Non-qualified deferred compensation plans (NQDCPs) are typically offered by companies to attract,...
When it comes to financial flexibility of employee benefit offerings, nonqualified deferred compensation plans (NQDCP) are unparalleled.
Although NQDCPs are commonly perceived as “401(k) excess plans,” they are much more than a supplemental retirement savings vehicle. For example, NQDCPs offer the flexibility to save for short-term needs, such as large purchases, like weddings or college tuition for children, in addition to long-term goals, like retirement.
How NQDCPs are Structured
Since NQDCPs are not tax-qualified plans under the Internal Revenue Code, they are not subject to limits on how much can be contributed each year and how much can be distributed, nor are they subject to the same distribution rules as qualified plans. Many companies offer NQDCPs to their higher paid employees to provide an opportunity for supplemental tax-advantaged savings above the limits that apply to the 401(k) plan.
Much like a 401(k) retirement account, NQDCP participants pay income tax only on the compensation they receive from their employer but the compensation contributed to the NQDCP and/or 401(k) is tax deferred, meaning that the participant’s taxable income during the year of the contribution will be reduced. In exchange, ordinary income tax will be due on the contributions when they, and any investment earnings accrued, are distributed from the NQDCP in the future, similar to a 401(k).
Collect Distributions While Working
The participant’s tax treatment of NQDCP accounts is similar to that of a 401(k) account but the rules around structuring distributions are quite different. Pursuant to Internal Revenue Code Section 409A, NQDCPs can allow participants to defer until separation from service with their employer and, if their employer allows it, they may also defer until any date (or dates) in the future when they would like to receive their distributions, even if they are still working for their employer on those dates. These elections are known as in-service distribution accounts. The concept of in-service distribution accounts is a bit unique because they have no counterpart in a 401(k) plan.
Unlike a 401(k) plan, there is no penalty for receiving distributions from a NQDCP before retirement or before a certain age, as long as the distribution date was specified by the participant at the time he/she elected to defer the compensation. Once the distribution elections are set, participants may not accelerate a distribution or take it any earlier than the date elected (except in the event of a legitimate financial emergency.) The only way for a participant to change an existing distribution election is to “re-defer” the payment according to the following rules:
- The re-deferral election must be made at least one year before the date on which the distribution was originally scheduled to occur.
- The re-deferral election must result in the payment being deferred for at least five more years after the original payment date.
Flexible Distribution Accounts
Considering the fact that NQDCP payments may not be accelerated, but may only be re-deferred for at least five more years, it becomes apparent that the best way to preserve flexibility to change distribution elections in the future is to defer in shorter increments of time – rather than deferring all the way to retirement or separation from service – and then have the opportunity to re-defer one year in advance of the scheduled payment if the participant decides they do not need the money (and the taxes). At Karr Barth, we refer to these short-term date-driven accounts with re-deferral rights as Flexible Distribution Accounts (FDAs) because they preserve the most flexibility in the timing and form of distributions from a NQDCP.
Flexible Distribution Strategy
To gain the ultimate flexibility, NQDCP participants can establish five separate FDAs, each one with a scheduled distribution date one year after the previous one. This way, participants will always have an account coming up for distribution each year and get to decide one year in advance of each payment whether to take the distribution or to re-defer for another five years. This Flexible Distribution Strategy is sometimes thought of as “laddering” one’s accounts over five consecutive years. It allows participants to use NQDCP distributions for near-term needs or wants, like a child’s college tuition, wedding, or a home renovation. It also allows participants to continue to re-defer their FDAs until they ultimately take distributions as retirement income.
Below is a chart that outlines how FDAs can be laddered. In this example, the accounts are created in the fall 2024 enrollment window to accept compensation deferred in 2025. The participant determines how they want to allocate deferred compensation across each of the FDAs. If the first FDA is scheduled for payment in January 2027, the participant will have until December 31, 2025 to decide whether or not to allow FDA 1 to pay out. And if the participant decides not to take the distribution in January 2027, then FDA 1 must be re-deferred for a minimum of five years, until January 2032 or later.
Use Case: Funding College Savings
According to the National Center for Education Statistics, in 2022-2023, the average cost of attendance for a full-time undergraduate student living on campus at a 4-year private institution was $58,600.[i] Unsurprisingly, most trends indicate that the price of college tuition will continue to rise so saving money for college has become a major priority. Many people have turned to 529 plans to help them save for college; these are state-sponsored investment plans that enable families to save money for a beneficiary and withdraw funds tax-free if they are used on qualified educational expenses. In short, 529 account holders fund their accounts with post-tax dollars so that they can be invested and then they can take distributions from the account for the account beneficiary’s educational expenses.
How an NQDCP Can Help
Alternatively, another tax-advantaged resource that has been found to be incredibly useful when it comes to saving for college is an NQDCP. Using FDAs, NQDCP participants can forecast their child or grandchild’s college timeline and design FDA ladders to meet their needs. For example, if an NQDCP participant expects their child or grandchild to graduate from high school in 2040, they could continue to contribute to five FDAs between now and then, and then they could elect to have a certain amount distributed to them in 2040, when the child begins college and for each subsequent year. Importantly, the amount elected for distribution can change each year; therefore, if the student were to receive a scholarship or transfer schools, the participant could modify their next FDA distribution election based on their new needs.
The flexibility to change FDA distribution elections offers participants a great advantage because they have the option to leave a certain percentage in the FDA so that it may continue to accumulate tax-deferred earnings. On the other hand, deposits made into a 529 account must be used for educational purposes. If withdrawals are made from a 529 account and not used for educational purposes, the account holder may be liable for taxes. Since the amount of money needed for college is typically unknown while money is being set aside, 529 accounts can become overfunded thereby leaving the account holder on the hook for taxes.
Do Your Homework
NQDCPs offer participants the flexibility to save for short-term or long-term expenses on a tax-deferred basis. Unlike a 529 plan that uses post-tax deposits and receives favorable tax-treatment on withdraws from investment account earnings for qualified educational expenses, NQDCPs can help families save money by reducing annual income tax burdens, and accumulating investment earnings that are taxed as ordinary income upon distribution. Importantly, these distributions can be used for any purpose, whether related to education or not. Participation in a NQDCP is a unique opportunity that is among the most valuable benefits an employer can offer its employees to help them plan for their future financial needs – whether in retirement or for shorter-term needs like funding a child’s education.
For more information about NQDCPs, please visit www.KBAdmin.com.
[i] National Center for Education Statistics. (2024). Price of Attending an Undergraduate Institution. Condition of Education. U.S. Department of Education, Institute of Education Sciences. Retrieved May 30, 2024, from https://nces.ed.gov/programs/coe/indicator/cua.
