Securing your financial future is rarely as simple as just deciding to save. You also have to choose how and where to invest your money. This is where retirement plans enter the picture. From individual IRAs and 401(k) plan options to more specialized strategies like a non-qualified deferred compensation plan, each route offers unique benefits and drawbacks.
In this post, we’ll walk through the major differences between deferred compensation plans and 401(k) plans. That way, if you’re a highly paid employee, you’ll be provided with the knowledge needed to decide which plan aligns best with your goals – or whether using both is the ideal approach.
Understanding Non-Qualified Deferred Compensation Plans
While 401(k)s are technically considered qualified deferred compensation plans, the term “deferred compensation plan” is often used to refer specifically to non-qualified deferred compensation plans (also called 409A plans). These plans differ from standard employer-sponsored qualified options—like 401(k)s—in several key ways.
Here are some of the major distinctions:
Structure: In a non-qualified deferred compensation plan, you and your employer agree that a portion of your salary or bonus will be placed aside and paid out on a future date—often retirement or after a certain number of years. Because the deferred compensation is not formally separated into an external account (like a 401(k)), so the money is essentially your employer’s “IOU.” It’s “promised” but remains part of the company’s assets until the agreed-upon disbursement date.
Tax Implications: The primary attraction of these plans is that you don’t have to pay taxes (beyond Social Security and Medicare taxes) on the deferred amount until you actually receive it, possibly decades later. This can help reduce your current taxable income, potentially keeping you in a lower tax bracket during your prime earning years. When you finally receive your deferred funds, you’ll generally pay income tax at your then-current rate.
High-Earner Appeal: Because there are no strict contribution limits like there are with a 401(k) plan, high earners can sock away substantial sums—sometimes up to 50% of their compensation. This arrangement can be especially attractive to executives who’ve already maxed out contributions to more traditional retirement account vehicles.
Restrictions and Risks: Unlike a 401(k), a non-qualified deferred compensation plan typically offers no early withdrawal provisions. You often cannot borrow against the deferred funds or pull them out for an emergency. Your deferred income is at risk if the company goes under or faces bankruptcy. There is no separate insurance or legal separation ensuring your funds can’t be touched by creditors; you become an unsecured creditor of your own employer.
Distributions from a Non-Qualified Plan
In a non-qualified deferred compensation plan, you often set up a distribution schedule at the time you enroll.
Common methods include:
- Lump sum at retirement
- Installment payments over 5, 10, or more years
- Deferred distribution triggered by specific dates or events
Once you pick a schedule, altering it can be tough or even impossible. When you finally receive payouts, you’ll owe income taxes based on your then-current rates.
Who Should Consider a Non-Qualified Deferred Compensation Plan?
While anyone who has access could theoretically opt into a deferred compensation arrangement, these plans offer the biggest advantages for certain types of employees.
These types of employees meet:
Anticipate a Lower Tax Bracket Later: If you expect to be in a substantially lower tax bracket in retirement, deferring a portion of your salary could yield a solid tax advantage. You skip paying higher rates in your working years and pay taxes in the future, ideally at a lower rate.
Need Little Current Income: Because these funds are locked away, you’ll want to make sure you’re not deferring income you depend on for day-to-day expenses or near-term financial goals. The arrangement often makes sense for executives, professionals with high monthly cash flow, or those receiving large bonuses who can easily live without that money now.
Want to Invest Larger Amounts: If you’ve maxed out your qualified deferred compensation plans (e.g., 401(k) or 403(b)) and you still have extra income, a non-qualified deferred compensation plan can be a powerful addition. You can stretch your retirement savings strategy well beyond standard contribution limits.
Are Confident in Their Employer’s Stability: Trust in the long-term viability of your company is key. In the event your employer encounters serious financial trouble, you could be at risk of forfeiting a portion—or the entirety—of the funds you’ve deferred. This plan is, therefore, most appealing at stable companies, particularly those with strong balance sheets and a consistent track record of honoring these commitments.
