For many executives, maximizing retirement savings involves more than simply contributing to a 401(k). While qualified retirement plans remain an important foundation, contribution limits and inflexibility often prevent highly compensated employees from sheltering enough income to fund their retirement. This is where non-qualified deferred compensation (NQDC) plans play an increasingly valuable role.
NQDC plans have become an increasingly important component of executive compensation packages, serving both as a tax-planning opportunity for executives and a retention tool for employers. Participation in these plans has grown significantly in recent years, up to nearly 70% of eligible executives actively participating in some sort of NQDC.¹
What Is a Non-Qualified Deferred Compensation Plan?
Very simply, a non-qualified deferred compensation plan is an arrangement that allows an employee to postpone receiving a portion of compensation until a future date. This can be a portion of salary income, bonus or equity compensation. Since the income is deferred, taxation on that income is also deferred until the compensation is ultimately paid.
Unlike qualified retirement plans such as 401(k)s and pensions, NQDC plans are not subject to the same contribution limits, nondiscrimination requirements, or many of the restrictions imposed by federal regulations. This flexibility allows employers to provide substantial supplemental retirement benefits to executives and other highly compensated employees.
The fundamental concept is simple: compensation earned today is paid and taxed later. However, the planning opportunities –and risks –can be significant.
Common Types of Non-Qualified Deferred Compensation Plans
There are several different types of NQDC plans, and employers can design deferred compensation programs in various ways depending on their objectives.
Salary Deferral Plans
The most common arrangement allows executives to defer a portion of salary, annual bonuses, or incentive compensation into a deferred compensation account. The executive elects to defer compensation before it is earned, and the deferred amount accumulates until a future distribution date.
SERPs (Supplemental Executive Retirement Plans)
A Supplemental Executive Retirement Plan is funded entirely by the employer and is designed to provide additional retirement benefits beyond what can be accumulated in qualified plans. Benefits are often based on a percentage of final compensation or years of service and can function similarly to a pension benefit for key executives.
Deferred Bonus Plans
Employers may allow annual bonuses to be deferred and paid at a future date, often retirement or separation from service.
Stock-Based and Phantom Equity Plans
Some arrangements tie the deferred compensation to company stock performance, an example of this is a “Phantom Stock Plan” The plan holder does not hold or ever receive the actual company stock. They receive cash compensation at a future date determined by the performance of the stock. This aligns the plan holders’ interests with the company performance but does not require actual equity ownership.
The Benefits of Non-Qualified Deferred Compensation
- Additional Tax Deferral: For executives already maximizing 401(k) contributions, NQDC plans provide an opportunity to defer substantially more income. This can be particularly valuable during peak earning years when income may fall into the highest federal tax brackets.
- Managing Lifetime Tax Brackets: Many executives experience unusually high income during their working years. Salary, bonuses, and stock compensation can easily cause income during working years to be in the highest marginal tax brackets. Deferring a portion of this compensation may reduce current taxable income and potentially shift taxation to years when income levels are lower.
- Flexible Retirement Income Planning: Executives can often schedule distributions at retirement, over a series of years, or upon specified future dates. This flexibility can help smooth taxable income and coordinate withdrawals with other assets and retirement benefits.
- Enhanced Wealth Accumulation: Because taxes are deferred until distribution, the full pre-tax amount remains available for growth throughout the deferral period.
- Executive Retention: From the employer’s perspective, deferred compensation plans are powerful retention tools. Long vesting schedules encourage valuable employees to remain with the company long term.
The Risks of Non-qualified Plans
While NQDC plans are a valuable tool they are not without risks. Unlike a qualified plan, most deferred compensation arrangements are entirely unfunded and represent only a contractual promise from the employer to pay benefits in the future. The obligations in the plan are typically not held in separate accounts; they are merely general obligations of the company.
If the company experiences financial distress or bankruptcy, executives may lose some or all of their deferred compensation benefits. It is the unfunded nature of the plans that allows them to defer the taxes.
Some employers use a “Rabbi Trust” to set aside assets to satisfy these obligations. This structure does not eliminate the risk though since the trust still generally remains subject to the corporations creditors. Insolvency of the corporation is the largest risk factor for NQDC plans.
Advanced Planning Strategies for NQDC Plans
- Tax Rate Arbitrage: The most common strategy is to defer income earned while in a high tax bracket and recognize it during retirement when taxable income may be lower.
- Gap-Year Planning: Executives anticipating a transition between employers, an early retirement period, or a future move to a lower-tax state may benefit from carefully timed distributions.
- Coordinating with Equity Compensation: Executives often face a choice between deferred cash compensation and various forms of equity ownership. Both offer advantages, with deferred compensation can give tax deferrals and greater income certainty, while equity compensation offers advantageous capital gain tax rates, and potential step-up at death. Evaluating and coordinating these two compensation types require careful planning and tax expertise.
- Retirement Income Layering: NQDC distributions can be coordinated with other income sources in retirement such as: Social Security, IRA’s, Roth assets, pension income and taxable accounts. Coordination and sequencing of all these sources can greatly improve tax efficiency and cash flow.
Making Deferred Compensation Part of Your Financial Strategy
Non-qualified deferred compensation plans can be one of the most valuable benefits available to executives. They provide opportunities to defer taxes, accumulate additional retirement assets, and manage cash flow across different stages of life. At the same time, participants must understand the unique risks.
When integrated into a broader financial plan NQDC plans can be a powerful tool for building long-term wealth and improving after-tax outcomes. Careful analysis and trusted financial advice is essential to determine how deferred compensation fits within an executive’s long-term financial plan.
At FCA Corp, we help executives navigate the complexities of compensation and retirement planning by evaluating how each benefit fits into a comprehensive financial strategy. Whether you’re deciding how much compensation to defer, coordinating NQDC distributions with stock-based compensation, or planning for retirement, our team works with you to develop strategies tailored to your goals, helping you make informed decisions with confidence.
