A nonqualified deferred compensation (NQDC) plan, also known as a Section 409A plan, is a contractual fringe benefit often included as part of an overall compensation package for key executives. It can serve as an important supplement to traditional retirement savings tools, such as individual retirement accounts (IRAs) and 401(k)s. Like a 401(k), you can defer compensation into the plan, defer taxes on any earnings until you make withdrawals in the future, and designate beneficiaries. Unlike a 401(k) plan or traditional IRA, there are no contribution limits for an NQDC, although your employer can set its own limits. Therefore, you can potentially defer up to all of your annual bonus to supplement your retirement.
The timing of when you take NQDC distributions is important since you’ll need to project your potential cash flow needs and tax liabilities far into the future. “Many deferred compensation plans require you to make an upfront election of when you will receive the funds,” says Chris Kampitsis, a financial planner at Barnum Financial Group in Elmsford, New York. “For example, you might time the payments to come at retirement or when a child is entering college. In addition, the funds could come all at once or in a series of payments. There is tremendous flexibility often in these plans.”
Taking a lump-sum payment gives you immediate access to your money upon the distributable event (often retirement or separation of service). While you will be free to invest or spend the money as you wish, you will owe regular income taxes on the entire lump sum and lose the benefit of tax-deferred compounding. If you elect to take the money in installments, the remainder can continue to grow tax deferred and you’ll spread out your tax bill over a number of years.
An NQDC does come with some risks, however. When you participate in a qualified plan, your assets are segregated from company assets and 100% of your contributions belong to you. Because a Section 409A plan is nonqualified, your assets are tied to your employer’s general assets. In case of bankruptcy, employees with deferrals become unsecured creditors of the company and must line up behind secured creditors in the hopes of getting paid. Thus, you should consider how much of your wealth, including salary, bonus, stock options, and restricted stock, is already tied to the future health and success of one company. Adding deferred compensation exposure may cause you to take on more risk than is appropriate for your personal situation.
Before you choose to participate in an NQDC, you should speak with both your financial advisor and your tax professional.
Representatives do not provide tax and/or legal advice. Any discussion of taxes is for general informational purposes only, does not purport to be complete or cover every situation, and should not be construed as legal, tax or accounting advice. Clients should confer with their qualified legal, tax and accounting advisors as appropriate.
Chris Kampitsis is a registered representative of and offer securities, investment advisory and financial planning services through MML Investors Services, LLC. Member SIPC. www.SIPC.org 6 Corporate Drive, Shelton, CT 06484, Tel: 203-513-6000