. Customers should consult their qualified legal, tax and accounting advisors as appropriate.