Non-Qualified Deferred Compensation Plan Gotcha!

Non-Qualified Deferred Compensations Plans ("NQDC"), sometimes called Executive Deferred Compensation Plans (and creatively nicknamed "EDCP") in-house, can be powerful wealth building vehicles that allow for massive tax shelter, but not without some possible "gotchas!"

NQDC and EDCP plans allow executives to defer pre-tax compensation above and beyond the regular IRS limits for 401k, 403b, and other defined contribution plans. These plans are allowed under Internal Revenue Code Section 409(A) as a selective benefit for highly-compensated individuals. NQDC and EDCP plans originally emerged because high-income earners aren't allowed to put away the same percentage of their income as workers who earn less money, and these types of plans were designed to help the high-income earners catch up.

NQDC Benefits

NQDC plans offer some appealing attributes:

  • Often have uncapped contribution limits
  • Usually allow deferred funds to be directed to the same investment options as the regular company 401k plan
  • In some cases, to compensate for extra risk compared to Qualified Plans, the NQDC plans even offer an "enhanced return"—making the deferral of funds extra attractive

NQDC Restrictions

After the shenanigans of the dot com days (e.g., $6,000 golden shower curtains at corporate residences, million-dollar birthday parties on the corporate dime, etc.), rules around NQDC plans were tightened. Today, there are some serious wrinkles that need to be carefully considered before deferring funds into an NQDC/EDCP plan:

  1. To avoid having the funds subject to taxation, the funds need to be an "unsecured promise to pay" and the dollars need to be subjected to a "substantial risk of forfeiture." This means your employer may be unable or unwilling to pay you the deferred benefits in the future. Depending on the plan design and your company's financial situation, these can be significant risk factors!
  2. You must select your contribution level for the following year in the year prior. This means that you need to decide by a specific date in late 2016 (those deadlines vary by company) how much money you want to defer into the plan in 2017.
  3. You must select how your funds will be distributed at separation of service, which means you must decide how you want to receive your deferred funds when your employment with your company ends (e.g., immediately in a lump sum, one year after retirement, equal installments over five or 10 years, etc.). 
  4. Unlike 401k plans, NQDC plans do not allow for plan loans or tax-free rollovers to individual retirement accounts (IRAs) or other qualified retirement plans.

Your NQDC Considerations are Unique

Every company's NQDC is unique and each participant's situation is unique, which is why it's important to have a full understanding of your big picture. Water cooler talk can be interesting, but shouldn't be taken too seriously. You never know the full picture of another person's financial situation or if they fully understand the plan nuances.

For instance, in point #3 above, I said "separation of service," which does not necessarily mean retirement. I work with several executives at Target Corporation. Target went through quite a bit of restructuring in recent years, which immediately presented a number of employees with the need to "seek new career opportunities...elsewhere." Many of these employees quickly found great jobs in 6-9 months—within the same tax year. So, what happened? In the same year they received a final bonus, a severance package, and unused vacation pay from Target, they also began a new job at a high-income pay level with a hiring bonus. They were now separated from service with Target and the trigger had been pulled on their EDCP plan payouts. If they had previously chosen an "immediate" payout for their annual EDCP deferrals, that lump sum payment (in some cases, hundreds of thousands of dollars) was now distributed and added to their final pay and new job hiring bonus. That can make for one very large income tax year!

Now, in some cases, those people were also eligible for an NQDC plan in their new position, and after evaluating the plan and running the numbers, in some cases I advised participating in the new employer’s NQDC.  This planning strategy provided the option to defer large amounts of the unexpected income pre-tax to somewhat offset the previously saved pre-tax dollars (EDCP payouts), which were being distributed and flooding their tax return.

Thoroughly Evaluate Your NQDC

The example above presents just one issue to consider when evaluating NQDC/EDCP elections. The trade-off for great tax deduction and tax-sheltered build-up is striking:

  • Serious lack of flexibility and liquidity when the commitment is made to fund the plan
  • Substantial risk of forfeiture
  • Unsecured promise to pay
  • Risk of the plan investments themselves
  • Risk that the plan may be triggered mid-career or even at a higher earning point in your career, rather than during a lower tax year in retirement as originally planned

Questions About Your NQDC Plan?

Your NQDC plan is likely just one component of your personal balance sheet and income statement. Working with an experienced Certified Financial Planner (CFP®) who specializes in executive compensation can help pull together all the pieces of the puzzle, and help you feel confident that you are optimizing your financial decisions.

If you have questions about your NQDC/EDCP elections, give me a call or send me an email. We can discuss your situation and how to maximize your NQDC benefit.