A nonqualified deferred compensation plan can be a tax-efficient way to save for specific goals, particularly retirement. But like any financial tool, a NQDC plan takes proper planning—sometimes decades in advance—to be effective. Let's look at the key considerations around NQDC participation.
1. Is a NQDC plan right for me?
Here are some important questions to answer when making this decision:
- Do you maximize contributions to traditional retirement plans and other savings options (like Health Savings Accounts and 401(k)s) every year?
- Will your tax rate change in the future and can you afford to defer compensation?
- Is the company providing the NQDC financially secure? How much of your wealth and potential future income do you have tied to your employer?
- Does the plan allow a flexible distribution schedule?
- What investment choices does the plan offer?
- Do you understand the risks?
- Are you comfortable with not having access to this money for several years?
If you do decide that a NQDC plan fits with your overall financial plan, then you should ask yourself about the details of the plan and how they will affect your finances.
2. How much should I contribute?
When making a deferral election, you should examine the following elements:
- Your total expected income for the coming year.
- How deferrals may affect your taxes.
- When you want payments to begin.
- Whether your plan allows you to make future changes in your distributions.
Please note that the amount of income deferred into a NQDC plan should never jeopardize your ability to maximize qualified savings or pay off any other necessary household expenses.
3. How should I invest this plan?
Consider the following factors to help ensure that your NQDC investment strategy complements your overall financial plan:
- Your financial goals and time horizon.
- Your diversification needs.
- Your risk tolerance.
Remember that market volatility isn't the only risk posed by a NQDC plan: These accounts are not guaranteed or protected from creditors in the case of a company bankruptcy. The money in a NQDC plan is not really invested; rather, your employer promises—not guarantees—to pay you the compensation you defer at a later date, along with the earnings you would have received if your assets had matched the return of a particular investment or index.
4. What are my distribution options?
NQDC plans should explain when and how you'll receive the compensation you've deferred, as well as any applicable earnings.
- Lump-sum distributions: You'll owe regular income tax on the entire lump sum upon distribution, which can result in a larger tax bill than installment distributions and may push you into a higher tax bracket. You lose the benefit of tax-deferred compounding when you withdraw money from the plan.
- Installment distributions: You take smaller distributions over time—typically yearly, quarterly, or monthly. The remainder of your deferred compensation remains in the account, where it can continue to grow tax deferred. Spacing distributions over several years may reduce your overall tax bill. However, if you choose an installment plan, you must be comfortable remaining one of the company's unsecured creditors.
No matter which distribution strategy you choose, it may be difficult to change the schedule and form of your payout. Distributions cannot be paid earlier than originally elected except in cases of extreme hardship, death, or disability. These restrictions on changing your distribution schedule are another reason why careful, up-front planning is essential to get the most out of your NQDC plan.
Your dedicated Fidelity Executive ServicesSM team can help you determine if participating in a NQDC plan is right for you, and can answer key questions regarding the plan going forward.