Have you ever heard the phrase ‘golden handcuffs’? Golden handcuffs was first coined in the 1970s and refers to financial benefits that encourage highly compensated employees, often executives or C-suite adjacent professionals, to remain at a company instead of moving on.
One of the most common golden handcuff financial incentives is also a clunky mouthful: the non-qualified deferred compensation (NQDC) plan. This is an executive level retirement benefit for a select group of employees that allows for the deferred payment of compensation to a future time you choose that is dictated by the plan provisions.
What do these plans do? They allow participants to gain more control over taxes, determine how and when to receive distributions, and how contributions are invested.
Below we explore how executives can leverage their NQDC compensation plan to maximize its impact on their financial journey and can retire on schedule.
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How a Non-Qualified Compensation Plan Works
The lifespan of a NQDC typically involves three main actions:
1. Decide
How much you can afford to defer into the plan – which is done during your enrollment period – is an extremely important decision. Abacus recommends you speak with an advisor to understand how much compensation to defer based on your financial goals. This election will reduce your taxable income in the year the deferrals are made, which can lower both your Federal and State effective tax rates (more on this later).
2. Invest
While not directly investing, your account is credited with gains or losses based on reference investments you choose. More on this pre-tax growth concept in a minute.
3. Enjoy
You’ll receive the compensation you deferred, plus potential earnings credited to your account in the future, once you are ready to cash in on your hard work. At that time, it will be taxed as ordinary income.
Additional considerations of NQDC plans include:
- The assets legally belong to your company until payouts begin.
- You are considered an unsecured creditor; this means if your company goes bankrupt, you may never receive the deferred income.
- Deferral decisions are done once per year and are final after the enrollment period ends, which is why speaking with an advisor is key to understanding how much you can afford.
- Unlike many employer-sponsored 401(k) plans, these plans do not allow for rollovers or loans.
Think 401(k) Before Turning to the Non-Qualified Plan
Before participating in a non-qualified deferred compensation plan, make sure you’re getting the most out of your company’s 401(k) or 403(b) plan. Unlike the NQDC plan, money in a 401(k) is yours and protected by the government. Max this out first!
If you’re over 50 and have reached the annual maximum contribution amount, you may have the opportunity to contribute extra dollars to your 401(k) plan. Called a catch-up contribution, this lets you defer even more money to the qualified plan on a tax-deferred basis ($6,500 for tax year 2022).
Only when you’ve hit the maximum deferral to your 401(k) plan should you think about using the NQDC plan to supplement your retirement income.
Non-Qualified Compensation Plan Possibilities
Significant achievement can come with your deferred compensation plan.
First, you can save more for retirement or other savings goals while you’re still working. Experts often suggest you need at least 80% of your pre-retirement income in retirement. The more you make, the harder it gets to save that amount because qualified plans have limits – meaning, you can only save so much per year and social security doesn’t scale for high earners.
Consequently, the gap between your income replacement goal and your standard retirement savings increases along with your income. The NQDC plan is one way to fill this gap: it lets you set aside more pre-tax dollars today while potentially enjoying additional tax-deferred growth in the future.
Second, you can retire on schedule with no age-based requirements. The NQDC plan lets you bridge the gap between earned income while working and other income available in standard retirement years (e.g. Social Security, 401(k), IRA, savings). This other income often has age-based rules for when you can take your money.
But the NQDC plan does not follow this framework. This means you may have an opportunity to retire sooner (yay!) or retire at the typical retirement age but let your other income grow. For example, the Social Security Administration notes that social security grows by roughly 8% each year you delay taking it.
Third, you can better manage your taxes. Deferring some of your income can help you reduce the actual tax rate you’re charged when you file. Here’s why:
- Each dollar is taxed at the rate of the marginal tax bracket it falls into; this means the first dollars you make are taxed at a lower rate no matter how much you make, while the last dollars you make are taxed at the highest marginal tax bracket reached.
- Your average, combined tax rate is called your effective tax rate.
- By preventing money from being taxed at the higher marginal tax rates, you will lower your actual, or effective, tax rate.
Moving money taxed at your highest marginal tax bracket into the NQDC plan (which grows tax-deferred), and then taking it out when your actual annual income is likely at a lower tax bracket, can offer you significant savings potential.
What’s more? Let’s not forget about state or local income taxes. If you find yourself living in a high income tax state (California) or a city with a high local income tax (New York City), the potential tax savings could be even larger.
Get Started with Your Non-Qualified Deferred Compensation Plan Today
You can achieve a lot with your non-qualified deferred compensation plan: more retirement savings, retiring on your schedule with no age-based requirements, and better tax management.
As you explore how NQDC plans work and how they compare to qualified ones, speak with an Abacus financial advisor who can best help you create a financial plan focused on your retirement and tax needs.
