What is Non-Qualified Deferred Compensation?
Non-Qualified Deferred Compensation is compensation that has been earned by an employee, but not yet received from their employer. Because the ownership of the compensation - which may be monetary or otherwise - has not been transferred to the employee, it is not yet part of the employee's earned income and is not counted as taxable income.
The Origins of Non-Qualified Deferred Compensation:
Non Qualified Deferred Comp Plans (NQDC), often referred to as 409A plans, due to the section of the tax code they exist in, emerged in response to the cap on employee contributions to government-sponsored retirement savings plans. Because high-income earners were unable to contribute the same proportional amounts to their tax-deferred retirement savings as other earners, NQDCs offer a way for high-income earners to defer the actual ownership of income and avoid income taxes on their earnings while enjoying tax-deferred investment growth.
For example, if Sarah, an executive, earned $500,000 per year, her maximum 401(k) contribution of $19,500 would represent just 3.9% of her annual earnings, making it challenging to save enough in her retirement account to replace her salary in retirement. By deferring some of her earnings to an NQDC, she could postpone paying income taxes on her earnings, enabling her to save a higher percentage of her income than is allowable under her 401(k) plan.
Savings in an NQDC are often deferred for five or 10 years, or until the employee reaches retirement. Source: Investopedia
Potential Benefits of NQ Deferred Comp:
For Participants:
- Income tax relief via unlimited pre-tax deferral of salary, bonuses, commissions, etc.
- Tax-deferred earnings on account balances
- A quality menu of diverse investment alternatives
- Enhanced planning flexibility for life-event purposes (college education, etc.), as well as retirement Schedule distributions without an early withdrawal penalty [10% in a 401(k)]
- All distributions are taxed as ordinary income to the participant and are tax deductible to the corporation
- Survivor benefits are taxed as ordinary income and are included in the participant’s estate and are tax-deductible to the corporation
For the Employer:
- Sponsor defines and controls eligibility to participate
- Employer controls the amount and vesting of employer contributions
- High-value recognition among HCEs
- Can supplement the qualified retirement plan
- The plan can be cost neutral to the employer
Click below to view a Non-Qualified Deferred Compensation presentation:
Non Qualified Deferred Comp Pres_1.pdf
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Disclosure: NQDCs are not without risk, and they’re not protected by the Employee Retirement Income Security Act (ERISA) like 401(k)s and 403(b)s are. If the company holding an employee’s NQDC declared bankruptcy or were sued, the employee’s assets would not be protected from the company’s creditors. An important point is that the money from NQDCs cannot be rolled over into an IRA or other retirement accounts after they’re paid out. Another consideration is that if tax rates are higher when the employee accesses their NQDC than they were when the employee earned the income, the employee's tax burden could increase. Lastly, there is a strict distribution schedule with no early withdrawal provisions.
Information presented on this site is for informational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any product or security. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed here.