Nonqualified Deferred Compensation Plan
Also called “top hat” plans, NQDC plans allow employees with large incomes to set aside significant amounts of tax-sheltered money and have no cap on contributions to the plan. However, these plans also come with significant downsides, including the possibility of losing out on the entire amount in the plan. Read on to find out whether it makes sense for you to participate in your organization’s NQDC plan.
What is an NQDC plan?
An NQDC plan is an agreement between you and your employer to defer some of the income you earn now until a specific time in the future. These plans don’t work like other, more common retirement plans offered by employers. Other plans, such as 401(k)s, allow employees to place earnings into a separate, tax-deferred account and place funds into a selection of investments. These accounts are owned by the employee or held in trust for the employee’s benefit. With NQDC plans, this isn’t the case. NQDC plans are promises rather than accounts. The employer does not set aside money for the employee and the employee doesn’t own a retirement account. Rather, the company promises to give the employee income they earn at a later date.
Executives or other highly compensated employees will find that while retirement plans such as 401(k)s or profit-sharing plans are helpful, they must save much more to support their retirement lifestyle goals. NQDC plans allow highly compensated employees to save significantly more on a tax-deferred basis for retirement or other large expenses than they would with other plans offered by employers. Where other retirement plans have strict requirements and contribution limits, NQDC plans have no such requirements. NQDC plans allow the employee and employer to agree upon much larger dollar amounts to set aside for retirement or other expenses, like college or a second home.
These plans allow for tax deferment of the money in the plan. Because future payouts are only a promise, the amounts are not taxed. Deferred compensation will be taxed as regular income when received, though this money will still be subject to Social Security and Medicare (FICA) taxes. This allows employees to defer income until they are in a lower tax bracket or until a time when the money will be better used. Most plans also allow deferred income to be invested so that it can experience tax-deferred growth. Of course, since an NQDC plan is simply an agreement, funds are not really invested. You will instead make notional investments for accounting purposes, and then will be paid as if you had been invested in those investments all along.
These plans also have several benefits to employers. Primarily, NQDC plans allow employers to offer a significant retirement benefit to key employees, which helps them attract and retain top talent. They can provide this benefit exclusively to top employees, something difficult to do with qualified retirement plans, which are subject to strict nondiscrimination rules. An NQDC plan is also a much simpler and more cost-effective plan to operate than a qualified retirement plan. While qualified plans must follow complex ERISA and IRS rules, NQDC plans are not subject to ERISA and must follow less complicated IRS rules. This removes much of the time and money it takes to offer qualified plans. Finally, it gives the employer more flexibility. Because NQDC plans are not subject to the framework provided by ERISA and the IRS, employers can be more creative when customizing a plan for their organization and employees.
The biggest disadvantage to an NQDC plan is that it is only an agreement. This means an employer has the contractual obligation to pay the deferred compensation, but the money is unsecured and unprotected from the claims of the company’s creditors in the event of bankruptcy. The employee must also usually wait years to receive the money and many times will forfeit the deferred compensation if they leave before funds are set to be distributed.
Also, despite NQDC plans being flexible during their creation, once they have been formed, there is less ability to make changes. You must elect to defer compensation before the compensation is earned and then cannot change the deferral election during the year. Election timing rules vary with different forms of compensation such as base pay, performance-based or other forms of compensation. Furthermore, the timing and method of distribution of the deferred compensation must be decided up front.
Most employees choose to defer compensation until years later and pick dates that correspond to major events such as a child’s college education or retirement. Also, unlike with other retirement plans such as 401(k)s, you cannot take a loan against the NQDC plan and cannot roll it into an IRA or other retirement account when the money is distributed to you.
For employers the main downside is that no tax deduction is available to them for any money set aside for the plan, as there is with amounts contributed to qualified retirement plans. In fact, if the funds are set aside in a separate account, any investments earnings will be taxable to the employer. Employers do get a tax deduction for paying deferred compensation to the employee, though they have no control over what year the employee will choose to receive the income.
Is an NQDC plan right for you?
Each individual must assess their financial plan with their advisor to determine whether it makes sense to participate in their employer’s NQDC plan. Generally speaking, however, here are some questions to ask to determine if such a plan is right for you:
1. Have you maxed out other retirement savings vehicles? Are you consistently contributing the maximum amounts allowed by your employer’s plan (such as a 401(k)) and your IRAs? NQDC plans are most helpful for going above and beyond these retirement vehicles.
2. Do you see yourself with your current employer for an extended period of time? NQDC plans, which usually don’t pay out until much later dates such as retirement, are usually forfeited upon the employee leaving the company.
3. Is the company you work for likely to be financially secure enough to pay deferred compensation in the future? Since money in an NQDC plan is not secured, you are never guaranteed the money in the plan. If the company files for bankruptcy, you are general creditor with regards to the plan amounts promised to you.
4. Is your tax scenario likely to be better when the compensation is received later? The primary benefit of deferring compensation is waiting to receive that compensation when your tax situation improves. If it’s unlikely your tax rate will change, you may need to consider other factors more when deferring compensation.
5. Can you afford to lose the money? While NQDC plans can be attractive savings vehicles, they do have risks and it’s possible you could forfeit the entire amount in the plan.
6. What investment options does the plan offer? Most plans offer a wide array of investment options so that your money is not only tax-deferred but grows as well. If your plan doesn’t, it may be less attractive as a long-term savings vehicle.
7. Can you make better use of the money independently? Despite the potentially significant tax benefits NQDC plans offer, it may be more productive to take your income now and invest it elsewhere. You may pay more in taxes, but you will have greater flexibility when choosing investments as well as immediate ownership of your earnings. Talk to your advisor about the pros and cons of this important decision in the context of your financial plan.
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