Watch our video explanation below for key insights on deferred compensation plans, or continue reading for a comprehensive guide to maximizing benefits while minimizing risks in your NQDC strategy.
If you're an executive at 3M, Boston Scientific, Target, or any other major corporation, there's a good chance you have deferred compensation as an option on your benefits sheet. We call it non-qualified deferred compensation, or NQDC for short. These plans offer tremendous tax advantages, but they're also complex and come with risks that aren't always clearly explained.
These plans first emerged in the 1980s when a congregation set up a special trust to defer a rabbi's compensation. The IRS challenged it but ultimately agreed the money wasn't taxable yet since it remained the synagogue's property. This created the foundation for today's NQDC plans—and their inherent risks, since the deferred money stays on the company's books and could be lost if the company faces financial difficulties.
While the tax benefits can be substantial, there's a critical balance between tax optimization and risk management that every executive needs to understand.
Non-qualified deferred compensation is exactly what it sounds like – you elect to not receive part of your compensation today, with the promise you'll receive it later. This arrangement allows you to defer taxes until you actually receive the money.
So what happens when you participate in an NQDC plan?
First, typically around November or during open enrollment, you'll receive notification that you can elect to defer part of your salary or bonus. Unlike 401(k) plans with strict contribution limits, NQDC plans allow you to defer much larger amounts – that's a significant advantage for highly compensated executives.
Second, you'll choose when to receive the money. Your options might include:
This is where many executives make mistakes. If you select a date while you're still working and in a high tax bracket, you could undermine the main tax advantage of these plans.
Third, you'll typically select investment options for the deferred amount. While the money technically remains the company's asset, most plans allow you to direct how it's invested, similar to a 401(k).
Finally, you'll choose a distribution method – lump sum or installments over several years. This decision significantly impacts your future tax situation and should align with your broader financial plan.
These plans vary significantly between companies. Some Minnesota employers like Target and 3M have robust plans with diverse investment options, while others offer more limited choices. The distribution options, deferral limits, and investment selections all differ, making it essential to understand your specific plan's details.
Understanding the key differences between non-qualified deferred compensation plans and qualified plans like 401(k)s is essential for making informed decisions about your financial future.
The most obvious advantage of NQDC plans is the absence of IRS contribution limits. While 401(k) plans cap your annual contributions (in 2025, the limit is $23,000 plus an additional $7,500 if you're over 50), NQDC plans allow you to defer significantly more income. This makes them particularly valuable for executives who want to shelter more of their compensation from current taxation.
However, this advantage comes with significant trade-offs:
Your 401(k) assets are held in a separate trust, protected from your employer's creditors even if the company faces bankruptcy. This ERISA protection doesn't extend to NQDC plans – your deferred compensation remains an unsecured promise from your employer. If your company faces financial difficulties, your deferred compensation could be at risk.
While both plans defer taxation on contributions, the similarities largely end there:
NQDC plans are only offered to select employees, typically executives and highly compensated individuals. This selective availability is by design – if these plans were broadly available to all employees, they would need to meet ERISA requirements that would eliminate much of their flexibility.
While 401(k) plans typically offer standard investment options, NQDC plans often provide more flexible distribution options. You can generally schedule distributions for specific future dates – not just at retirement – without penalties. This can be valuable for planning around specific financial needs or anticipated lower-tax years.
The different tax treatment and security profile of these plans means they should be prioritized differently in your financial planning. I generally recommend maxing out your 401(k) before considering an NQDC plan due to the security difference alone.
The most compelling reason to consider an NQDC plan is the potential for significant tax savings. Let's look at how this might work in practice.
Imagine you're deciding what to do with a $50,000 bonus. Let's compare two approaches:
This illustrates the power of:
The timing of your distributions is critical to maximizing tax benefits. Poor planning can negate much of the advantage of deferral.
Many executives make the mistake of setting distribution dates while they're still working and in high tax brackets. For optimal results, coordinate your distributions with your broader retirement income plan to maintain the lowest possible tax bracket each year.
Another common error is "stacking" too many distributions in a single year. This can push you into higher tax brackets and diminish the benefits of deferral. Spreading distributions across multiple years often results in lower overall taxation.
Minnesota's top income tax rate of 9.85% is among the highest in the nation. This creates an additional planning opportunity - if you anticipate relocating to a lower-tax or no-income-tax state in retirement, deferring compensation could save you nearly 10% in state taxes alone.
