A non-qualified deferred compensation plan (NQDC), also known as a 409(a) plan, is an employee-sponsored program for deferring income used by corporations to attract and retain senior executives. It is not a qualified retirement plan, like a 401(k), which is covered by the Employment Retirement Security Income Act (ERISA).
If you are eligible to participate in an non-qualified deferred compensation plan, you can postpone taking a portion of your compensation until a future date – which means you can delay paying income tax on these earnings until a time when you expect to be in a lower tax bracket, typically retirement. Many high-earning eligible executives who are already saving as much as possible via their 401(k)s use an NQDC plan as a way to defer additional compensation, above and beyond traditional retirement savings.
However, when you choose to participate in an non-qualified deferred compensation plan, you are subject to the provisions of your company’s plan and your money is generally not accessible until the date you originally elected, so the decision is not without risks.
Here are five questions to ask yourself before deciding whether to participate, how much to defer, and when you plan to take your distributions.
1. What are your future cash requirements?
Think about potentially significant expenses you may encounter in the future and estimate your liquidity requirements before deciding how much of your compensation to defer. For example, do you have a child about to enter college? Is your home due for major repairs? Or might you need to provide financial assistance to an elderly loved one? Keep in mind that a longer deferral period is potentially better for the investments and tax deferral but there is greater risk that something unexpected could occur in your personal life, leading to a need for these funds.
2. How financially healthy is your company?
When you participate in a non-qualified deferred compensation plan, you are considered an “unsecured creditor” of the company — and if your employer were to go bankrupt, the compensation you’ve deferred is at risk. A longer time horizon exposes you to a greater possibility that competitive pressures or other variables might negatively impact your employer.
One way to assess your employer’s financial health is to look at the financial health of its competitors, the competitive pressures it faces, and the long-term outlook for the industry in which your company operates. In addition, a deeper dive into the firm’s performance can give you a better perspective. Look at your firm’s:
• History of headcount reductions, high turnover, etc.
• Recent financial performance and projections
• Funding status
If you see any red flags, you may want to reconsider deferring.
3. What do you expect your tax rates to be in the future?
The U.S. has a progressive tax code, which means that the “marginal” rate you pay is based upon your earnings. The primary reason people defer their income is to reduce their taxes by receiving their pay at a time when they expect to have lower income. Consider whether you expect your tax bracket to change when you have elected to receive payments.
In addition, the Tax Cuts and Jobs Act of 2017, which lowered the highest marginal tax rate from 39.6% to 37%, is scheduled to sunset at the end of 2025. This means that when you receive your deferred income, your tax rate may be higher.
4. What is the quality of your non-qualified deferred compensation plan?
Not all plans are created equal. Before deciding whether or not to participate, also consider the investment options that are available to you, how diversified the options are, how flexible the distribution schedule is, whether your company offers an investment match, and if there is an investment minimum required to get the match.
5. Does a non-qualified deferred compensation plan fit within your overall financial strategy?
There are many complexities associated with deferred compensation. A Mason Financial Planner can help you review your financial plan holistically to help you create a deferral strategy, help you review your plan, explain your distribution options, and help you keep track of your deadlines, so you can maximize this corporate benefit.
