Table of Contents Hide
- What are Nonqualified Deferred Compensation (NQDC) Plans?
- Non-Qualified Deferred Compensation: An Overview (NQDCs)
- Qualified Plans vs. Nonqualified Deferred Compensation Plans
- Considerations for Nonqualified Deferred Compensation (NQDC) Plans
- Employers’ Benefits From Nonqualified Deferred Compensation Plans
- Benefits for Employees
- Employee Disadvantages
- Nonqualified Deferred Compensation FAQs
- What is the difference between a qualified and nonqualified deferred compensation plan?
- How is nonqualified deferred compensation reported?
- How do I avoid taxes on deferred compensation?
Some of the most important hires your firm can make are on its executive team. Attracting, keeping, and motivating these best personnel is generally a major goal for organizations. Nonqualified deferred compensation (NQDC) plans offer top employees a competitive benefit. According to one study, 92 percent of firms provide such plans. An NQDC plan is an excellent addition to your compensation and benefits toolkit. You can ensure that you’re putting these plans to the best use for your organization by recognizing their benefits and hazards. Continue reading.
What are Nonqualified Deferred Compensation (NQDC) Plans?
Nonqualified deferred compensation plans are essentially agreements between you and your company that state you will get compensation at some point in the future. Nonqualified deferred compensation (NQDC) plans and qualified deferred compensation (QDC) plans are the two types of deferred compensation plans. The distinction between the two types of plans is found in how people utilize them and how the law regards them.
Employers can offer bonuses, salaries, and other types of compensation through NQDC plans. Employers, however, defer payment and distribute the excess money at a later date, rather than immediately. When the payment of extra money and perks is deferred, the tax payable on this excess income is also delayed. NQDCs are especially beneficial for employees who have exhausted their qualifying plans, such as 401(k) plans.
Stock options and retirement plans are examples of NQDC plans. They are also known as 409(a) plans.
Non-Qualified Deferred Compensation: An Overview (NQDCs)
NQDCs, often known as 409A plans due to the portion of the tax code in which they are found, arose in response to the cap on employee contributions to government-sponsored retirement savings plans. Because high-income earners are unable to contribute the same proportionate amounts to their tax-deferred retirement savings as lower-income earners, NQDCs provide a way for high-income earners to defer actual ownership of income and avoid income taxes on their earnings while enjoying tax-deferred investment growth.
For example, if Sarah, an executive, earned $750,000 per year, her maximum 401(k) contribution of $19,500 would represent only 2.6 percent of her yearly earnings, making it difficult for her to save enough for retirement. By deferring a portion of her earnings to an NQDC, she may postpone paying income taxes on her earnings, allowing her to save a bigger percentage of her income than her 401(k) plan allows.
Savings in an NQDC are frequently deferred for five or ten years, or until the employee retires.
NQDCs do not have the same constraints as retirement plans; an employee could spend their deferred income for other purposes, such as travel or education. Investment vehicles for NQDC contributions vary per workplace and may be similar to a company’s 401(k) investment alternatives.
Qualified Plans vs. Nonqualified Deferred Compensation Plans
#1. The Tax Treatment
The tax treatment of contributions is the primary distinction between the two types of plans. As previously stated, nonqualified deferred compensation plan payments are not tax deductible for the employer and must be made after-tax. Qualified plans allow businesses to deduct employee contributions and provide certain tax benefits that non-qualified plans do not.
Another significant distinction between the two types of plans is involvement. Non-qualified plans are exclusively available to senior executives, but qualified plans must be available to all employees who meet the eligibility conditions.
#3. Contribution Caps
Finally, qualified plans avoid excessive contributions that might benefit higher-paid employees by limiting contributions through various IRS-mandated caps, limitations, and restrictions. Non-qualified plans are exempt from these restrictions and allow businesses and employees to contribute as much as they like.
Considerations for Nonqualified Deferred Compensation (NQDC) Plans
Nonqualified deferred compensation plans are not suitable for all employees. It’s wise to consider whether participating in one makes sense for your financial situation. Participating in an NQDC plan, for example, because you want to save more money for retirement may be worthless if you don’t max out your 401(k) every year.
After employees retire, NQDC plans often distribute deferred income. You should also consider how your tax bracket will change once you stop working (or whenever you elect to receive the deferred payments). Because you’ll be paying income taxes on the deferred funds, having an NQDC plan will help you the most if you end up with a lower tax rate.
Another element to consider is the type of assets that will be associated with your NQDC plan. If your investment alternatives are the same as those available by your 401(k), you may not require an NQDC plan, especially since employer-sponsored plans (such as 401(k)s and 403(b)s) are more secure.