However, timing matters. Minnesota may attempt to tax deferred compensation earned while you were a resident, even after you've moved. Proper planning around your relocation timing and distribution schedule is essential.
Unlike qualified retirement plans with their 10% penalty for withdrawals before age 59½, NQDC plans allow you to access funds according to your predetermined schedule without early withdrawal penalties. This makes them valuable for bridging the gap if you plan to retire before 59½.
The tax planning opportunities with NQDC plans are substantial, but they require careful integration with your overall financial plan, retirement timeline, and potential relocation plans. When executed properly, the tax savings can significantly enhance your long-term financial position.
After discussing the compelling tax benefits, I need to emphasize the significant risks that come with NQDC plans. These risks aren't theoretical – they've impacted executives at many once-stable companies.
The fundamental risk of deferred compensation is that it represents an unsecured promise by your employer. Unlike your 401(k), which is held in a separate trust protected from your employer's creditors, your deferred compensation remains on the company's books as a liability.
This means that if your company faces financial difficulties or bankruptcy, your deferred compensation could be at risk. You would likely become an unsecured creditor of the company, standing in line behind secured creditors, with potentially little or no recovery of your deferred funds.
Everyone loves their own company and has confidence in its future, but history is littered with examples of seemingly stable companies that faced unexpected financial problems:
Many of these failures were unexpected and occurred quickly. The executives at these companies likely felt confident about deferring compensation – until they weren't.
What makes this risk particularly concerning is that company financial problems often coincide with broader market turmoil. Consider this scenario:
This creates a perfect storm where multiple sources of retirement security are threatened simultaneously – exactly when you might need them most.
Given these risks, I strongly recommend that executives limit their exposure to deferred compensation. My rule of thumb is that no more than 20% of your retirement assets should be in deferred compensation plans.
At this level, even if the worst happens and you lose your deferred compensation, it's a mistake you can recover from by adjusting spending or other aspects of your retirement plan. If deferred compensation represents 50% or more of your retirement assets, the impact could be devastating.
Minnesota is home to several stable Fortune 500 companies, but stability is always relative and temporary. Consider these factors when assessing your company's risk profile:
Even strong Minnesota companies like 3M have faced challenges in recent years that might have seemed unlikely a decade ago.
Some companies use a "Rabbi Trust" to hold deferred compensation in a separate account, which can feel more secure. However, these trusts still remain subject to the company's creditors in a bankruptcy scenario, so the fundamental risk remains.
The longer you plan to defer compensation, the more critical this risk assessment becomes. Being confident in your company's outlook for the next 2-3 years is reasonable – but can you realistically predict its stability over 10-15 years, especially after you're no longer working there?
Given the tax advantages and substantial risks we've discussed, how do you decide if an NQDC plan makes sense for your situation? Let's establish a clear framework to guide your decision.
Before considering deferred compensation, you should follow this priority sequence for retirement savings:
Deferred compensation tends to be most valuable when:
Deferred compensation might not be suitable if:
Before participating, make sure you understand:
After working with numerous executives on their deferred compensation decisions, I've seen several common mistakes that can significantly undermine the benefits of these plans. Being aware of these pitfalls can help you avoid costly errors.
This is perhaps the most dangerous mistake. Many executives have an inherent optimism about their employer's future – after all, your career success is often tied to the company's success. This can lead to underestimating the genuine risk that deferred compensation represents.
Remember that many once-thriving companies have faced unexpected difficulties. Your decision should be based on an objective assessment of your company's financial health, not just your confidence in its future performance. The fact that a company has been successful for decades doesn't guarantee its continued stability, especially over the lengthy timeframe of deferred compensation.
I've seen executives become so enamored with the tax benefits that they defer excessive amounts of their compensation, only to find themselves cash-constrained when unexpected expenses arise. This is particularly problematic because deferred compensation typically cannot be accessed early, even for emergencies.
Before making deferral elections, ensure you have:
The tax benefits of deferral mean little if you're forced to take on high-interest debt to cover expenses that arise before your deferred compensation becomes available.
Many executives select distribution dates without considering their broader tax situation. Common mistakes include:
The ideal strategy typically involves spreading distributions across multiple years during retirement to maintain the lowest possible tax brackets while meeting your income needs.
Unlike 401(k) plans where you can generally change contribution levels throughout the year, NQDC plans have strict election deadlines – typically during annual enrollment periods. Once these deadlines pass, you cannot participate until the next enrollment period.
