Your employer may offer you the option of postponing the receipt of compensation in addition to, or in place of, a qualified retirement such as a 401(k) plan, through a non-qualified deferred compensation (NQDC) plan. If you have such an option, understand how you’ll be taxed before you agree to any deferrals.
How Income Tax Works on These Plans
Salary, bonuses, commissions and other taxable compensation you agree to defer under a NQDC plan is not taxed to you in the year in which you earn it. (The deferral amount may be indicated on your Form W-2, in box 12 using Code Y.) You are taxed on the compensation when you actually receive it. This can be when you retire or meet any other triggering event allowed under the plan (e.g., disability). Income tax withholding applies in the year of the actual payment. The eventual payment of the deferred compensation is reported on another Form W-2, even if you are no longer an employee at the time.
You are also taxed on the "earnings" you get on your deferrals when such amounts are paid to you with the deferred compensation. This is a reasonable rate of return fixed by the plan. It may, for example, be a rate of return on a predetermined actual investment (e.g., the return on the S&P index).
When compensation is payable in stock and stock options, special tax rules come into play. You aren’t normally taxed at the time you receive this property if the property is either transferable or not subject to a substantial risk of forfeiture. Thus, compensation paid in the form of stock or options that are currently nontransferable or subject to a risk of forfeiture amount to deferred compensation. In effect you usually aren’t taxed until the stock or options are yours to transfer, sell, give away, etc.
However, you can elect to report this compensation immediately (this is called a Section 83(b) election). Doing this allows you to report the value of the property as income now, with all future appreciation growing into what may become capital gains taxed at favorable tax rates. (If you don't make the election and the property is taxable when the property is transferrable or there is no longer any risk of forfeiture, the value of it may have grown substantially and will be taxed as ordinary income.) The IRS has a sample election form that can be used to report this compensation currently rather than deferring it.
Heavy Tax Consequences for Early Distributions
If you receive funds from the NQDC plan before a triggering event or the plan otherwise fails to meet tax law requirements for a NQDC plan, there are heavy tax consequences:
- You are taxed immediately on all of the deferrals made under the plan, even if you only receive a portion.
- You are taxed on interest (one percentage point higher than the rate paid on underpayments). As of Dec. 2019, the rate of underpayments was 5%, so the taxable interest rate would be 6%.
- You are subject to a 20% penalty on the deferrals.
Social Security and Medicare taxes
FICA taxes are paid on compensation when it is earned, even though you opt to defer it. This can be beneficial because of the Social Security wage base. Take this example: Say in 2015 your compensation was $150,000 and you made a timely election to defer $25,000. For 2015, the earnings subject to the Social Security portion of FICA were capped at $118,500. Thus, $31,500 of total compensation for the year is not subject to the Social Security portion of FICA. When the deferred compensation is paid out, say in retirement, there is no additional FICA at that time.
The Bottom Line
Tax deferral is a significant savings over the long run. Your nest egg grows without being reduced for taxes, giving you greater accrual of earnings. However, the day of reckoning comes when you start to collect your deferred compensation. If you want to defer compensation under your employer's NQDC plan, be prepared for the tax cost at that time.