Understanding the 401(k) Plan
No conversation about retirement is complete without mentioning the 401(k) plan. Created to provide employees with a straightforward path to saving for retirement, 401(k)s have become a hallmark of corporate benefits.
That said, they differ from non-qualified deferred compensation plans in important ways:
Employer-Sponsored and Regulated: A 401(k) is an employer-sponsored plan that must comply with the Employee Retirement Income Security Act (ERISA) guidelines. ERISA enforces specific regulations around how 401(k) accounts are handled, ensuring that employee funds are kept separate from the employer’s operational assets.
Contribution Limits: Federal contribution limits for 401(k)s, set annually by the IRS, cap how much you can contribute each year on a tax-deferred basis. While these caps ensure broad accessibility, high earners sometimes find them restrictive when trying to save aggressively.
Roth Options: Similar to non-qualified deferred compensation, your contributions grow tax-deferred. You only pay income tax when you start taking out money—usually in retirement. However, you may have a Roth 401(k) option at some companies, which involves contributing after-tax money but withdrawing it tax-free later.
Withdrawal Options and Loans: Although 401(k)s come with penalties for early withdrawals (typically before age 59½), participants may still have opportunities to borrow against their balance or take hardship withdrawals under qualifying circumstances. This built-in flexibility can be a financial safety net.
Employer Matching: Many companies sweeten the pot by matching your contributions up to a certain percentage. This is effectively free money going into your retirement account—a significant edge that non-qualified deferred compensation plans rarely match.
Distributions from a 401(k)
With a 401(k), you typically begin withdrawals after age 59½ without a penalty. You’ll owe taxes on distributions if it’s a traditional 401(k). Additionally, traditional 401(k)s account holders will have to satisfy required minimum distribution (RMD) requirements to avoid penalties after age 73.
However, you can start taking penalty-free distributions as early as age 55 if you’ve left your job. You can also roll your 401(k) into an IRA, offering more investment options and continued tax-deferred growth.
The Importance of a 401(k)
No retirement conversation is complete without addressing the pivotal role a 401(k) plan can play. For most employees, a 401(k) stands as the cornerstone of retirement savings—often before considering more specialized options like a non-qualified deferred compensation plan.
Here’s why leveraging a 401(k) is so important:
Maximizing Employer Matching: Several employers will match your contributions to your 401(k) plan—often up to a certain limit—effectively adding free money to your retirement savings. If your employer offers such a matching program, taking advantage of it can significantly increase the total amount you’ll have for retirement.
Flexibility for Loans or Emergencies: While early withdrawals can incur penalties, 401(k) plans offer certain hardship distributions and loan provisions. Although borrowing against your retirement account isn’t always advisable, it can serve as a financial cushion if life throws an emergency your way—something that a non-qualified deferred compensation plan rarely allows.
Built-In Federal Protections: Remember, 401(k) accounts must comply with the ERISA guidelines. This allows your funds to be held in a separate trust, offering a layer of security if the company faces financial issues. You’re not at risk of losing your contributions due to your employer’s bankruptcy.
Portability: Should you switch employers, transferring your 401(k) balance to your new company’s plan or an IRA is usually a straightforward process. NQDC funds often aren’t portable in the same way, requiring you to adhere to company-specific rules or forfeit benefits if you depart early.
Roth Option Simplicity: Many 401(k) plans include a Roth option, giving you a straightforward way to make post-tax contributions and enjoy tax-free withdrawals in retirement—no juggling multiple deferral schedules or complex distribution restrictions.
Can You Use Both?
Yes—and many high-level employees do precisely that. After you’ve hit the IRS limit on your 401(k) contributions, you can continue to defer additional funds into a non-qualified plan (assuming your employer offers one).
The biggest reasons to take advantage of both include:
Balanced Risk: In this two-tiered approach, your 401(k) is safeguarded by ERISA, while the deferred compensation portion carries more risk. This diversification ensures that if your employer faces financial trouble, only your deferred compensation portion is at risk, not your entire retirement portfolio.
