Should You Participate in Your Non-Qualified Deferred Compensation Plan? 8 Questions to Answer First

You earn $650,000.

You already contribute heavily to retirement accounts, invest outside of work, and have more cash flow than you need for your current lifestyle.

Then open enrollment arrives and your employer gives you another decision:

How much of next year’s income do you want to defer?

Putting $100,000 into a non-qualified deferred compensation plan could reduce the income you recognize for federal income tax purposes this year and allow that money to grow tax deferred until it is paid to you.

Sounds appealing.

But you are also giving up access to the money, choosing when you may receive it years from now, and relying on your employer to eventually pay you.

So should you participate in your non-qualified deferred compensation plan?

For some high-income executives, the answer may be yes.

But “defer as much as possible” is not a financial plan.

What is a non-qualified deferred compensation plan?

A non-qualified deferred compensation plan, often called an NQDC plan or deferred compensation plan, allows certain employees to postpone receiving part of their compensation until a future date.

These plans are commonly offered to executives and other highly compensated employees.

Unlike a 401(k), an NQDC plan is generally not a separate retirement account holding assets that belong to you.

You are essentially agreeing:

Don’t pay me this income today. Pay me later according to the plan’s rules and the distribution election I make.

Properly structured NQDC plans can allow you to defer federal income taxation on compensation until it is paid, while potentially allowing the deferred amount to grow based on the plan’s available investment choices or notional investment options.

But the money generally remains part of the employer’s assets.

That creates opportunities a 401(k) does not have, along with risks a 401(k) does not have.

Here are the questions I would work through before making an election.

1. Are you already using your other tax-advantaged accounts?

An NQDC plan should not be evaluated in isolation.

Before committing a large amount of compensation to an account you may not be able to access for years, look at the other savings opportunities available to you.

That may include:

• 401(k)
• HSA
• Backdoor Roth IRAs
• Mega backdoor Roth contributions, if available
• Employee stock purchase plans
• Taxable investment accounts

A 401(k), for example, has protections and portability that an NQDC plan generally does not.

If you leave your employer, qualified retirement assets can often be rolled into another qualified plan or IRA.

NQDC benefits generally cannot.

For that reason, I usually want to understand why someone is not using available qualified retirement accounts before deciding how aggressively to fund deferred compensation.

2. What tax rate are you avoiding today?

Taxes are one of the biggest attractions of deferred compensation.

Suppose you earn $650,000 and elect to defer $100,000 of compensation.

Instead of receiving that $100,000 as current taxable compensation, you postpone recognizing that income for federal income tax purposes until the plan distributes it to you, assuming the plan complies with applicable tax rules.

That can be valuable if you are currently paying tax at a high marginal rate.

But today’s tax savings are only half of the equation.

You eventually receive the money.

And when you do, the distribution is generally taxable as ordinary income.

So the better question is:

What tax rate am I avoiding today compared with the tax rate I may pay when this money comes back to me?

If you are earning $650,000 today and expect distributions during retirement when your taxable income is considerably lower, the difference could be meaningful.

If you defer income today only to receive a large lump sum during another high-income year, the benefit may be much smaller.

The timing of the distribution matters almost as much as the amount you defer.

3. When will you actually get the money?

This is where many executives focus too little attention.

The deferral election feels like today’s decision.

The distribution election can affect you 5, 10, or 20 years later.

Depending on your employer’s plan, you may be able to select:

• A lump-sum payment
• Installments over several years
• Payments beginning at retirement
• Payments after separation from service
• An in-service distribution on a future date
• Different distribution elections for different years of deferrals

The available choices vary by plan.

These decisions can be difficult to change later.

Section 409A imposes strict rules around the timing of deferred-compensation elections and distributions. In many cases, changing an existing distribution election requires significant advance notice and pushes the payment at least five additional years into the future.

So before selecting “age 65” because retirement feels like the obvious answer, ask:

What might I actually want this money to accomplish?

