Equity Compensation
By: Brian Watson August 7, 2024
Contributing to tax-advantaged accounts like 401(k)s and IRAs is one of the most effective ways to build a substantial nest egg that will allow you to live comfortably in retirement. However, these types of plans are subject to IRS rules that restrict annual contribution amounts and can limit your savings. If you’re looking for other ways to boost your retirement savings and your employer offers one, you may consider enrolling in your company’s nonqualified deferred compensation plan (NQDC). Let’s look at what you should consider before deciding if and how much to contribute to a NQDC plan.
What Is a Deferred Compensation Plan?
In the strictest definition, a deferred compensation plan is any plan, including a traditional 401(k), IRA or pension, that allows you to set aside pre-tax dollars that grow tax-deferred until you make withdrawals.
But when someone uses the term deferred compensation plan, they aren’t usually referring to one of these standard retirement savings plans. They’re referring to supplemental retirement plans employers often offer high earners to attract and retain top talent.
There are two types of deferred compensation plans — qualified and nonqualified. The rules and risks of qualified plans are similar to those of traditional retirement plans. But nonqualified plans have different features and additional risks. We will be discussing these types of plans from here on and will refer to these with the blanket term: deferred compensation plan.
What makes a Deferred Compensation Plan unique?
Most notably, nonqualified deferred compensation plans aren’t eligible for protection under ERISA laws.
When you contribute to a deferred compensation plan, you receive the equivalent of an IOU from the company. You don’t truly own anything until you receive a payout.
In the meantime, contributions made become corporate assets that are exposed to the company’s creditors. They aren’t held in a separate account the way 401(k) or IRA contributions are and in a worst-case scenario if the company goes under, that value could drop to zero.
For this reason, it’s essential to understand the risks and weigh the pros and cons before contributing to a deferred compensation plan.
Evaluating the following five factors can help you determine whether contributing to a deferred compensation plan makes sense or if a different savings route might be more beneficial.
1. Current Cash Flow
The number one factor to consider when deciding whether to contribute to a deferred compensation plan is whether you have excess cash flow.
You should prioritize having a fully funded emergency fund, paying down high interest debt, saving for other short- and mid-term goals like buying a house or paying for your children’s education and maxing out your 401(k) and IRA first.
Then, if you have cash left over to invest, stashing it in a deferred compensation plan may make sense, especially if contributing reduces your taxable income to at or below what you expect to be at when taking distributions from the plan.
2. Plan Payout Rules and Restrictions
Since deferred compensation plans aren’t subject to ERISA protection, plan administrators don’t have to follow as many stringent rules and can add in lots of plan specific rules and features.
The summary description of your employer’s plan will outline key provisions you need to be aware of before deciding whether to enroll, including:
- Payout timing: Some plans have a fixed payout start date, such as when you turn 65, retire, or reach a chosen age. Most plans defer payouts until you separate from the employer.
- Payout structure: Depending on the plan’s rules, you may receive your payout in a single lump-sum distribution or installments over a specific number of years (usually five to 15). Some plans force you to elect a payout structure when you make the deferral, while some allow you to wait until later (often with a one-time election to change your payout structure). You need to be extremely mindful of these rules when building your deferred compensation plan into your overall financial plan.
The more flexibility the plan offers, the more likely it is to make sense to contribute because you can adapt your elections as your life changes and plan strategically to accept that as income at a time and level that reduces tax impact.
3. Investment Options
Evaluating the investment options within the plan is crucial to making the most of the potential for tax-deferred growth.
Most plans have a good mix of investment options. However, if you’re unsure about whether to contribute to a deferred compensation plan vs. another savings account and the deferred compensation plan investments have high expense ratios or a lack of diversification, you may want to consider a different route.
Working with your financial professional to evaluate the investment options available to you is helpful to ensure all the pieces of your portfolio are working in sync, towards the same goal.
4. Stage of Life
Because you don’t truly own the assets in the plan, contributing to one early in your career with the goal for retirement use is often risky as there is lots of time for your employer to experience cash flow issues.
Early in your career you are also less likely to be maxing out your 401(k) and IRA contributions warranting these elections. It’s important to understand these risks and order of tax-advantaged contributions so you don’t jump on something too early just because it sounds good.
If the company files for bankruptcy, is named in a lawsuit, or experiences other financial difficulties, your deferred compensation contributions could be at risk.
Since you typically don’t start receiving payouts from deferred compensation plans until retirement, the best time to contribute to one is as you approach retirement age because the company has less time to run into financial trouble that could affect its ability to pay you and you have more information on upcoming cash needs to know how much to defer to meet your goals.
Additionally, you tend to earn the most toward the end of your career. Deferring more of your income during high earning years can result in more significant tax savings.
However, there is one caveat to this recommendation.
If you’re planning to take time off earlier in your career and won’t have any income, contributing to a deferred compensation plan when you’re younger could make sense from a tax and cash flow standpoint. We’ve seen this be the case for folks working within startup environments where you may take extended breaks between companies.
5. Current Savings Mix
While the tax advantages of deferred income can be a powerful incentive to defer as much money as possible today, it’s important to consider other factors before contributing to a deferred compensation plan.
If you’re planning to retire before your Required Minimum Distributions (RMDs) and Social Security begin and need to generate cash flow in the meantime, diverting extra cash to a deferred compensation plan to payout in this time period might be ideal to give you cash for spending and fill low tax brackets.
If you’re receiving payouts at the same time you’re required to take RMDs from traditional retirement accounts or Social Security, you could potentially put yourself in a higher tax bracket in retirement than when you were employed.
In that case, it may be better to pay income tax at today’s tax rates and invest the after-tax proceeds differently.
Next Steps
Deferred compensation plans can be complicated, and there are significant tax and cash flow implications to think through before deciding whether participating in one makes financial sense.
A financial advisor can help you project your future taxes, retirement income and cash flow, including social security payments, RMDs, and projected interest and dividends from your portfolio.
Having a strong estimate of those numbers and layering on the potential payout from a deferred compensation plan can help you make an informed decision about whether contributing to a NQDC plan fits into your comprehensive wealth management plan.
If you could use a second opinion on your current financial plan, take our two-minute financial analysis and get personalized feedback based on your responses.