Greater Total Savings: Using both can supercharge your retirement savings. You take full advantage of your employer’s match on the 401(k) and still sock away more than the 401(k) alone allows. By retirement, you can have a substantial nest egg in multiple “buckets,” each with different tax obligations and payout schedules.
Tax Planning Flexibility: By splitting contributions between a 401(k) and a non-qualified plan, you spread out how and when you’ll pay income tax in retirement. You might receive a lump sum from one plan or schedule incremental payouts from both, giving you nuanced control over your retirement cash flow.
Steps to Help You Decide Between a Deferred Compensation Plan and a 401(k)
Before you commit to deferring a large portion of your salary—or decide to stick solely with a 401(k)—it’s wise to evaluate both your personal financial situation and the stability of your employer. Following the right process can provide a clear framework for making a decision that aligns with your current needs and future goals.
Consider running through the following steps:
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- Evaluate Your Cash Flow: Do you need every dollar of your current salary to meet expenses and goals? If so, deferring a large chunk of it might strain your budget. A 401(k) alone might suffice, given it still allows you to save in a tax-deferred environment without risking immediate liquidity needs.
- Check Your Employer’s Offerings: Does your employer match 401(k) contributions? Does your company have a robust history of meeting deferred compensation obligations? Evaluate any non-compete clauses or vesting requirements. If you’re unsure about the longevity of your role or the company’s stability, be cautious about deferring too much.
- Assess Your Risk Appetite: How comfortable are you with tying up a portion of your salary in your employer’s hands? Yes, non-qualified deferred compensation plans can yield major tax advantages. However, they can carry far larger risks if your employer dissolves.
- Forecast Your Future Tax Status: Estimating your future tax bracket can be challenging, but a rough forecast can guide you. The higher your current bracket and the lower your expected future bracket, the more beneficial deferral might be.
- Consult a Financial Planner: A professional can run projections and model various outcomes, helping you see if deferring more pay could set you up for long-term success or if maxing out your 401(k) plan is sufficient. A financial planner can also help with estate planning and other long-range financial planning goals fueled by your retirement accounts.
Other Steps You May Want to Consider
Beyond a 401(k) and non-qualified deferred compensation plan, high earners often benefit from exploring additional savings vehicles to build a solid, diversified retirement strategy. IRAs—particularly Roth IRAs—can offer tax-free growth that may prove invaluable if you anticipate higher tax rates down the road.
Health Savings Accounts (HSAs), when paired with a high-deductible health plan, deliver triple tax advantages that both ease medical costs and accumulate long-term wealth. Meanwhile, taxable brokerage accounts, though they lack immediate tax deferral, grant flexibility and no required minimum distributions (RMDs).
Given the range of choices, it’s wise to establish a strategic order for contributions. Many high earners start by maximizing any 401(k) match before exploring options like a backdoor Roth IRA, contributing to an HSA if eligible, and ultimately leveraging a non-qualified plan or brokerage account. This careful prioritization helps you tailor your savings mix, manage tax obligations, and strengthen overall financial security.
We Can Help You Further
Deciding how best to leverage a 401(k) alongside a non-qualified deferred compensation plan can feel like walking a tightrope. Each option has distinct tax implications, risk profiles, and benefits that may—or may not—fit your long-term needs. By understanding how they differ, and how they can work together, you’re better positioned to craft a balanced strategy that aligns with both your current lifestyle and future retirement goals.
However, navigating these choices (along with many others) without personalized guidance can be overwhelming. That’s where our financial advisory team comes in. We specialize in helping high-earning professionals design tailored retirement roadmaps, accounting for market fluctuations, changing regulations, and the evolving world of executive compensation.
Ready to make more progress towards your ideal financial future? Schedule a complimentary consultation with us today. We’ll assess your current situation, identify hidden opportunities, and develop a cohesive plan to help you maximize benefits from the accounts that best serve you and your retirement.