The ins and outs of nonqualified deferred compensation - Butler Financial, LTD
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The ins and outs of nonqualified deferred compensation

A versatile tool that can help enhance the benefits package you offer your employees. 

What is an NQDC plan?

While nonqualified deferred compensation (NQDC) plans can vary slightly from one another, they generally act as an agreement between employers and employees to defer a portion of the employees’ annual income to a future date – that could be one year later or once the employee retires. Deferred compensation isn’t counted as earned income, so it’s not subject to taxes.

Who does an NQDC plan serve best?

NQDC plans are utilized by companies with a need to recruit, retain and reward key employees. They were created as a counteraction to the cap that high-earning employees face when it comes to government-sponsored retirement plans.

Highly compensated employees are often limited in retirement savings due to federal legislative limits. Participating in an NQDC plan can allow high earners to accrue additional pre-tax savings and tax-deferred growth. Employers can harness the tax deferring benefits of NQDC plans as an incentive to entice and retain top talent.

Nonqualified plans also offer more flexibility than qualified retirement plans in that savings can be accessed before an employee reaches retirement. While NQDCs are a popular component of a retirement planning strategy, deferred compensation can also be used in a variety of other situations: toward education expenses, to cover a home remodel, or even to supplement income during an extended period off from work. That said, nonqualified plans don’t simply function like a savings account. They require the employee to pick the distribution date they will receive their funds in advance. The main benefit here for employers is that it affords the freedom to offer plans to a more specific subset of employees, such as higher earners.

SECURE 2.0 Act changes

The SECURE 2.0 Act is a recent regulatory update designed to encourage more employers to offer retirement plan benefits through practices such as automatically enrolling eligible employees and allowing catch-up contributions, among other measures.

Most highly compensated employees take advantage of catch-up contributions in their qualified retirement plans, but things are about to change.

Starting in 2024, if the employee has income of at least $145,000 for the year, the catch-up contributions under 401(k), 403(b) or governmental 457(b) plans must be treated as a Roth contribution, which is a change to the current pre-tax contribution. That means these funds will be saved as after-tax dollars, no longer reducing taxable income but allowing for tax-free withdrawals in the future. Note that the $145,000 income threshold will also be indexed for inflation in future years.

An NQDC plan gives highly compensated employees the option to defer an unlimited amount of their income on both a pre-tax and tax deferred basis – providing greater flexibility with distributions.

For people with access to a nonqualified deferred compensation plan there’s a bigger question: Is it more beneficial to contribute the catch-up amount to the NQDC plan for the pre-tax deferral or a Roth contribution to the qualified retirement plan? Everyone’s circumstances are different, but a financial advisor can offer guidance.

What can business leaders do to prepare?

Recent legislative changes mean that, for companies and business leaders, now is a great time to review your benefit packages. If an NQDC plan is the right fit for your needs, it’s worth considering implementing one to help highly compensated employees effectively prepare for retirement.

Before you begin to leverage the flexibility NQDC plans offer, it’s important to weigh your options. NQDC plans can be a useful tax deferral tool, but there’s a strong likelihood that employees who qualify have maxed out their employer-sponsored retirement plan contributions. Therefore, offering different investment options from those typically found in a standard retirement plan can diversify employee retirement holdings and differentiate your NQDC plan as an enticing benefit.

Talk to your financial advisor to determine whether the addition of NQDC plan types could be beneficial for your business.

Raymond James and its advisors do not offer tax advice. You should discuss any tax matters with the appropriate professional.

Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted.

This material is being provided for information purposes only and is not a complete description, nor is it a recommendation.

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