Non-qualified deferred compensation plans (NQDCs) allow an employee to earn wages compensation, and bonuses in one year while deferring the income tax payment on them to be settled in a later year.1
Pros of Contributing to an NQDC
As with any type of compensation plan, there are both pros and cons of contributing to them. When it comes to the NQDCs some of the advantages that come from contributing include:
An Ability to Save More
When contributing to a 401(k) or another qualified retirement plan, there are limitations on the amount of money that is allowed to be contributed. With a deferred plan, there are no set limits except ones that may be imposed by the employer. This allows you to contribute more and build your retirement savings more rapidly.
Reduced Tax Liability
You will not only enjoy tax benefits by being able to contribute more but also may reduce your annual tax liability by deferring compensation. It might even put you into a lower tax bracket, which reduces tax liability even further.2
The Ability to Invest on a Larger Scale
NQDC plans provide for investment options similar to 401(k) plans, such as stock options and mutual funds. But since there are no limits to your contributions, you will be able to possibly grow your wealth at a more exponential rate, making larger-scale investments that might lead to higher gains.
Cons of Contributing to an NQDC
There are some drawbacks to contributing to an NQDC. While one of the most significant downsides to an NQDC for many people is the fact that they can't roll their deferred compensation into a non-qualified plan, there are other issues that may make contributions to an NQDC a less appealing option.
A Strict Schedule for Distribution
With a 401(k), you are allowed to withdraw money when you need it, though, in some instances, it may result in fees and interest. With an NQDC, the schedule for the distribution of your funds will need to be determined in advance and will not be able to be changed.2 This means the timing of your distribution could result in a loss during the liquidation of the assets in your portfolio. There are no provisions for early withdrawal in an NQDC, even for financial hardship, which means your money will be tied up until the designated distribution date.
No Protection From Creditors
The Employee Retirement Income Security Act of 1974 (ERISA) provides protections from creditors for many forms of retirement plans.3 Since an employee deferral is seen as a liability on an employer's balance sheet, it is considered to be an unsecured loan between the employer and the employee, and it is not protected by ERISA laws. Your employer has agreed to pay in the future based on a distribution schedule, but the promise to pay does not provide any protection in the event that the employer has difficulty paying debts. In this situation, the funds that are being put aside to pay the employee are susceptible to be taken for payment by creditors.
There are both pros and cons to choosing to contribute to an NQDC. An employee will have to decide whether the removal of contribution restrictions and tax benefits are worth the restrictions on distributions and possible vulnerability to creditors before making a decision.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial professional prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
The information provided is not intended to be a substitute for specific individualized tax planning or legal advice. We suggest that you consult with a qualified tax or legal advisor.
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