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Pros and Cons of Deferred Compensation Plans

Author: Andrew Davis

While non-qualified deferred compensation (NQDC) plans allow you to save an unlimited amount for retirement, they also have some serious drawbacks. In addition to requiring income distribution to be scheduled ahead of time, deferred compensation plans do not allow early access to your account under any circumstances, even if you need those funds for an emergency.

Unlimited Savings and Tax Benefit

The Internal Revenue Service (IRS) imposes strict limitations on the amount of money you contribute to a qualified retirement savings plan. Deferred compensation plans have no such IRS-imposed limits. Though employers may specify a contribution limit based on your compensation, there is no federally mandated contribution restriction. If you are a highly compensated employee, you can maximize contributions to your 401(k) and then continue to build your retirement savings through an NQDC plan without restriction.

The ability to defer any amount of compensation also reduces your annual taxable income. This can, in turn, put you in a lower tax bracket, further decreasing your tax liability each year. However, deferred compensation is still subject to FICA and FUTA taxes in the year it is earned.

No ERISA Restrictions

Because NQDC plans are not covered under the Employee Retirement Income Security Act (ERISA), they offer a greater amount of flexibility for employers and employees. Unlike ERISA plans, employers can elect to offer NQDC plans only to key employees who are most likely to use and benefit from them. This greatly reduces administrative and operational costs incurred by the plan.

Investment Options

Many NQDC plans offer investment options similar to 401(k) plans, such as mutual fund and stock options. NQDC plans aren't just fancy deposit accounts for high rollers. Instead, they allow you to grow your wealth over time. However, you can invest on a larger scale because your contributions are unlimited, increasing the potential for bigger gains.

Strict Distribution Schedule

Unlike a 401(k), you must schedule distributions from an NQDC plan in advance. Rather than being able to withdraw funds at will after retirement, you must choose a distribution date at some time in the future. You must take distributions on the designated date, regardless of whether you need the funds or how the market is doing. This means that your taxable income for the year is increased, and the timing of the distribution may mean that the assets in your investment portfolio are liquidated at a loss.

You may defer distributions, but you must give notice one year in advance and the distribution must be deferred by at least five additional years.

No Early Withdrawal Provision

Though is it discouraged, employees who contribute to 401(k)s or other qualified plans are legally allowed to withdraw funds at any time. While distributions taken before a certain age may incur tax penalties, there is nothing preventing you from accessing funds in an emergency. In addition, most plans provide for a number of penalty-free early withdrawal if you can prove financial hardship.

NQDC plans, conversely, have no such provisions. You must withdraw funds according to the distributions schedule and no earlier. Funds contributed to an NQDC plan are not accessible before the designated distribution date, even if you have an emergency financial need that you cannot meet by other means.

No ERISA Protections

Because NQDC plans are not covered under ERISA, they are not afforded the same protections from creditors as other retirement plans. In fact, as a plan participant, you don't actually own an account of any kind, because your employer simply reduces your compensation by the deferral amount rather than depositing funds into an account held with a financial institution. The amount of the employee deferral represents a liability on the employer's balance sheet, essentially making the NQDC plan an unsecured loan between the lending employee and the borrowing employer.

If you have contributed to an unfunded NQDC plan (which is the most common type), you must rely on the employer's promise to pay in the future according to the distribution schedule. If the employer falls on hard times and must pay off debts, the funds that might have been used to pay your employee distributions can be claimed by creditors. Funded NQDC plans offer more protection for employee contributions, but deferrals are generally taxable in the year they were earned, nullifying the tax benefit that unfunded plans provide.

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