Skip to main content
diversification.com
← Back to N Definitions

Nonqualified deferred compensation

What Is Nonqualified Deferred Compensation?

Nonqualified deferred compensation (NQDC) refers to an agreement between an employer and an employee to pay a portion of the employee's income in a future tax year. Unlike qualified plans like 401(k)s, NQDC plans do not adhere to the same stringent rules under the Employee Retirement Income Security Act (ERISA) or the Internal Revenue Code (IRC), allowing for greater flexibility in design and contribution amounts. This type of arrangement is a component of executive compensation and retirement planning, primarily utilized to attract, retain, and incentivize key employees, particularly those who are highly compensated. The core benefit of nonqualified deferred compensation lies in the tax deferral it offers, as employees do not pay income tax on the deferred amounts until they are actually received.72, 73, 74

History and Origin

The landscape of nonqualified deferred compensation underwent significant changes with the enactment of the American Jobs Creation Act of 2004, which introduced Section 409A to the Internal Revenue Code. Prior to this legislation, NQDC plans operated with fewer regulatory constraints, sometimes allowing executives to exert influence over the timing of payouts, which raised concerns about potential abuse, especially if a company faced financial distress.71

In December 2004, the Treasury Department and the IRS issued Notice 2005-1, providing initial guidance on the new Section 409A rules.69, 70 This section mandated new requirements for nonqualified deferred compensation plans concerning the timing of deferral elections, permissible distribution events, and plan documentation. Its broad definition of deferred compensation extended to various arrangements not traditionally considered NQDC, such as certain bonuses and equity compensation.65, 66, 67, 68 The objective of Section 409A was to curb perceived abuses and ensure that deferred compensation arrangements served legitimate business and compensation purposes, rather than primarily as a means to accelerate income or manipulate tax outcomes.64

Key Takeaways

  • Nonqualified deferred compensation (NQDC) plans allow employees, typically high-earners, to postpone receiving a portion of their current income until a future date.62, 63
  • The primary benefit for employees is the deferral of income tax until the funds are distributed.60, 61
  • Unlike qualified retirement plans, NQDC plans are generally exempt from most ERISA requirements and do not have IRS-imposed contribution limits.57, 58, 59
  • These plans are typically unfunded and unsecured, meaning the deferred amounts remain subject to the employer's general creditors.56
  • Strict rules under IRC Section 409A govern deferral elections and distribution timings, limiting flexibility once decisions are made.54, 55

Interpreting Nonqualified Deferred Compensation

Nonqualified deferred compensation plans are interpreted as a contractual agreement where an employer promises to pay future compensation to an employee for services rendered. The "nonqualified" aspect means these plans do not receive the same favorable tax treatment or protections as qualified retirement plans under ERISA and other sections of the Internal Revenue Code. For an employee, participation signifies a strategic decision to defer a portion of their current taxable income, often to a point in retirement when their income tax bracket may be lower. This can be a key component of an individual's long-term financial planning strategy.

The terms of an NQDC plan are highly customizable, allowing employers to tailor benefits to specific executives or groups. However, this flexibility comes with a trade-off: the employee becomes an unsecured creditor of the employer. This means the deferred funds are not held in a separate trust for the employee's sole benefit and remain subject to the claims of the company's general creditors, particularly in the event of the employer's bankruptcy.53

Hypothetical Example

Consider Sarah, a highly compensated executive at Tech Innovators Inc. In 2025, Sarah earns a base salary of $300,000 and a performance bonus of $100,000. Recognizing her high current tax bracket and aiming for a lower taxable income in retirement, Sarah decides to defer $50,000 of her 2025 bonus into her company's nonqualified deferred compensation plan.

According to the plan's terms, she elects to receive this deferred amount, plus any earnings, as a lump sum five years after her separation from service. Tech Innovators Inc. credits the $50,000 to a bookkeeping account in Sarah's name, which tracks hypothetical investment returns based on a selection of market indices. While the company may informally set aside assets to cover this future liability, these assets remain part of the company's general assets and are not protected from its creditors.

In 2035, Sarah retires. Five years later, in 2040, she receives the deferred $50,000 plus its accrued earnings, totaling $75,000. At this point, her post-retirement income is significantly lower, and the $75,000 is then taxed as ordinary income. This demonstrates how nonqualified deferred compensation allows for a strategic postponement of income tax on current earnings to a future date.

Practical Applications

Nonqualified deferred compensation plans are widely applied in several financial areas, particularly in human capital management and corporate finance.