Are you thinking about signing up for a non-qualified deferred compensation (NQDC) plan? If so, you’re agreeing to defer part of your annual income until you retire (or some other future date). Before signing up, you should understand the impact to your future taxes of how and when you receive the income. You need to assess your tax liabilities and cash flow needs well into the future. You also need to understand how the deferred compensation helps achieve your goals. Before enrolling in a NQDC plan, thoroughly evaluate your current situation and future expectations. You need to ensure you make the best possible decision.
Planning Retirement Distributions
Rules for NQCD plans are very different from 401ks, IRAs, and other retirement plans. For example, 401k withdrawals can begin after age 59 ½ without penalty. However, you must start taking distributions at the time you reach age 70 ½. (This is commonly referred to as required minimum distributions, or RMDs.) In contrast, there aren’t any age restrictions on distributions in deferred compensation plans. There aren’t any RMDs.
Based on individual plan options, you may be able to choose how to receive your deferred compensation. The choices are a lump-sum payment or installments. Here are the specifics of each to help you make your decision:
A lump-sum distribution allows you to reinvest the money however you see fit. It’s also a way to ensure your former employer doesn’t control your compensation. Just remember that while you have immediate access to your money, you also owe income tax on the entire lump-sum. Unfortunately, that may push you into a higher tax bracket. You should also remember that selecting a lump-sum distribution means you lose the benefit of tax deferred compounding.
If you’re comfortable being one of your former company’s creditors, this option may work for you. With installment distributions, you take smaller distributions over time. This is done on a predetermined schedule of yearly, quarterly, or monthly distributions. Balances not taken stay in your account where they continue to grow tax deferred. This may reduce your overall tax bill, especially if your income tax rate declines.
Taking distributions over 10 years or more, means you pay taxes in the state where you live when taking distributions. Moving to a state with lower income tax rate could result in a tax benefit.
You need to plan deferred income distributions around other sources of income like RMDs to ensure your cash-flow needs. Also consider the timing of distributions related to other benefits. Restricted stock vesting, exercising stock options, and any other forms of income should figure into your NQDC plan.
Planning Preretirement Distributions
For some people, the flexibility of “in-service” distributions are one of the biggest benefits of deferred compensation plans. It allows you to schedule distributions based on a specific date while offering a tax-advantaged way to save. They can also help partially mitigate the risk of your company defaulting on its obligations. If you’re uncomfortable leaving deferred compensation in your employer’s hands, shorter deferral periods may be a good compromise.
In-Service Distribution Strategy:
If you want to schedule in-service distributions, you need to do more than just defer all compensation until retirement. One strategy to consider is the class-year approach. Also known as “laddering”, you schedule distributions for specific years and create separate accounts and portfolios for each.
For example, you may want to schedule distributions for years you’ll need to pay college tuition. Assuming your child begins college in 2018, you could schedule distributions for 2018, 2019, 2020, and 2021. You can also schedule a distribution on your anticipated retirement date.
If you defer $100,000 compensation each year, and your plan tracks deferred compensation for each year, you may be able to schedule a different distribution amount for each year. In this scenario, if your plan allows for installments as a form of payment, you can elect one class year to be paid as a four-year installment payment that begins in 2018. The remaining class years, can be paid at separation.
If your plan allows, payment of deferred compensation can be structured to reduce tax liability. Spreading out distributions in a series of installments or lump sum payments could reduce your income for each applicable year.
One Important Note
It’s difficult to change your schedule once you create it. Unless you experience an extreme situation, you can’t change your mind and ask for your deferred compensation earlier than scheduled. In contrast, you can postpone provided you follow strict “re-deferral” rules. You have to request postponement at least 12 months prior to the planned distribution date. In addition, you must defer for a minimum of five years beyond the original distribution date.
As an example, let’s assume you scheduled a distribution for May 2019. Your plans change and you’d rather put the money toward your retirement than buy a second home. First you have to request to postpone the distribution before May 2018. Second, you can’t take the distribution until May 2024 without paying taxes and penalties. This is another reason why careful planning is so critical in a NQDC plan.
NQDC can be a great tool for high earners who want to keep more of their income while realizing the benefits of compounded tax deferred growth. However, you should thoroughly understand the distribution rules and know how to maximize them to be as tax efficient as possible. If you’re unsure how to best utilize a NQDC, your Maestro Wealth team is more than happy to answer any questions you may have.