How to Make the Most of Your Non-Qualified Deferred Compensation (NQDC) Plan
Today’s job market is more competitive than ever. Employers are offering more than just your standard benefits package to retain top leadership talent. That’s where a non-qualified deferred compensation plan (NQDC) comes into play.Let’s look at NQDC plans, how to maximize them, and if they’re the right savings vehicle for you.
What Is An NQDC?
Deferred compensation plans can be excellent savings vehicles for employees who are maximizing their qualified plan options and still have available savings for retirement. These plans allow employees to defer compensation that they earn in one year—including salary, bonus, and equity—to a specific future date, which is most commonly in retirement. This means that even though you're earning the income now, you won't have to pay taxes on it until you receive it.NQDC plan participants must elect how to invest their contributions like they would with 401k distributions, but unlike 401k distributions, participants must make distribution elections at the time of deferral. Because of this limited flexibility, NQDC plans aren’t the best fit for everyone.
How Do They Work?
NQDC plans must be in writing and specify four things:
Deferral timeline
Amount to be paid
Payment schedule
Triggering event that results in payment (i.e., retirement, change in company ownership, death)
The income is held in a separate investment account that earns a rate of return set by the employer and is usually invested in areas that align with the company's 401k offerings. Taxes on earnings and the growth of the funds in the account are also deferred until the distribution date.NQDC plans are flexible because you get to select how much you'd like to defer in a given year, and you and the company agree on the timeline of the distributions. There are also no contribution caps, which makes these plans appealing to high-income earners.
Taking Advantage of NQDC Plans
NQDC plans give you another opportunity to save more for retirement, and who doesn’t want that? This could be an excellent option if you've maxed out your 401k, HSA, IRA, or other retirement savings account. Since any contribution limits do not restrict you, you can further build your retirement savings through an NQDC plan without any red tape.NQDC plans also have attractive tax benefits. By deferring your income, you can significantly lower your taxable income the year you defer. But you’ll still have to pay taxes eventually, so you will benefit the most if you end up in a lower tax bracket when you have to pay the tax bill.Some NQDC plans allow you to schedule distributions at different times on a yearly, quarterly, or monthly schedule. These staggered distributions help you spread the tax bills when you eventually withdraw.
Things to Watch Out For In An NQDC Plan
On the surface, NQDC plans may seem like the perfect option, but some downsides exist.
You have to pay taxes eventually.
No magic potion can get you out of paying taxes. But, if you find yourself in a higher tax bracket when it comes time to pay the tax bill, that might not be ideal.
Distributions must be scheduled.
You cannot make withdrawals from an NQDC like you can with other retirement accounts. So, should you need the funds sooner than the agreed-upon date, you may need more time.
A noncompete clause may be in the fine print.
NQDC plans can also have specific stipulations that refrain you from competing with the company after retirement. So if you wanted to consult or stay in the industry after retirement, your NQDC plan could break that dream.
The plan may contain a minimum balance clause to meet the desired payout schedule.
NQDC plans can also have specific stipulations that require a specific balance by the time payouts are supposed to begin. For example, a NQDC plan for one of our clients specified that their balance must be $100,000 or above in order for the company to follow the agreed upon payment schedule. In this case, the individual’s balance was less than $100,000 at retirement so the full balance of the plan was paid out as a lump sum in the year of retirement vs. the anticipated five year payment schedule.
You can’t make early withdrawals.
Other retirement savings vehicles may allow you to take early withdrawals with a penalty, but NQDC plans do not allow for early withdrawals under any circumstances.
Should You Participate In an NQDC Plan?
There’s much to consider when deciding whether to participate in an NQDC plan. You should consider a few things:
The financial security of your employer: A NQDC plan is essentially an IOU from your employer, so you need to be confident that they can honor this commitment down the line. If the company goes bankrupt, you may lose your contribution completely.
Your retirement timeline: If you’re 5-10 years from retirement, an NQDC plan could better fit you. The longer you have until retirement, the more financial risk the company can face.
Your risk tolerance: Can you afford to lose the money, or will it ruin your dreams for retirement? NQDC plans are risky because, unlike 401ks and HSAs, they are not protected under the Employee Retirement Security Act, so they should only be considered if you’ve maxed out other retirement savings vehicles.
Bring In a Professional to Help Maximize Your NQDC Plan
Before committing to an NQDC plan, we strongly recommend reviewing the plan and your retirement goals with a financial advisor you trust. Deferring compensation with an NQDC plan is complex, and a financial advisor can help you decide whether it fits your financial needs and goals well.Reach out to schedule some time to speak with one of our financial professionals.
