Participants in nonqualified deferred compensation (NQDC) plans are able to set large amounts of tax-deferred compensation aside. They are also able to schedule distributions in ways that will best meet their financial planning goals. There are some advantages to participating in an NQDC plan, however, participation can prove risky to some. Before you take advantage of an NQDC plan your employer is providing or make the decision, as a business owner, to offer this type of plan to your employees, you should carefully consider the advantages and disadvantages.
What is a Nonqualified Deferred Compensation Plan?
An NQDC plan is a type of benefit employers offer to their employees. Under an NQDC plan, an employer is able to make after-tax contributions on behalf of a participating employee, directing a portion of the employee’s salary into separate accounts that are held in trust. Participating employees essentially defer a portion of their compensation until either a single date or multiple dates in the future. The contributions the employer makes for their employees may utilize a vesting schedule according to the employee’s years of service to the organization or their performance. Vesting schedules may also be tied to an event such as an IPO or sale. Some employers allow their employees to match the corporate contribution being made on their behalf while others restrict contributions to those made by the employer, exclusively.
How do Qualified Defined Compensation Plans Differ from NQDC Plans?
Qualified defined contribution plans rely upon tax-deferred contributions made by the employee. Participants are allowed to direct how their contributions will be invested, making selections from the investment options offered in the plan. Employers are also permitted to contribute to the plan and take a deduction for the amount they contribute. Qualified defined compensation plans are subject to the applicable requirements of the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code which include annual contribution limits, early withdrawal penalties, required minimum distributions, and nondiscrimination rules.
What are the Benefits?
One of the pluses of being a participant in an NQDC plan is that you can defer income taxes on the compensation you set aside to go into the plan until you actually receive that compensation. Although you do not pay income taxes on that compensation until you receive it, you may or may not have to pay FICA taxes on the compensation in the year that you earn it.
Unlike qualified defined compensation plans which usually include a contribution limit, some NQDC plans may not have a contribution limit associated with them, allowing you to put aside a good portion of your earnings.
NQDC plans also afford participants greater flexibility in scheduling their distributions so that they can plan more precisely on how to meet financial goals such as the funding of a retirement plan or saving for college tuition. There is no penalty for distributions taken before the age of 59½ and there is no requirement to take required minimum distributions at a certain age.
Employers may be interested in offering an NQDC plan to select employees as they have the ability to limit the NQDC plans to include only employees who fall into a certain category such as those who are highly compensated. Additionally, these plans allow the employer to avoid costs associated with ERISA’s reporting and administrative compliance requirements.
The Downside to NQDC Plans
For those who choose to participate in an NQDC plan, the most significant disadvantage is that deferred compensation is an item that is subject to the claims of the employer’s creditors. Deferred compensation can also be compromised if an organization faces bankruptcy or insolvency issues. Furthermore, you may not be able to take loans from the NQDC plan and are not permitted to roll over distributions into an IRA, qualified plan, or other retirement accounts. Finally, there are limitations regarding the timing of deferral elections.
Another drawback is that NQDC plans are secured only by the employer’s promise to pay out the deferred compensation. Participants do have the ability to earmark funds in a special type of trust to ensure that their employer doesn’t use their contributions for other purposes, but even these funds are not protected from creditors’ claims.
The disadvantage of NQDC plans for employers is that, unlike contributions employers make to qualified plans, deferred compensation contributions are not tax-deductible by the employer until the deferred compensation is paid.
Though NQDC plans offer attractive benefits, they come with their own set of challenges. To determine whether or not it’s a good idea for you to participate in your company’s NQDC plan or, as an employer, if it’s wise for you to implement one, contact your Untracht Early advisor.