In the world of compensation management, Nonqualified Deferred Compensation (NQDC) plans stand out as a mix of opportunity and complexity. Think of them as meticulously choreographed dances between your current and future earnings, allowing high-earning employees to have a say in their income while deftly handling taxes.
This article will explore the ins and outs of NQDC plans, including their regulations, types, benefits, disadvantages and tax implications. We’ll also help you decide whether to opt for an NQDC plan.
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Article Roadmap
- What Is Nonqualified Deferred Compensation?
- Regulations
- Types
- Nonqualified Vs. Qualified Deferred Compensation
- Benefits
- Disadvantages
- Tax Implications
- Should You Opt for This Plan?
- Next Steps
What Is a Nonqualified Deferred Compensation Plan?
Nonqualified deferred compensation is a payment plan where high-earning employees receive a portion of their annual salary that accumulates tax-free on a later date.
This plan offers savings for the future and may reduce the taxes due on the income if the employee is in a lower tax bracket when the deferred compensation matures.
It’s a high-risk, high-reward form of deferred pay that doesn’t have annual contribution limits, and employees receive the payments at junctures like:
- Retirement
- Termination of services
- An agreed-upon date
- Company handovers
- Cases of disability or death
Regulations
While presenting NQDC plans to your staff, you must follow a standardized format. Let’s explore this in detail.
The term “nonqualified” means that the plan doesn’t meet all of the technical requirements imposed on “qualified plans” (such as pension and profit-sharing plans) under the Internal Revenue Code (IRC) or Employee Retirement Income Security Act (ERISA).
They must, however, comply with the standards of IRC 409A, such as:
- Initial deferral arrangements must be made before the calendar year in which the employee undertakes the services for which the compensation is paid, specifying the timing and mode of payment.
- Through a subsequent deferral choice, a taxpayer may choose to amend the manner in which deferred compensation is paid out or to postpone its payment date, but only if certain timing-related conditions are satisfied.
- Only one or more of the following permitted payment events may result in the payment of NQDC: the occurrence of a set time or established schedule, separation from service, unanticipated emergency, disability, change of control or death.
- Except as permitted by law, the payment of NQDC cannot be accelerated or delayed.
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Types
Whether salary reduction or group insurance deferrals, NQDCs take many forms. HR professional should be conversant with the popular types of nonqualified deferred compensation plans and offer them accordingly.
Salary Reduction Arrangements
A part of an employee’s income is delayed under these plans into a secondary account, where it will grow tax-deferred until its distribution in the future. Contributions to these programs are subject to investment, limits and a vesting schedule.
Bonus Deferral Plans
Principal executives receive additional payment from the company under executive bonus programs. Typically, bonuses are postponed and paid out later, like retirement. In a few cases, the employer may give the executive a bonus and a premium payment to cover taxes.
Supplemental Executive Retirement Plans (SERPs)
SERPs grant highly compensated employees more substantial retirement income. Such initiatives frequently close the income gap between executives’ desired retirement income and the benefits offered by eligible retirement plans.
Sponsors can use employer contributions or a combination of employer and employee contributions to fund SERPs.
Split-Dollar Plans
Plans for split-dollar life insurance combine a deferred compensation scheme with life insurance protection. Employee’s life insurance coverage is premium-paid by the employer, who also covers the death benefit.
Deferred compensation may also originate from the policy’s cash value.
Group Carve-Out Plans
In this nonqualified deferred compensation plan, the employer carves out a key employee’s group life insurance policy worth more than $50,000 and replaces it with an individual policy.
This approach lets the key employee avoid paying the assumed income on group life insurance policies worth more than $50,000. The company redirects the premium it would have spent on the excess group life insurance to the employee’s policy.
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Nonqualified Vs. Qualified Deferred Compensation
The table illustrates the distinctions between qualified and nonqualified deferred compensation plans.
| Conditions | Qualified | Nonqualified |
|---|---|---|
| Participants | All employees | Highly compensated employees or key executives |
| Contribution |
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| Investments |
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| Funding |
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| ERISA Coverage | Unless the plan is a governmental plan, a non-electing church plan or a plan that does not cover any common law employees, it’s protected by ERISA. | Unfunded NQDC plans are not subject to ERISA’s participation, funding, vesting or fiduciary provisions. |
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Primary Benefits
Nonqualified deferred compensation plans provide significant savings regarding tax-exempt deferrals without rigid ERISA rules. Now we’ll help you decide whether the benefits of NQDCs outnumber their drawbacks.