Maybe it funds retirement.

Maybe a distribution at age 55 helps one spouse step back from work.

Maybe you want money available when your kids reach college.

Maybe it helps fund a future home purchase.

Deferred compensation can sometimes be used for goals before retirement, but only if the plan permits it and you make the appropriate election in advance.

4. Can you afford to give up access to the money?

A tax benefit is not valuable if you create a cash-flow problem to get it.

Suppose you defer $100,000 next year.

That is $100,000 of gross compensation that will not arrive in your bank account.

Before making the election, consider what else is coming.

Are you:

• Buying a home?
• Renovating?
• Paying private school tuition?
• Funding 529 accounts?
• Increasing taxable investments?
• Taking a large family trip?
• Supporting parents?
• Planning parental leave?
• Considering one spouse stepping back from work?

You may technically have enough income to make a large deferral.

That does not necessarily mean the largest possible deferral is the right choice.

I would rather see a family make an intentional election that fits the rest of the plan than maximize a tax benefit and later wish the money were accessible.

5. How financially strong is your employer?

This is one of the biggest differences between an NQDC plan and a 401(k).

Money in a qualified retirement plan is generally segregated from the employer’s assets.

Non-qualified deferred compensation generally is not.

An NQDC plan represents an unsecured promise from your employer to pay you in the future. If the company becomes insolvent, participants may be treated as unsecured creditors and could lose some or all of the deferred amount.

That makes employer risk part of the decision.

Imagine you already have:

• $400,000 of employer stock
• $200,000 of unvested RSUs
• A large annual bonus tied to company performance
• Your salary
• $350,000 accumulated in the company’s deferred compensation plan

A significant portion of your financial life now depends on the same employer.

Your paycheck depends on the company.

Your equity compensation depends on the company.

Your employer stock depends on the company.

And your deferred compensation depends on the company keeping its promise.

That does not automatically mean you should avoid the plan.

But you should know how much employer exposure you are accumulating.

This is closely related to the same concentration issue that arises when too much of your portfolio is invested in company stock.

6. What happens if you leave the company?

People often make deferred compensation elections assuming their career will continue as planned.

Careers rarely cooperate that neatly.

You could:

• Take another job
• Retire earlier than expected
• Be laid off
• Be acquired
• Move into another division
• Decide you no longer want the role
• Have a family change that alters your plans

Your plan document determines what happens next.

Some plans may trigger a distribution after separation from service.

Others may preserve the distribution schedule you previously selected.

You also generally cannot take your NQDC balance and roll it into an IRA or your next employer’s retirement plan.

This makes the distribution rules especially important if you think your current employer may not be your last.

Before making a major election, I would want to understand exactly what happens under your plan if you leave in:

• 2 years
• 5 years
• 10 years
• retirement

Do not wait until you resign to read that section of the plan document.

7. Could where you live later affect the tax strategy?

This is particularly relevant for executives living in Texas.

Texas currently has no individual state income tax.

That can make the state-tax discussion simpler for compensation earned and received while you live and work here.

But deferred compensation becomes more complicated when your career crosses state lines.

Maybe you previously worked in California or New York.

Maybe your company relocates you.

Maybe you leave Dallas later.

Maybe you earn the compensation in one state and receive it years later while living somewhere else.

State taxation of NQDC can depend on where you lived and worked when the compensation was earned, where you live when distributions occur, the structure of the plan, and how payments are made. Certain qualifying installment structures can receive different interstate tax treatment under federal law.

For example, Fidelity illustrates cases where an executive earns deferred compensation in a state with an income tax and later moves to Texas before receiving qualifying long-term installment payments. Depending on the plan and payout structure, the former state may be restricted from taxing those later distributions.

This is an area where I would coordinate with your CPA before making a long-term distribution election.

The tax decision you make today may interact with where you live years from now.

8. What is this money supposed to do for you?

This is the question that ties everything together.

It is easy to start with:

How much should I defer?

