When you sign up for a nonqualified deferred compensation (NQDC) plan, you agree to set aside a portion of your annual income until some future date such as beginning retirement or funding your children’s college education.
In our experience, plan participants do not spend enough time determining when and how to receive this money, let alone understanding how it affects their taxes.
Admittedly, deciding how much to defer, when to receive payment, and how to invest can be confusing. The process involves assessing potential cash flow needs and tax liabilities out many years—even decades—into the future.
You need a crystal-clear picture of what role deferring taxes and accumulating tax-deferred money plays in achieving a comfortable retirement or any other financial goals.
So, before you enroll in an NQDC plan, please consider these factors to help you make the most of your distributions, whenever you decide to take them and, as you will learn, where you take them.
As a long-time consultant in the executive benefits business, I am regularly asked by highly compensated executives how much to defer when enrolling in a NQDC plan.
My steadfast answer? “It depends.”
Sorting out the ideal amount to defer is difficult unless you can examine the entire picture.
That’s why we like the platform offered by My Financial Coach (MFC) calledSmart Tech, along with critical guidance from MFC’s cadre of unbiased Certified Financial Planner® professionals who do see the full picture.
Not only do you need to determine how much to defer, but also from what source, which may include base salary, bonus, long-term incentive payments or restricted stock units (RSUs) before they vest. And on the RSUs, should you diversify some or all of them into other investments inside the deferred compensation plan to minimize risk?
Once these decisions are made, the next question is to determine when you want to receive payments. Our post today discusses the options and their impact on your decision making.
When electing your NQDC plan deferral, you must decide when and how to receive the deferred compensation, as well as any applicable earnings. I encourage you to think about where you want to live during retirement. That decision alone could save you a significant amount of money if you make the right distribution election.
Distribution rules for NQDC plans are considerably different from those governing distributions from qualified retirement plans, such as 401(k)s, 403(b)s, 457(b)s or IRAs.
For example, the Internal Revenue Code (IRC) allows for 401(k) withdrawals to begin penalty-free after age 591⁄2—but the IRC also requires that you start taking distributions at age 701⁄2. By contrast, there are no IRC age restrictions on distributions from a NQDC plan. NQDC plans do not feature required minimum distributions either. Based upon your plan options, generally, you may choose several ways to receive your deferred compensation such as a lump-sum payment or installments or some combination. Here are a few considerations:
By selecting a lump-sum distribution, you gain immediate access to all your deferred compensation upon the distributable event (often at retirement or a specified date or separation from service). That may be important if you’re uncomfortable with your former employer controlling your previously deferred compensation.
At the time of distribution, you will owe regular income tax on the entire lump sum upon distribution, both state and Federal tax. That liability can result in a larger tax bill than if you select installment distributions (see below); in part, because it may push you into a higher tax bracket. You also lose the benefit of tax-deferred compounding when you withdraw money from the plan.
With an installment plan, you take smaller distributions over time—typically on a yearly, quarterly, or monthly schedule. The remainder of your deferred compensation remains in the account, where it can continue to grow tax-deferred.
If you space distributions over several years, it may reduce your overall tax bill, especially if your personal income tax rate declines. However, if you select an installment plan, you must be comfortable remaining one of the company’s unsecured creditors. Until now, that position was the primary reason people took short distributions.
However, today you can access a risk management tool (not a hedge) that can protect those assets against an employer’s bankruptcy. Referred to as the Deferred Compensation Protection Trust®, this mechanism adds many flexible options, especially in retirement planning.
One area often overlooked is the timing of your distributions. Because you retire at a certain age doesn’t mean you need to take distributions then. When most executives retire, they’re paid out from other compensation and benefit plans and taxed on personal investments or assets.
Let’s say you live in New York and decide to retire and take residence in Florida. You sell your residence in New York (which could produce a taxable gain) and downsize in a home in Florida. As a result, you may have excess cash to use toward your retirement, especially in the first few years.
You may also be forced to exercise stock options upon termination, again producing taxation and cash flow for retirement. Also, you must plan your distributions around other sources of income, such as social security and mandatory minimum IRA withdrawals, to accommodate your cash flow needs and tax situation. With this level of complexity, you need to work with a financial coach who can help you model out distributions and cash flows from all sources, not only your NQDC plan. The same issues factor in when you plan in-service distributions, discussed later in this text.
When you make payments over ten years or more, you may also have the option to take a special state tax benefit. This option is a valuable benefit in our New York to Florida example above. With payments structured this way, you only pay taxes in the state of residence when paid, not in the state where income was earned and deferred. This option is a tax benefit for those planning to move to a state with lower income tax rates. From our New York example, that’s a savings of 8.82 percent. California is 13.3 percent.
