Most people are familiar with common qualified retirement plans such as a 401(k), but many are unsure of additional retirement plans they may be eligible for. Deferred compensation is one of those plans with many ins and outs that are often available as an added benefit to those in managerial positions at larger corporations.
While each employer’s deferred compensation plan is slightly different, there are some general features of most plans. We will take you through exactly what deferred compensation is and what the features and benefits of these plans are. We will also present some pitfalls to these plans that you should be aware of when participating.
At its heart, a Non-Qualified Deferred Compensation (NQDC) plan is an arrangement between an employer and their employee whereby the employer “promises” to pay the employee a predetermined amount of money in the future.
Why would an employer offer this? The simple answer is that there are several benefits to the employer. The main benefit for the employer is that cash outflows to the employee are deferred until the future. This frees up cash to use for other business purposes. The employer can also choose who they offer these plans to (often they are reserved for upper management employees). Other types of retirement plans, such as 401(k) plans, are governed by ERISA rules and must be offered to all employees who meet certain age and service requirements.
This certainly sounds like a good deal for the employer but why would anyone participate in this sort of plan? These plans provide several benefits to the employee. By deferring compensation into the future, the employee can defer income taxes on the amounts deferred under these plans. This can allow the employee to receive compensation at a time when they may be in a lower tax bracket (i.e. retirement). Additionally, the employee can potentially lower their current income tax rate by deferring their income into these plans. These two items together can lead to substantial tax savings. Employees who defer some of their compensation may also lower the chances they get caught in the alternative minimum tax (AMT), which may bring back some lost deductions under AMT rules. Finally, unlike 401(k) plans, NQDC plans do not have limitations on the amount that can be contributed annually. Therefore, these plans can be seen as “supplemental retirement savings” to a 401(k) plan.
With great benefits come certain risks, and NQDC plans are no different. The primary disadvantage of these plans is that they are not protected from the company’s creditors. Therefore, if the company becomes insolvent there is a risk that they may not be able to make good on that “promise” to pay you in the future. Another disadvantage of these plans is the lack of flexibility around distributions. In a 401(k) plan, the employee is usually able to control when distributions are made. With NQDC plans, this is often not the case. Distributions from these plans usually only take place after a qualifying event such as retirement, separation from service or change of control of the company.
Stay tuned for our follow-up post where we discuss the various ways in which you can take distributions from these plans once one of these “qualifying” events takes place.
If you have questions about your specific deferred compensation plan or need help understanding how your deferred compensation plan fits into your overall financial picture please contact us here.