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The Pros and Cons of Non-Qualified Deferred Compensation Plans

The Pros and Cons of Non-Qualified Deferred Compensation Plans

May 24, 2023

Non-Qualified Deferred Compensation Plans (NQDCPs) often help individuals secure their long-term financial security while also potentially deferring taxes on their earnings. This blog post explores some of the pros and cons of NQDCPs with the aim of providing valuable insights so one can make informed decisions about this type of retirement plan.

Pros of Non-Qualified Deferred Compensation Plans:

  • Tax Deferral: A significant advantage of utilizing an NQDCP is gaining the ability to potentially defer taxes on earnings until receipt. This deferral can help reduce current tax burdens, allowing one to allocate funds toward savings and investments instead. This benefit tends to be particularly attractive to high-income professionals seeking to reduce tax liabilities.
  • Enhanced Retirement Savings: NQDCPs can provide an additional avenue for accumulating retirement savings. Unlike traditional retirement plans, such as 401(k)s and IRAs, NQDCPs generally have no contribution limits. This can allow one to set aside a larger portion of their income for retirement, potentially boosting their retirement nest egg. This can be especially beneficial for individuals who have maximized their contributions to other retirement accounts.
  • Flexibility and Customization: NQDCPs often offer flexibility in contribution amounts and payout options. The plan can be tailored to specific financial needs, providing greater control over retirement income. Some plans even offer investment options, enabling the potential growth of deferred compensation over time.
  • Talent Attraction and Retention: Employers frequently use NQDCPs as an incentive to attract and retain top talent. Deferred compensation plans demonstrate commitment to employees' long-term financial well-being, fostering job satisfaction and loyalty, benefiting both employees and organizations.

Cons of Non-Qualified Deferred Compensation Plans:

  • Limited Immediate Access: One drawback of NQDCPs is the lack of immediate access to deferred funds. Compensation remains inaccessible until the agreed-upon payout date or triggering event, such as retirement, disability, or separation from service. This lack of liquidity can be a challenge if immediate access to funds is required for unforeseen circumstances or emergencies.
  • Potential Employer Risk: NQDCPs are subject to potential risks associated with the financial health of an employer. Financial difficulties, bankruptcy, or insolvency may lead to potential loss of deferred compensation. It is crucial to carefully evaluate the stability and reputation of an employer before committing to a deferred compensation plan.
  • Tax Implications: While tax deferral can be a significant benefit of NQDCPs, careful consideration of potential tax consequences during distribution is necessary. Upon payout, deferred compensation is generally subject to income tax, with additional taxes such as the Medicare surtax possibly applying as well. Thorough tax planning (including consultation with a trusted tax advisor) is vital to minimize one’s tax burden during payout.
  • Limited Portability: NQDCPs often lack portability compared to qualified retirement plans. Changing employers before the payout date may result in the forfeiture of some or all deferred compensation. It is essential, therefore, to pre-emptively review plan provisions and assess the potential impacts of job changes on deferred compensation benefits before committing to one.

Non-Qualified Deferred Compensation Plans can offer many advantages, including tax deferral, enhanced retirement savings, and customization options. However, limited liquidity and portability, potential employer risk, and tax implications are also possible drawbacks of this type of retirement plan. Individuals should evaluate all these pros and cons while also taking their personal financial goals and risk tolerance into consideration. Seeking advice from financial professionals who specialize in executive compensation can provide valuable guidance. Making informed decisions is critical to securing one’s long-term financial well-being while also optimizing the benefits and managing the risks associated with Non-Qualified Deferred Compensation Plans.