Were you offered participation in your company’s non-qualified deferred compensation (NQDC) plan and find yourself grappling with the decision? You are not alone. Every Fall, we receive numerous inquiries from corporate executives navigating this choice. Despite the substantial time and resources companies invest in crafting these compensation and benefits packages, many participants have a limited understanding of how these plans operate and the best way to maximize the benefits from these programs. Adding to the complexity, a looming deadline often makes the decision time-sensitive. To shed light on this, let’s explore the features, benefits, and risks associated with NQDC plans.
What is a NQDC plan?
Given the unique nature of an executive’s employment income, they do not typically have as much flexibility to defer income or accelerate deductions as an entrepreneur or business owner. A NQDC plan is one tool available to them. These plans allow individuals to defer salary, bonus, and/or commissions into future years, thereby postponing the associated income tax liability until a later date when the income is received, typically in retirement.
When an employee chooses to participate in a deferred compensation program, several questions arise:
- How much income should I defer? You can select a percentage to defer and even set a cap on the dollar amount deferred each year.
- Will I defer a portion of my salary and/or bonus?
- When do I want the income to be distributed to me in the future? Options may include at retirement, in a specific year, or perhaps at retirement plus one, three, or five years.
- For how long will it pay out? This could be in a lump sum or spread over a number of years.
*It is important to note that the elections made in the autumn of each year pertain to income earned in the following year but not necessarily paid that year. For instance, if I enroll in my NQDC plan for 2024 and elect to defer a portion of my salary and bonus, a portion of my 2024 salary will be deferred each pay period. However, I am not deferring the bonus paid to me in 2024; instead, I am deferring a portion of the bonus paid to me in 2025 for the work I did in 2024. Because this decision must be made so early, it can be challenging, as you typically do not know what to expect for your bonus almost a year and a half in advance, or if any changes in your financial or family situation might impact your need for cash flow.
What’s in it for me?
Tax Benefit: The primary appeal of the NQDC plan is the opportunity to defer income, reduce your current income tax liability, and allow the account to grow tax-deferred. Keep in mind that to benefit from the tax deferral and growth, you will need to be in a lower tax bracket at that future date when you receive the income.
However, it is important to consider that individuals often assume that they will be in a lower income tax bracket in retirement. Depending on when they retire, this may not be the case. There is always the possibility that changes in tax laws may result in higher tax rates than when the income was originally deferred. Additionally, if retirement occurs close to when required distributions from retirement plans (such as 401(k), pension, or IRA) must begin, there could be a significant amount of ordinary income still being recognized in retirement. In fact, some individuals who have deferred salary and bonuses for many years may find themselves in the highest tax bracket due to substantial growth in their NQDC plan, which can also impact Medicare premiums.
Cash Flow Planning: Some individuals appreciate the idea of creating an annuity for themselves in the future by deferring a portion of their bonus and having it pay out over a period of years, perhaps to coincide with the need to pay college expenses for a child. Alternatively, if they wish to retire early without tapping into other investment or retirement accounts, they can establish a cash flow stream, allowing them to delay collecting their Social Security benefits or from taking IRA distributions until required. NQDC can also serve as a form of forced savings, designating the funds toward a retirement goal and keeping them out of sight, out of mind.
What am I missing?
No access: In order to receive an income tax deferral, you are relinquishing access to those dollars until a specified time in the future. Unlike a 401(k) plan, which permits loans or hardship withdrawals in certain circumstances, you cannot request a distribution from your deferred compensation plan to cover a cash flow shortfall in the case of an unexpected expense. Therefore, you must be confident that the income you are deferring will not be needed in the near term.
No transferability: The lack of access to the NQDC plan also means the inability to use it for wealth transfer planning. The plan is not able to be transferred to another person, eliminating the opportunity to shift the income tax liability to a future generation or move any growth in the account out of the participant’s estate. If, instead, an individual had taken the income, paid the tax liability, and added it to a taxable investment account, it could have been shifted into a wealth transfer vehicle, with the value frozen at that time and any subsequent growth outside of the participant’s estate.
Additionally, growth in the taxable account would be subject to more favorable capital gain rates, unlike NQDC distributions, which are taxed as ordinary income. While NQDC plan distributions follow a previously chosen payout schedule, capital gains from a taxable account can be managed strategically over time.
It’s worth noting that as the NQDC account is pre-tax, it will not receive a step-up in basis at the owner’s death and will be subject to ordinary income tax when disbursed to the designated beneficiary.
Creditor risk: A NQDC plan does not offer the same protections in the event of a company insolvency as a plan governed by ERISA like a 401(k) plan or pension. As a participant in a NQDC plan, you will be an unsecured creditor of the company if it faces financial difficulties and there is no guarantee that you will receive the income that you deferred into the plan. While this risk may seem unlikely, it should not be ignored. During the 2008 financial crisis, I worked closely with many banking executives who faced the reality that their employers could become insolvent, putting NQDC assets at risk.
Summary
As you can see, there are numerous considerations when evaluating your company’s NQDC plan and how it aligns with your personal financial situation. There is not a “one-size-fits-all” approach. If you need help navigating compensation planning decisions, please reach out to one of our advisors. We will be happy to work with you to review your full balance sheet, cash flow needs, and tax situation to determine if utilizing your NQDC plan is the right choice for you.
