Non-Qualified Deferred Compensation Plans: Pros and Cons
By: Kevin O’Brien, CFP®, AIF®, CAP®
The majority of people have heard of 401Ks and IRAs as being the preferred methods of saving towards their retirement goals. However, not many people have heard of, nor do they have access to, a Non-Qualified Deferred Compensation Plan (NQDC). If you’ve heard of them, and have access to one, then this article is for you.
Similar to 401Ks, But Not Really:
The benefits and trade-offs of NQDCs are many. Similar to your 401K, NQDCs allow you to defer your income into the plan on a pre-tax basis, make investment choices inside of the plan, and obtain tax-deferred growth on your assets until distributions are taken. Unlike a 401K, you must usually select when and how you want the distributions to be taken beforehand. If the plan allows it, “in-service” distributions can be elected while you are still employed at the company, and before age 59 ½ without penalty. This is important, because personal goals that occur earlier than retirement can be saved for on a pre-tax basis, such as children’s education. Also, unlike 401Ks, there are no contribution limits and no required minimum distributions.
Other Factors to Consider:
Qualified plans, such as 401Ks, are governed by IRC 401A and ERISA laws. Because NQDCs do not fall under these provisions, other factors must be weighed before you decide to participate. The money you defer into an NQDC plan is considered an asset of the company’s until you take it out. Therefore, it is subject to the risk of creditors in the event the company goes bankrupt. Also, barring termination of employment, getting at your money can be restricted solely to the distribution timing and method you originally chose before participating in the plan. There are no loan provisions, rollovers to IRAs are no allowed. Other than by death, disability, or separation from service, there are no other hardship or early withdrawal allowances.
Great Tax Mitigation Tool:
If you determined the benefits outweigh the trade-offs, then read on. Executives who have access to NQDCs will usually have other compensation benefits such as performance bonuses, stock options, and restricted stock or RSUs. With proper planning and foresight, NQDCs can play an integral role in reducing income taxes on these other plan benefits. As an example, if the executive has a systematic strategy for exercising stock options or certain tranches of RSUs are vesting each year, they can anticipate these taxable events and elect to defer a similar amount of income into the NQDC, effectively exercising and vesting in company shares without any increase to their tax liability.
Like most financial decisions, the one you make about your NQDC plan should not be done in a silo. A comprehensive wealth management approach to your finances will take into consideration your goals, time constraints, tax actuation, and risk tolerance. Taken in this context, the answers to, “should I invest in my NQDC and how much should I defer?” can be answered with clarity and confidence.
Kevin M. O’Brien, CFP, AIF, CAP is Founder and President of Peak Financial Services, Inc. Advisory Services offered through Peak Financial Services, Inc., a Registered Investment Advisor. Securities offered through Triad Advisors, member FINRA/SIPC. Triad Advisors and Peak Financial Services, Inc. are not affiliated.