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Non-Qualified Deferred Compensation Distributions

Today’s question is brought to us by Publius Aelius Hadrian. Hadrian is employed as Consul, at Rome, Inc. Like many company officers and other highly-compensated executives, Hadrian is given not only a 401(k) plan and a pension plan as part of his retirement benefit package, but a non-qualified deferred compensation (NQDC) plan as well. It is the NQDC – with its multiple distribution options – that Hadrian writes to us about today. Unsure which NQDC distribution option to choose, Hadrian says:

How should I take money out of my non-qualified deferred compensation plan? Should I make a lump-sum distribution, and pay a bunch of taxes!? Or should I spread out the payments over time via annuitization – so I can pay taxes on those distributions at a lower tax bracket each year?

(To gain some insight on how distribution options work, check out a previous blog post on pension plan distribution options.)

Hadrian has amassed a tidy sum in his company’s NQDC plan: $1,000,000. Therefore, were Hadrian to make a lump-sum distribution, he would be looking at a monster tax bill – and at the highest tax bracket. Were Hadrian to spread distribution payments out over 20 years, his annual distribution of just $50,000 would be taxed at a much lower rate.

Were taxes the only consideration, the answer to Hadrian’s question about NQDC distributions seems obvious:

spread out the distribution to save money on taxes

However, in addition to an individual’s needs for liquidity, there is an important distinction of NQDC plans that deserves consideration.

What is a Non-Qualified Deferred Compensation plan?

A NQDC plan is a tax-deferred investment account. It is similar, in some ways, to a 401(k) account. Like a 401(k), pre-tax money goes into a NQDC plan. And just like a 401(k), money coming out of a NQDC plan is taxed at the marginal rate. However, one very important distinction between a NQDC plan and a conventional 401(k) is creditor protection. That is, money in a 401(k) is relatively safer than money in a NQDC plan. This is because . . .

Non-Qualified Deferred Compensation plan Risk

Non-Qualified Deferred Compensation (NQDC) arrangement assets may be subject to a company’s creditors. That is, if Hadrian’s employer goes bankrupt, it may be possible that the entirety of Hadrian’s NQDC contributions are lost. This is not the case for Hadrian’s 401(k), which receives superior creditor protection under the Employee Retirement Insurance Security Act (ERISA).

How to Distribute Assets from a Non-Qualified Deferred Compensation plan

Therefore, money in a NQDC plan may – or may not – come to fruition. Thus, choosing how to receive that NQDC money (i.e. electing a distribution option) is a very important decision.

As mentioned, Hadrian may be able to plan annual installments from his NQDC so as to minimize taxation. (Electing for annual installments, as opposed to a lump-sum distribution, is called annuitization.) However, an annuitization strategy subjects Hadrian to the continued risk that these assets could be seized by his employer’s creditors. Therefore, electing a strategy that greatly spreads out distributions over time (so as to minimize taxation) may prove less fruitful than a lump-sum distribution – if the total of all NQDC assets are seized by creditors at the second annual installment. In short, a lot of taxes on a lot of money is a much better scenario than no taxes on no money.

So, at one end of the spectrum, Hadrian may be able to spread distributions from a NQDC out over time. This option results in the lowest tax-bill (and provides the greatest potential for tax-deferred growth). However, this option puts the vast majority of the principal of the NQDC assets at risk. At the other end of the spectrum is the lump-sum distribution. The lump-sum distribution ensures that Hadrian will receive every (after-tax) penny of his NQDC plan that he is entitled to.

How Should Hadrian Distribute Assets from his Non-Qualified Deferred Compensation plan?

What sort of distribution option should Hadrian elect for his non-qualified deferred compensation plan? Like all good financial planning questions, the answer is, “it depends.” The answer will change based upon a variety of other important variables:

Variable #1: What sort of difference does the NQDC money make in Hadrian’s life?

If the NQDC assets make up the vast majority of Hadrian’s net worth (and therefore his retirement nest egg), he may not want to put the funds at further risk. Given that, Hadrian may wish to take a lump-sum distribution at separation from his employer. Though this may mean paying a lot in taxes, it also means that Hadrian can count on having the money for his retirement.

Alternatively, if Hadrian has a substantial 401(k) balance and multiple income-generating rental properties, he may decide to be a little risky with his NQDC funds. That is, Hadrian can consider his “small” NQDC assets gambling, or fun, money. This is because if the company providing the NQDC goes belly up, the impact on Hadrian’s life will be marginal. Why? Because Hadrian will be able to enjoy retirement with the income generated from his other assets. Given this, Hadrian can stretch out his NQDC distributions with the intent to save money on taxes – but may end up with him losing the value of the NQDC entirely (assuming his employer goes belly up).

Variable #2: How healthy is the company?

A quick glance at a company’s financial statements will line item existing liabilities and cash flow. If the company is financially unhealthy (showing increasing debt and decreasing revenue, for example), a lump-sum distribution may be the smarter move – despite the tax consequences. Again, a lot of taxes on a lot of money is a much better scenario than no taxes on no money.

Variable #3: How else will the company make a difference in Hadrian’s retirement lifestyle?

As mentioned, not only does Hadrian have a NQDC plan with Rome Inc., but a pension plan as well. Therefore, in the event that Rome Inc. goes belly up, Hadrian stands to lose not only his NQDC assets (if he chooses to annuitize), but possibly a chunk of his pension income stream too. Because Hadrian’s lifestyle in retirement is so severely dependent upon the financial well-being of Rome Inc., Hadrian may decide to decrease some of this dependency by electing a lump-sum distribution whenever possible – as he can do with his NQDC plan.

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If you’re unsure which non-qualified deferred compensation distribution option is right for you, work with a fee-only financial planner to determine the best solution for your particular situation. Working with a fee-only financial planner means your financial advisor has the single objective of mapping out your life for your benefit, without the conflict of interest that comes the desire to sell financial products for a commission. As a fiduciary, a fee-only Certified Financial Planner® (CFP®) works for you!

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