How Non-qualified Deferred Compensation Plans Work
A non-qualified deferred compensation (NQDC) plan allows a service provider (e.g., an employee) to earn wages, bonuses, or other compensation in one year but receive the earnings—and defer the income tax on them—in a later year. Doing this provides income in the future (often after they've left the workforce), and may reduce the tax payable on the income if the person is in a lower tax bracket when the deferred compensation is received.
- Non-qualified deferred compensation (NQDC) is compensation that has been earned by an employee, but not yet received from their employer.
- The tax law requires the plan to be in writing; the plan document(s) to specify the amount to be paid, the payment schedule, and the triggering event that will result in payment; and for the employee to make an irrevocable election to defer compensation before the year in which the compensation is earned.
- The intended tax benefits of NQDC plans are realized only if the plan conforms to tax law requirements, and other restrictions can become onerous.
Conditions of NQDC Plan
Deferred compensation plans can be qualifying or non-qualifying. The non-qualified type is created by an employer to enable employees to defer compensation that they have a legally binding right to receive. There are several varieties of NQDC plans (also called 409A plans after the section in the tax code governing them, introduced in 2004); the one discussed here is the basic unfunded plan for deferring part of annual compensation (the most common type).
The tax law requires the plan to meet all of the following conditions:
- The plan is in writing.
- The plan document(s) specifies, at the time an amount is deferred, the amount to be paid, the payment schedule, and the triggering event that will result in payment. There are six permissible triggering events: a fixed date, separation from service (e.g., retirement), a change in ownership or control of the company, disability, death, or an unforeseen emergency. Other events, such as the need to pay tuition for a child, a change in the financial condition of the company, or a heavy tax bill, are not permissible triggering events.
- The employee makes an irrevocable election to defer compensation before the year in which the compensation is earned. However, a special deferral election rule applies to commission payments.
The NQDC plan can also impose conditions, such as refraining from competing with the company or providing advisory services after retirement.
The deferred amount earns a reasonable rate of return determined by the employer at the time that the deferral is made. This can be the rate of return on an actual asset or indicator—say, the return on the Standard & Poor's 500 Index. Thus, when distributions are made, they include both the compensation and what amounts to earnings on that compensation (though there are no actual earnings; it's merely a bookkeeping entry).
Violating the stringent conditions in the law triggers harsh results. All of the deferred compensation becomes immediately taxable. What's more, there is a 20% penalty, plus interest, charged on this amount.
Examples of NQDC Plans
NQDC plans refer to supplemental executive retirement plans (SERPs), voluntary deferral plans, wraparound 401(k) plans, excess benefit plans, and equity arrangements, bonus plans, and severance pay plans.
Teachers' salaries are non-qualified compensation plans that meet the requirements of IRC Section 409A. If a teacher earns $54,000 a year and works from Aug. 1, 2016, to May 31, 2017, she earns $5,400 a month. If the teacher is paid for only the months she worked, she is paid $5,400 a month for 10 months. If, however, she is paid over 12 months, she earns $4,500 a month.
In the example dates above, with a 10-month salary, the teacher earns $27,000 in 2016 and $27,000 in 2017. With a 12-month salary, she earns $22,500 in 2016 and $31,500 in 2017. Based on the hours worked, if she is paid a 12-month salary, $4,500 worth of work conducted in 2016 is paid out in 2016. Under IRC Section 409A, the $4,500 from 2016 is considered non-qualifying deferred compensation that meets the requirements of the code.
Advantages for Employers
Because NQDC plans are not qualified, meaning they aren't covered under the Employee Retirement Income Security Act (ERISA), they offer a greater amount of flexibility for employers and employees. Unlike ERISA plans, employers can elect to offer NQDC plans only to executives and key employees who are most likely to use and benefit from them. There are no non-discrimination rules, so deferral need not be offered to the rank-and-file. This gives the company considerable flexibility in tailoring its plan. The plans are also used as "golden handcuffs" to keep valued staff on board, as leaving the company before retirement can result in forfeiting deferred benefits.
