Taxation on Non-Qualified Deferred Compensation Plans

Some companies offer employees the option of postponing part of their pay until after they retire through what is called a non-qualified deferred compensation (NQDC) plan. The plan may be offered in addition to, or in place of, a qualified retirement plan such as a 401(k) plan.

The plans are typically offered as a type of bonus to upper-level executives, who may max out their allowable contributions to the company's qualified retirement plan. In an NQDC plan, both the compensation and the taxes owed on it are delayed until a later date.

If you are considering such an option, you should understand how you’ll be taxed on that money and any profits it earns over the years ahead. 

How NQDC Plans Are Taxed

Any salary, bonuses, commissions, and other compensation you agree to defer under an NQDC plan are not taxed in the year in which you earn it. (The deferral amount may be recorded on the Form W-2 you receive each year.)

You will be taxed on the compensation when you actually receive it. This should be sometime after you retire, unless you meet the rules for another triggering event that is allowed under the plan, such as a disability. The payment of the deferred compensation will be reported on 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 they are paid to you. The rate of return is fixed by the terms of the plan. It may, for example, match the rate of return on the S&P 500 Index.

Compensation in Stock or Options

When the compensation is payable in stock and stock options, special tax rules come into play. In such cases, the taxes will not be owed until the stock shares or options are yours to sell or give away as you choose.

However, you may want to report this compensation immediately. The IRS calls this a Section 83(b) election. It allows the recipient to report the value of the property as income now (versus when vested), with all future appreciation growing into capital gains that could be taxed at a favorable tax rate.

If you don't make the Section 83(b) election, you will owe taxes on the property and its appreciation at the time it is received. However, if you make the election you will be giving up the ability to deduct any losses in the future should the value depreciate.

The IRS has a sample 83(b) form that can be used to report this compensation currently rather than deferring it.

Tax Penalties for Early Distributions

There are heavy tax consequences if you withdraw money from an NQDC plan before you retire or when no other acceptable "trigger event" has occurred.

• You are taxed immediately on all of the deferrals made under the plan, even if you have only received a portion of it.
• The tax penalty for overpayments and underpayments for Q1 2023 is 7%.

How It Affects FICA Taxes

The Social Security and Medicare tax (FICA on your W-2) is paid on compensation when it is earned, even if you opt to defer it.

This can be a good thing because of the Social Security wage cap. Take this example: In the 2022 tax year, your compensation was $170,000 and you made a timely election to defer another $25,000. For the 2023 tax year, earnings subject to the Social Security portion of FICA are capped at $160,200. Thus, $34,800 ($170,000 - $160,200 + $25,000) of total compensation for the year is not subject to the FICA tax.

When the deferred compensation is paid out, say in retirement, no FICA tax will be deducted.

Is It Worth It?

A non-qualified deferred compensation plan, if one is available to you, can be a considerable benefit over the long run. You're investing money for your future while delaying taxes owed on earnings. That should get you a greater accrual of earnings.

However, the day of reckoning will come when you start to collect your deferred compensation. Just be prepared for the impact when it hits.

The Bottom Line

Non-qualified deferred compensation plans are offered to select employees for retention purposes or for providing benefits in addition to traditional qualified deferred compensation plans, such as 401(k)s.

The amount an employee chooses to defer reduces their taxable income and the amount deferred is not taxed until they receive the funds, which is usually in retirement. These types of plans are more complicated than traditional retirement plans and individuals should carefully understand them before taking part.