Employers’ Benefits From Nonqualified Deferred Compensation Plans
Because NQDC plans are not qualified, which means they are not protected by the Employee Retirement Income Security Act (ERISA), they provide greater freedom to businesses and employees. Employers, unlike ERISA plans, can choose to provide NQDC plans solely to executives and key employees who are most likely to use and benefit from them. Because there are no non-discrimination provisions, deferment does not have to be extended to the rank-and-file. This allows the corporation a lot of leeway in adapting its plan. The plans are also utilized as “golden handcuffs” to retain valuable employees on board, as leaving the company before retirement may result in the forfeiture of deferred benefits.
Because currently earned compensation is not payable until the future, a nonqualified deferred compensation plan can be beneficial to cash flow. However, until the compensation is paid, it is not tax deductible for the corporation.
The expenditures for establishing and managing a nonqualified deferred compensation plan are negligible. There are no additional annual expenditures after the initial legal and accounting fees have been paid, and there are no obligatory filings with the Internal Revenue Service (IRS) or other government authorities.
Benefits for Employees
#1. Savings and tax advantages are limitless.
The IRS has rigorous limits on the amount of money you can contribute to a qualifying retirement plan, such as a 401(k) (k). There are no such legally mandated limits in deferred compensation plans, 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 then continue to expand your retirement savings without restriction through an NQDC plan.
The ability to postpone any amount of compensation reduces your taxable income each year. This can therefore put you in a reduced tax rate, lowering your tax payment year after year. Deferred compensation, on the other hand, is still liable to FICA and FUTA taxes in the year it is earned.
#2. Alternative Investments
Many NQDC plans include investment alternatives similar to 401(k) plans, like mutual funds and stock options. NQDC plans are more than just high-end deposit accounts. Instead, they enable you to accumulate wealth over time. However, because your contributions are unlimited, you can invest on a greater scale, boosting your chances of making huge gains.
#1. Strict Distribution Plan
Unlike a 401(k), payouts from a nonqualified deferred compensation plan must be scheduled in advance. Rather than being able to withdraw assets at your leisure after retirement, you must select a distribution date in the future. Regardless of whether you need the funds or how the market is performing, you must take distributions on the appointed date. This increases your taxable income for the year, and the timing of the distribution may result in the liquidation of assets in your investment portfolio at a loss.
Only under limited conditions does the NQDC plan permit a further deferral or change in an election (e.g., to receive deferred compensation at age 70 rather than age 65). This requires that the subsequent election be made at least 12 months before the payment was originally planned to commence, that the subsequent election change postpones the payment date for at least five years, and that the election is not effective until at least 12 months after it is made.
#2. There is no early withdrawal provision.
Employees who contribute to 401(k)s or other qualifying plans are legally permitted to withdraw funds at any time, 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 can demonstrate financial difficulty.
In contrast, there are no such provisions in NQDC plans. You must withdraw funds no earlier than the distribution timetable. Even if you have an emergency financial need that cannot be met by other means, funds contributed to a nonqualified deferred compensation plan are not accessible before the designated distribution date.
#3. There are no ERISA safeguards.
Because NQDC plans are not covered by ERISA, they do not 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 compensation 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 basically an unsecured loan between the lending employee and the borrowing employer.
If the plan is underfunded, you must rely on the employer’s pledge to pay according to the distribution schedule in the future. If the business runs into financial difficulties and must pay off obligations, creditors may seek repayment of monies used to pay your employee distributions. Funded NQDC plans provide greater protection for employee contributions, but deferrals are often taxable in the year they are earned, negating the tax benefit provided by unfunded plans.
Another financial risk is the rate of return on deferred compensation. Without deferral, an employee may be able to earn a higher rate of return than what is offered under the deferred compensation plan.
Nonqualified deferred compensation (NQDC) plans can be used for a variety of purposes. As a result, they are exceedingly sophisticated agreements. Before you enter one, be sure you fully understand what it entails. It might even be worthwhile to seek the advice of a financial counselor. An expert in this field can explain how an NQDC plan may affect your long-term retirement planning and tax situation.
Nonqualified Deferred Compensation FAQs
What is the difference between a qualified and nonqualified deferred compensation plan?
Employees can put their money into a trust that is distinct from your company’s assets with qualified plans. 401(k) plans are one example. Nonqualified deferred compensation plans allow your employees to contribute a portion of their wages to a permanent trust, where it grows tax-free.
How is nonqualified deferred compensation reported?
Nonqualified plan dividends are reported as compensation on Form W-2 in Box 1. The nonqualified plan deferrals reduce the amount in Box 1. Box 11 of Form W-2 may also be used to disclose deferrals and dividends.
How do I avoid taxes on deferred compensation?
If your deferred compensation is paid in a lump sum, you can reduce the tax impact by “bunching” additional tax deductions in the year you receive the money.
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