Nonqualified deferred compensation (NQDC) plans allow you to set aside large amounts of tax-deferred compensation — well beyond the contribution limits for 401(k)s and other qualified plans. Many NQDC plans also give you the flexibility to schedule distributions to align with your financial goals.
However, NQDC plans also pose substantial risks, including loss of compensation should your company declare bankruptcy or become insolvent. If your employer offers an NQDC plan, weigh the pros and cons before you choose to participate.
What is the difference?
It is important to note how NQDCs differ from the similar-sounding qualified defined contribution plans. The latter allows employers to contribute to their employees’ behalf and employees to direct a portion of their salaries into a segregated account held in trust. These plans also generally allow participants to direct the investment of their account balances among the plan’s investment options. These plans are subject to the applicable requirements of the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code, including annual contribution limits, penalties for early withdrawals, required minimum distributions and nondiscrimination rules.
For 2019, pretax employee contributions to qualified plans are limited to $19,000 ($25,000 for those age 50 and over). The combined employee and employer contribution limit for all defined contribution plans is $56,000 ($62,000 for employees age 50 and over).
By contrast, an NQDC plan is simply an agreement with your employer to defer a portion of your current compensation to a future date or dates. Many NQDC plans provide for matching or other employer contributions, while some permit only employer contributions. Employer contributions may be subject to a vesting schedule based on years of service, performance or the occurrence of an event (an IPO or sale, for example).
Some plans offer a fixed rate of return on deferred compensation. But more commonly, growth is tied to the performance of certain investments, such as a stock index or the investments offered by your employer’s 401(k) plan.
To avoid current taxation, NQDC plans may not be “funded” and they cannot escape your employer’s creditors. So, compensation is not held in a trust separate from your employer’s general assets. The plan is secured only by your employer’s promise to pay. It is possible to set aside funds in a special type of trust to ensure that your employer does not use them for other purposes, but they remain subject to creditors’ claims.
What are the pros?
Like qualified plans, NQDC plans allow you to defer income taxes on compensation until you receive it — although you may have to pay FICA taxes in the year the compensation is earned. NQDC plans also offer significant advantages over qualified plans. Depending on the specific plan’s limits and distribution rules, you may enjoy:
- No contribution limits, allowing you to set aside substantial amounts of wealth;
- Greater flexibility to schedule distributions to fund retirement, college expenses or other financial goals without penalty for distributions before age 59½; and
- No required distributions at age 70½.
From an employer’s perspective, NQDC plans are attractive because they can be limited to highly compensated employees and they avoid the cost of compliance with ERISA’s reporting and administrative requirements. However, unlike contributions to qualified plans, deferred compensation is not deductible by the employer until it is paid.
And the cons?
The biggest disadvantage of NQDC plans for participants is that deferred compensation is subject to the claims of the employer’s creditors and could be lost in the event of bankruptcy or insolvency. Also, you may not be able to take loans from the plan and cannot roll over distributions into an IRA, qualified plan or other retirement account.
Generally, NQDC plans allow you to receive benefits only on the scheduled distribution date or dates. Qualified plans may allow you to take penalty-free hardship withdrawals or to withdraw funds at any time if you are willing to pay a penalty.
Is it right for you?
An NQDC plan offers attractive benefits, but it can be risky. Typically, they are most appropriate for employees who: Are already contributing the maximum to qualified plans, IRAs and other tax-advantaged retirement vehicles; feel comfortable with their employer’s long-term financial security; and understand and accept the risks.
For more information, contact Adam M. Levine at a[email protected] or 312.670.7444. Visit ORBA.com to learn more about our Wealth Management Services.