I would start with:

What do I want the deferred compensation to accomplish?

Consider a Dallas couple earning $700,000.

They already:

• Max their retirement accounts
• Invest regularly in a taxable account
• Have adequate cash reserves
• Save for their children’s education
• Own a diversified portfolio

One spouse has access to an NQDC plan.

Instead of simply deferring the maximum available, they might decide that deferred compensation will serve a specific purpose:

Create an income bridge from age 55 to 65 so that work becomes optional earlier.

Now the election has context.

You can model:

• How much annual income they will need
• When distributions should begin
• Lump sum versus installments
• Expected taxes
• Other investment accounts available at the time
• Future RSUs and company stock
• Social Security timing
• Retirement-account withdrawals later

That is very different from saying:

I make a lot of money, so I should defer as much as possible.

Lump sum or installments?

Once you decide to participate, another decision appears.

Should you receive the money all at once or over several years?

A lump sum can give you immediate control of the money and remove ongoing employer credit exposure.

But receiving a large amount in one year can also create a significant tax bill.

Installments may spread taxable income across multiple years and allow the remaining deferred amount to continue receiving tax-deferred treatment within the plan.

The tradeoff is that the undistributed balance generally remains exposed to the employer’s credit risk for longer.

Neither option is automatically better.

The answer depends on:

• Expected retirement income
• Other deferred compensation payments
• RSU vesting
• Investment income
• Required retirement-account withdrawals later
• Cash needs
• Employer strength
• Future state of residence

This is why I consider the distribution strategy part of the original deferral decision.

You are deciding how to get into the plan and how you eventually want to get out.

How much should you defer?

There is no universal percentage.

For one executive, $25,000 might make sense.

Another might comfortably defer $150,000 or more.

Instead of starting with the plan maximum, I would work backward.

First, determine how much income your family actually needs

Include:

• Regular spending
• Travel
• Childcare
• Private school
• Housing
• Taxes
• Cash reserves
• Near-term purchases

Then fund other priorities

Consider:

• Qualified retirement accounts
• HSA
• College savings
• Taxable investments
• Charitable giving
• Other goals

Then determine how much compensation you can reasonably make inaccessible

Only after understanding the first two would I decide how much additional income belongs in deferred compensation.

The answer should fit the plan.

Deferred compensation is one piece of your financial life

An NQDC election touches far more than taxes.

It can affect:

• Cash flow
• Retirement timing
• Investment strategy
• Employer concentration
• Equity compensation
• College funding
• Major purchases
• Career flexibility
• Future tax brackets

That is why I would not make the election by looking only at the tax savings shown on the employee benefits website.

A decision can look attractive in isolation while creating a less attractive result somewhere else.

So, should you participate in your deferred compensation plan?

Possibly.

If you have strong cash flow, already use other tax-advantaged savings opportunities, expect the plan to improve your long-term tax picture, trust the financial strength of your employer, and can choose a distribution schedule that supports your goals, an NQDC plan can be a useful planning tool.

But participation comes with tradeoffs.

You give up liquidity.

You take employer credit risk.

You make distribution decisions that may be difficult to change.

And you eventually have to coordinate those distributions with the rest of your income.

I would not ask only:

How much can I defer?

I would ask:

How much should I defer, when should I get it back, and what do I want that money to make possible?

Those are three different decisions.

They should be planned together.

Trying to decide how much to defer this year?

Motif Planning works with high-income families who want ongoing financial planning and investment management.

I help coordinate deferred compensation with taxes, investments, equity compensation, employee benefits, cash flow, retirement, and the other decisions competing for your money.

If you want to understand the tradeoffs without personally managing every financial detail, schedule a 15-minute discovery call to see if Motif Planning is a good fit.

_{This article is for educational purposes and does not constitute individualized investment, tax, or legal advice. Deferred compensation plans vary significantly by employer. Review your plan documents and consult appropriate financial, tax, and legal professionals regarding your individual circumstances.}