Your Employer Offers You Non-Qualified Deferred Compensation (NQDC): Now What?

retirement planning | Savings

 Daniel Lee By: Daniel Lee

It’s always nice to be recognized for a job well done. Being invited to participate in your employer’s non-qualified deferred compensation (NQDC) plan, is one such vote of confidence; it’s typically offered exclusively to select executives or similar high-performing employees.

That said, just because you can participate in your employer’s NQDC, does not always mean you should. Properly deployed, an NQDC can be a powerful tool for reducing your federal and state tax liabilities. But determining whether this benefit actually benefits you requires careful planning, and a solid understanding of the perks and perils involved.

What Is an NQDC?

As an NQDC plan participant, you make pre-tax contributions into an investment account where your holdings grow tax-deferred until you receive distributions.

If you’re thinking this sounds very similar to a traditional 401(k) plan, you are correct. In fact, your company’s 401(k) and NQDC plans often share the same investment options and recordkeeper.

Similarities between NQDC and 401(k) plans

Contributions

Pre-Tax*

Growth

 Tax-deferred

Distributions

Taxed as income

 * Federal and state tax-deferred; payroll tax is required

So, what’s an NQDC got that a 401(k) does not?

The big advantage of NQDC plans is there is no regulatory limit on how much income you can defer into one, although your company may have a limit of its own. For example, your company may limit deferrals to 50% of your eligible base pay and 100% of your eligible variable pay. That still provides an opportunity to defer income tax on potentially six-figure levels of wealth per year

So, if you’re a high-income earner, an NQDC plan can supercharge your ability to build tax-deferred retirement wealth. In comparison, 2020 contribution limits for 401(k) plans are $19,500, plus an extra $6,500 catch-up contribution if you’re 50 or older. This may not be a meaningful amount relative to your income.

What’s the Catch?

Before you start pouring all of your hard-won pay into your employer’s NQDC, there is a big drawback you’ll want to know about: To maintain their tax-deferred status, your participant contributions must be an unfunded and unsecured company obligation. In other words:

If your employer faces financial hardship, you could lose some or all of the pay you’ve deferred into their NQDC accounts.

Your employer could fully secure employee NQDC assets by setting them aside in an irrevocable secular trust. But if they do, the NQDC plan loses all of its tax benefit.

There is another possibility. To offer some level of security, your employer can place NQDC assets in a rabbi trust (named after an IRS private letter ruling involving a rabbi). Once they’ve committed the assets to this irrevocable rabbi trust, your employer cannot access them again.

A rabbi trust protects you from losing your assets due to employer financial mismanagement or a hostile takeover. That said, the protection is not iron-clad. For the NQDC plan to maintain its tax advantage, the assets are still subject to employer creditor claims and other company financial crises. For example, Chrysler executives were left with nothing in their NQDC accounts after the company declared bankruptcy in 2008.

 

Unfunded Promise

Rabbi Trust

Secular Trust

Funded with assets

No

Yes

Yes

Tax benefits

No

Yes

Yes

Risk of forfeiture if employer mismanages the assets

No

No

Yes

Risk of forfeiture if employer becomes insolvent

Yes

Yes

No

 

Added Complexities

NQDC plans also involve strict contribution rules and complicated distribution options. Rules can vary by plan. But in general, you must select your contribution elections ahead of time for the following year, often during a fall open enrollment. Once you’ve made your elections, you cannot change them.

You also must elect an up-front distribution method when you enroll. Here are some of the common distribution elections and options we’ve seen:

  • You can elect to receive distributions after separation of employment (voluntary or involuntary). At retirement, you can receive the distribution in a lump-sum payment, or in annual installments over five, 10, or 15 years.
  • You can elect to receive a lump-sum, in-service distribution while still employed with the employer. You can select any calendar year at least two years after the year of contribution.
  • You can opt to receive a distribution earlier than scheduled if you become disabled. You can receive the distribution in a lump-sum payment, or in annual installments over five, 10, or 15 years.
  • You can opt to receive a distribution earlier than scheduled if your employer experiences a “change in control,” such as a merger or acquisition. If you elect this option, you will receive a lump-sum payment within 60 days of the change.

It is important to be thoughtful when you make your distribution election, because changes are strictly limited by federal tax regulations. In general, you must meet two requirements to change your distribution election:

  1. You must make the change at least one year before the previously scheduled payment commencement date.
  2. The timing should defer any distribution at least five years beyond the previously scheduled payment commencement date (unless you have become disabled or there is a change of control, as described above).

Cart vs. Horse Considerations

As touched on earlier, participating in an NQDC can give you a nice boost for tax-deferred retirement assets. But to avoid costly mistakes, you’ll want to ensure that your personal financial circumstances lead the way, rather than your tax-planning “cart.”

For that, careful planning is in order. Here are a few key considerations.

  1. Your time horizon: How long do you expect to hold your NQDC in general, and each annual contribution in particular (given potentially different distribution elections for each year)? For distant time horizons, you might take extra investment risk in pursuit of higher expected returns. For those closer in, you’re probably best off allocating to safer holdings.
  2. Relative tax rates: Do you expect your tax rate to be lower or higher when you take your distributions vs. when you took the deferral? If it is likely to be lower upon distribution, participating in an NQDC plan might be beneficial. Remember, the Tax Cuts and Jobs Act of 2017 lowered the highest federal income tax bracket from 39.6% to 37% – potentially temporarily. The top rate since the 1990s has been roughly 39.6%, aside from 2003–2012 when it was temporarily 35%.
  3. State tax codes: Where do you plan to live in retirement? If you live in a high (or low) tax state and plan to retire in a lower (or higher) tax state, the income tax laws can be complicated. We recommend consulting an accountant or attorney well ahead of time.
  4. Risk management: No matter how solid it may seem, any company can unravel. We advise looking across your net worth and limiting your NQDC plan and employer stock offerings to the amount you could afford to lose entirely, should worse come to worst. Company-specific default risk applies to both benefits.
  5. Risk tolerance: If the possibility of a default is still a concern, you could wait until you are closer to retirement to contribute to the NQDC plan, or shorten the distribution period after retirement. This further minimizes your company-specific risk exposure.

Measure Twice Before Committing at Once

Again, if circumstances are right, you may be able to reap considerable tax breaks if you are invited to participate in your company’s NQDC. But we also advise engaging in considerable planning before you commit, to determine whether it’s actually likely to benefit you.

Your comprehensive plan and tax projections should include forecasting estimated cash flow in retirement. This includes coordinating all sources of retirement income, such as Social Security, distributions from pre-tax 401(k) and IRA accounts, Roth accounts, HSAs, and taxable portfolio income. It also includes ticking off the considerations described above.

If everything checks out for you, consider yourself fortunate to have access to your employer’s NQDC. If not, don’t hesitate to respond with a “Thanks, but no thanks … at least for now.”

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Disclaimer: This material has been prepared for informational purposes only and should not be used as investment, tax, legal or accounting advice. All investing involves risk. Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. You should consult your own tax, legal and accounting advisors.

 

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Daniel joined Plancorp in 2019 after spending over a decade with a local Bay Area firm. He leads our Silicon Valley office and specializes in helping busy professionals optimize complex retirement and equity compensation plans. Daniel also researches socially and environmentally responsible investing for the firm. Daniel earned a BS in Economics and Biopsychology from the University of Michigan and completed the UC Berkeley Extension Personal Financial Planning program. More »