Say you are a corporate executive making an annual salary of $250,000. Every year, you maximize your contributions to your 401(k), which for 2022 is $20,500 for individuals under 50 and anyone over 50 is eligible to contribute an additional $6,500. Although that’s clearly the right move, you can see how saving this amount will likely not be enough to live your current lifestyle in retirement without finding other ways to save outside of your 401(k).
Recognizing this gap and wanting to financially incentivize highly valuable executives like you to stay, many employers offer a supplemental type of savings plan called a non-qualified deferred compensation (NQDC) plan. It is offered only to high-earning employees and only during open enrollment. [Qualified deferred compensation plans are 401(k)s, but you can usually make changes to them at any time during the year.]
Similar to a 401(k), a NQDC plan allows you to set aside part of your salary, stock compensation income or a bonus to be taken later at a future date, whether that’s five or 25 years down the line. And just like a 401(k), taxes on the income in this NQDC plan are deferred until the plan is paid out. This is especially pertinent today because you are likely to see higher tax rates in 2022.
But most high-earning executives do not evaluate the pros and cons of participating in these types of deferred compensation plans because their complexity can take some time to understand. Part of what drives this complexity is that each NQDC plan is unique in terms of its structure and stipulations.
At Van Leeuwen & Co., we believe this time investment in understanding a NQDC is worthwhile because leveraging it might provide you with an opportunity to save money by paying less tax and help meet your financial goals.
Additionally, the NQDC plan your company is offering may be more generous in 2022 than in previous years, as more and more employers enhance such benefits to retain key talent. This is another reason we believe it makes sense to evaluate what’s being offered and weigh up the risks and rewards for your own individual situation.
The advantages of non-qualified deferred compensation plans
The most immediate and impactful benefit of a non-qualified deferred compensation plan is the potential that you can save money on Federal, State, and local taxes.
Similar to your 401(k), with a NQDC plan, you do not pay income taxes on the portion of your compensation the year that it is deferred. In our experience, this is the main reason many of our clients consider participating. And when you take that income later, often in retirement, you are more likely to be in a lower tax bracket than when you were working.
Also similar to your 401(k), the money that you set aside in a NQDC plan can grow tax-deferred in an investment pool of your choosing. A significant difference and advantage, however, is that NQDC plans do not tend to have capped contribution
limits. This means you can set aside much larger amounts than, for example, the 2022 401(k) cap of $20,500 for individuals under 50 and an additional $6,500 if over 50. The result is you might be able to more fully fund your current lifestyle in retirement or shorter-term financial goals you have, such as paying for a relative’s care or purchasing a second home.
If you’re looking to retire early, a NQDC plan can also be a great tool to financially bridge you to 65. For example, say you decide you want to retire at 60, but you do not want to start tapping into your retirement accounts, and you are still a few years away from availing of programs like Social Security. A NQDC plan could bridge you to 65 by providing a few years of income to fill that gap.
Speaking of gaps, an important question to consider before deciding to participate in a NQDC plan is: can you afford it from a cash flow perspective? If you have excess cash flow and receive a large bonus then yes, it may be worth considering this type of savings plan.
The risks of non-qualified deferred compensation plans
For all the potential upside, there are risks to consider. Unlike a qualified plan, such as a 401(k) or IRA, which is protected under the law, a non-qualified deferred compensation plan is not.
What this means is that a NQDC plan is a type of IOU from your company to you and held as part of their assets. If the company declares bankruptcy then your plan could be subject to creditors' claims, and you could lose your
contributions. Although the percentage of publicly traded companies that file for bankruptcy protection each year is in the low single digits, it is still a risk.
It is also critical to review your overall total financial exposure to your employer, including benefit plans, company stock and options when evaluating your participation in a NQDC plan.
In our experience, many corporate executives can view their company in an overly positive and emotional way, which can bias them to tying a great deal of their net worth to their employer and being less diversified than is prudent. As I often ask clients, “If you didn’t work for the company, would you hold 50 percent in stock?”
Hence, we recommend speaking with a trusted financial advisor to independently check the future financial strength of your company, as well as the diversity of your investments.
Another potential disadvantage to a NQDC plan is that you do not usually have the option to pay a penalty to withdraw funds early, which you can often do with your 401(k). NQDC plans tend to be more rigid in terms of their rules than 401(k)s, and many of those rules must be agreed upon when the plan is established. Also, if you leave your employer, you cannot “rollover” your deferred contribution balances to your new employer’s plan or to an IRA. You will have to take it as income by a formula that you decided upon when you enrolled.
For example, if you choose to participate in a NQDC plan, you usually need to determine how and when you want the funds distributed in the future at the time of set up. Some key questions include: When do you want to start receiving the payments? How long would you like the payments to last? Would you like the payments received as a lump sum or spread out over time? As you can tell, there is a lot to think through at the start as many of these decisions are irrevocable.
Yet given the potential to minimize taxes and maximize savings with a NQDC plan, we believe it is worth conducting an evaluation exercise of participating in one.
This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material. Thank you.