Whether you're currently participating in your company's nonqualified deferred compensation (NQDC) program or are deciding if it's right for you, two key questions to ask yourself are:
"What are my distribution options, and what impact could each have on my financial plan?"
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. Generally, you can choose one of two ways to receive your deferred compensation.
- 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 also 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. Typical choices might be to take distributions over two to 20 years.
Participants should consider taking NQDC payouts before qualified deferred compensation in meeting cash flow needs in retirement as it defers qualified plan assets longer and reduces credit exposure for the NQDC plan.
What impact does my distribution strategy have on my financial plan?
While it's important to work with a financial and tax professional when developing a plan for distribution timing, here are some ideas for employing NQDC:
- Use NQDC distributions as income to delay taking Social Security benefits.
- Delay taking from other qualified plans by utilizing NQDC distributions to increase the time qualified plans enjoy tax deferral.
- Schedule distributions for specific years and establish separate accounts and investment portfolios for each one—known as the class-year approach or "laddering." For example, if you have a child starting college in 2026, you could schedule distributions for 2026, 2027, 2028, and 2029 (the years you'll need to pay tuition). You also can schedule a distribution for your anticipated retirement date.
- Make use of a special state tax benefit when payments are made over 10 years or more if you plan on moving to a state with lower income taxes.1 Payments structured this way are taxed in the state of residence when paid, not in the state in which the income was earned.
- Take advantage of a company match. Some companies offer a match to contributions so an employee could contribute to the plan and choose the shortest deferral period possible to obtain the company match and have it distributed to them within a few years—maximizing the amount received by the participant and limiting default risk.
Depending on the employer, even if installments over several years are elected, many companies will pay out NQDC balances in a lump sum upon separation of service. Corporate actions may also accelerate payments, and the payment of associated taxes.
Remember, no matter which distribution strategy you choose, it's difficult to change the schedule and form of your payout. Distributions cannot be paid earlier than originally elected, except in some cases of extreme hardship, death, or disability. The request to push back a distribution, if allowed, must be made at least 12 months before the planned date, and you must defer the compensation for at least five additional years beyond the original distribution date.
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.