Non-qualified deferred compensation (otherwise referred to as deferred compensation or NQDC in this article) is an employee benefit available for some high-earning tech professionals planning their financial future.
So if you are looking for answers to questions like…
… then this guide is for you!
A deferred compensation plan is offered as a company benefit giving individuals the opportunity to defer a percentage of base pay, commissions, and bonuses to a later date to better align with retirement or other financial goals.
NQDC stays “unfunded”, meaning that an individual participant does not retain their rights to any specific assets until distribution.
Deferred amounts are held in an account with investment options similar to what one mind find in a 401(k) plan. While the individual may not retain their rights, the individual gets to choose how their investments are allocated.
NQDC allows individuals to receive tax benefits. FICA tax is paid when income is earned. Meanwhile, federal tax, state tax, and local tax is deferred until the deferred compensation plan distributes proceeds.
The plan is written. Plan documents specify a timing schedule and how frequently one is paid. An individual generally makes an election to defer compensation during open enrollment for the following year’s income.
A timing schedule may give an individual the option to receive distributions over one lump-sum or spread over multiple installments (ex. over 10 to 15 years). In many cases, an individual has the option to select a year in the future for distributions. Beware, some deferred compensation plans begin distributions with a job separation prior to the desired distribution serving as the triggering event.
It depends. Like most financial questions, there is no 100% correct answer to participating in your plan’s nonqualified deferred compensation plan. Here are a few questions to help in answering if you should participate.
Deferred compensation is a tool that can help you get below the a certain tax bracket if used properly.
It’s difficult to project future tax projections because the current tax rules are set to sunset in 2025. No one knows what future taxes are going to look like. That’s why it’s best to analyze projections based on assumptions on an annual basis.
A good financial advisor or CPA can help you run tax planning projections to share if your taxes will be higher, the same, or lower in the future. But keep in mind, that’s all they are… projections.
While it depends on one’s unique financial situation, contributing to and investing in nearly all account types should generally be considered before a nonqualified deferred compensation plan.
Nonqualified deferred compensation remains unfunded, meaning that there is no creditor protection for an individual.
In the event of the company’s bankruptcy, the right of an individual to receive deferred amounts are the same as all other unsecured creditors.
If you never see this money again, how would it impact your financial plan? Alright, now we can step away from the ledge. How much trust do you have in your employer? What percentage of your investment portfolio’s overall risk is in the deferred compensation plan?
As a general rule of thumb, some financial planners suggest not holding more than 5% to 10% of total investments within a nonqualified deferred compensation plan.
I strongly suggest determining your comfort level and the optimal amount for your unique financial situation.
While it depends on one’s unique situation, low-income, gap, and retirement years generally allow for good opportunities to recognize distributions from NQDC plans.
It depends. In most cases no. One should generally always max out their 401(k) before considering if they should participate in a nonqualified deferred compensation plan.
Like Texas Hold’em, there are no limits to nonqualified deferred compensation contributions. In 2022, 401(k) plans limit individual contributions to $20,500 of elective deferrals and $6,500 for above 50 catch-ups. Including after-tax 401(k), an individual cannot contribute more than $61,000 total, or $67,500 if above age 50 (see mega-backdoor Roth for more information).
If you’re a high-earner with the ability to save aggressively, a more appropriate question might be is NQDC better than a taxable brokerage? And the answer to that is… it depends.
Here are some considerations:
Jared (56) is a single distinguished engineer at Dell.
Jared is an aggressive saver that is currently maxing out his 401(k) and is looking for additional ways to save tax-efficiently and position himself for early retirement.
Jared is planning to retire in five years. Jared is comfortable with the risks in deferred compensation. Jared’s tax projections show a lower expected tax rate in early retirement years than in high-income years.
For 2022, Jared expects to earn $200,000 in base pay, another $50,000 in bonus, and approximately $50,000 in vesting RSUs. Jared expects to use the standard deduction in 2022.
By working closely with his financial advisor and CPA to better understand his current and future tax projections, Jared chooses to enroll in Dell’s Deferred Compensation plan to save an additional $100,000 towards retirement and lower his federal marginal tax rate from 35% to 24%.
Participating in a NQDC plan can make financial sense if…
Deferred compensation doesn’t make sense in every scenario. Understanding your unique financial situation and tax planning picture allows for a better decision-making process and can help you determine how to best move forward.