A nonqualified deferred compensation (NQDC) plan is a workplace benefit that allows eligible participants to defer a portion of their compensation. NQDC is typically offered to a select group of highly compensated employees and can be a tax-efficient way to build wealth. By enrolling in an NQDC plan, you have the potential to reduce total lifetime taxes, allow more time for 401(k) assets to potentially grow and maximize Social Security benefits if NQDC distributions are used as an income strategy to delay 401(k) distributions or Social Security collection. Plan provisions may limit the timing and level of contributions (typically expressed as a percentage of compensation).
Like any financial tool, an NQDC plan takes proper planning—sometimes decades in advance—to be effective. Below you'll learn some ways to use your NQDC plan to potentially help meet your financial goals as well as some risks to be aware of. Remember, your Executive Services team is just a call away to answer questions specific to your plan.
Contributing to an NQDC can advance your ability to build wealth by:
Deferring taxation on current-year compensation
The higher your marginal tax bracket is, the more significant those savings can be. For example, if you are in the 24% federal income marginal tax bracket and contribute $200,000 into an NQDC plan, you could see a federal income tax savings of $48,000 (e.g., $200,000 x 24%). However, if that same $200,000 is contributed by someone who is in the 35% federal income marginal tax bracket, the resulting tax benefit will be proportionately larger (e.g., $200,000 x 35% = $70,000). Note: Income directed to an NQDC plan will still be subject to FICA and FUTA taxes.
Deferring taxation on investment income
The ability to defer current taxes is not confined only to compensation contributed into an NQDC plan. The investment income generated by such deferrals (interest, dividends, or capital appreciation) is also shielded from taxation until it is distributed later. This tax deferral adds to the potential for compounding growth over time which can lead to more funds being available to draw on when you move from the accumulation phase of your career to a drawdown of your assets at retirement.
Lowering tax rates
Time can be a powerful driver of wealth not only through the power of potential compounding, but also because of the potential change to your tax rates. One can only estimate the rates and regulations around future tax laws or the income brackets associated with them, but when you reach retirement, you may be at a lower marginal tax rate than when you were when working.
Managing cash flow
If your plan permits, you may use your NQDC distribution as an income source as you transition to retirement. Doing so allows more time for 401(k) assets to potentially grow and maximizes Social Security benefits because you can delay collection of benefits up to age 70. Delaying collection of Social Security benefits can result in a higher total benefit payout.
NQDC plans have the potential for tax-deferred growth, but they also come with substantial risks such as:
- An NQDC plan is an unsecured promise by a company to pay out a participant's account balance in the future. It's not covered by the Employee Retirement Income Security Act (ERISA), which protects qualified employer retirement plan assets, therefore you risk losing the full value of your NQDC plan if your employer becomes insolvent.
- Assets within the plan are generally not accessible until the distribution date or another allowable event such as termination. Unlike a 401(k) plan, NQDC generally does not allow early distributions. There is no ability to borrow against one's account balance, and it cannot be rolled over into an IRA or another company's retirement plan.
- Tax liability may be higher than anticipated at the time of distribution thus reducing the benefit of deferring income to a later date.
If you do decide that enrolling in your employer's NQDC plan fits with your overall financial plan, then you should understand the details of the plan and how they may affect your finances. Your Executive Services team can help with this. Remember that the amount of income deferred into an NQDC plan should never jeopardize your ability to maximize qualified savings or pay off any other necessary household expenses.