Abstract: Nonqualified deferred compensation plans allow
participants to set aside large amounts of tax-deferred compensation, but also
pose substantial risks. This article distinguishes NQCD plans from qualified
defined contribution plans and discusses the pros and cons.
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 also pose
substantial risks. If your (or a prospective) employer offers an NQDC plan, or
you’re considering one for your business, weigh the pros and cons carefully.
What’s
the difference?
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.
Qualified
defined contribution plans also generally allow participants to direct the
investment of their account balances among the plan’s investment options. The plans
are subject to the applicable requirements of the Employee Retirement Income
Security Act (ERISA) and the Internal Revenue Code, including annual
contribution limits, penalties for early withdrawals, 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. Employer contributions may be subject to a vesting schedule
based on years of service, performance or the occurrence of an event (an IPO or
sale, for example).
To
avoid current taxation, NQDC plans may 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 set aside funds in a special type of trust to ensure
that your employer doesn’t use them for other purposes, 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 significant advantages over
qualified plans. Depending on the specific plan’s limits and distribution
rules, you may have no contribution limits, allowing you to set aside
substantial amounts of wealth. Participants may also enjoy greater flexibility
to schedule distributions to fund retirement, college expenses or other
financial goals 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 avoid the cost of compliance
with ERISA’s reporting and administrative requirements. 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 is subject to the claims of the employer’s creditors and could be
lost in the event of 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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