You’re an exceptionally talented individual, and you’ve been offered a shiny new position with a company that is in line with your values, aspirations, and overall goals for your future. Yet, before you commit, you want to consider the overall compensation picture. Points to examine include, sign-on bonuses, increase in base pay, as well as additional complex compensation offers and how they will affect your tax strategy.
In this article we will explore the potential pros and cons associated with Nonqualified Deferred Compensation (NQDC) Plans for high-earning folks like you. We’ll offer insights into the different types of NQDC plans and how they can help you defer discretionary income and reduce tax liability. Finally, we’ll look at strategies for reducing risk and making informed decisions about NQDC participation.
Getting Started with Nonqualified Deferred Compensation Plans
What are Nonqualified Deferred Compensation (NQDC) Plans?
NQDC plans are arrangements to save part of your annual income for future use, like retirement, education, or when in a lower tax bracket.
Typically, NQDC plans are designed to attract and retain highly-compensated top-level employees.
What are some risks associated with NQDC Plans?
NQDC plans lack the protections of qualified plans, such as 401(k)s, and depend heavily on your company’s financial stability.
During open enrollment, you decide how much and when you’ll contribute to your chosen NQDC plan and how you’ll receive the deferred income. NQDC plan elections are irrevocable and cannot be rolled over into an IRA.
How do I get the most out of my NQDC Plan?
Choose smaller contributions and shorter deferment periods and stay mindful of your company’s financial health.
Carefully evaluate NQDC plans and consider your long-term financial goals, job stability, and risk tolerance. Seek guidance from a financial advisor or tax expert to make informed decisions.
What are Nonqualified Deferred Compensation Plans?
Broadly, NQDC plans are agreements between you and your employer to set aside a portion of your income earned in each tax year for use at a later time – perhaps for retirement or a child’s college tuition, or for a time when you’ve dropped into a lower tax bracket. Essentially, these plans are a tool for automatic, or “forced” savings into an investment account that come with the potential to significantly lower your current and future tax liability.
NQDC plans are different from qualified retirement savings plans. Qualified plans are available to everyone, and contributions made to one of these plans – such as a 401(k) – are made on a pre-tax basis and are subject to IRS rules and regulations. If your company offers NQDC plans and you are eligible, your benefits package will spell out all the details.
NQDC plans are used to specifically attract and/or retain highly-compensated, top level employees. Unlike qualified plans such as 401(k)s, there are no limits imposed by the IRS as to how much you can contribute (although, it is possible your company imposes a contribution limit), offering a greater degree of flexibility for plan beneficiaries.
While most NQDC plans are subject to payroll taxes at the time you make your contributions, you won’t be on the hook for federal and state income taxes until the funds are actually paid out to you. With adequate planning, your tax savings can be significant when opting to take deferments at a time when you aren’t in such a high-income tax bracket.
Types of NQDC Plans
- Supplemental Executive Retirement Plans (SERPs): These are in addition to your 401(k) or other retirement benefits and may have a different tax benefit structure.
- Salary Reduction Arrangements: Programs allowing employees to defer a portion of their salary into a nonqualified account, often for retirement or other long-term goals.
- Deferred Bonus Plans: Compensation plans that defer payment of cash or stock bonuses to a later date, typically for tax or retention purposes.
- Long Term Incentive Plans (LTIPs): Programs that grant employees incentives, often in the form of stock options or grants, tied to long-term company performance.
- Phantom Stock Plans: Compensation plans that mimic stock ownership without actual equity issuance, providing employees with a share in a company’s financial success without real stock ownership.
How can I elect to participate?
Most companies offer an open enrollment period when you can choose to defer either a fixed dollar amount or a percentage of your income into your chosen NQDC plan(s).You’ll also choose when your deferred income will be distributed and in what form – usually as a lump sum or as regular payments over time. It is important to remember that NQDC plan elections are irrevocable and cannot be rolled over into an IRA.
NQDC Plans in Practice: A Case Study
Consider the following situation in which a new employee saw a golden opportunity to leverage a nonqualified Deferred Compensation Plan (NQDC):
With a significant severance package from their previous employer, a generous sign-on bonus, and a boost in base pay from their new employer, our client effectively doubled their annual income for the year. By deferring the sign-on bonus into a NQDC plan, they reduced their overall tax bill by a whopping $200,000. Of course, there will be tax distributions in retirement, but thanks to this savvy strategy, they’re already well ahead of the game when it comes to their tax situation.
This is a prime example of how NQDC plans can be a powerful financial tool in the right circumstances. In this case, the client was not risk averse, nor was there any concern that their new employer would run into financial trouble in the future.
Risks Associated with NQDC Plans
- FInancial Health of Employer: If your NQDC plan includes equity compensation, it will not protect your investment should your employer get into financial trouble. When GM filed for bankruptcy in 2009, for instance, they dipped into NQDC funds to settle with creditors. Plan participants received one-third of their deferred compensation. The financial health of your employer should be a key consideration when making participation and election decisions.
- Termination Risk: If you leave your job, by choice or otherwise, you’ll likely be forced to cash out your deferred compensation in one lump sum, which could trigger some hefty and unexpected tax consequences.
- Location-Based Tax Liability: NQDC plans are subject to state taxes based on your employer’s location, not your place of residence at the time of distributions.
- Concentration Risk: While qualified plans like 401(k)s come with plenty of safeguards and protections, NQDC plans have a higher risk exposure. Aim to strike a balance between your contributions to your qualified and nonqualified benefit plans.
Measures Businesses Can Take to Protect You From Risk
Your company may have a few options at its disposal to protect you from harsh losses, but none of them guarantee you’ll get out what you put in.
- Rabbi Trust: Here, plan funds are managed by a third party so that your company is unable to dip into your funds should they suddenly need access to cash to stay afloat. Rabbi Trusts may also offer you the option to defer for shorter periods of time which may reduce risk, but may also reduce tax savings. The Rabbi Trust does not, however, offer protection against a company’s creditors.
- Stock Shield is a company that offers a type of safeguard called a Deferred Compensation Protection Trust (DCPT). Stock Shield’s DCPT is a risk management tool in which a diversified pool of 20 persons from different companies and industries contribute a portion of their NQDC plan balance to be invested in secure U.S. Treasury Securities for a chosen protection period of at least five years. Should one or more companies file for bankruptcy, the trust will pay out to those affected. If there have been no bankruptcies by the time the trust matures, all participants will be refunded the contributions, less administrative fees.
The Bottom Line
For high-earners, NQDC plans offer a valuable means to defer income and potentially lower your current tax liability, but they come with risks. They don’t offer the same protections as qualified plans, like 401(k)s, and are much more vulnerable to the financial well-being of your company. How much you choose to contribute to your NQDC plan and for how long you elect to defer payout is subject to your personal risk tolerance and your assessment of your employer’s overall viability. In general, consider opting for smaller contributions, shorter deferment periods, and be thoughtful and aware of your company’s overall health.
Conclusion
Careful consideration is essential when opting into an NQDC plan. To make informed decisions, you’ll need to thoroughly understand the terms of your plan as well as its pros and cons. It’s also smart to take into account your long-term financial goals, job stability, and risk aversion. Seek advice from a financial planner or tax expert who can help you navigate the complexities of NQDC plans and help you make the best decisions for yourself.
At SK Wealth, our financial planners are all about helping you make informed choices regarding your complex compensation package and how to plan for your financial future. We’ve honed our financial planning process, The Integrated Financial Advantage™, over the past 25 years to offer you our personalized recommendations that empower you to live life with intention, tomorrow and today.
