How To Completely Master Your Equity Compensation: Exploring NQDC Plans
In our last post, we reviewed the intricacies of Restricted Stock Units (RSUs).
In part two of our mastering equity compensation series, we jump into the world of NQDC plans. Nonqualified deferred compensation plans (NQDC) are a type of employee retention benefit that allows certain employees to defer a portion of their pay until a later date.
You might be asking yourself, why on earth would I do that?
If you are earning more than $200,000, you should consider investment options over and above your typical 401(k). Since a 401(k) is limited to $19,500/year(2021) contribution, a high earner will only be able to defer a small fraction of their pay.
NQDC plans are perhaps a perfect example of delayed gratification. These plans allow an employee to earn benefits (i.e., cash, bonuses, wages, equity compensation) from their employer in one year and receive the income in another.
The best part?
The taxes are delayed until the compensation is received.
What Are Non-Qualified Deferred Compensation Plans?
Most companies offer NQDCs to executives and other highly compensated employees. These investment vehicles enhance employee plans by allowing highly compensated employees the ability to save over and above 401(k) limits. There are two primary benefits that employers and employees should consider.
To some extent, you can look at NQDCs as an alternative to a pension. You and your employer agree to defer a certain amount of your income until a specified date in the future.
Depending on the plan, this date could be in the not-so-distant future (i.e., five years) or as far out as retirement (which is more common). This structure is quite appealing for those who will notice a substantial dip in income once they retire.
Potential Plan Benefits
There is preferential tax treatment available for NQDC plans. Because you are deferring income to the future, you pay zero taxes on the amount deferred during the current tax year. Doing so can have a positive impact on your effective tax rate in the short term (dropping it to much lower levels).
In addition, you may end up in a lower tax bracket when you receive deferred compensation (i.e., during retirement). NQDC plans provide an opportunity to leverage your tax situation and adequately manage your tax bracket to reduce your overall tax liability.
Some NQDC plans permit employees to defer RSUs. Why would that be beneficial? With RSUs and restricted stock, the vesting date marks a taxable event. By rolling your RSUs into an NQDC plan, you could avoid immediate taxation once the shares vest. You will also have more opportunities for diversification.
On top of tax deferral, many employers reward high-level employees by funding the NQDC plan with profit sharing too! The mix of tax-deferral and profit-sharing possibilities can make this an enticing offer for the right family.
Who Benefits From A NQDC Plan?
Now that you understand the basics, you might be wondering who stands to benefit the most from using them.
NQDC plans can provide an opportunity to defer income and lower current tax bills for highly compensated employees. These individuals often don’t need a portion of their income to support their lifestyle. In this scenario, it makes sense to defer some compensation to a later date.
Some employees have entirely exhausted their qualified contributions (i.e., maxed out their 401k) and are looking for additional ways to save for retirement. NQDC plans do not have contribution limits (unlike their 401k counterparts). You can defer as much or as little in a year as you like. The money is then invested and has the potential for compounding greater returns in the future.
The “Planning” Type
NQDC plans are not only an excellent vehicle for enhancing retirement savings but also “bucketing” for the future. Some people like the idea of having some income waiting for them at a future date. You could earmark this income for big-ticket items such as a wedding, home purchase, or even a trip to Machu Picchu or another international dream destination. Keep in mind that these so-called ‘scheduled distributions’ will need to be chosen before you begin saving.
Important Drawbacks To Consider
Unfortunately, NQDC plans aren’t all rainbows and sunshine. There are some critical drawbacks to understand.
While you have the opportunity to select the type of distributions—lump sum, term, or scheduled—most distribution schedules are quite rigid. If you elect to receive your deferred compensation at age 65, you’ll get your money at 65 (whether you need it or not). Compare this to a typical 401k plan where you have more flexibility when you withdraw your funds (outside of RMD requirements).
Future Tax Rates
Deferring your income always comes with the risk of higher future tax rates. A higher future tax rate will minimize this crucial benefit. Political changes regarding taxation also remain a concern. When you consider a rigid distribution schedule, NQDCs do come with a lack of control.
Lack Of Protection
Since these plans generally cover high earners, they offer less protection than qualified plans and don’t offer ERISA protection like 401(k)s do. Any deferred income becomes a part of the company’s assets. If the company were to experience a hardship down the line (such as declaring bankruptcy), it could jeopardize your deferred compensation.
Should You Participate in an NQDC Plan?
As you can see, NQDC plans are a long-term investment tool that high-income earners and diligent savers should seriously consider.
When deciding whether to participate in an NQDC plan, projecting your future income from all other assets (and your future tax bracket) will undoubtedly come into play.
A few critical questions to ask yourself:
- Can you afford to defer your compensation?
- Are the payout periods fixed or flexible?
- Are you happy with the investment options?
- Are you confident that your company can hold up its end of the bargain?
If you’re wondering if an NQDC plan is right for you, you’re not alone.
Schedule some time with our team today, and let us guide you through this decision-making process.