For many corporate executives, nonqualified deferred compensation represents one of the largest pools of wealth they may access in retirement. It can also be one of the more complex — and decisions made years before retirement may have a significant impact on how those assets are ultimately received.
This article outlines some of the planning considerations executives may want to explore with their advisors well before retirement approaches.
What Is a Nonqualified Deferred Compensation Plan?
A nonqualified deferred compensation plan (NQDC) allows executives to defer a portion of their salary or bonus to a future date, typically retirement. The deferred income grows on a tax-deferred basis and is generally taxed as ordinary income when distributed.
Unlike qualified plans such as a 401(k), NQDC plans are not subject to IRS contribution limits — which may make them a meaningful wealth-building tool for high earners. However, they also carry risks and constraints worth understanding well in advance of retirement. For a general overview of how the IRS classifies and treats nonqualified deferred compensation, IRS Publication 525 provides a helpful starting point.
Some Planning Areas Executives May Want to Consider
Distribution Elections Are Generally Made in Advance
One aspect of deferred compensation planning worth understanding early is that distribution elections are generally irrevocable. Under IRS Section 409A, executives must typically elect when and how they will receive distributions — often years before the money is paid out.
Common choices include a lump sum or installment payments over a set number of years. This decision may have tax implications and is worth evaluating alongside your broader retirement income picture.
Tax laws are subject to change. This material is for informational purposes only and does not constitute tax advice. Please consult a qualified tax professional regarding your specific situation.
Distributions Are Generally Taxed as Ordinary Income
Distributions from NQDC plans are typically taxed as ordinary income in the year they are received, not as capital gains. As noted in IRS Publication 525, if a plan fails to meet certain requirements at any time during the tax year, all amounts deferred under the plan for that year and all preceding tax years may be included in income for the current year — underscoring why plan compliance and distribution timing are worth understanding carefully.
For executives with significant deferred balances, receiving a large lump sum in a single year could affect your tax bracket and may trigger additional Medicare surtaxes. Spreading distributions over several years through installment payments is one approach some executives consider, though the right structure depends on your individual circumstances.
Deferred Compensation Carries a Different Risk Profile Than Qualified Plans
Unlike a 401(k), assets in a nonqualified deferred compensation plan are not held in a separate trust for your benefit. As outlined in the IRS Nonqualified Deferred Compensation Audit Technique Guide, NQDC plan assets generally remain on the company’s balance sheet and may be subject to the claims of corporate creditors in the event of bankruptcy or insolvency.
This is a distinction worth understanding when evaluating how much to defer and for how long.
Deferred Compensation May Interact With Other Retirement Income Sources
Deferred compensation does not exist in isolation. It may interact with Social Security timing, Required Minimum Distributions from qualified accounts, investment portfolio withdrawals, and other income sources in retirement.
Some executives find it helpful to look at how deferred compensation distributions fit within their broader retirement income timeline — for example, whether taking distributions in certain years may affect taxable income relative to other sources. These are conversations worth having with a qualified advisor.
Early Separation From Service May Affect Distribution Timing
Most NQDC plans include provisions that may accelerate distributions if an executive separates from service before a planned retirement date. Understanding your plan’s specific provisions — and how an unexpected transition might affect your distribution schedule — is worth exploring before retirement approaches.
The Years Before Retirement May Offer More Planning Flexibility
Deferred compensation considerations are often most productive when explored well in advance of retirement. The years leading up to a transition may offer more time to evaluate elections, model scenarios, and coordinate your NQDC plan alongside the rest of your financial picture.
A Note on Working With an Advisor
Because deferred compensation touches on tax strategy, income sequencing, and investment decisions, some executives choose to work with a fee-only fiduciary advisor who can help evaluate options across these areas. A fee-only fiduciary is legally obligated to act in your best interest and does not earn commissions on product recommendations.
At TandemGrowth Financial Advisors, we work with executives and high-net-worth families on long-term financial planning that includes deferred compensation as one piece of a broader picture. If you would like to explore these topics further, we welcome the conversation.
This material is for informational purposes only and does not constitute financial, tax, or legal advice. All planning considerations should be evaluated in the context of your individual circumstances with the guidance of qualified professionals. TandemGrowth Financial Advisors is a registered investment adviser.
TandemGrowth Financial Advisors, LLC (“TandemGrowth”) is a registered investment adviser with a primary business location of Alpharetta, Georgia. Registration as an investment adviser is not an endorsement by securities regulators and does not imply that TandemGrowth has attained a certain level of skill, training, or ability.
This material has been prepared for informational and educational purposes only and does not constitute investment, tax, or legal advice. The information contained in this publication is general in nature and should not be relied upon as the sole basis for any financial decision. Individual circumstances vary significantly, and you should consult with qualified tax, legal, and financial professionals before making decisions regarding employment transitions, retirement timing, or investment planning.
All expressions of opinion reflect the judgment of TandemGrowth as of the date of publication and are subject to change.Not all services will be appropriate or necessary for all clients, and the potential value and benefit of TandemGrowth’s services will vary based upon the client’s individual investment, financial, and tax circumstances. The effectiveness and potential success of a tax strategy, investment strategy, and financial plan, including those depicted here, depends on a variety of factors, including but not limited to the manner and timing of implementation, coordination with the client and the client’s other engaged professionals, and market conditions.
Tax-related content is general in nature. Tax laws are complex and subject to change. TandemGrowth does not provide tax or legal advice. Clients should coordinate with their own CPA and legal counsel regarding the tax implications of any employment transition or retirement decision.
About the Author: Jeff Bernier