This information is believed to be accurate at the time of publication but should not be used as specific investment or tax advice as opinions and legislation are subject to change. You should always consult your tax professional or other advisors before acting on the ideas presented here.
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December 27, 2023Were you offered participation in your company’s non-qualified deferred compensation (NQDC) plan and find yourself grappling with the decision? You are not alone. Every Fall, we receive numerous inquiries from corporate executives navigating this choice. Despite the substantial time and resources companies invest in crafting these compensation and benefits packages, many participants have a limited understanding of how these plans operate and the best way to maximize the benefits from these programs. Adding to the complexity, a looming deadline often makes the decision time-sensitive. To shed light on this, let’s explore the features, benefits, and risks associated with NQDC plans.
What is a NQDC plan?
Given the unique nature of an executive’s employment income, they do not typically have as much flexibility to defer income or accelerate deductions as an entrepreneur or business owner. A NQDC plan is one tool available to them. These plans allow individuals to defer salary, bonus, and/or commissions into future years, thereby postponing the associated income tax liability until a later date when the income is received, typically in retirement.
When an employee chooses to participate in a deferred compensation program, several questions arise:
*It is important to note that the elections made in the autumn of each year pertain to income earned in the following year but not necessarily paid that year. For instance, if I enroll in my NQDC plan for 2024 and elect to defer a portion of my salary and bonus, a portion of my 2024 salary will be deferred each pay period. However, I am not deferring the bonus paid to me in 2024; instead, I am deferring a portion of the bonus paid to me in 2025 for the work I did in 2024. Because this decision must be made so early, it can be challenging, as you typically do not know what to expect for your bonus almost a year and a half in advance, or if any changes in your financial or family situation might impact your need for cash flow.
What’s in it for me?
Tax Benefit: The primary appeal of the NQDC plan is the opportunity to defer income, reduce your current income tax liability, and allow the account to grow tax-deferred. Keep in mind that to benefit from the tax deferral and growth, you will need to be in a lower tax bracket at that future date when you receive the income.
However, it is important to consider that individuals often assume that they will be in a lower income tax bracket in retirement. Depending on when they retire, this may not be the case. There is always the possibility that changes in tax laws may result in higher tax rates than when the income was originally deferred. Additionally, if retirement occurs close to when required distributions from retirement plans (such as 401(k), pension, or IRA) must begin, there could be a significant amount of ordinary income still being recognized in retirement. In fact, some individuals who have deferred salary and bonuses for many years may find themselves in the highest tax bracket due to substantial growth in their NQDC plan, which can also impact Medicare premiums.
Cash Flow Planning: Some individuals appreciate the idea of creating an annuity for themselves in the future by deferring a portion of their bonus and having it pay out over a period of years, perhaps to coincide with the need to pay college expenses for a child. Alternatively, if they wish to retire early without tapping into other investment or retirement accounts, they can establish a cash flow stream, allowing them to delay collecting their Social Security benefits or from taking IRA distributions until required. NQDC can also serve as a form of forced savings, designating the funds toward a retirement goal and keeping them out of sight, out of mind.
What am I missing?
No access: In order to receive an income tax deferral, you are relinquishing access to those dollars until a specified time in the future. Unlike a 401(k) plan, which permits loans or hardship withdrawals in certain circumstances, you cannot request a distribution from your deferred compensation plan to cover a cash flow shortfall in the case of an unexpected expense. Therefore, you must be confident that the income you are deferring will not be needed in the near term.
No transferability: The lack of access to the NQDC plan also means the inability to use it for wealth transfer planning. The plan is not able to be transferred to another person, eliminating the opportunity to shift the income tax liability to a future generation or move any growth in the account out of the participant’s estate. If, instead, an individual had taken the income, paid the tax liability, and added it to a taxable investment account, it could have been shifted into a wealth transfer vehicle, with the value frozen at that time and any subsequent growth outside of the participant’s estate.
Additionally, growth in the taxable account would be subject to more favorable capital gain rates, unlike NQDC distributions, which are taxed as ordinary income. While NQDC plan distributions follow a previously chosen payout schedule, capital gains from a taxable account can be managed strategically over time.
It’s worth noting that as the NQDC account is pre-tax, it will not receive a step-up in basis at the owner’s death and will be subject to ordinary income tax when disbursed to the designated beneficiary.
Creditor risk: A NQDC plan does not offer the same protections in the event of a company insolvency as a plan governed by ERISA like a 401(k) plan or pension. As a participant in a NQDC plan, you will be an unsecured creditor of the company if it faces financial difficulties and there is no guarantee that you will receive the income that you deferred into the plan. While this risk may seem unlikely, it should not be ignored. During the 2008 financial crisis, I worked closely with many banking executives who faced the reality that their employers could become insolvent, putting NQDC assets at risk.
Summary
As you can see, there are numerous considerations when evaluating your company’s NQDC plan and how it aligns with your personal financial situation. There is not a “one-size-fits-all” approach. If you need help navigating compensation planning decisions, please reach out to one of our advisors. We will be happy to work with you to review your full balance sheet, cash flow needs, and tax situation to determine if utilizing your NQDC plan is the right choice for you.
This information is believed to be accurate at the time of publication but should not be used as specific investment or tax advice as opinions and legislation are subject to change. You should always consult your tax professional or other advisors before acting on the ideas presented here.
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