What Is Non qualified deferred compensation plan?
A Non qualified deferred compensation plan (NQDC) is a contractual agreement between an employer and an employee, typically a highly compensated executive, to defer a portion of current income until a future date. This arrangement falls under the broader category of Employee Benefits and Executive Compensation. Unlike qualified retirement plans, an NQDC plan does not need to comply with many of the stringent rules of the Employee Retirement Income Security Act (ERISA). The primary appeal of a Non qualified deferred compensation plan is the ability to achieve tax deferral on compensation, allowing funds to grow without current income tax until they are distributed in retirement or at a specified event.
History and Origin
The concept of deferred compensation has existed for decades, but the regulatory landscape significantly evolved with the passage of the American Jobs Creation Act of 2004, which introduced Internal Revenue Code Section 409A. This legislation codified and tightened the rules surrounding nonqualified deferred compensation plans, particularly concerning the timing of deferrals and distributions. Prior to Section 409A, there was less formal guidance, leading to greater flexibility but also more potential for abuse or unintended tax consequences. Section 409A was enacted to prevent executives from manipulating the timing of their income to avoid or minimize taxes27. It specifies that unless deferred compensation falls into certain qualified categories, it is automatically considered nonqualified and subject to specific design and operational rules26. For a nonqualified deferred compensation plan to be exempt from most ERISA requirements, it must generally be an "unfunded" plan maintained "primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees," often referred to as a "top-hat" plan. This exemption stems from the recognition that highly compensated individuals have the ability to influence or negotiate the design and operation of their plans, thus not requiring the same protections as broad-based qualified plans24, 25.
Key Takeaways
- A Non qualified deferred compensation plan allows certain employees, typically executives, to defer current income taxation on compensation until a later date.
- These plans are not subject to the same strict rules as qualified plans under ERISA, offering greater flexibility in design but less protection for the employee.
- Participants in an NQDC plan are generally considered unsecured creditors of the employer, meaning their deferred funds are at risk if the company faces financial distress or bankruptcy.
- Compliance with Internal Revenue Code Section 409A is crucial for an NQDC plan to avoid immediate taxation and penalties for the employee.
- Nonqualified deferred compensation plans are often used as tools for executive compensation and retention.
Interpreting the Non qualified deferred compensation plan
A Non qualified deferred compensation plan is interpreted as a flexible tool for both employers and high-income employees. For employers, it serves as a means to attract, retain, and incentivize key talent by offering significant future financial benefits without the immediate tax deductions or broad compliance requirements of qualified plans. The deferred amounts typically remain assets of the company, subject to the claims of general creditors, which is a key aspect of their "unfunded" nature for tax deferral purposes.
For the employee, participating in an NQDC plan involves weighing the benefits of tax deferral and potential wealth accumulation against the inherent risk. Unlike assets in a defined contribution plan like a 401(k), NQDC funds are not held in a separate trust protected from the employer's creditors. This means that if the company experiences financial difficulties, such as bankruptcy, the employee's deferred compensation could be significantly reduced or lost22, 23. The terms of the plan, including vesting schedules and distribution triggers (e.g., retirement, separation from service, specified date), are critical in understanding the employee's rights and the timing of their deferred income.
Hypothetical Example
Consider Sarah, an executive at TechCorp, earning a substantial annual salary and a significant bonus. She has already maximized her contributions to her 401(k) and other qualified plans. To further supplement her retirement planning and reduce her current taxable income, Sarah elects to defer $100,000 of her annual bonus into TechCorp's Non qualified deferred compensation plan.
Under the terms of the NQDC plan, this $100,000 is not immediately taxed as income to Sarah. Instead, it is recorded as a liability on TechCorp's books. TechCorp informally invests these deferred funds, and any earnings generated by these informal investments also grow on a tax-deferred basis. Sarah's plan specifies that the deferred amount, plus any earnings, will be paid out to her in a lump sum upon her retirement, provided she meets the vesting requirements. If TechCorp were to face bankruptcy before her retirement, Sarah's claim for this deferred compensation would be as an unsecured creditor, putting her funds at risk.
Practical Applications
Non qualified deferred compensation plans are widely applied in corporate settings as a strategic component of executive compensation packages. They allow companies to provide substantial benefits to key employees beyond the limits of traditional qualified retirement plans. Common applications include:
- Executive Retention and Recruitment: NQDC plans can act as "golden handcuffs," tying executives to the company through long-term deferred payouts that often include specific vesting schedules. This is a powerful tool for retaining top talent.
- Tax-Efficient Savings: For high-income earners, NQDCs offer an avenue to defer current income taxes on significant portions of salary, bonuses, or equity awards (like stock options), reducing their immediate tax burden and allowing for greater tax-deferred growth21.
- Supplemental Retirement Income: Beyond standard 401(k)s, these plans provide a means for executives to save additional amounts for retirement planning, helping them maintain their lifestyle in retirement.
