Non-Qualified Deferred Compensation (NQDC) refers to a contractual agreement in which an employee voluntarily defers a portion of their income to a future date, frequently post-retirement, to potentially benefit from tax advantages and enhanced retirement planning.
What Is Non-Qualified Deferred Compensation?
Definition
Non-Qualified Deferred Compensation (NQDC) is a scheme wherein an employee postpones the receipt of a part of their compensation until a predetermined future date. Unlike qualified plans such as 401(k)s, NQDC plans do not have to meet the requirements of the Employee Retirement Income Security Act (ERISA). However, they offer flexibility for customization between the employer and the employee, accommodating higher earners who wish to manage taxable income and retirement planning more strategically.
Key Features of NQDC Plans
Key Elements
Deferral of Income
The primary feature of an NQDC plan is the deferral of income. The deferred portion of the salary, bonuses, or incentives is set aside for future distribution, typically during retirement or upon the occurrence of specific events such as reaching a certain age, termination of employment, or disability.
Tax Considerations
- Tax Deferral: One of the significant benefits of NQDC plans is the tax deferral feature. The income deferred is not subjected to income tax until it is actually received. This can lower current taxable income and allow for tax-efficient retirement savings.
- Payroll Taxes: Despite income deferral, payroll taxes (Medicare and Social Security) are still due when the income is earned, not when it is received.
Employer and Employee Agreement
The specifics of NQDC plans are customizable and established through a mutual agreement between the employer and the employee. This agreement covers the timing of deferrals, vesting schedules, and distribution formats.
Types
Salary Reduction Arrangements
In these arrangements, the employee elects to receive less compensation than they have earned. This deferred amount is then set aside according to the NQDC plan.
Bonus Deferral Plans
These plans involve deferring bonus payments, enabling employees to align their receipt of income with future financial needs and tax situations.
Supplemental Executive Retirement Plans (SERPs)
SERPs are a type of NQDC plan specifically designed for executives. These plans provide additional retirement benefits beyond those of qualified plans.
Special Considerations
Risks
NQDC plans carry certain risks since they are non-qualified. They do not provide the same protections as qualified plans under ERISA, and deferred amounts are considered unsecured liabilities of the employer, exposing the employee to the employer’s credit risk.
Forfeitability and Vesting
Employees often need to comply with vesting schedules, which may require continued employment for a defined period. Non-compliance may result in forfeiture of deferred amounts.
Examples of NQDC Plan Scenarios
Example 1: Deferred Salary
An executive decides to defer 20% of her annual salary until retirement. This decision lowers her immediate taxable income, potentially placing her in a lower tax bracket, while allowing the deferred amount to grow tax-deferred until distribution.
Example 2: Bonus Deferral
An employee defers a significant annual bonus into an NQDC plan. By deferring the bonus, he avoids immediate high taxation, and the deferred sum grows tax-deferred, available for future financial goals.
Historical Context
Non-Qualified Deferred Compensation plans originated as a response to IRS limitations on qualified plans, providing additional flexibilities and savings opportunities for high-earning executives beyond the limits imposed on qualified plans like 401(k)s.
Applicability
NQDC plans are particularly beneficial for high-income earners looking for additional ways to manage their taxable income and save for retirement:
- Tax Optimization: Strategizing deferral to optimize tax situations over different years.
- Retirement Planning: Augmenting benefits from qualified retirement plans.
Comparison with Qualified Plans
NQDC vs. Qualified Plans
- Regulation: NQDC plans do not need to meet ERISA requirements.
- Contribution Limits: NQDC plans have no contribution limits unlike 401(k)s.
- Risk: NQDC plans expose employees to the employer’s credit risk.
Related Terms
- Qualified Plans: Retirement plans that meet standards set by ERISA.
- 401(k) Plans: A type of qualified plan offering tax-deferred savings.
- Deferred Compensation: The general concept of delaying income to a future date.
FAQs
What are the tax consequences of an NQDC plan?
Can non-executive employees participate in NQDC plans?
What happens to deferred compensation if an employer goes bankrupt?
References
- IRS Non-Qualified Deferred Compensation Plans Guide
- Employee Retirement Income Security Act (ERISA) Overview
- Financial Planning Association: Deferred Compensation Insights
Summary
Non-Qualified Deferred Compensation (NQDC) plans provide a sophisticated method for high-income earners to defer portions of their income until a future date, typically post-retirement, offering significant tax advantages. While these plans offer lucrative benefits, including flexibility and tax deferral, they come with associated risks such as the employer’s credit risk and lack of ERISA protection. Used strategically, NQDC plans can greatly enhance retirement planning and tax management.
