Abstract: Nonqualified deferred compensation (NQDC) plans
allow participants to set aside large amounts of tax-deferred compensation, but
they may also pose substantial risks. This article distinguishes NQDC plans
from qualified defined contribution plans and discusses the pluses and minuses.
The pros and cons of NQDC
plans
Nonqualified
deferred compensation (NQDC) plans allow participants to set aside large
amounts of tax-deferred compensation while enjoying the flexibility to schedule
distributions to align with their financial goals. However, the plans aren’t
without risks so before you jump in, consider the pros and the cons.
What
makes an NQDC plan different?
NQDC
plans differ significantly from qualified
defined contribution plans.
The latter allows employers to contribute on their employees’ behalf and
employees to direct a portion of their salaries into segregated accounts held
in trust.
In
addition, qualified defined contribution plans generally allow participants to
direct their investments among the
plan’s available options. The plans are subject to the applicable requirements
of the Employee Retirement Income Security Act (ERISA) and the Internal Revenue
Code. This includes annual contribution limits, early withdrawal penalties,
required minimum distributions and nondiscrimination rules.
By
contrast, an NQDC plan is simply an agreement with your employer to defer a
portion of your compensation to a future date or dates. Many NQDC plans provide
for matching or other employer contributions, while some permit only employer
contributions. Such contributions may be subject to a vesting schedule based on
years of service, performance or the occurrence of an event (such as a sale).
To
avoid current taxation, NQDC plans must not be “funded,” and they can’t escape
your employer’s creditors. The plan is secured only by your employer’s promise
to pay. It’s possible to secure funds in a special trust, but they remain
subject to creditors’ claims.
What
are the pros?
Like
qualified plans, NQDC plans allow you to defer income taxes on compensation
until you receive it — although you may have to pay FICA taxes in the year the
compensation is earned. NQDC plans also offer some advantages over qualified
plans. That is, they may have no contribution limits. Participants may enjoy greater flexibility to
schedule distributions to fund financial goals such as retirement, without
penalty for distributions before age 59½ or required distributions at a certain
age.
From
an employer’s perspective, NQDC plans are attractive because they can be
limited to highly compensated employees and they don’t require compliance with
ERISA’s reporting and administrative specifications. However, unlike
contributions to qualified plans, deferred compensation isn’t deductible by the
employer until it’s paid.
And the cons?
The biggest
disadvantage of NQDC plans for participants is that deferred compensation isn’t
shielded from the claims of the employer’s creditors, possible bankruptcy or
insolvency. Also, you may not be able to take loans from the plan and can’t roll
over distributions into an IRA, qualified plan or other retirement account.
What’s more, there are limitations on the timing of deferral elections.
Is
it right for you?
An
NQDC plan offers attractive benefits, but it can be risky. Contact our firm to
discuss how such a plan might affect your financial situation or whether it’s
right for your company.
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