By Carmine Coppola
Deferred compensation allows you to delay receiving a portion of your income until a later date, which can be particularly advantageous if your taxable income is expected to be lower in the future. For many, this strategy mirrors the familiar 401(k) plan, a qualified deferred compensation plan protected by the Employee Retirement Income Security Act of 1974 (ERISA). While 401(k) plans have their benefits, particularly for the average employee, they come with restrictions that can limit their utility for high earners. This is where non-qualified deferred compensation (NQDC) plans step in, offering far greater flexibility and potential benefits.
What Are Non-Qualified Deferred Compensation Plans?
Non-qualified deferred compensation plans, often referred to as elective deferral plans or supplemental executive retirement plans (SERPs), provide a powerful tool for high-income earners to manage their income and tax liabilities strategically. Unlike qualified plans like 401(k)s, NQDC plans do not have the same contribution limits, age restrictions on withdrawals, or required minimum distributions (RMDs). This means you can defer a significant portion of your income, reducing your taxable income for the current year while allowing the deferred amount to grow tax-deferred until you choose to withdraw it.
Moreover, many NQDC plans allow you to select your investments and may even include a company match—essentially a raise that can further enhance your financial growth. These plans are sometimes called “golden handcuffs” because they can be used by employers to incentivize retention among their most valuable employees. The more you earn and defer, the more you stand to benefit from the tax advantages, making NQDC plans an attractive option for those planning to stay with their employer long-term.
Strategic Considerations for NQDC Plans
Participation in an NQDC plan requires careful planning and decision-making. Typically, you’ll need to enroll during a designated period and establish a written agreement with your employer. This agreement outlines critical details, such as the amount of income you’ll defer, the deferral period or distribution schedule, and your investment choices. Once these elections are made, they can be challenging, if not impossible, to change, so it’s essential to approach this decision with a clear understanding of your financial goals and the potential long-term impact.
To simplify the process, it’s helpful to break down your strategy into three main components:
1. Purpose: What specific goals do you want to achieve with your deferred compensation? Are you saving for retirement, a child’s education, or a major purchase like a vacation home?
2. Amount: How much of your salary or bonus will you defer each year? This decision will depend on your current financial needs and your future goals.
3. Timing: When do you want to start receiving distributions, and how long do you want them to last? Your timing will affect your tax liabilities and your ability to meet your financial goals.
Practical Examples of NQDC Plan Utilization
To illustrate how NQDC plans can be strategically leveraged, consider the case of Gianna, a highly compensated employee with a salary and bonus totaling $550,000 per year. Gianna also receives $50,000 annually in restricted stock units (RSUs) and is withdrawing $25,000 per year from an inherited IRA. This puts her total income at $625,000, placing her in the highest federal tax bracket with an effective tax rate of 30.7%. Gianna doesn’t need the additional $75,000 in income from the RSUs and IRA, so she decides to defer $75,000 of her bonus each year into her NQDC plan. By doing this, she reduces her taxable income to $550,000, dropping her just below the threshold for the highest tax bracket and saving her approximately $27,000 in federal taxes annually. Over ten years, this strategy could add $750,000 to her retirement savings, not including investment growth, while maintaining her current lifestyle.
Another example involves Bill and Laura, a couple with ambitious financial goals. They plan to cover their children’s college expenses and purchase a dream vacation home. Bill, who has an NQDC plan through his job, decides to defer $50,000 per year into three different accounts within the plan, each aligned with a specific goal. One account will cover their son’s college expenses, another their daughter’s college expenses, and the third will be used for the down payment on the vacation home. By carefully structuring their deferrals and distributions, Bill and Laura can achieve these goals without disrupting their cash flow or lifestyle.
Addressing Income Gaps and Retirement Planning
NQDC plans can also be a valuable tool for addressing income gaps in retirement. For example, John and Sarah plan to retire at 62 but want to delay taking Social Security until they turn 67. This creates a five-year income gap. By deferring a portion of her bonus each year, Sarah can use the distributions from her NQDC plan to fill this gap, allowing their retirement and investment assets to continue growing. This strategy also gives them the flexibility to maximize their Social Security benefits by delaying them until age 70.
Mitigating Risks and Planning for the Unexpected
It’s essential to recognize that while NQDC plans offer significant benefits, they also come with risks. For instance, if your company undergoes layoffs or restructuring, you could face financial uncertainty. However, if you’ve been deferring a portion of your income into an NQDC plan, you may have a financial cushion to fall back on. Consider the case of Mike, a 55-year-old vice president who began deferring part of his bonus each year. With a current plan value of $350,000, Mike has the flexibility to manage his income if he’s laid off, retires early, or decides to work for a lower salary. His NQDC plan allows him to supplement his income, cover health insurance costs, and delay taking Social Security until it’s more advantageous.
Non-qualified deferred compensation plans are a potent tool for high-income earners looking to strategically manage their income, reduce tax liabilities, and achieve long-term financial goals. However, these plans are complex and require careful planning and ongoing management. Before making any decisions, it’s crucial to collaborate with a seasoned financial professional who can help you navigate the options and ensure your deferred compensation plan is intricately woven into your broader financial and retirement strategy. By taking a thoughtful approach, you can leverage your NQDC plan to secure a more flexible and financially stable future.