Have a Plan for Your Non-Qualified Deferred Compensation

Posted on November 14, 2011

A Non-Qualified Deferred Compensation (NQDC) Plan allows eligible employees to save a portion of their income for retirement or other purposes on a tax-deferred basis without the limitations of qualified retirement plans like a 401(k). For highly compensated employees who are limited in their participation in qualified employer plans, NQDC Plans can be an attractive investment vehicle.

However, several details of NQDC Plans make creating a strategy essential before you participate. By allowing employees to defer a portion of their income to a future year, NQDC Plan assets can grow, tax-deferred, while reducing the current year’s tax liability. Once the NQDC Plan assets are distributed, they are taxed as ordinary income, similar to a 401(k). Unlike a 401(k), employees can contribute well above the levels dictated by qualified plan rules and may be eligible to withdraw assets from the plan before retirement age. If you are an executive or sales professional who expects to receive a large bonus in a given year, you can defer a portion of the bonus and reduce the portion of current year’s income that could bump you into a higher tax bracket. In addition, if you needed to reduce income for college financial aid eligibility or knew your cash flow needs would be greater a few years down the road, deferring your income to a NQDC Plan may prove advantageous.

Each company’s NQDC Plan may vary significantly and will affect your strategy for withdrawing assets from the plan. Most plans require the assets to be deferred for a minimum amount of time, such as two years. Some companies may limit your distribution options either before or at retirement, impose contribution limits or may offer a company match. These details become important as we look into the potential pitfalls associated with NQDC Plans.

The first and most important risk to assess before contributing to an NQDC Plan is the risk of your employer’s default. Most all plans carry some sort of risk of forfeiture so that you are not taxed on the assets contributed to the Plan. Unfortunately, this means that if the company goes bankrupt, the NQDC Plan assets are subject to the company’s creditors and you may not receive anything. Recent highly publicized bankruptcies shine a light on the distinct possibility that seemingly large, stable companies carry some default risk. If you suspect that your company has even a small risk of default, you may want to think twice about investing in your NQDC Plan. If your employer is going through bankruptcy talks, you may want to take whatever assets you can from your NQDC Plan now, while you still have the opportunity.

Another risk associated with NQDC Plans is the possibility of future tax rate increases. Traditionally, tax-deferred vehicles like 401(k)s and NQDC Plans were thought to provide an advantage over after-tax savings because most people believed their effective tax rate in retirement would be much lower than when they were working. Unfortunately, there are several reasons why this may not be true for you. If you are expecting a large pension, large IRA required distributions or any other type of income in retirement, you may be bumped into a higher tax bracket, reducing the benefits of before-tax deferral. The distribution option of your NQDC Plan may affect your tax rate, too, should your plan require you to distribute the entire amount over a short time such as one or two years. Finally, the possibility of rising tax rates caused by government bailouts and ever-increasing entitlement spending may also reduce the efficacy of tax-deferred savings vehicles such as NQDC Plans. Increased tax rates in retirement can reduce the net benefit from your NQDC Plan, especially if there is no employer match.

While the tax benefits of spreading out the distributions from your NQDC Plan must be weighed against your employer’s risk of default during that time, your investment options within that plan play an important part in your strategy, too. The investment options of the plan are up to the employer and may be limited, so you’ll need to research your options to see if they fit with the rest of your investment strategy. The timing of your investment elections can also influence the net benefit you receive from your NQDC Plan. For instance, investing aggressively in equity funds may be the right long-term strategy for your retirement assets, but if your company plan requires a lump-sum distribution at retirement, a short-term bond fund may be more appropriate if you’re getting close to hanging up your spurs. Equities can be volatile, and a short-term market downswing could greatly reduce your NQDC Plan benefit just as your co-workers plan your retirement party. The same is true for anyone looking to defer income for just a few years into the future. Make sure your investment choices match not only your time horizon, but the NQDC Plan’s distribution requirements as well.

NQDC Plans offer a tremendous opportunity to highly compensated executives, but the conditions must be right before participating in your employer’s plan makes sense. Talk with your Wealth Advisor about your situation and develop a strategy before you invest in your NQDC Plan. And review your plan contributions and investment options with your Advisor annually to maximize the long-term benefit.