For every one million dollars, that’s $133,333 in savings.
Whatever form of distribution you choose, be sure to consider the timing of those distributions relative
to personal investment portfolios and other company benefits such as the vesting of restricted stock, the exercise of stock options, and income from other retirement plans.
In our example above, the executive decided to pay down debt on his vacation home by liquating an
investment portfolio with no tax deferral rather than take a distribution from the NQDC plan. You need to look
at all assets, not only your retirement plans. While using that portfolio, our executive was paying capital gains on the realized gains. You must factor in that calculation.
Most NQDC plans allow you to schedule distributions based on a specific date—also known as an “in- service” distribution. For some participants, this flexibility is one of the major benefits of a deferred compensation plan. It offers a tax-advantaged way to save for a child’s education, a new house, or other short- and mid-term goals.
However, because the timing of payouts could put you in a much higher tax bracket than previously, it is important to work with a planner and the modeler outlined in the chart above. From our experience, most participants in NQDC plans don’t take other sources of income into consideration when planning distributions or the re-deferral of income. My Financial Coach’s tools and personal coach can help make a major difference in how much one keeps.
Scheduling in-service distributions requires more work upfront than simply deferring all compensation until retirement. Consider this strategy for scheduling preretirement distributions:
The class-year approach: This strategy, known as “laddering,” involves scheduling distributions for specific years and establishing separate accounts and investment portfolios for each one. For example, if you have a child starting college in 2025, you could schedule distributions for 2025, 2026, 2027, and 2028 (the years you’ll need to pay tuition). You also can schedule a distribution for your anticipated retirement date.
If you elect to defer $100,000 of your compensation each year and the plan tracks your deferred compensation for each class year, you may be eligible to schedule a different payment for each year. For example, if your plan allows for installment as a form of payment, you could elect for one class year to be paid as a four-year installment payment beginning in 2025.
You can pay the other class years you elect to defer compensation at separation from your employer. Again, by working with a financial coach who understands NQDC plans and modeling tools, you will better prepare for sound decision making.
And if your other compensation is going to put you in a higher tax bracket the year of planned distribution, you can always re-defer those dollars under the rules of IRC § 409A. You and financial coach can help monitor this for you.
Depending on your plan provisions, the payment of deferred compensation can also be structured to reduce your tax liability through a series of installment payments or lump-sum payments, based on a specified time. By spreading out the payments, you could potentially reduce your income for each applicable year.
In addition to the tax-efficient strategies outlined above, keep in mind, the potential exists that federal law or your income may affect your tax rate down the line. Also, the state you live in makes a difference in how to schedule your distributions; certain states carry lower or higher income tax rates than others.
One final and important note: No matter which distribution strategies you choose, it’s difficult to change the schedule once you’ve created it. A subsequent distribution election, if allowed by the plan, cannot permit the payment to be paid earlier than originally elected except in cases of extreme hardship, death, or disability—so you can’t simply change your mind and ask for your deferred compensation a year or two earlier than your scheduled distribution date. Remember, you can always push your deferrals forward (five years), but you can’t accelerate them backward.
You can postpone a distribution as long as you follow strict “re-deferral” rules under IRC § 409A: The request to push back a distribution must be made at least 12 months before the planned date, and you must defer the compensation for at least five additional years beyond the original distribution date.
Working with a financial coach who understands these rules and your plan can produce more after-tax income in the future.
For example, one executive working with an MFC coach recently had accumulated all his NQDC retirement savings into a lump-sum distribution. Now 60 and ready to retire in five years, he has made a re-deferral from his previous lump sum to take a 15-year payout. Because of re-deferral rules, he will now take that distribution starting at age 70.
Guided by his financial coach, this executive decided to defer income for the next five years and take these deferrals, plus earnings, over five years to fill the gap on the re-deferral.
These payments, coupled with cash from other sources like his final exercise on options, gave him the income stream he sought. What’s more, he is moving to Florida (0% state tax) from Minnesota (9.85% max tax) which will increase his income. To further protect himself and his family, he purchased the Deferred Compensation Protection Trust® for a fraction of the tax savings for the state.
The subject of retirement taxes on NQDCs is dense, complex, and challenging even for experts.
Let’s shift the mood a bit.
A wildly popular song wafted onto the scene in 1988 by ten-time Grammy winner Bobby McFerrin called, Don’t Worry, Be Happy.
Open the link above (you’ll feel better) and take a listen because we want to remind you not to worry about your retirement. You can implement many options today and enjoy a worry-free retirement tomorrow.