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A Guide to Non-Qualified Deferred Compensation Plans

A Guide to Non-Qualified Deferred Compensation Plans

May 20, 2023

Non-qualified deferred compensation plans (NQDC) are one possible way executives and key employees can potentially optimize their finances and build a more secure financial future. NQDC plans can offer a range of possible benefits to workers, including tax deferral, retirement planning, asset protection, and flexibility in distributions. In this article, we'll explore how NQDC plans work and why one might consider them as part of their retirement planning. So, without further ado, let's dive in and learn more about NQDC plans.

What is a Non-Qualified Deferred Compensation Plan?

In essence, a non-qualified deferred compensation plan (NQDC) is simply an agreement between an employer and an employee to defer a portion of the employee's income until a later date. NQDC plans are not generally subject to the same government regulations and restrictions as qualified plans like 401(k)s and IRAs.

Companies typically offer NQDC plans to high-level executives and important employees in order to attract and retain them. These plans allow employees to defer a portion of their salary and bonuses, which means these amounts are then paid out at a later date (like during retirement).

How Do NQDC Plans Work?

NQDC plans are usually structured as a series of elections made by the employee. In other words, the employee chooses the amount of their compensation they wish to defer, the timing of the deferral, and the investment options for the deferred amounts. The deferred compensation is then held in a separate account, usually invested in a selection of mutual funds or other investment vehicles chosen by the employee. The employer may also offer a matching contribution, which is typically subject to vesting requirements.

Once the employee reaches the designated distribution date, usually retirement, the deferred compensation is paid out in a lump sum or in installments over a specified period. At this point, the deferred compensation is generally subject to income tax and may also be subject to an additional penalty tax if the distribution is made before the employee reaches age 59 ½. In all cases, however, one should confirm these details with their tax advisor.

Why Might Someone Consider a NQDC Plan?

Tax Deferral – By deferring income, individuals can potentially reduce their current tax liability. This might also help lower their overall tax rate, as the deferred income is generally taxed when they are in a lower tax bracket (later in life).

Retirement Planning – In some instances, NQDC plans can potentially provide a valuable source of retirement income for individuals who have already maxed out their qualified retirement plan contributions. Additionally, NQDC plans may be useful for individuals who are at risk of exceeding the contribution limits for their qualified plans due to their high level of income.

Asset Protection – Unlike qualified plans, NQDC plans are not generally subject to ERISA regulations and are therefore not subject to the same creditor protections. However, some states do offer protection for NQDC plans, so it's important to consult with a financial advisor to understand the laws in one’s state.

Flexibility – NQDC plans usually offer flexibility in terms of the timing and structure of distributions, which can potentially enable individuals to tailor their retirement income to their specific needs and goals. Additionally, NQDC plans may allow for early withdrawals in certain circumstances, such as a financial hardship.

It's important to note that NQDC plans are not without risks. If an employer goes bankrupt, the employee could lose the deferred compensation they've rightfully earned. Furthermore, because these plans are not usually subject to the same government regulations as qualified plans, they can be subject to change at any time. It's critical that one reviews the plan document and seeks professional advice before enrolling in an NQDC plan.

While NQDC plans may be attractive to high-earning individuals, they are not necessarily suitable for everyone. It's important to carefully evaluate one’s financial situation, goals, and risk tolerance before considering an NQDC plan. Additionally, NQDC plans may not be available to all employees or may only be offered to a select group of employees, so it's necessary to check with one’s employer to see if they're eligible.

In conclusion, non-qualified deferred compensation plans can potentially offer many benefits to individuals who want to build a secure financial future. By deferring income, possibly reducing tax liability, and potentially providing a valuable source of retirement income, NQDC plans may be able to help some individuals achieve their retirement goals. However, it's important to carefully consider all the risks and to seek professional advice before enrolling in one of these plans. With the right planning and guidance, however, NQDC plans can be a powerful tool to help one build a strong financial future.