Nonqualified Deferred Compensation Plans: Benefits and Risks for Executives
For executives and other highly compensated employees, a nonqualified deferred compensation plan can be one of the most valuable, and most misunderstood, benefits on the table. It may allow you to set aside salary or bonus beyond the limits of a 401(k), postpone income tax on that pay, and receive it later when your income may be lower. It also comes with risks and rigid rules that a 401(k) does not have.
Deciding how much to defer, how to invest it, and when to take it out are wealth management decisions and tax planning decisions at the same time. This article explains how an NQDC plan works, the benefits and risks to weigh, and the questions to bring to your advisors.
Start Here: A Complimentary Wealth and Tax Review
Deferral elections are often due before the year begins, so planning ahead matters. Compound offers a complimentary, no-obligation wealth and tax review that may include:
Your compensation picture: salary, bonus, equity awards, and deferred compensation balances
Tax projections: how deferring income may affect your taxes now and in future years
Distribution planning: how payout elections fit with retirement income and other accounts
Concentration review: how much of your net worth depends on your employer
Request your wealth and tax review.
What Is Nonqualified Deferred Compensation?
Nonqualified deferred compensation is an arrangement in which an employee agrees to receive part of their pay in a future year. "Nonqualified" means the plan does not have to meet the same rules as qualified retirement plans such as a 401(k). That gives employers flexibility to offer the plan to a select group of executives and highly compensated employees, and it typically means there is no IRS limit on how much can be deferred, although the plan itself may set limits.
Most deferred compensation plans are governed by Section 409A of the Internal Revenue Code, which sets strict rules for when deferral elections are made and when distributions can be paid. Violating those rules can lead to immediate taxation plus additional penalties, so plan documents and elections deserve careful attention.
Benefits of an NQDC Plan
An NQDC plan may offer several advantages for the right person:
Income tax deferral. Deferred pay is generally not subject to federal income tax until it is paid, which may allow you to shift income from high-earning years into years when your income and tax bracket may be lower.
Savings beyond qualified plan limits. For executives who already contribute the maximum to a 401(k), a deferred compensation plan can provide additional tax-deferred savings.
Tax-deferred growth. Deferred balances are usually credited with returns based on investment options you select, without current taxation on that growth.
Planned income in retirement or transition. Distribution elections can create a stream of payments in the years after you leave, which can help bridge the gap before Social Security or required distributions begin.
State tax considerations. Federal law may limit a former state's ability to tax certain deferred compensation payments after you move, depending on how payments are structured. This is worth reviewing if you expect to relocate in retirement.
Risks and Tradeoffs to Understand
The same features that make an NQDC plan attractive also create risk.
Employer credit risk. Deferred compensation is generally an unsecured promise to pay. If your employer faces bankruptcy, you may become an unsecured creditor and could lose some or all of your balance. This is a major difference from a 401(k), where assets are held in trust for participants.
Limited flexibility. Elections about timing and form of payment are typically made in advance and are difficult to change. Accessing funds early is usually not allowed except in specific circumstances defined by the plan.
Concentration with one employer. If your salary, bonus, equity awards, and deferred compensation all depend on the same company, your financial life may be heavily concentrated in one place.
Future tax uncertainty. Deferral assumes your future tax rate may be lower. Changes in tax law, a large distribution in a single year, or other income in retirement could reduce or reverse that benefit.
Payroll taxes. Social Security and Medicare taxes often apply at a different time than income tax, frequently when amounts are earned or vest, so they may not be deferred along with income tax.
How to Evaluate a Deferred Compensation Plan
Before making elections, it may help to work through these questions with your wealth management and tax planning and preparation advisors:
How financially strong is your employer? Your comfort with credit risk may shape how much you defer.
Are your other savings fully funded? Many people prioritize qualified plans, an emergency reserve, and taxable savings before deferring.
What will your income look like later? Modeling your tax picture across several years can help you decide whether deferral may make sense.
How should payouts be timed? Spreading distributions over several years may help avoid bunching income into one high-tax year. Payouts can also be coordinated with Roth conversion opportunities and retirement account withdrawals.
How are the deferred dollars invested? Your plan investment choices should fit with your overall allocation, not sit apart from it.
To see how deferred dollars might grow over time under different assumptions, try the Compound calculator. Results are hypothetical, but comparing scenarios can help frame the decision.
Fitting NQDC Into Your Executive Financial Plan
A deferred compensation plan is one piece of a larger plan that may also include equity compensation, concentrated stock, charitable giving, and estate goals. Our guides on wealth planning for rising executives and financial planning for younger executives in private companies cover related decisions. High earners may also find it useful to read why high-income individuals may miss planning considerations without coordinated advice.
Compound works with executives and professionals throughout Wisconsin, including Milwaukee, Madison, Waukesha, Brookfield, Green Bay, Appleton, and Racine, as well as surrounding areas, bringing investment management and multi-year tax strategy together.
Weighing your deferral election? Request a complimentary wealth and tax review.
Frequently Asked Questions
What is a nonqualified deferred compensation plan?
It is an arrangement that lets eligible employees, usually executives, defer part of their salary or bonus to a future year. Income tax on the deferred amount is generally postponed until it is paid.
What is the biggest risk of an NQDC plan?
Deferred compensation is typically an unsecured promise from your employer. If the company becomes insolvent, you may lose some or all of your balance.
How is a deferred compensation plan different from a 401(k)?
A 401(k) has annual contribution limits and holds assets in trust for participants. An NQDC plan usually has no IRS deferral limit but is subject to employer credit risk and strict timing rules.
When is nonqualified deferred compensation taxed?
Income tax generally applies when payments are received. Social Security and Medicare taxes often apply earlier, when amounts are earned or vest.
Does Compound work with executives outside of Wisconsin?
Compound serves clients throughout Wisconsin and in surrounding areas. Availability of investment advisory services in a given state may depend on registration requirements.
Compound is a registered investment adviser. Registration does not imply a certain level of skill or training. This article is for informational and educational purposes only and should not be construed as personalized investment, tax, or legal advice. Tax laws are complex and subject to change. Strategies discussed may not be suitable for everyone, and there is no guarantee that any strategy will achieve its objectives or reduce taxes. Calculator results are hypothetical, are not guarantees of future results, and do not reflect any actual investment. Investing involves risk, including possible loss of principal. Diversification does not ensure a profit or protect against loss. Please consult your tax, legal, and financial professionals before acting on any information in this article. For more information, see Compound's Form ADV, available at adviserinfo.sec.gov.
About Compound Wealth
Many financial decisions involve more than one area of expertise. Compound Wealth provides integrated tax planning, wealth management, accounting, and business transition services so clients can evaluate financial decisions within a broader planning framework. This collaborative approach supports thoughtful conversations across multiple areas of financial life.
