Are you looking to save on current federal income taxes? Are you looking to save more than what you are allowed in your 401(k) plan? If so, and you find yourself being offered a non-qualified deferred compensation (NQDC) plan, it may be something you want to consider.
A non-qualified deferred compensation plan can be a great strategy to save on current taxes and to save for retirement. However, before you jump in with both feet, let’s take a look at what a non-qualified deferred compensation plan is and what you need to know.
What is a Non-Qualified Deferred Compensation Plan?
A non-qualified deferred compensation plan allows an employee, often a highly compensated employee, to defer taking income in the year they earn it. Instead, they elect to collect this earned income later.
What is the single largest benefit? You can defer when you pay federal income taxes. An employee elects to participate in a non-qualified deferred compensation plan because they want to delay paying income tax. Here is how it works:
- An employee is offered the option to participate in the NQDC plan (unlike a 401(k) plan, where the employer is required to meet strict standards regarding participation, an NQDC plan CAN discriminate. The employer can offer the plan to only a select group of employees).
- The employee elects to participate and defers taking a portion of their income (often a stated percentage of their income).
- Because they do not actually take constructive receipt of their earnings, the portion of their income deferred is not reported on their W2.
- Because the income is not on their W2, it is not reportable for taxes
- Because it is not on the tax return, it is not taxed (Well, not taxed for federal income purposes. It’s important to know that the employee will still be required to pay FICA – Social Security and Medicare – on this income in the year it is earned).
Where Does My Money Go?
When you defer your money into a non-qualified deferred compensation plan, your money goes into a trust established by your company. Inside this trust, it is possible that you will have a number of investment options to which you can allocate your money.
The money inside the trust is a general asset of the company. This means that it is subject to creditors of the company should they go bankrupt. In this sense, the money you defer into a NQDC plan is not guaranteed. It is not your money. You should consider the money in the NQDC plan as a promise by your company to pay you at a future date.
Your money inside the trust grows, tax-deferred, for as long as it remains invested in the plan.
When Do I Get My Money?
It depends. Some non-qualified deferred compensation plans require you to defer your money until retirement. Others have more flexible provisions, allowing you to access some or all of your money in as little as 5 years.
Plans often require that you state in advance when you need your money. For example, if you defer money in 2015, you will need to elect when you will receive this money. Perhaps in 2020. This means that you will receive the amount deferred plus earnings in 2020, at which time it will be taxable. Maybe you will be retired by then or have a large college expense at that time (hopefully you planned it this way). Should you not need the money in 2020, some plans will allow you to re-defer the money back into the plan and continue to forego paying tax.
When participating in a NQDC plan, consider when you may need your income and how the plan allows for access.
How is My Money Taxed?
Money contributed to a NQDC plan is not federal income-taxable in the year of deferral. The money does become taxable at the federal level when you take it out of the plan. It will be included in taxable income and will be taxed at whatever tax bracket you are in that year.
The hope and planning opportunity is to distribute the money from the plan in a year when your tax rate is lower. For example, let’s assume an executive is making $500,000. This executive may find themselves paying 35% or more in federal income tax.
If they choose to defer money into a non-qualified deferred compensation plan and take the money once they have retired, it’s possible that they could be in a 15% or 25% tax bracket for their retirement years. If they collect the NQDC money in retirement, it could lead to a tax savings of 15-20% or more.
What Else Should I know?
NQDC plans can be a fantastic answer to this popular question – How can I Pay Less in IncomeTax? This question is one of the most common questions that needs to be addressed with highly compensated and executive-level employees.
With that said, NQDC plans, like everything, have a give and take that needs to be fully understood. Before you participate in your employer-provided NQDC plan, you should be sure to check all the boxes.
- Are you sure you will not need the money?
- Do you understand when and how you can get to your money?
- Have you maxed out your 401k?
- Do you understand this is a promise, not a guarantee, from your employer?
- Do you realistically expect to be in a lower tax bracket when you are planning to take out the money?
If you can answer these questions correctly, a NQDC plan may be a good place for your money.
None of the information in this document should be considered as tax advice. You should consult your tax advisor for information concerning your individual situation.