Q: I have been offered the chance to participate in my company’s nonqualified deferred compensation plan. Is that something I should consider?
A: Nonqualified deferred compensation plans can be an effective way to boost retirement savings, but the decision to participate depends on your personal financial circumstances. For example, you should think twice about participating if you are not already taking full advantage of your company’s 401(k), including maxing out your contributions (plus a catch-up contribution, if you’re eligible). You might also want to fully fund your health savings account (HSA), if you have access to one, before you start nonqualified plan contributions.
Of course, with today’s tight labor market, you probably wouldn’t want to participate if you think you might leave your company since these plans are for long-term savings—and that would likely trigger a distribution. But if your 401(k) and HSA are maxed out and you want to defer more pre-tax dollars, it’s worth a look. Let’s talk nonqualified deferred compensation plans.
A nonqualified deferred compensation plan is an arrangement between an employer and employee that allows the employee to defer receipt of currently earned compensation. Employers can also make contributions to participant accounts. Because these plans are not required to comply with many of the rules that govern qualified plans—like 401(k) plans—they can offer appealing options in terms of contribution amounts, investment options, and distribution options.
Unlike cash compensation that is taxed in the current year, deferred compensation plans generally aren’t subject to federal income taxes until you begin receiving distributions from the plan. So, contributing can both reduce your current tax bill and boost your savings.
So far, that sounds pretty good, right? What’s the downside?
Probably the biggest consideration is that, unlike your 401(k) account, the compensation that you defer into the plan is not your money. This means that, when it comes time for you to receive the compensation you deferred, your employer may be unwilling or unable to pay the amount or that a creditor may seize the funds through foreclosure, bankruptcy, or litigation. Typically, employers set aside funds deferred, but they remain part of the general assets of the company, subject to the claims of creditors.
That said, your employer may also take steps to help make you comfortable that your funds (plus earnings) will be there when you need them, including setting assets aside to pay your future benefits and securing them in a rabbi trust. An irrevocable rabbi trust, adequately funded, can help provide you with the assurance that your benefits will be paid in all events other than the insolvency or bankruptcy of your employer.
Nonqualified deferred compensation plans offer unique benefits and come with some important considerations, so they are not right for everyone. As always, you should speak with your financial and tax advisors about your company’s plan and your personal financial situation before you make any decision to participate.