Maximize Tax Savings
The ability to postpone pay reduces your taxable income each year. This practice can therefore put you in a reduced tax bracket, lowering your payment year over year.
Deferred remuneration is still liable to FICA and FUTA taxes in the year earned. We’ll talk about those in the taxation section.
Elevate Contribution Limits
Nonqualified deferred compensation plans don’t incur the strict rules that the IRS levies on qualified plans. There are no legally mandated limits, though employers may designate a contribution cap depending on your compensation.
If you are a highly compensated employee, you can maximize your 401(k) contributions and expand your retirement savings without restriction through an NQDC plan.
Customize Plans
You can customize nonqualified deferred compensation plans to suit individual goals. This personalization can assist employees in aligning their salary with their specific financial goals.
Participants can choose how much of their pay to delay, when to receive payouts, and, in some cases, how the deferred funds get invested.
Many NQDC plans provide 401(k)-style investment alternatives, including mutual funds and stock options. They enable you to accumulate wealth over time. Since your contributions are unlimited, you can invest on a grander scale, boosting your chances of making significant gains.
Exercise Greater Flexibility
Nonqualified deferred compensation plans are available for individual contractors as they come with a non-discrimination clause. Employers exercise great flexibility while choosing whom to offer these plans to, how much to contribute and when to pay them.
Since currently earned remuneration isn’t payable until the future, an NQDC plan benefits cash flow. Until the funds get paid, they’re not tax deductible for the company.
The costs of creating and overseeing an NQDC plan are slight. There are no additional annual expenditures after the initial legal and accounting fees have been paid, and there are no obligatory filings with the IRS or other government authorities.
Enhance Employee Retention
Offering nonqualified deferred compensation is a surefire way to gain a competitive edge in the hiring landscape. You’ll do so by attracting high-quality candidates looking for comprehensive compensation packages that go beyond salary and conventional benefits.
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Disadvantages
It’s best to err on the side of caution with nonqualified deferred compensation plans.
Can you secure your funds without ERISA safeguards? Additionally, some companies set strict distribution policies, so deferred funds remain inaccessible even during emergencies.
We’ve outlined the drawbacks of NQDCs here.
Rigid Distribution Policy
Unlike a 401(k), you must plan for distributions from an NQDC plan beforehand. Rather than being able to withdraw assets at your leisure after retirement, you must select a future distribution date.
You must take distributions on the appointed date regardless of market performance or personal needs. This clause increases your taxable income for the year, and the distribution timing may result in liquidating assets in your investment portfolio at a loss.
No Early Withdrawal
Employees who contribute to 401(k)s or other qualifying plans can legally withdraw funds anytime, but this is discouraged. While early distributions may result in tax penalties, nothing prevents you from accessing assets in an emergency.
Furthermore, most plans allow for numerous penalty-free early withdrawals if you demonstrate financial difficulty.
In contrast, there are no such provisions in NQDC plans. You must withdraw funds no earlier than the distribution time.
Even if you have an emergency financial need that other means cannot meet, funds contributed to an NQDC plan are not accessible before the designated payout date.
No ERISA Safeguard
Since ERISA doesn’t cover NQDC plans, they don’t have the same creditor protections as other retirement plans. In fact, as a plan participant, you don’t own any form of account because your employer deducts the deferral amount from your pay rather than depositing funds into an account with a financial institution.
The amount of the employee deferral is a liability on the employer’s balance sheet, making the NQDC plan an unsecured loan between the lending employee and the borrowing employer.
If the plan is insufficiently funded, you must rely on the employer’s pledge to pay according to the distribution schedule in the future. If the business has financial difficulties and must pay off dues, creditors may seek repayment of money used to pay your employee distributions.
Tax Implications
The tax implications of nonqualified deferred compensation plans vary depending on whether they are funded or unfunded. However, because of the unfavorable tax laws connected with funded plans, most businesses in the United States opt for unfunded NQDC plans. We’ll talk about unfunded plans.