Even worse, many plans require you to make distribution elections at the time of deferral. These elections are often irrevocable, meaning a hasty decision during enrollment could lock you into a suboptimal distribution schedule for years to come.
Deferred compensation shouldn't be viewed in isolation. I often see executives making deferral decisions without considering how they fit into their overall retirement and tax planning. Your NQDC strategy should be coordinated with:
Life doesn't always follow our plans. Major life changes can significantly impact the wisdom of past deferral decisions:
While you can't predict everything, you should reassess your deferred compensation strategy regularly as your life circumstances evolve. Future deferral decisions should account for these changes, even if past elections cannot be modified.
One of the most significant considerations with deferred compensation is how it's affected by changes in your employment status. Unlike your 401(k), which remains yours regardless of employment changes, your deferred compensation can be dramatically impacted by job transitions.
The treatment of your deferred compensation when you leave your employer depends entirely on your specific plan's terms. There are typically three possible outcomes:
Before participating in an NQDC plan, it's crucial to understand which approach your employer's plan takes and how it aligns with your career plans and time horizon.
Many plans distinguish between voluntary and involuntary termination:
If you're approaching retirement age, the definition of "retirement" in your plan becomes critically important. Some plans might require you to reach a specific age combined with years of service to qualify for favorable treatment. Understanding these provisions might influence your timing decisions about when to retire.
Mergers, acquisitions, and other significant corporate events can create uncertainty for deferred compensation participants. Most plans include specific "change of control" provisions that determine what happens to your deferred compensation in these scenarios:
These provisions have become increasingly important as merger and acquisition activity continues to reshape corporate America. In Minnesota specifically, several major companies have gone through significant transformations in recent years, highlighting the importance of understanding these provisions.
While you can't completely eliminate the risks associated with employment changes, you can take steps to mitigate them:
The impact of employment changes represents one of the most significant risks of deferred compensation plans. By understanding these implications before making deferral elections, you can make more informed decisions that align with your career trajectory and minimize potential adverse consequences.
After understanding the benefits and risks of deferred compensation plans, the next step is developing a strategic approach that works for your specific situation. A well-designed NQDC strategy requires careful consideration of multiple factors across your entire financial picture.
The right amount to defer is a balancing act between maximizing tax benefits and managing risk:
Beyond this matrix, consider:
Distribution timing can make or break your NQDC strategy. Consider these approaches:
The Retirement Bridge Strategy - Perfect for executives planning early retirement, this approach schedules distributions to provide income between retirement and when other retirement income (Social Security, pensions) begins.
The Tax-Bracket Ladder - Schedule distributions to "fill up" lower tax brackets each year, maintaining the most favorable tax treatment possible throughout retirement.
The Milestone Approach - Time distributions to coincide with planned major expenses – college tuition payments, a vacation home purchase, or charitable giving goals.
The Geographic Arbitrage Play - For executives planning to relocate in retirement, this strategy delays distributions until after establishing residency in a lower-tax state.
A hybrid approach often works best, with distributions starting a year or two after retirement and spread across 5-10 years to maintain tax efficiency.
Your deferred compensation strategy shouldn't exist in isolation – it should be one piece of your comprehensive financial puzzle:
| Financial Element |
NQDC Integration Approach |
| Investment Strategy | Balance NQDC risk with more conservative positions in other accounts |
| Tax Planning | Coordinate NQDC with Roth conversions, charitable giving, and capital gains strategies |
| Estate Planning | Ensure beneficiary provisions align with overall estate plan |
| Risk Management | Consider additional life/disability insurance to offset NQDC risk |
| Spouse's Planning | Diversify employer risk across both careers |
| Legacy Goals | Structure distributions to align with philanthropy or wealth transfer objectives |
Tom, a 52-year-old VP at a Minnesota-based healthcare company, plans to retire at 62. His strategy:
1. Gradual Deferral Approach: Instead of maxing out deferrals, Tom defers 15% of his base salary and 40% of his annual bonus – keeping his total NQDC balance under 18% of his retirement assets.
2. Distribution Planning: Tom structured his deferrals with varying distribution schedules:
3. Integration: Tom's strategy allowed him to:
The key to Tom's success wasn't maximizing deferrals – it was strategic integration with his overall financial plan and thoughtful distribution timing.
