When considering participating in your company's non-qualified deferred compensation (NQDC) plan, it’s important to understand both the advantages and potential drawbacks. These Section 457 plans can be valuable for retirement savings, especially for highly compensated employees, but they come with unique features and risks.
Benefits of NQDC Plans
Tax Deferral Benefits: One of the primary benefits of NQDC plans is the ability to defer income taxes on the compensation until it is paid out. This can be particularly helpful if you expect to be in a lower tax bracket during retirement. By deferring a portion of your income, you reduce your taxable income for the current year, potentially lowering your overall tax liability. This strategy can result in significant tax savings over time, especially if your future tax rate is lower than your current rate.
Cash Flow Considerations: While the tax deferral aspect is beneficial, it requires careful planning. You must have sufficient cash flow to forgo the deferred income in the present year. Ensure that you can meet your current financial obligations and lifestyle needs without the deferred portion of your compensation. You’re unlikely to be able to modify your contribution amount outside of specified windows, so it’s important to think ahead when opting into the plan. You can’t just log in and change your election like you can with a 401(k) or other workplace retirement account.
Maximizing Retirement Savings Beyond Qualified Plan Limits: NQDC plans can be especially helpful for highly compensated employees who have already maxed out contributions to qualified plans like 401(k)s, IRAs, and health savings accounts (HSAs). The contribution limits for these qualified plans can be restrictive, and NQDCs offer an opportunity to save more for retirement on a tax-deferred basis.
Investment Options
As with a 401(k) or other qualified savings plan, many NQDC plans provide a range of investment options, including a variety of mutual funds, stocks, and bonds. This allows the funds you contribute to grow on a tax-deferred basis.
Evaluate the investment choices offered by your NQDC plan to ensure they align with your overall investment strategy. Consider factors such as risk tolerance, investment horizon, and diversification needs when selecting your investment options.
Pre-Retirement Distributions
Some NQDC plans offer the flexibility to take distributions while you are still employed, which can be beneficial for funding goals such as college tuition or buying a home. Review the distribution rules of your plan to understand the timing and circumstances under which you can access your deferred funds.
Keep in mind that this income will be added on top of your wages for tax purposes, so you will take a hit from a tax perspective if you take money out of this plan while working. If you know you will need the funds in the short term, consider opting out of the NQDC plan and instead invest in a more flexible account.
Risks of NQDC Plans
Limited Liquidity and Access to Funds: Oftentimes, deferred compensation is not accessible until the predetermined future date or triggering event, such as retirement or separation from the company. This lack of liquidity can be problematic if you need funds for emergencies or other purposes before the payout date.
Employer Insolvency Risk: NQDCs are unfunded and unsecured, meaning the deferred compensation remains part of the company's general assets and is at risk if the employer faces bankruptcy or financial troubles. Employees are essentially creditors of the company for their deferred amounts. This differs from qualified plans such as 401k(s) wherein the money is held in an account separate from company assets.
Limited ERISA Protections: Unlike qualified retirement plans, NQDCs are not covered by the Employee Retirement Income Security Act (ERISA) and lack many of the associated protections, such as funding requirements and restrictions on amending or terminating the plan. If the company goes under, you may never again see the funds that you deferred over the years.
Rigid Distribution Rules: You must schedule distributions from an NQDC plan in advance, limiting flexibility. Distributions are taxed as ordinary income when received, regardless of market conditions or your financial needs at that time. Retirement or separation from service are typically triggering events that will begin the payout schedule. The schedule varies by employer, but five- to 10-year schedules are common.
Each year, you should be given the option to elect into your preferred distribution schedule that your company offers, and it’s important to take this decision seriously because it’s the only time of the year you’re eligible to make changes.
These strict rules make tax planning difficult because you have to accept the income even if you’re not in need of the cash.
Tax Implications: Tax planning can be difficult with NQDC funds because you must accept the income on its designated distribution schedule even if you’re not in need of the cash at the time. Also, if you leave the company to work somewhere else, you’re at risk of taking this forced income on top of your new salary. This can push you into a higher tax bracket, losing out on any previous tax benefits.
These plans tend to be more beneficial for highly compensated employees who are nearing retirement. While many people end up working longer than originally planned, it reduces a lot of the tax risks associated with younger employees who have many working years ahead of them. The income may be added on top of your Social Security income rather than a salary.
Summary
Participating in an NQDC plan can offer significant benefits for retirement savings and tax planning. By deferring income, maximizing investment growth, and leveraging flexible distribution options, you can enhance your retirement security. However, be mindful of the risks and make sure your decision aligns with your overall financial strategy. Proper planning and professional advice are key to making the most of a non-qualified deferred compensation plan.
Discuss your situation with a fee-only financial advisor.