Non-Qualified Deferred Compensation: Part II

In the second part of the non-qualified deferred compensation plans Q&A, we go over some critical differences between 401(k) and NQDC plans. You can read the first part of the blog.

Is my money safe with an NQDC plan?

The Employee Retirement Income Security Act (ERISA) is a federal law that sets minimum standards for most voluntarily established retirement and health plans in private industry to protect individuals who have these plans. Certain protections offered to 401(k) plans that ERISA covers are not available for non-qualified deferred compensation plans (NQDCs). 

For example, one essential protection ERISA provides is the requirement that 401(k) plan assets be held in trust. This means that the assets in a 401(k) plan are legally separated from your employer’s assets and are not subject to the claims of the employer’s creditors. In contrast, the assets in an NQDC plan are not required to be held in trust and may be considered part of your employer’s assets in the event of bankruptcy or other financial difficulties. 

If your company is secure and you do not intend to keep your savings in the plan for decades, this may not be an important consideration, but it is prudent to keep this fact in mind.

When do I get my money if I participate in an NQDC plan?

One of the most significant differences between traditional 401(k)s and non-qualified plans is when and how you will get your money back. While the specific terms of an NQDC plan will determine when an employee will receive their deferred compensation, often, NQDC plans will distribute deferred compensation when the employee leaves the company. This starkly contrasts with 401(k) plans, which typically are not distributed until retirement. 

While 401(k) plans may offer to leave your money with the company or rollover your savings to a traditional IRA, this option is often unavailable with non-qualified plans.

Like 401(k)s, with NQDC plans, you typically cannot get your money while you are still with your company. Some plans allow hardship withdrawals, but, in general, your money is locked until the plan distribution date, which is often the separation date. And the amount you will pay in taxes on the deferred compensation is based on your tax bracket at the plan distribution date.

This makes planning ahead of paramount importance. For example, if you switch from one job to another and your former employer distributes all your deferred compensation at once, your total income may move you up to a much higher marginal tax bracket. In this case, you may pay quite a lot in taxes. On the other hand, taking annual installment payments over several years might reduce the overall tax bill.

What are the typical distribution options for an NQDC plan?

Typically, non-qualified deferred compensation (NQDC) plans offer participants various distribution options, including lump-sum payments, installments over a fixed period, or a combination of the two. Some plans may also offer the option to receive the funds as an annuity, which provides a regular income stream over a specified period. 

This variety of options is significant, given that you have to decide how the funds will be distributed before your contributions begin.

When should I choose my distribution options?

A typical NQDC plan will require you to choose a distribution option before you contribute the money, not when you are about to take the cash. This, again, is a significant departure from the typical 401(k) operation. You will need to consider your financial situation several years from now when deciding on your distribution option. Such decisions require you to consider tax rules, investment performances, future financial and personal plans and circumstances.

Are there any state tax considerations related to NQDC?

Yes. If you live in a high-tax state such as California, New York, or New Jersey, participate in an NQDC plan, and want to move to a lower or no-income tax state in the future, it is important to remember that these states have something called source tax.

In New York, for example, source tax refers to the tax imposed on certain types of income considered to be sourced from the state of New York. This means that the income is deemed to have been earned or derived from New York and is subject to state income tax even if the individual who earned the income does not reside in New York.

However, if you take your deferred compensation payments in annual installments over ten years or more, those payments may be taxed in the state where you reside rather than in the state where you earned the compensation.

Summary of other considerations

There are many other facts to consider before you decide to participate in an NQDC plan. These include in-plan options, such as hardship withdrawals and available investment choices. They may also include future plans, such as when and how you plan to leave the company, whether you are in a high-tax state and will move to a lower-tax state, your current cash needs, etc.

While these are typical decisions that people face when deciding whether or not to defer compensation, with NQDC plans, many of these choices have to be made in advance. This critical distinguishing feature, mandated by the IRS, makes advanced planning especially important. Consulting a financial professional may help you sort out all the variables.