An NQDC plan can be a boon to cash flow, since currently earned compensation is not payable until the future. However, the compensation is not tax-deductible for the company until it is actually paid.
The costs of setting up and administering an NQDC plan are minimal. Once initial legal and accounting fees have been paid, there are no special annual costs, and there are no required filings with the Internal Revenue Service (IRS) or other government agencies.
Advantages for Employees
Unlimited Savings and Tax Benefit
The IRS imposes strict limitations on the amount of money you contribute to a qualified retirement plan, like a 401(k). Deferred compensation plans have no such federally mandated limits, though employers may specify a contribution limit based on your compensation. If you are a highly compensated employee, you can maximize contributions to your 401(k) and then continue to build your retirement savings through an NQDC plan without restriction.
The ability to defer any amount of compensation also reduces your annual taxable income. This can, in turn, put you in a lower tax bracket, further decreasing your tax liability each year. However, deferred compensation is still subject to FICA and FUTA taxes in the year it is earned.
Many NQDC plans offer investment options similar to 401(k) plans, such as mutual fund and stock options. NQDC plans aren't just fancy deposit accounts for high rollers. Instead, they allow you to grow your wealth over time. However, you can invest in a larger scale because your contributions are unlimited, increasing the potential for more significant gains.
Disadvantages for Employees
Strict Distribution Schedule
Unlike a 401(k), you must schedule distributions from an NQDC plan in advance. Rather than being able to withdraw funds at will after retirement, you must choose a distribution date at some time in the future. You must take distributions on the designated date, regardless of whether you need the funds or how the market is doing. This means that your taxable income for the year is increased, and the timing of the distribution may mean that the assets in your investment portfolio are liquidated at a loss.
The NQDC plan can allow for a subsequent deferral or a change in election (e.g., to receive deferred compensation at age 70 rather than at age 65) only under certain conditions. This requires that the subsequent election be made at least 12 months before the date that payment was originally scheduled to begin, that the subsequent election change delays the payment date for at least five years, and that the election is not effective until at least 12 months after it is made.
No Early Withdrawal Provision
Though is it discouraged, employees who contribute to 401(k)s or other qualified plans are legally allowed to withdraw funds at any time. While distributions taken before a certain age may incur tax penalties, nothing is preventing you from accessing funds in an emergency. In addition, most plans provide for several penalty-free early withdrawal if you can prove financial hardship.
NQDC plans, conversely, have no such provisions. You must withdraw funds according to the distributions schedule and no earlier. Funds contributed to an NQDC plan are not accessible before the designated distribution date, even if you have an emergency financial need that you cannot meet by other means.
No ERISA Protections
Because NQDC plans are not covered under ERISA, they are not afforded the same protections from creditors as other retirement plans. In fact, as a plan participant, you don't own an account of any kind, because your employer reduces your compensation by the deferral amount rather than depositing funds into an account held with a financial institution. The amount of the employee deferral represents a liability on the employer's balance sheet, essentially making the NQDC plan an unsecured loan between the lending employee and the borrowing employer.
If the plan is unfunded, you must rely on the employer's promise to pay in the future according to the distribution schedule. If the employer falls on hard times and must pay off debts, the funds that might have been used to pay your employee distributions can be claimed by creditors. Funded NQDC plans offer more protection for employee contributions, but deferrals are generally taxable in the year they were earned, nullifying the tax benefit that unfunded plans provide.
There's another financial risk: the rate of return paid on the deferred compensation. An employee may be able to earn a greater rate of return on the after-tax amount without deferral than what is paid under the deferred compensation plan.
The Bottom Line
A NQDC plan can supplement or supplant a qualified retirement plan to create retirement savings for an employee on a tax-advantaged basis. It can also be used for independent contractors, corporate directors, and other non-staffers. However, the intended tax benefits are realized only if the plan conforms to tax law requirements, and other restrictions can become onerous.