There are two types of deferred compensation plans: qualified and nonqualified. Qualified deferred plans are 401(k)s and similar plans. Nonqualified Deferred Compensation (NQDC) plans, or 409A plans, are very specific and intended to help highly compensated employees defer their income (and the tax bill) to a later date.
Section 409A of the tax code that dictates how NQDC plans are administered was adopted in the wake of the Enron controversy. Many Enron executives, aware of the imminent collapse of the company, initiated payment of their NQDCs. This code is meant to stiffen the guidelines and restrictions around modifying, terminating, and distributing NQDCs.
- NQDC plans can be created by an employer, typically for high-earning employees to defer income and related taxes on a portion of their salary, a bonus, or other types of compensation.
- There are no contribution limits with NQDC, making them a great supplement to your 401(k).
- The “nonqualified” part of the plan means the deferred income is not protected by ERISA and can be lost if the employer needs to pay creditors or becomes insolvent.
What is an NQDC?
Let’s break down the name of the plan: nonqualified deferred compensation plan. First, it’s a deferred compensation plan similar to a 401(k), where you defer part of your income to be distributed later, usually during retirement. Like a traditional retirement plan, you can defer part of your salary. You can also defer one-time compensations or bonuses. Since the income is deferred, the taxes you owe are also deferred until the money is distributed.
Unlike traditional plans, contributions are unlimited. If you typically max out your 401(k) contribution limits and you have more money you can afford to defer, consider NQDCs as another pillar of your retirement plan. However, NQDCs are nonqualified. Whatever income is deferred is tied to the company’s assets and not protected under the Employee Retirement Income Security Act (ERISA).
How do NQDC plans work?
You decide how much you’d like to defer in a given year and work with your employer to set up an NQDC plan during the same year in which you would have been paid. You and your employer will decide on the terms of the deferment, such as the distribution timeline and schedule.
This plan or agreement is very strict and deviating from it—pulling out money too early or making investment changes—may trigger a 20% tax penalty, as well as normal tax obligations.
Until distribution, the deferred income can be invested in a trust or an investment account.
NQDCs can also grow and accumulate earnings at a reasonable rate of return that are also tax deferred until distributed.
The Pros of Contributing to NQDC Plans
NQDCs are particularly attractive to high-income earners. Most companies use these plans to attract top talent and encourage them to stay until retirement or whenever distributions are received. Let’s break down some of the top advantages.
- You can save much more for retirement. If you’ve already maxed out your 401k, HSA, IRAs, and other tax-advantaged vehicles, this could be a good next step. Where there are annual contribution limits for accounts listed above, NQDCs offer unlimited contributions. Though you must be strategic with how much income you wish to defer. Determining how much you can currently afford to defer, as well as factoring in the tax obligation at the time of distribution, should be part of your NQDC research.
- You could significantly lower your taxable income. If you’re a top executive, you’re likely in a higher tax bracket, and reducing your taxable income now could save you money on your tax bill. You may even pay less in taxes if you’re in a lower tax bracket during retirement.
It is important to be mindful of having tax diversity in retirement, balancing your tax obligations between pre-tax, after-tax, and taxable income. You can work with a financial advisor, like Metanoia, to find the right balance.
- You can take advantage of compounding returns. NQDCs aren’t a savings plan. They are an investment, which is yet another way to help your nest egg grow. Carefully make your investment elections it’s nearly impossible to make modifications after the fact.
- Potential for staggered withdrawals. You might be able to schedule distributions at different stages of your career, not just during retirement, meaning you have different options to leverage your cash flow and tax liability. Similar to cutting wood, you’ll want to measure twice before you commit once. Check your distribution plan against other sources of income and associated tax requirements.
NQDC plans are also advantageous to the employer. They are able to retain money that would have been paid to employees, but they do assume the risk of paying (or not paying) the distribution later on.
The Cons of Contributing to NQDC Plans
As enticing as all of the pros to NQDC plans might be, there are some significant cons to consider before committing to one.
- NQDCs are nonqualified. This means they are not protected under ERISA. As such, they function more like promissory notes between you and your employer. If the employer is ever called upon by creditors, files bankruptcy, or becomes insolvent, your deferred income could disappear
- Tax deferred does not mean tax exempt. Distributed wages are typically subject to FICA and FUTA taxes. Since you didn’t pay them in the year you earned the wages, you’ll have to pay them when you receive the distribution.
- You Must Schedule Distributions. While you can remove money from your 401(k) when you’d like after the age of 59½, you have to schedule when you receive NQDC payments. The schedule is strict. It doesn’t leave much room for flexibility or changing plans, except for these exceptions: your separation from the company, your death, disability, the time of the change in the employer’s ownership or effective control, and the occurrence of an unforeseen emergency.
NQDC funds can’t be rolled over. You can’t roll over your balance to IRAs or Roth accounts, and you can’t take out a loan as with 401(k)s.
Is Contributing to an NQDC a good option for you?
Given the rigidity of NQDCs, consider a few of these qualifying questions.
- How would this plan complement your existing retirement savings strategy?
- Is your company financially secure? Do you have confidence they will be able to honor the terms of the agreement?
- Are you comfortable with the employer’s terms? They may require tenure before distribution starts or have specific investment accounts that hold NQDC funds.
- Have you evaluated your present and potential future tax situation and made a plan for your income in retirement?
- How much can you afford to defer?
Nonqualified deferred compensation plans have the potential to be a goldmine or a landmine. Work with your financial advisor to weigh the risk and rewards of diversifying your retirement plan with NQDCs. Building income and tax diversity in retirement are especially important for high earners to maintain their lifestyle, plan for the unexpected, and make the best use of their income-earning years.
Schedule a free consultation with Metanoia today to see how and if an NQDC is right for you.