A nonqualified deferred compensation (NQDC) plan is an arrangement that an employer and employee agree to where the employer accepts to pay the employee sometime in the future. Executives often utilize NQDC plans to defer income taxes on their earnings. They differ drastically from qualified plans, like 401(k)s. As you explore how NQDC plans work and how they compare to qualified ones, you may also consider finding a financial advisor who could help you create a financial plan for your retirement and tax needs.
What Is a Nonqualified Deferred Compensation (NQDC) Plan?
Deferred compensation plans are essentially agreements your employer makes with you saying that you’ll receive compensation at some point in the future. There are two types of deferred compensation plans: nonqualified deferred compensation (NQDC) plans and qualified deferred compensation plans. The difference between the two kinds of plans lies in the way people use them and how the law views them.
Through NQDC plans, employers can offer bonuses, salaries and other kinds of compensation. But instead of giving out this additional income right away, employers defer payment and give it out at a later date. In the process of postponing the payment of extra money and benefits, the tax owed on this extra income gets deferred as well. NQDC’s are especially good for employees who are already maxing out their qualified plans, such as 401(k) plans.
NQDC plans can exist in the form of stock options and retirement plans. People also call them 409(a) plans.
Nonqualified Deferred Compensation (NQDC) Plans vs. Qualified Deferred Plans
There are a few things you’ll need to consider when trying to decide between a qualified deferred compensation plan and a nonqualified deferred compensation plan. Qualified deferred compensation plans must abide by rules under the Employee Retirement Income Security Act (ERISA). While there are rules regarding NQDC plans, the guidelines these plans are subject to aren’t as strict.
Another key difference between the two kinds of plans is the fact that qualified deferred compensation plans have income caps. For example, a 401(k) is a qualified deferred compensation plan. Each tax year, there’s a limit to how much you can contribute.
NQDC plans don’t come with contribution caps. That’s why they can be beneficial to high-income earners who want to contribute more than qualified deferred compensation plans allow them to. At the same time, since NQDC plans are merely agreements there’s no guarantee that the benefits will be available to employees (especially if a company has financial problems and has to declare bankruptcy in the future).
Plans must me in writing and specify the amount paid, the payment schedule and the event that will trigger payment. This event could be a fixed date, retirement or another event.
What to Consider About Nonqualified Deferred Compensation (NQDC) Plans
Nonqualified deferred compensation plans aren’t for everyone. It’s best to think about whether participating in one makes sense based on your own financial circumstances. For example, participating in a NQDC plan because you want to save more money for retirement might be pointless if you’re not maxing out your 401(k) every year.
NQDC plans typically hand out deferred income after employees retire. So you might also want to think about how your tax bracket will change when you stop working (or whenever you elect to receive the deferred payments). You’ll benefit the most from having a NQDC plan if you wind up in a lower tax bracket since you’ll be paying income taxes on the deferred funds.
Another factor you’ll need to consider is the kind of investments that will be tied to your NQDC plan. If the investment options are the same as the ones offered through your 401(k) you may not need a NQDC plan, particularly since employer-sponsored plans (like 401(k)s and 403(b)s) are more secure.
The table below summarizes three key advantages and disadvantages when considering a NQDC plan:
|Nonqualified Deferred Compensation (NQDC) Plan Comparison|
|– No federally mandated contribution limits (but employer could set contribution limits based on compensation)||– Must schedule distributions in advance (taxable income will be bigger on set tax year)|
|– Reduce annual taxable income by deferring compensation (though FICA and FUTA taxes on deferred compensation must be paid on earned year)||– Cannot make early withdrawals|
|– Bigger investment options||– No ERISA protections|
There are a number of different purposes that nonqualified deferred compensation (NQDC) plans serve. This makes them extremely complicated agreements. Before you enter one, be sure that you have a full understanding of what they entail. It might even be worth consulting a financial advisor. Such an expert can teach you how an NQDC plan could affect your long-term retirement planning and tax situation.
Retirement Planning Tips
- If you have an NQDC, you might want to work with a financial advisor to help you create a financial plan for your retirement needs and goals. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Don’t forget to take Social Security into account when you project how much you will need to save for retirement. Although it’s nearly impossible to live off Social Security on its own, these payments can help fill the gaps if your savings come up just short. For an accurate assessment as to what your benefits will look like, stop by SmartAsset’s Social Security calculator.
- A 401(k) account is one of the easiest retirement savings vehicles to utilize. In fact, they are usually available right through your employer. You can set a specific amount of money to transfer from every paycheck. Your employer may even match contributions. The SmartAsset 401(k) calculator makes it easy to figure out how much your money will be worth in retirement.
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