Non qualified deferred compensation plans

What Is Non qualified deferred compensation plans?

Non qualified deferred compensation plans (NQDC plans) are agreements between an employer and an employee in which a portion of the employee's income is paid out in a future tax year, rather than when it is earned. These plans fall under the broader financial category of Compensation and Benefits and are primarily used by highly compensated individuals, such as executives and key employees, to defer income taxes on compensation that exceeds the contribution limits of traditional qualified plans like 401(k)s²¹. Unlike qualified retirement plans, non qualified deferred compensation plans are not subject to the strict regulations of the Employee Retirement Income Security Act (ERISA), allowing for greater flexibility in their design and who can participate²⁰.

History and Origin

The landscape of deferred compensation in the United States has evolved significantly, particularly with legislative changes impacting how and when compensation can be deferred. A pivotal moment for deferred compensation, including the subsequent distinction between qualified and non qualified plans, occurred with the passage of the Revenue Act of 1978. This act introduced Section 401(k) to the Internal Revenue Code, which initially aimed to limit executive compensation but inadvertently paved the way for the tax-advantaged retirement savings vehicles we recognize today. While 401(k)s became popular due to their tax deferral benefits and employer matching contributions, the stringent non-discrimination rules and contribution limits that govern qualified plans created a need for alternative solutions for high-earning individuals¹⁹. Non qualified deferred compensation plans emerged as a flexible mechanism for employers to offer additional executive compensation and retirement planning opportunities beyond what qualified plans could provide, without adhering to ERISA's extensive rules, though they are subject to specific IRS regulations, notably Section 409A¹⁷, ¹⁸.

Key Takeaways

Non qualified deferred compensation plans allow select employees to defer a portion of their income and taxes to a future date.
They are not subject to the same strict IRS or ERISA rules as qualified plans, offering greater flexibility in design and eligibility.
NQDC plans are typically unfunded, meaning deferred amounts remain part of the employer's general assets and are subject to the claims of general creditors in the event of employer bankruptcy.
Taxation on deferred amounts and earnings is generally postponed until the employee receives the payment.
These plans are frequently used by companies to attract, retain, and incentivize key employees.

Formula and Calculation

Non qualified deferred compensation plans do not have a universal formula in the same way a loan interest or investment return might. Instead, the "calculation" primarily revolves around the amount of compensation deferred, the deemed investment returns on that deferred amount (if applicable), and the eventual payout schedule.

The deferred amount is simply the portion of an employee's salary, bonus, or other compensation that they elect to postpone receiving.

The growth of the deferred amount within the plan is typically based on:

\text{Future Value} = \text{Initial Deferred Amount} \times (1 + \text{Assumed Return Rate})^{\text{Years Deferred}}

Where:

(\text{Future Value}) = The total value of the deferred compensation at the time of distribution.
(\text{Initial Deferred Amount}) = The amount of salary, bonus, or other compensation deferred in a given year.
(\text{Assumed Return Rate}) = The hypothetical rate of return credited to the deferred amount, which may be tied to market indices, a fixed rate, or company performance.
(\text{Years Deferred}) = The number of years the compensation remains deferred until distribution.

This calculation is not a true investment return, as the funds are generally not held in a separate account for the employee but are merely a book-keeping entry by the employer. The concept of tax deferral is central to the benefit, as taxes on the "Future Value" are only applied when the employee actually receives the funds.

Interpreting Non qualified deferred compensation plans

Interpreting non qualified deferred compensation plans involves understanding their core purpose and the unique risks and benefits they present, particularly when contrasted with traditional retirement vehicles. These plans are essentially a contractual promise from an employer to pay an employee at a future date¹⁶. The interpretation hinges on the fact that the deferred funds remain assets of the company, subjecting the employee to the employer's credit risk¹⁵. This differs significantly from qualified plans, where assets are held in a trust for the exclusive benefit of employees and are generally protected from the employer's creditors.

From an employee's perspective, interpreting an NQDC plan means evaluating the long-term financial stability of their employer. It requires considering whether the potential for significant tax deferral and supplemental retirement planning outweighs the inherent risk of forfeiture if the company faces financial distress. For employers, interpreting these plans involves assessing their utility as tools for talent retention and attraction, balancing the benefits of offering flexible executive compensation with the need for careful corporate governance and adherence to IRS Section 409A rules.

Hypothetical Example

Consider Sarah, a highly compensated executive earning a substantial annual salary. Her employer offers a Non qualified deferred compensation plan. In 2024, Sarah's base salary is $500,000, and she receives a $200,000 bonus. She has already maxed out her 401(k) contributions. To further enhance her retirement planning and reduce her current taxable income, Sarah elects to defer $100,000 of her 2024 bonus into the NQDC plan.

The plan agreement specifies that this deferred amount will be paid out to her in a lump sum upon her separation from service, which she anticipates will be in 10 years. The plan credits a hypothetical 5% annual return on deferred amounts.

Initial deferred amount: $100,000
Assumed annual return: 5%
Years deferred: 10

After 10 years, the deferred amount, with credited earnings, would hypothetically grow to:

\$100,000 \times (1 + 0.05)^{10} \approx \$162,889.46

When Sarah separates from service in 2034, she receives $162,889.46 from the non qualified deferred compensation plan. This entire amount is then subject to income taxes at her tax rate in 2034. Her current income for payroll purposes in 2024 would reflect the deferred amount, but her income tax liability on that $100,000 is postponed. It's important to note that throughout this period, the $100,000 (and its credited earnings) remained an unsecured asset of her employer and was subject to the company's general creditors.