- Strategic Financial Planning: Companies use NQDCs to manage their cash flow by deferring the payout of compensation until a later date, which can be particularly useful for high-growth companies that prefer to reinvest cash in operations20. Publicly traded companies are required by the SEC to disclose information about their nonqualified deferred compensation plans and amounts deferred by named executive officers in their proxy statements, providing transparency on these arrangements18, 19.
Limitations and Criticisms
Despite their advantages, Non qualified deferred compensation plans come with significant limitations and criticisms, primarily from the perspective of the employee.
The most substantial risk for participants is the lack of protection in the event of employer insolvency or bankruptcy. Because NQDC plans are "unfunded" for tax purposes—meaning the deferred assets remain part of the company's general assets—participants are treated as unsecured creditors of the company. If the employer files for bankruptcy, the deferred compensation may be significantly reduced or entirely lost, as was evident in some high-profile corporate failures where executives lost substantial deferred amounts. Th16, 17is contrasts sharply with qualified plans, where assets are held in a separate trust and are protected from the employer's creditors under ERISA.
Another limitation is the irrevocability of deferral elections. Once an employee elects to defer compensation, the decision is generally binding and cannot be changed, or the funds accessed, prior to the predetermined distribution event, except under very limited circumstances as defined by IRS Section 409A. Th14, 15is lack of liquidity can be a significant drawback if an employee faces an unforeseen financial emergency.
Furthermore, changes in tax laws could impact the ultimate benefit received. While the intention is to defer income to a potentially lower tax bracket in retirement, there is no guarantee that future tax rates will be lower. Some critics also argue that NQDC plans contribute to a growing disparity in fringe benefits between highly compensated executives and the general employee population.
Non qualified deferred compensation plan vs. Qualified deferred compensation plan
The key distinctions between a Non qualified deferred compensation plan (NQDC) and a qualified deferred compensation plan (like a 401(k) or traditional pension) lie in their regulatory oversight, participant eligibility, funding, and tax treatment.
| Feature | Non qualified deferred compensation plan (NQDC) | Qualified deferred compensation plan |
|---|---|---|
| Regulatory Body | Primarily IRS Section 409A; largely exempt from ERISA 12, 13 | Governed by ERISA and IRS (e.g., 401(k), 403(b), traditional pension) |
| 11 Eligibility | Select group of management or highly compensated employees 10 | Broad-based, available to most employees (non-discriminatory) |
| 9 Funding | "Unfunded" for tax purposes; assets remain with employer 8 | "Funded" in a separate trust, protected from employer's creditors |
| 7 Contribution Limits | Generally no statutory limits, company-defined 6 | Subject to IRS annual contribution limits |
| Taxation (Employee) | Income tax deferred until distribution 5 | Contributions are tax-deductible or pre-tax; earnings grow tax-deferred |
| 4 Creditor Protection | None; employee is an unsecured creditor | S3trong; assets protected from employer bankruptcy 2 |
| Flexibility | High flexibility in design, distribution timing 1 | Less flexibility due to strict regulations |
While both types of plans offer tax-deferred growth and are valuable for retirement planning, the NQDC plan's lack of ERISA protection and the associated creditor risk are fundamental differences that create a higher level of risk for the participant compared to a defined benefit plan or defined contribution plan.
FAQs
Q: Who is eligible to participate in a Non qualified deferred compensation plan?
A: NQDC plans are typically offered to a "select group of management or highly compensated employees" within a company. They are not broadly available to all employees, unlike qualified plans such as 401(k)s.
Q: How does deferring compensation benefit an employee?
A: The primary benefit is tax deferral. Employees can postpone paying income tax on the deferred compensation and its earnings until a future date, often when they expect to be in a lower tax bracket (e.g., in retirement). This allows the deferred amount to grow on a pre-tax basis for longer.
Q: What happens to my Non qualified deferred compensation if my company goes bankrupt?
A: If your company declares bankruptcy, your deferred compensation is at significant risk. Since NQDC plans are generally "unfunded" and the assets remain part of the company's general assets, you would be treated as an unsecured creditor. This means your claim for the deferred funds would be alongside other general creditors, and you might receive only a portion, or none, of your deferred compensation.
Q: Can I change my mind after electing to defer compensation?
A: Generally, no. Under IRS Section 409A rules, elections to defer compensation must be made irrevocably before the compensation is earned. This strict rule is in place to prevent manipulation of tax timing. Once the election is made, the distribution schedule is set and can only be changed under very limited and specific circumstances.
Q: Are there other forms of non-cash or deferred compensation besides NQDC plans?
A: Yes, companies use various forms of incentive compensation and deferred benefits. Examples include phantom stock plans, stock options, restricted stock units, and long-term incentive plans, many of which can also be structured as nonqualified deferred compensation arrangements.