When planning for retirement is a priority, your employee benefits package is likely to be your starting point. Having access to a tax-advantaged employer savings plan – such as a 401(k) or 403(b) – can help you to build wealth for retirement while deferring taxes on your portfolio’s growth.
Nonqualified deferred compensation plans (NQDC) offer another path to building retirement wealth. These plans are used by private companies to attract and retain executives and other highly compensated employees. In a 2017 Newport Group survey, 92% of companies polled said they offered NQDCs to their executives at some level in the organization.
These plans make it possible for eligible employees to save more for retirement when they’ve maxed out an existing employer savings plan. At the same time, NQDCs allow employees to reap the benefits of deferred taxation. (For more, see Executive Deferred Comp: Understanding NQDC.)
How Nonqualified Deferred Compensation Plans Work
In a nutshell, an NQDC allows highly compensated employees to defer some of their compensation to a later year. You decide how much of your salary, bonuses, commissions or other compensation to defer. Essentially, your employer agrees to pay you that money down the road, which could be five or 10 years in the future, or even upon your retirement date.
That’s different from a 401(k) and other defined-contribution plans, which allow you to contribute a percentage of your income each year, up to the annual contribution limit. Once you retire, you’d begin taking distributions from your plan, which would be subject to your ordinary income tax rate. With an NQDC, you don’t pay any income tax on the part of your compensation you’re deferring, just Social Security and Medicare taxes. In doing so, you’re letting that money grow tax-deferred until you receive it.
That’s a boon for higher income earners. For 2018, for instance, the maximum annual contribution limit to a 401(k) is $18,500 for employees. Employers can also make matching contributions, with total contributions topping out at $55,000 for the year.
For someone making $1 million a year, that $18,500 contribution represents just a fraction of their income. A nest egg to support that income level in retirement requires considerably more savings and finding tax-advantaged routes to accomplish this can be difficult, even if the employee also maxes out an IRA and health savings account (HSA). (See a detailed explanation in Why Retiring on 70% of Your Income Might Be Tough. Then review Why HSAs Appeal More to High-Income Earners)
An NQDC accomplishes this goal, allowing employees put aside additional money beyond their employer plans for their later years on a tax-advantaged basis. For some highly compensated employees, an NQDC may be a more attractive option than paying taxes on all their compensation each year and supplementing their tax-advantaged plans with a taxable brokerage account.
Potential Downsides of Using an NQDC to Fund Your Retirement
Deferring compensation can yield tax benefits, but there are some things to consider before taking advantage of one of these plans.
First, you must be strategic in how much of your compensation you defer. Internal Revenue Code Section 409A states that employees must choose their deferral election in the year before it takes effect. Once you make that election, you can’t change it once the working period begins. Under those rules, it's possible to defer too much – or not enough – of your compensation in any given year.
Another potential downside is that you can’t roll over money from an NQDC into an IRA or another retirement plan, the way you can with a 401(k) or similar plan. That, together with the fixed rules for making deferral elections, makes these plans less flexible compared to other employer retirement savings options.
A third issue – and this is a big one – is that the assets in an NQDC are typically viewed as unsecured general assets of the company. If your employer were to file bankruptcy or be sued, those assets would be vulnerable to creditor claims. If you’ve deferred a sizable amount of compensation into your plan, you’re assuming a certain degree of risk, in addition to any risk you might incur if your contributions were being invested in the market, the way they would with a 401(k).
The Bottom Line
Nonqualified deferred compensation plans may be a more appropriate choice for some employees than others. If you have a high annual income and are consistently maxing out your 401(k) or a similar plan, an NQDC could help you add to your savings while leveraging some tax benefits. Just remember to weigh the potential risks of adding one of these plans to your retirement strategy against any rewards you stand to gain.