Practical Applications

Non qualified deferred compensation plans are versatile tools with several practical applications in modern finance and financial planning:

Executive Retention and Incentive: Companies utilize NQDC plans as a powerful incentive to attract, retain, and motivate top-tier talent, such as key employees and executives. By offering the ability to defer substantial portions of their compensation, including salary and bonuses, beyond qualified plan limits, employers can create compelling long-term reward structures¹³, ¹⁴.
Supplemental Retirement Benefits: For high-income earners who quickly reach the contribution limits of 401(k)s and other qualified plans, NQDC plans provide a crucial avenue for additional retirement planning and savings on a tax-deferred basis¹².
Tax Planning Strategy: Participants can strategically defer income from high-earning years to lower-earning years, potentially reducing their overall tax burden by recognizing income when they anticipate being in a lower tax bracket, for example, in retirement¹¹.
Golden Handcuffs: The structure of NQDC plans often includes a vesting schedule or conditions for payout that effectively serve as "golden handcuffs." This encourages executives to remain with the company for a specified period to receive their deferred compensation, aligning their long-term interests with the company's success¹⁰.

Limitations and Criticisms

While non qualified deferred compensation plans offer significant benefits, particularly for highly compensated employees, they also come with notable limitations and criticisms. A primary concern is the inherent risk to the employee because the deferred funds are generally unsecured and unfunded⁹. This means the deferred compensation is typically held as a book-keeping entry on the employer's balance sheet, remaining part of the company's general assets. Consequently, if the employer faces bankruptcy or severe financial distress, employees become general creditors and may lose some or all of their deferred compensation⁷, ⁸. The high-profile Lehman Brothers bankruptcy case served as a stark example where executives lost their deferred compensation because they were treated as unsecured creditors⁶.

Another criticism revolves around the inflexibility of distribution elections. Once an employee elects to defer compensation and chooses a distribution schedule, IRS Section 409A imposes strict rules regarding the timing of deferral elections and permissible distribution events⁴, ⁵. This rigidity can limit an individual's access to their funds in unforeseen circumstances or if their financial planning needs change unexpectedly. Unlike 401(k)s, NQDC plans typically do not allow for loans or early withdrawals for hardship without severe tax penalties, including a 20% additional tax and interest², ³. Furthermore, employer contributions to non qualified deferred compensation plans are not tax-deductible until the employee receives the compensation, which can affect the company's current tax liability¹.

Non qualified deferred compensation plans vs. Qualified deferred compensation plans

The primary distinction between non qualified deferred compensation plans and qualified deferred compensation plans lies in their regulatory oversight, tax treatment, and accessibility to employees.

Feature	Non qualified deferred compensation plans	Qualified deferred compensation plans
Regulatory Body	Primarily governed by IRS Section 409A (Internal Revenue Code)	Governed by ERISA and the IRS (e.g., 401(k), 403(b), pensions)
Contribution Limits	Generally no IRS-imposed limits; plan design dictates maximums	Strict IRS-imposed annual contribution limits
Eligibility	Select group of highly compensated employees or key employees	Broad employee coverage required (non-discrimination rules apply)
Asset Protection	Unsecured promise; funds remain part of employer's general assets; subject to employer creditors in bankruptcy	Funds held in a trust, separate from employer's assets; protected from employer's creditors
Tax Deduction (Employer)	Deductible when paid to employee	Deductible when contributed to the plan
Withdrawal Flexibility	Very limited; strict rules on timing and events; no loans or rollovers to IRAs	More flexible; allows for loans, hardship withdrawals, and IRA rollovers
FICA Taxes	Generally due when the deferred compensation is no longer subject to a substantial risk of forfeiture or becomes vested, even if not yet paid.	Generally paid at the time compensation is earned.

The main point of confusion often arises because both types of plans involve tax deferral of income to a future date. However, the "non-qualified" aspect signifies that these plans do not meet the extensive requirements of the Internal Revenue Code and ERISA that afford qualified plans their significant asset protection and broader employee participation mandates.

FAQs

Who typically participates in non qualified deferred compensation plans?

Non qualified deferred compensation plans are primarily designed for and offered to a select group of highly compensated employees, such as senior executives, directors, and other key employees within a company. These individuals often exceed the contribution limits of traditional qualified plans, making NQDC plans a valuable supplemental benefit for their retirement planning.

What are the tax implications of non qualified deferred compensation?

For the employee, the main tax benefit is the deferral of income taxes until the compensation is actually paid out in a future year. This allows the deferred amount and any credited earnings to grow on a tax-deferred basis. However, FICA taxes (Social Security and Medicare) are typically due earlier, usually when the compensation is earned or when it vests, even if the payment itself is deferred.

Are non qualified deferred compensation plans safe in a company bankruptcy?

No, generally they are not fully safe. Unlike qualified plans where assets are held in a protected trust, funds in non qualified deferred compensation plans remain part of the employer's general assets. This means that if the company declares bankruptcy, employees with NQDC claims are treated as unsecured creditors, ranking behind secured creditors and potentially losing all or part of their deferred compensation.