Nonqualified Deferred Compensation (NQDC)
NQDC is a special type of employment benefit that is used in some worker situations. Nonqualified means there are no limits on how this money can be invested and distributed to the employee in the future. It has no restrictions on who receives the funds when the distributions begin (the employee does not have to retire or reach a certain age or time period in service). Nonqualified deferred comp is often used in executive compensation packages, but others may use it as well. Nonqualified deferred compensation can be paid in cash, stock, bonds, life insurance policies, annuities (fixed and variable) spousal benefits among other things depending on the details of the plan. It is a special kind of noncash benefit that has special tax treatment. Nonqualified deferred compensation plans are used in conjunction with Qualified plans, which have stricter limits on how the money within them can be invested and distributed to employees. NQDC should not be confused with other types of non-taxed employee benefits such as health and welfare benefits. It is not taxed at the time of deferral or when it vests, but it is taxed in some circumstances when distributed to employees and in others (called “constructive receipt”) even if the employee does not receive the money.
Understanding Nonqualified Deferred Compensation
Nonqualified deferred comp is a special type of compensation that allows an employee to defer the receipt of cash or other types of income in order for it to be taxed at a later date when the person might be in a lower tax bracket. The benefit can take many different forms, but typically it involves allowing employees to postpone receiving some sort of compensation in the form of cash, stock, bonds, insurance contracts, investments that are intended to produce income or other assets. The compensation is not taxed when it is earned or vested—it is only taxed in some circumstances when distributed to employees and in others (called “constructive receipt”) even if the employee does not receive the money. Nonqualified deferred comp is often used in executive compensation packages, but others may use it as well.
How Nonqualified Deferred Compensation Works
Nonqualified deferred compensation does not have to meet the strict standards that apply to qualified plans such as those that cover retirement or profit-sharing plans, employee stock ownership plans, and some other plan types. Nonqualified benefits usually are set up as an employer contribution to a special account for the employee but can take other forms depending on the details of the plan. Nonqualified benefits usually are set up as an employer contribution to a special account for the employee but can take other forms depending on the details of the plan.
Nonqualified Deferred Compensation Tax Implications
Nonqualified deferred compensation plans are subject to special tax rules, but they can help employers offer additional benefits to employees. You must review the details of your plan and discuss ways in which you may be able to minimize taxes when participating. The tax treatment of deferred income depends on whether Nonqualified Deferred Compensation is subject to Code Section 409A. Nonqualified Deferred Compensation not subject to Code Section 409A is taxed in the same manner as Nonqualified Deferred Compensation that is subject to Code Section 409A. Nonqualified Deferred Compensation that is subject to Code Section 409A, may be either “separate treatment” Nonqualified Deferred Compensation or “integrated” Nonqualified Deferred Compensation. Nonqualified Deferred Compensation that is subject to Code Section 409A and treated as Nonqualified Separate Treatment Non-compensation may be either: (i) includible in the income of the Service recipient when there is no substantial risk of forfeiture of the rights to such amounts, or (ii) includible in the income of the Service recipient when there is a substantial risk of forfeiture of the rights to such amounts but subject to a Substantial Risk of Forfeiture Waiver. Nonqualified Deferred Compensation that is Nonqualified Deferred Compensation that is subject to Code Section 409A and treated as Nonqualified Non-compensation is includible in the income of the Service recipient at all times unless an exception applies.
What Doesn’t Qualify as Nonqualified Deferred Compensation?
Non-taxed benefits that are not Nonqualified Deferred Compensation include health and welfare benefits including:
- Health Insurance
- Medical Reimbursement Plans
- Disability Insurance or Long-Term Care Coverage
- 401(k) plans are qualified plans unless they are Nonqualified Deferred Compensation
Limitations of Nonqualified Deferred Compensation
Unlike 401(k)s and 403(b)s, NQDC is not protected by the Employee Retirement Income Security Act (ERISA). Also, the money from NQDC cannot be rolled over into an IRA or other qualified plan if the NQDC is distributed from the employer. When the company goes bankrupt, Nonqualified Deferred Compensation usually is treated like all other unsecured claims. Nonqualified deferred compensation benefits may be reduced or eliminated in these circumstances. Employers can require that NQDC distributions are made only on termination of employment, disability, death, an unforeseeable emergency, or some other condition. It can be subject to a substantial risk of forfeiture, such as vesting requirements.
Key Nonqualified Deferred Compensation Plan Tips
Benefits of Nonqualified Deferred Compensation (NQDC)
The employer is not taxed until Nonqualified Deferred Compensation is paid to the employee. Nonqualified deferred compensation allows employers to provide a greater level of benefits without adding costs to their operating budget. It also avoids “double taxation” where income used for a benefit would otherwise be subject to tax. NQDC can be part of a tax-advantaged executive benefits program. Nonqualified Deferred Compensation is also more protected from creditors. It can increase an employee’s retirement plan contributions by permitting matching deductions even if the employer lacks a qualified retirement plan. Nonqualified Deferred Compensation plans may help attract and retain employees with competing job offers.
Nonqualified Deferred Compensation Plan Criticisms
The Nonqualified Deferred Compensation plan is expensive for the employer. NQDC plans make employees more vulnerable to termination at a time when they need income most. NQDC can be abused by employers as a supplemental wage to avoid mandatory withholding and by executives as a means of deferring taxes on compensation income. Nonqualified Deferred Compensation plans may encourage employees to stay with their employer past retirement age or until they need Nonqualified Deferred Compensation benefits due to hardship situations.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.