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How Non-Qualified Deferred Compensation Plans Work

Author: Matthew Williams

A non-qualified deferred compensation (NQDC) plan allows a service provider (e.g., an employee) to earn wages, bonuses or other compensation in one year but receive it — and defer the tax on it — to a later year. Doing this provides income in the future, and may reduce the tax payable on the income if the person is in a lower tax bracket when the deferred compensation is received. This favorable tax treatment applies as long as the arrangement conforms to tax law requirements explained below.

What is a non-qualified deferred compensation plan?

This is a plan created by an employer to enable employees to defer compensation that they have a legally binding right to receive. There are several varieties of NQDC plans (also called 409A plans because of the section in the tax code governing them); the one discussed here is the basic unfunded plan for deferring part of annual compensation.

The tax law requires the plan to meet all of the following conditions:

  • The plan is in writing.

  • The plan document(s) specifies, at the time an amount is deferred, the amount to be paid, the payment schedule and the triggering event that will result in payment. There are six permissible triggering events: a fixed date, separation from service (e.g., retirement), a change in ownership or control of the company, disability, death or an unforeseen emergency. Other events, such as the need to pay tuition for a child, a change in the financial condition of the company or a heavy tax bill are not permissible triggering events.

  • The employee makes an irrevocable election to defer compensation before the year in which the compensation is earned. However, a special deferral election rule applies to commission payments.

The NQDC plan can also impose conditions, such as refraining from competing with the company after retirement or providing advisory services after retirement.

The NQDC plan can allow for a subsequent deferral or a change in election (e.g., to receive deferred compensation at age 70 rather than at age 65 as previously agreed to when the original deferral was made) only under certain conditions. This requires that the subsequent election is made at least 12 months before the date that payment had originally been scheduled to begin, the subsequent election change delays the payment date for at least five years and the election is not effective until at least 12 months after it is made.

Instead of paying the compensation when it is earned, it becomes a credit in an account created on the company's books. The deferred amount earns a reasonable rate of return determined by the employer at the time that the deferral is made. This can be the rate of return on a predetermined actual investment (e.g., the return on the S&P index). Thus, when distributions are made, they include both the compensation and what amounts to earnings on that compensation (there are no actual earnings; it's merely a bookkeeping entry).

Advantages and disadvantages

Assuming the technicalities of the plan can be met, what does it mean for an employee as well as for the company? Some aspects of non-qualified deferred compensation plans may be beneficial to employees and employers, while there are some disadvantages to consider.

Employee's perspective. A highly compensated employee who can afford not to receive compensation currently can postpone receipt until retirement or some other event in the future. For example, you earn a big year-end bonus but opt to defer receipt under the terms of your employer's deferred compensation plan. As mentioned earlier, this gives you income in the future, and you won't be taxed on the compensation until it is received. The longer that the receipt of income is postponed, the greater the deferred amount becomes because there is no reduction in the compensation or earnings on it for taxes over the years.

Of course, if tax rates increase significantly in the future or the employee has higher total income than in the year that the income is earned, he/she may pay more taxes on the deferred compensation than if the income had been taxed when earned. Nonetheless, it would take a significant tax hike to lose the tax savings from deferral.

There is no income cap on deferral amounts. In contrast to contributions to qualified retirement plans, such as a 401(k), which have limits on salary deferrals, the amount deferred is up to the employee. This can help a person build up a sizable retirement nest egg.

However, violating the stringent conditions in the law triggers harsh tax results. All of the deferred compensation becomes immediately taxable. What's more, there is a 20% penalty plus interest on this amount.

There's a financial risk in deferring compensation. The promise by the company to pay the compensation in the future cannot be secured (secured means the funds are segregated from other funds and not available to pay the company's other creditors). This means employees are relying on the probability that the company will be in business when they want to receive the deferred compensation, and that it will have the funds to pay what's owed.

There's another financial risk: the rate of return paid on the deferred compensation. An employee (service provider) may be able to earn a greater rate of return on the after-tax amount without deferral than what is paid under the deferred compensation plan.

Employer's perspective. The company can use the plan to benefit only owners, executives and highly compensated employees. There are no nondiscrimination rules, so deferral need not be offered to rank-and-file employees. This gives the company considerable flexibility in tailoring its plan. The plans are also used as golden handcuffs to keep valued staff on board because leaving the company before retirement can result in forfeiting deferred benefits.

A NQDC plan can be a boon to cash flow since currently earned compensation is not payable until the future. However, the compensation is not tax-deductible for the company until it is actually paid.

The costs of setting up and administering a NQDC plan are minimal. Once initial legal and accounting fees for setting up the plan have been paid, there are no special annual costs, and there are no required filings with the IRS or other government agencies.

The Bottom Line

A non-qualified deferred compensation plan can supplement or supplant a qualified retirement plan to create retirement savings for an employee on a tax-advantaged basis. They can also be used for independent contractors, corporate directors and other non-employees. However, the intended tax benefits are realized only if the plan conforms to tax law requirements.

For related reading, see Not All Retirement Accounts Should Be Tax-Deferred and Setting Retirement Goals: What's Your Number?

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