Are you one of the people who maxed out the 401(k) or 403(b) savings plans at work, but still wants more? In this case, you may want to take advantage of the NQDC (non-qualified deferred compensation plan), if it’s made available by your employer. Today we are going to find out more about the NQDC and understand how it works.
Non-Qualified Deferred Compensation Plan Definition
The NQDC plan is an agreement, arrangement, or method between an employer and an employee. It can also work for a service recipient and service provider, and it can be elective or non-elective. The employee or the independent contractor will receive the compensation in the future. As opposed to the qualified plans, the NQDC ones don’t offer tax benefits because they don’t fall under the requirements specified in IRC § 401(a). There are various options for these plans, which are also called 409A plans 9from the section in the tax code that refers to them).
NQDC vs 401(k)
Many people are confused when it comes to the differences between an NQDC and a 401(k). Usually, the workplace saving options let an employee defer part of their salary to a segregated account. Then, they can invest the funds in a variety of investment options. Meanwhile, an NQDC plan resembles more an agreement between the employee and the employer. They agree to defer a portion of the annual income of the employee until a certain date in the future. Depending on the kind of plan, the future date can be in 5 or 10 years, or even in retirement.
The employee chooses how much to defer each year from the forms of compensation they have (salary, bonuses, etc.). The best thing about it is that you don’t get to pay income tax on the part of the compensation in the same year you defer it. You just need to pay the Medicare and Social Security taxes. This means that it can grow tax-deferred by the time you receive it.
Types of Non-Qualified Deferred Compensation Plan
Even though you can find them under plenty of names, the NQDC plans usually fall into 4 categories:
1. Excess Benefit Plans
These are plans that offer benefits only to a certain category, including the flexible benefit plans. The employees who have benefits that fall under the qualified plan offered by the employer, which are limited by the IRC § 415.
2. Salary Reduction Arrangements
With such a plan, you will defer receipt of part of the employee’s salary by deferring the receipt of a compensation which is currently includible.
3. Top-Hat Plans
Also known as Supplemental Executive Retirement Plans (SERPs), these are NQDC plans that address a select group of employees. They belong to a select group of managers or from a category that receives a high compensation.
4. Bonus Deferral Plans
This resembles the salary reduction agreements, only that they let the participants defer receipts of bonuses.
Here you can see other types of NQDC plans:
Key Elements to Consider
1. Use the 401(k) or 403(b) before using the NQDC
First, make the maximum contribution to these two types of plans, before taking advantage of the NQDC one. Why? Because the IRS Section 401(k) and 403(b) plans get to be funded directly, plus they are protected by the Employee Retirement Income Security Act, whereas the NQDC plan doesn’t get these benefits.
2. Paying Income Tax
Just as we mentioned earlier, you don’t need to pay any income taxes on the deferred compensation until you receive the funds. What convinces people to participate in this plan is the fact that they are in a lower tax bracket when they retire. However, the decision is entirely up to you. Have a look at the cash flow needs, as well as the upcoming expenses. Then, estimate whether you can forgo the income you should expect in the following years. Keep in mind that you can’t change your mind once you select a deferral amount.
3. Checking the Company
Many people fear that the company isn’t financially secure, so they can’t honor the commitment. Consequently, make sure your employer or contractor can fulfill this promise.
4. Flexible Distribution Schedule
Some of the plans ask the employees to defer the compensation until a specified date, that can even be during the retirement. Meanwhile, there are other plans that allow for the distributions to be made earlier. Depending on what income needs you have, as well as the personal situation, you should look for plans that allow you greater flexibility. Remember that the employer may force the payments and ask for a lump-sum distribution.
5. Investment Choices
Once again, you need to be well informed before deciding on a plan. Some of them have a fixed rate of return on your deferred amount, but this happens rather rarely. Meanwhile, most companies rely on specific investments to base the growth of the deferred compensation. For instance, part of the NQDC plans have the same investment choices as those in the 401(k). Other plans let you follow the major stock and bond indexes. The idea here is that the more investment choices you have available, the easier it is to use an NQDC plan to diversify your own investment strategy.
6. Who Can Use It?
Theoretically, every case that respects all the requirements for the plan can use it. However, would this be a good solution for you? Think about the possibility of losing the money. Could you do without them? Do you enjoy a substantial wealth besides the non-qualified deferred compensation plan? Are you aware of the risks that come together with such a plan? If you answered yes to all the questions above, the NQDC plan can be a great option for you.
To draw a conclusion, the non-qualified deferred compensation plan is a great extra source of income. However, it’s a wise idea to consider it only after you completed the 401(k) or the 403(b) plans, for the reasons we exposed above. Even though it sounds appealing, you should stop and consider all the risks involved in it before making a decision.
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