Navigating Your Options: Key Benefits and Considerations for Highly Compensated Employees in Nonqualified Deferred Compensation Plans

Authored by Chris Vidler, CFP®, CIMA®, RICP®, CLU®

Planning for a comfortable, tax-efficient retirement often requires exploring creative options. While there are several ways to invest your discretionary income in retirement accounts, not all retirement accounts are created equal, or taxed in the same way.

One often-overlooked option, especially for high-earning employees, is found in their executive compensation package. In recent years, equity compensation and employee stock purchase plans have gained a lot of attention, but deferred compensation plans offer additional opportunities to reduce your lifetime tax burden, particularly beyond the limits of traditional retirement accounts like 401(k)s.

In this article, we'll explain how Nonqualified Deferred Compensation (NQDC) plans work, their benefits to your financial strategy, and how they compare to 401(k) plans. We’ll explore different considerations a NQDC plan can make available to its eligible employees.

A NQDC plan is a type of deferred compensation program that allows eligible employees to delay receiving a portion of their income until a later date, usually upon retirement, resignation, or a specified future event, and in doing so, defer the taxation of that income. Unlike qualified plans such as a 401(k), NQDC plans do not adhere to the Employee Retirement Income Security Act (ERISA) regulations, meaning they are not protected by government insurance and can be selectively offered to key employees or executives. For example, eligibility could be limited to US-based associates only, who are Director-level, or above.

One of the primary benefits of participating in a NQDC plan is the tax advantage it offers. Deferring compensation into a plan is valuable both for the current year tax benefits (by deferring income to a future year, you avoid paying income tax on it in the current year) and for the tax-deferred growth on the income before it pays out from the plan. It’s important to remember that you aren’t escaping paying taxes, however, and you will be taxed on this income when it eventually pays out. Working with a financial advisor to understand your projected tax picture in retirement can help you understand the potential tradeoffs.

Utilizing a deferred compensation plan on an ongoing basis is common, but there are sometimes reasons to elect a deferred compensation strategy for very specific years, as part of a college education funding plan, for example. There are a variety of reasons why deferring some of your current income is valuable, such as:

1. You expect to be in a lower tax bracket in retirement.
2. You expect a large bonus in the year you make the election.
3. You would like to execute a large nonqualified stock option.
4. You are planning to sell an appreciated asset such as stock or an investment property.

In addition to the tax benefits, using a deferred compensation plan may help high-income earners receive increased matching. Employees earning above what is called the “annual compensation limit” (defined by Internal Revenue Code 401(a)(17)) receive no matching contributions on income above the annual compensation limit (set at $345,000 in 2024). To account for this, some deferred compensation plans provide a match on amounts above the annual compensation limit. For these high-income earners, this additional match can mean significant additional contributions to retirement.

As with any financial decision, there are always tradeoffs. The first thing to understand is that, unlike a 401(k), NQDC plans aren’t covered by ERISA. What does that mean? Primarily differences in flexibility and asset protection:

1. Limited flexibility—you can’t change your deferral mid-year, and early access to your funds is rare in a NQDC plan.
2. NQDC plans are backed by your employer, not the government like 401(k) plans. Simply put, if the company goes bankrupt, there's a chance you could lose your contributions. Unlike 401(k) or other qualified plans where your deferrals are held separately, in some NQDC plan, your contributions are mixed together with the company’s assets.

Further, there are strict rules on the timing of distributions which often can’t be changed. When making your deferral, it is important to think ahead to when you will want to receive this income. Remember, this is deferred income, so when you receive it, taxes will be owed. Carefully thought-out distribution elections are crucial to helping to ensure you don’t trigger a variety of issues, like inadvertently pushing yourself into an even higher tax bracket at the start of retirement and being forced to pay higher Medicare premiums.

Every plan is different, so it's important to fully understand what you're committing to before getting involved, and to know how this benefit fits into your longer-term financial planning. For example, one of the most significant considerations may be the plan’s termination clause, in which a participant who terminates employment for any reason other than death, disability, or retirement (as defined by the plan), will have an immediate distribution of the account balance in the same year as termination. While it's beneficial that the participant retains all deferred income in the plan, you might have opted to leave for a higher-paying job and receiving a lump sum payout of your deferred income could result in substantial tax implications in that specific year.

When deciding whether to take deferred compensation, it's essential to think long-term. Consider these questions:

• Are you making the most of your traditional retirement plan contributions?
• Do you expect to remain with your company until retirement (and specifically as “retirement” may be defined in your company’s plan document)?
• Will you likely be in a lower tax bracket when the deferred compensation payments begin?
• Are you comfortable with the plan's distribution options?
• What are the investment choices available in the plan?
• Is your company financially stable?
• Do you plan to move after you retire?
• Will you need access to funds soon for expenses like medical bills?
• Does your employer offer company stock purchases in both the deferred compensation plan and the 401(k)?

Deferred compensation plans offer an excellent way to save extra funds for retirement and other financial goals, especially when 401(k) contributions alone may not meet your needs. However, they go beyond just additional savings—they also provide tax benefits and flexibility to help you manage significant financial events throughout your life.

Navigating your company’s plan, and how deferrals can impact your financial plan, can be challenging. We invite you to schedule an introductory call with a member of our team to learn how we can help.

NQDC plans are subject to the credit worthiness of the sponsoring company. NQDC plans are regulated by IRC Sec. 409(a). As such, they require a third-party administrator. Raymond James and its representatives do not give legal or tax advice. You should consult your legal or tax advisor for answers to specific tax questions.

The information contained in this blog does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Opinions expressed are those of the author and are not necessarily those of Raymond James. All opinions are as of this date and are subject to change without notice. Prior to making an investment decision, please consult with your financial advisor about your individual situation.

401(k) plans are long-term retirement savings vehicles. Withdrawal of pre-tax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59 1/2, may be subject to a 10% federal tax penalty. Matching contributions from your employer may be subject to a vesting schedule. Please consult with your financial advisor for more information.

Certified Financial Planner Board of Standards, Inc. (CFP Board) owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER®, and CFP® (with plaque design) in the United States, which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements.