Deferred compensation plans have become an integral way to save for retirement. They typically come in two general forms. The first is a qualified deferred compensation plan that is governed by ERISA rules, which include the more familiar 401(k) and 403(b) plans. The second is less common and technically known as a non-qualified deferred compensation plan (NQDC), also known as IRS section 409A plans or golden handcuffs. Although NQDC plans are less familiar than qualified plans, they have become increasingly common as an executive perk due to their potentially amazing tax benefits and their ability to help companies retain key employees. In this article, I’ll be breaking down the non-qualified deferred compensation plan to help you better understand what they are, how they work, and if participating makes sense for you.
What is a Non-Qualified Deferred Compensation (NQDC) plan and how does it work?
A NQDC plan allows you to defer earned compensation to a later date. In most cases, taxes on this income are deferred until that compensation is paid out.
A person may opt for deferred compensation because it can allow them to pay less in taxes on their total compensation by deferring a part of it to the future. Ideally you do this when you expect to be in a lower tax bracket, which is typically due to retirement or a reduction in income.
These are some key points to be aware of:
· You must make an irrevocable election to defer compensation before the year in which the compensation is earned.
· At the time of deferral, the amount paid, payment schedule and the triggering event resulting in payment is specified.
· The 6 permissible triggering events are: a fixed date, separation from service (i.e. retirement), a change in ownership of control of the company, disability, death or an unforeseen emergency.
· The NQDC plan can also impose other conditions such as non-compete clauses and refraining from providing advisory services after retirement.
· The compensation in the plan is technically seen as an unsecured loan between the lending employee (you) and the borrowing employer. It is basically an employer’s promise to pay in the future.
Should I participate?
Determining whether you should participate hinges upon how you answer a few key questions.
1) What is the financial strength of your employer? NQDC plans are basically an IOU from your employer. If the company goes bankrupt, a NQDC plan is considered an unsecured debt of the company, which may mean a total loss of your contribution.
2) How much of your wealth is already tied to your employer? This question begs you to consider your income and wealth concentration risk. In addition to salary, you may have stock options, restricted stock units or stock purchase plans, all of which are tied into the future of one company. Adding NQDC further increases your exposure and risk here.
3) How long before you plan to retire or leave your current employer? The longer you have until a triggering event like retirement, the greater the risk of financial instability for your employer. During times of economic crisis that are very difficult to predict (i.e., the covid-19 pandemic), the financial health of even the largest companies can quickly deteriorate. Remember Chrysler in 2008 and Hertz in 2020?
4) Can deferring now put you in a lower tax bracket and what is your tax bracket likely to be in retirement? Consider what your tax bracket is now versus what it might be in the future. This is particularly hard since no one knows for sure what tax rates or brackets will be in 5, 10 or 15 plus years. Speaking to a qualified tax professional can be a critical part in guiding you on this type of planning.
When should I take it?
The primary motivation for participating in a deferred compensation plan is to lower your taxes so your timing should coincide with when you think you will derive the greatest tax benefit, i.e., when your taxable income would be lowest or at least lower (according to marginal tax brackets). Take time to think through your future expense needs and your plans to continue working in addition to your Social Security withdrawal strategy. NQDC can be a great way to cover the gap between retirement and claiming Social Security so that you can benefit from the guaranteed income increases from delaying benefits (8% per year after full retirement age) while paying less in taxes.
How should I take it?
How to take your payments should be dictated by your expense needs, your other forms of income, and the tax bill they could generate. The two typical forms of payment are either lump sum distributions or equal distributions over a period of years. The lump sum allows you to take all your money at once, which gives you immediate control of and access to your money but also subjects you to a potentially higher tax bill. The equal distribution approach can allow you to spread payments over a series of years (in monthly, quarterly, or annual installments). This can allow you to ladder your payments based on your expense needs and potential tax obligations but delays receipt of all your contributions.
Take time to estimate your retirement expense needs. Be sure to consider health care expenses and any other obligations that might come up during retirement. You can use a worksheet like this to help you get organized. Then list out all income resources and options while considering the potential tax implications. Use this to then map out how to strategically receive your NQDC plan payments.
NQDC plans can be a great way to save more for retirement and save on taxes. To have the greatest chance of success though, be sure to invest your time to think through the pros and cons and how this opportunity fits into your financial plan. If you need additional help deciding, do not hesitate to consult with a qualified tax professional or a trusted financial planning professional to guide you in the process.