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A non-qualified deferred consideration (NQDC) plan is a great way for employers to attract and retain key talent. It also represents a potentially huge tax savings for high-compensation employees. However, there is a lot you should know about these plans before you decide to participate. So let’s get to the basics.
A non-qualified deferred compensation (NQDC) plan allows employees to earn their wages, potential bonuses, and other forms of compensation in one year, but receive that income in a future year. This also defers the income tax on the reimbursement. It helps generate income for the future and there is a possibility for a reduced amount of income tax to be paid if the employee is in a lower tax bracket at the time of the deferment.
It is worth noting that tax law requires these NQDC plans to be in writing. There must be documentation on the amount to be paid, the payment schedule and what the future trigger event will be for the compensation payout. There must also be a statement from the employee that they intend to defer compensation beyond the year.
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Retirement planning
An NQDC plan is a contractual fringe benefit that is often included as part of an overall key executive compensation package. It can serve as an important complement to traditional retirement savings tools such as individual retirement accounts – IRA and 401(k) plans.
As with a 401(k), you can defer reimbursement in the plan, defer taxes on any income until future withdrawals and designate beneficiaries. Unlike a 401(k) plan or traditional IRA, there are no contribution limits for an NQDC — although your employer can set its own limits. Therefore, you may be able to defer all of your annual bonuses to supplement your retirement. We’ve seen companies also allow you to defer as much as 25-50% of your base salary.
Employers: take note
NQDC plans also have some advantages for employers. The plans are a cheap venture. After the initial legal and accounting fees, no annual payments are required. There are no unnecessary declarations to government agencies such as the Tax and Customs Administration.
Since the plans are not qualified, they are not covered by the Income Security Pension Employees Act (ERISA). This provides more flexibility for both employers and employees. Employers can offer NQDC plans to select executives and employees who will benefit the most.
Companies can tailor plans to valued members of their workforce, incentivizing those employees to stay with the company. For example, an employee’s deferred compensation may be forfeited if the employee decides to leave the company before retirement. We call this strategy a “golden handcuffs” approach.
Related: Why Good Employees Leave — And What You Can Do About It
Employees: beware
For high-paid workers, Social Security and 401(k) can replace only a limited portion of your retirement income. You may be able to build most of your retirement savings with your NQDC plan. There’s also the bonus of reducing your annual taxable income by deferring your reimbursement. This brings into play the idea of being in a lower tax bracket, lowering the amount of taxes you would have to pay. Many employers even encourage this by offering some kind of match.
Time of payment
The timing of when you take NQDC distributions is important because you need to project your potential cash flow needs and tax liabilities well into the future.
Deferred compensation plans require you to choose in advance when you will receive the money. For example, you can time the payments to retire or when a child starts college. In addition, the funds can come all at once or in a series of payments. There is often enormous flexibility in these plans.
Paying a lump sum gives you immediate access to your money at the distributable event (often retirement or separation). While you are free to invest or spend the money as you see fit, you regularly owe income tax on the entire lump sum and lose the benefit of deferred tax preparation. If you choose to withdraw the money in installments, the remainder can continue to grow with tax deferrals and spread your tax bill over several years.
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Risks
An NQDC plan carries some risks. When you participate in a qualified plan, your assets are segregated from the business assets and 100% of your contributions are yours. Because a Section 409A plan is non-qualified, your assets are tied to your employer’s general assets. In the event of bankruptcy, deferred employees become unsecured creditors of the company and must stand behind secured creditors in hopes of getting paid.
So you need to consider how much of your assets – including salary, bonus, stock options and limited shares – is already tied to the future health and success of one company. Adding deferred offset exposure may result in you taking on more risk than is appropriate for your personal situation.
Before choosing to participate in an NQDC plan, you should speak with both your financial advisor and your tax advisor. You really want to model how and when you get these payouts. Ideally, you plan with enough foresight that you will offset this income tax event in retirement with withdrawals from a brokerage account or a Roth IRA or 401(k). You’ll also want to pay attention to the impact of high income with the Medicare Part B tax — if you think there are a lot of moving parts here, you’re right! Done right, you can really develop a unique plan tailored to your exact living situation and future goals.
Any discussion of taxes is for general informational purposes only, is not intended to be exhaustive or cover every situation, and should not be construed as legal, tax, or accounting advice. Clients should consult with their qualified legal, tax and accounting advisors as appropriate.