Some businesses set up grantor trusts to hold NQDC funds, imitating the structure of a fully funded plan. However, the assets of these grantor trusts are accessible to the company’s creditors in the event of bankruptcy, rendering the plan unfunded.
Employers can create NQDC plans with different vesting rules, such as vesting over time, vesting at the moment of issuance or no vesting conditions at all.
If a plan meets Section 409A requirements, the promised amount is included in the employee’s taxable income as it’s paid or made available to the employee.
Employers record the distribution amount as taxable compensation, and contributions and earnings eventually get taxed as compensation.
Funding Strategy
All NQDC plans are unfunded commitments that sponsors might choose to fund publicly or informally. This condition gives businesses a lot of leeway in determining how or if to fund their NQDC strategy.
You may choose not to finance the plan and use the participant deferrals to fund additional employment and growth.
Another alternative is to use Corporate Owned Life Insurance (COLI) to fund the plan, which provides a tax-efficient funding vehicle and key person insurance.
A third approach is to use regular mutual funds to fund your plan. The good news is that you don’t have to choose just one sort of funding and can mix and match different investment vehicles to create a customized solution.
Taxation Timing
Timing is integral to effective financial agendas, and this is particularly true for taxation. Nonqualified deferred compensation plans offer a fantastic opportunity for eligible key employees to control the timing of their deferred income.
You get the enticing option of choosing installment-based rewards.
Furthermore, participants can delay dividends if unanticipated tax-related changes arise, nimbly adjusting to new conditions.
The link between taxation timing and the difference between marginal and effective tax rates is at its core.
The marginal tax rate is the percentage of tax paid on each additional dollar of taxable income. This tax rate applies to any current deferrals, as each dollar deferred is deducted from the total taxable income.
The effective tax rate is the total tax paid divided by the total taxable income on the payout. This approach takes into consideration all tax brackets that affect taxpayer distributions. These tax brackets are frequently applied to payments from deferred compensation plans in the early retirement years when many members rely on them as their principal source of retirement income.
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Should You Opt for This Plan?
It’s time to decide whether a nonqualified deferred compensation plan suits you.
While they provide splendid retirement savings, their distributions ultimately depend on your company’s credibility.
We’ve compiled the top considerations in the form of questions to ask yourself before opting for a nonqualified deferred compensation plan.
1. Do you max out traditional savings plans like the 401(k) every year?
If the IRS constraints on qualifying retirement plans like 401(k), SIMPLE IRAs, and SEPs prevent you from saving a big enough proportion of your pay to fund your retirement, setting up a nonqualified plan will allow you to save far more.
2. Could you benefit from deferring income taxes until a later date?
Contributions to a nonqualified deferred compensation plan will reduce your current income taxes (but you will still have to pay Social Security and Medicare taxes). Because you will owe taxes when you receive plan payouts, it allows you to regulate the timing of your tax payments before retirement.
3. Is your employer financially secure enough to fund future payouts?
Since the company promises to pay the delayed income later, you and your highly rewarded staff must be certain that the funds will be available when needed.
4. Does the plan allow flexible distributions?
Some companies may mandate lump-sum distributions as per plan rules, while others ask you to defer income until a specific date, which could be during retirement. Other plans permit earlier releases. Depending on your unique position and income demands, greater flexibility with distribution elections can be a considerable advantage.
5. Could you afford to lose the deferred pay?
Generally, NQDC funds aren’t accessible until the distribution date or another allowed event, such as termination. Unlike a 401(k), NQDC plans typically don’t permit early distributions or borrowing. Nonqualified deferrals are considered general assets of the corporation and are available to creditors in the event of bankruptcy.
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Next Steps
With a comprehensive understanding of the risks and rewards of nonqualified deferred compensation plans, you can chalk out the mix of investment options and funding strategies for your chosen path to wealth maximization.
Compensation management solutions come with bonus deferral modules that can help you reward executive employees while staying compliant. Our free comparison report can provide valuable insights on the top modules to include in your planning solution.
What kind of NQDC plan is your company offering? Comment below!