Pros and Cons of Non-Qualified Deferred Compensation (NQDC) Plans

What is Non-Qualified Deferred Compensation or NQDC?

Non-Qualified Deferred Compensation, or NQDC, is compensation that has been earned by an employee but has not yet been transferred from the employer to the employee. Because the employer still has ownership of the compensation, it is not included in the employee’s earned income and therefore is not considered taxable income. This allows an employee to postpone or defer compensation and receive it sometime in the future, usually for purposes of retirement income.

NQDC Pros

• Unlike a 401(k), there is no cap on the amount of compensation that is deferred under an NQDC plan, unless your employer imposes a cap that is normally a percentage of your compensation.
• There is no minimum distribution required at age 70½; however, plan rules may exist.
• You are able to set the distribution date to fund your retirement or another goal, such as your child’s college education.
• You don’t pay income tax on the compensation you defer until you actually receive it in the future.
• These are great tools for income tax arbitrage (forgo income at a 35%+ tax rate, and realize this income at a 25% or lower tax rate in the future).
• From the employer’s standpoint, NQDC plans are attractive because they come with great flexibility, aren’t subject to Employee Retirement Income Security Act (ERISA) regulations, and are usually inexpensive to establish, being that there is minimal reporting and filing required.

NQDC Cons

• The deferred compensation account is subject to creditors of the business.
• You may not access your deferred compensation until the distribution date, meaning you can’t take out a loan or take distributions before that date under any circumstances.
• Your employer will most likely impose limitations on your choice of how and when you begin taking distributions.
• Rolling deferred compensation into an IRA, 401(k), or another non-qualified plan isn’t an option.
• Since you didn’t pay income tax on deferred compensation on the front end, once you start receiving your distribution, you must not only pay income tax but FICA taxes as well.
• Employees who don’t complete their tenure with the business generally forfeit their benefits, which is often called the “Golden Handcuff” provision.

If you have the option of participating in an NQDC plan, it is important to understand what you’re getting into, especially the inherent risks and tax consequences. Speaking with a fee-only CERTIFIED FINANCIAL PLANNER™ professional about your retirement plan and goals can help you pursue your lifetime goals and maximize after-tax wealth.