How nonqualified deferred compensation plans can benefit high earners — and their employers

High-income individuals have a unique challenge: Traditional sources of retirement income are likely not going to be enough for them to maintain their quality of life once they stop working. So, where do they turn to bolster their retirement savings? Traditionally, they have turned to after-tax investments and savings accounts, which can be effective. However, there is another option that can give high earners the ability to keep their income in a pre-tax savings environment: a nonqualified deferred compensation plan (NQDC).

“In a lot of cases, a nonqualified deferred compensation plan can complement your 401(k) or 403(b) account,” says Hunter Penland,* Vice President of Nonqualified Markets Sales & Service at Voya Financial. “These plans may allow executives and highly compensated individuals to effectively bridge the retirement gap.”

If you are a high earner — or a company looking to use nonqualified deferred compensation to attract or retain talent — here is what you need to know about NQDC plans.

When does a NQDC make sense?

To understand how NQDC plans may make sense, first consider the restrictions on common tax-advantaged retirement accounts, such as 401(k)s, 403(b)s and traditional IRAs. According to IRS rules, an employee can contribute only a certain amount in pre-tax dollars to these accounts.

For high earners, these limits may feel restrictive. Some individuals might instead turn to regular brokerage or savings accounts, but these accounts don’t offer the same tax advantages. NQDC plans provide another option by allowing high earners the opportunity to defer their earnings from the current year to another year, which can also lower their yearly tax burden.¹

“In theory, you could put 100% of your bonus and 75% to 100% of your compensation into one of these plans,” says Penland. “There are also a lot of different employer contributions that can be made to these plans, all of which can be highly discretionary.”

How NQDCs work

NQDCs are sometimes called 409A plans after the corresponding tax code.² The most common types are corporate 409A plans, but there are also tax-exempt 457(b) and 457(f) plans and governmental 457(f) and 415(m) plans. Here, we’ll talk specifically about 409A plans.

Retirement savings plans are categorized as qualified or nonqualified. What does it mean that NQDC plans are nonqualified? Qualified strategies, such as 401(k)s and 403(b)s, are required to fulfill specific criteria, such as disclosures, coverage and participation rules, vesting schedules, and non-discrimination rules. They can be defined by their contribution amounts, which is the amount that a participant or employer puts into the account over time, or their benefit amounts, which is the amount that will be available to the participant in retirement, but defined contribution plans are more common these days. With qualified strategies, an employer benefits by reducing their own tax burden by claiming contributions to employee’s accounts.³ 

Nonqualified strategies, such as NQDCs, are exempt from most rules and reporting that are required by the Employee Retirement Income Security Act (ERISA), which governs how tax-qualified accounts operate.⁴ 

NQDC participant benefits

“If you’re earning $500,000 a year but only need $350,000 for expenses, you can use these plans to defer the other $150,000 and reduce your current period taxes,” says Penland. “NQDC plans allow high earners the opportunity to fill that retirement gap faster while managing their tax exposure in the years when they have their highest income.”

Delaying income until retirement can help high earners because when they retire, they may earn less, so deferred income may be taxed in a lower tax bracket. Deferral amounts may appear on W-2 forms in the year that they are deferred, but they will not be subject to taxes until they are distributed.⁵

Another benefit is that compensation that has been deferred using an NQDC plan can be invested while it is still in the plan, so the funds may grow over time. Similar to a 401(k) or other ERISA-qualified plan, NQDC plans have a yearly enrollment period where participants can choose their allocations. When participants eventually realize any growth above the initial amount, the whole amount is treated as ordinary income, just like a 401(k). Separation from service is normally the trigger for distributions to begin, and for most plans, there are no required minimum distributions.

NQDC funds can also be allocated to pay for intermediate expenses before retirement if you need them. NQDC plans can be used to save for a child’s education, for example. “These plans give you a little more flexibility than traditional 529 plans,” says Penland.

However, there are some risks involved with NQDC plans. Penland notes that the assets you defer into the plan will remain assets of the company and subject to the company’s creditors until a distribution is made. These plans may offer alternative investment options, such as access to private equity options which can involve more risk, including liquidity and volatility risk, than market investments.

NQDC employer benefits

“For the employer, these plans boost their ability to recruit, reward and retain their top talent,” says Penland. “When you think of employee turnover, particularly in key management positions, these individuals are expensive to replace in terms of lost productivity and actual replacement.” NQDC plans can help retain talent and, because of the risk of forfeiting the funds, encourage key employees to stay the course. Because plans can be complicated, they are often deployed with employee education programs.⁷

Since the plans do not need to follow non-discrimination rules from ERISA, they can be tailored for a few key employees. That includes a company setting vesting schedules and investment options. There are also no limits to how much can be deferred and there are no Required Minimum Distributions (RMDs) for 409A plans.

Need NQDC guidance?

Nonqualified deferred-compensation plans can benefit executives by deferring tax burdens. But like any financial plan, getting insight from professionals at the start of planning is essential. Ask your Voya Representative your NQDC questions today.

If you are an employer looking to find a solution that fits your business needs, read more about NQDCs or contact us.