Creating an effective deferred compensation strategy isn't about following a rigid formula – it's about crafting an approach that aligns with your unique circumstances, goals, and risk tolerance. For many executives, this complexity is precisely why professional guidance can be invaluable.
Minnesota's unique tax environment creates both challenges and opportunities for executives considering deferred compensation plans:
Minnesota's High Tax Burden
With a top state income tax rate of 9.85%, Minnesota has one of the highest tax burdens in the nation. This amplifies the potential tax advantages of deferred compensation – pushing current income into the future potentially saves nearly 10% in state taxes alone.
State Taxation of Retirement Benefits
Minnesota fully taxes distributions from deferred compensation plans, unlike some states that offer exemptions for retirement income. This creates planning opportunities around potential relocation in retirement.
Residency and Taxation Rules
Minnesota can be aggressive in claiming tax residency. If you defer compensation while a Minnesota resident and later relocate, the state may attempt to tax those distributions. Careful documentation of residency change and proper timing of distributions is essential.
The Snowbird Strategy
Many Minnesota executives adopt a "snowbird" approach in retirement, maintaining residences in both Minnesota and a lower-tax state. This requires careful planning to establish proper tax domicile in the lower-tax state before receiving distributions.
Minnesota Company Plan Features
Major Minnesota employers like 3M, Target, and Boston Scientific have different NQDC plan structures and features. Understanding the specific provisions of your employer's plan is critical – some offer more investment options, more flexible distribution schedules, or better security provisions than others.
Deferred compensation decisions are complex and have long-term implications. At Quarry Hill Advisors, we specialize in helping Minnesota executives optimize these plans within their broader financial strategy.
To discuss your specific situation and how deferred compensation might fit into your financial plan, schedule a consultation with our team. The right approach to deferred compensation can significantly enhance your long-term financial position – but only when it's properly aligned with your unique circumstances and goals.
Q: Can I change my distribution elections after making them?
A: Generally, once you make a distribution election, it's difficult to change. Most plans allow changes only if:
Some plans are more restrictive and don't allow any changes, while others might permit changes in cases of documented financial hardship. This inflexibility is why it's crucial to carefully consider your initial distribution elections.
Q: What happens to my deferred compensation if I die before receiving it?
A: If you die before receiving your deferred compensation, the plan typically pays the balance to your designated beneficiary according to the terms of the plan. These payments are usually made either:
The deferred compensation becomes income in respect of a decedent (IRD) and will be subject to income tax when your beneficiaries receive it. It may also be included in your estate for estate tax purposes. This dual taxation makes it important to coordinate your deferred compensation with your estate plan.
Q: Are there ways to secure my deferred compensation against company risk?
A: There are limited options for securing deferred compensation:
The reality is that the tax benefits of deferred compensation come with inherent company risk. This is why I recommend limiting your exposure to no more than 20% of your retirement assets.
Q: How do NQDC plans interact with Social Security benefits?
A: Deferred compensation impacts Social Security in several ways:
Strategic timing of your deferred compensation distributions can help minimize the taxation of your Social Security benefits.
Q: What records should I maintain regarding my NQDC plan?
A: Maintain comprehensive records of your deferred compensation plan, including:
These records are particularly important given the long timeframe involved with deferred compensation and the potential for company changes over time. I've seen situations where comprehensive records were needed to prove a participant's rights to deferred compensation years after leaving the company.
Q: Do I need to be concerned about the Section 409A regulations?
A: Yes. The IRS regulations under Section 409A govern deferred compensation plans and impose strict requirements. Violations can result in immediate taxation of all vested deferred amounts plus a 20% penalty and interest charges.
Most company-sponsored plans are designed to comply with these regulations, but it's important to understand that:
While you don't need to become a 409A expert, you should be aware that these regulations significantly limit flexibility once elections are made.
Q: How does deferred compensation impact my ability to secure loans?
A: Deferred compensation is often not considered by lenders when calculating your debt-to-income ratio because:
If you're planning major purchases requiring financing, consider how deferring income might impact your ability to qualify for loans. This is particularly important for executives who defer significant portions of their compensation.
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This material is intended for educational purposes only. You should always consult a financial, tax, or legal professional familiar with your unique circumstances before making any financial decisions. Nothing contained in the material constitutes a recommendation for purchase or sale of any security, investment advisory services or tax advice. The information and opinions expressed in the linked articles are from third parties, and while they are deemed reliable, we cannot guarantee their accuracy.