Non-Qualified Deferred Compensation (NQDC)

What is Non-Qualified Deferred Compensation (NQDC)?

A non-qualified deferred compensation plan is an agreement between employees and employers to pay compensation at some time in the future. Employers can defer compensation and pay it off at a later date rather than paying it off immediately.

Generally, employers offer bonuses, salaries, and other forms of compensation to attract and retain highly qualified employees and key executives. However, under NDQC, employers can defer payments and distribute the compensation later. It is also known as 409(a) plans.

Employees can determine how much of their annual income they wish to postpone from their wages each year. Once the compensation is delayed, the tax due on this additional income is also delayed and must be paid once employees get paid.

Throughout this plan, most employees put off getting paid until retirement, when they are likely to have a lower tax rate. Employees taking full advantage of their qualifying plans, such as 401(k) plans, might consider NQDCs.

Employers can construct Ndqs at any moment, typically included in job offers or as retention or performance incentives. Additionally, NQDCs can help restore benefits that have been reduced or lost due to IRS laws and restrictions.

Plan distributions can be structured in various ways, including payments over a defined period and lump sum payments. Along with salaries, equity and bonuses are also subject to customization, which means a company can design a plan for a single employee.

In the process of delaying the distribution of compensations, the tax on this income is also deferred. NQDCs are particularly advantageous for individuals who have already contributed the maximum amount to qualified plans, such as 401(k)s.

Unlike 401(k)s, NQDCs do not have contribution restrictions, which makes them even more attractive to high-earning individuals who are likely to reach the contribution limit of an employer-sponsored qualified retirement plan.

How NQDC Plans Work

NQDC plans are not suitable for everyone, so it is essential to understand how these plans operate and how they can fit into your overall financial strategy before enrolling in this plan.

This kind of plan has the potential for tax-deferred growth. Still, they also carry significant risks, including the danger of total loss of your non-qualified deferred compensation plan's assets.

It is essential to consider whether participation makes sense based on your financial situation. For example, participating in this plan because you want to save more for retirement may be worthless if you're not contributing the annual maximum to your 401(k).

You must follow particular laws when establishing a this compensation plan for your employees.

IRS Section 409A specifies the guidelines for this compensation arrangements. For example, it isn’t allowed to verbally agree with employees to defer their pay until later.

To create this plan, you must prepare the following:

1. Put a plan in writing format

Consider this writing plan as a contract with your employee. The plan document includes the deferred amount, payment schedules, and triggering events.

Triggering events include but are not limited to retirement, death, termination, a fixed date, a change in business ownership, and an unforeseeable emergency.

2. Determine plan restrictions or exclusions 

Specify any requirements your employee must meet to obtain payment. For example, non-qualified deferred compensation plans prohibit employees from working for a competitor after retirement.

Although these plans offer several unique benefits, there are vital things to remember, including the following:

1. The main one is that any contributions made by the business to a plan are not tax deductible until the employee is paid. So that might have an impact on some business tax planning.
2. The deferred payments under the schemes are unsecured and not guaranteed, which means there is an inherent risk for the employees. For example, employees might not get the money they were promised if the company files for bankruptcy and faces creditor demands.
3. The type of investments associated with your non-qualified deferred compensation plan is something to consider. For example, you might not need an NQDC plan if the investment alternatives are the same as those provided by your 401(k).

Advantages of NQDC Plans

This compensation plan has a lot of advantages for employers and employees, but it also has major risks. That’s why it is essential to know how it works and how it might fit into your entire financial strategy.

For employers, this compensation plan offered the following benefits:

1. Flexibility

Employers can choose which executives or highly paid workers can participate in this plan. They are not required to make this plan available to every employee because there are no non-discrimination laws.

2. Small management fees

There are small upfront expenses to establish an NQDC plan in companies and are no ongoing administrative fees.

3. Cash flow growth

The money your firm earns can be utilized for other investments because it does not have to be used immediately to pay your employees.

For employees, this plan offered the following benefits:

1. No limit to the contribution plan

There is no annual limit on the amount employees can contribute to a non-qualified deferred compensation plan. On the other hand, IRS determine limits on how much employees can contribute to their 401(k) every year.

2. Tax advantages

Any payment that can be postponed lowers your taxable income annually. In addition, this may move you into a lower tax bracket, lowering your annual tax obligation even further. 

3. Investment options

This plan offers various investment options, such as stock options and mutual funds. It also allows employees to invest on a larger scale, potentially increasing the probability of profit growth.

Disadvantages of NQDC Plans

There are some disadvantages for employees who participate in this plan, such as:

1. Strict schedule (funds withdrawing)

Employees can withdraw money from a non-qualified deferred compensation plan only on a specific date. Employees must take the fund on the scheduled date, meaning they cannot take money out once they need it.

In contrast to 401(k)s and other eligible retirement plans, they cannot withdraw early.

2. No fund protection

There is an inherent risk for employees because ERISA does not guarantee the compensation payments. As a result, if the company declares bankruptcy and is forced to pay off creditors, the employees may not receive the promised compensation.

Can I afford to lose the deferred compensation? 

You must understand the dangers associated with NQDC programs. If the company is approaching bankruptcy, it may need to use deferred income. You should be okay with not receiving their deferred compensation if this occurs.

Consider the issues included in the previous questions and consult with your tax and financial experts. Then, you might be able to determine whether or not an NQDC plan would be a good fit for the requirements of your financial situation.

All parties involved in a non-qualified deferred compensation arrangement, including employers and employees, should be well-versed in its details.

It is in the company's and its employees' best interest for the company to take the initiative to ensure that its employees fully comprehend its plans. Companies can offer employees some education sessions around offering these plans.

Companies can educate their employees in the following aspects:

• Assisting workers in making informed decisions about when and how to access delayed pay.
• Informing workers of the potential downsides of taking part in such programs.
• Making tools available for financial planning can help workers evaluate non-qualified compensation in the context of their overall financial plans.
• Examining potential differences between qualified retirement plan investments and non-qualified ones.
• Maintaining employee knowledge and interest in their NQDC plans through annual updates and online tools.

NQDC Vs. 401(k) Plans

Non-qualified deferred compensation and 401 (k) plans allow employees to defer a portion of their annual salary until a future date for their retirement.

NQDC plans don’t set limits on the contribution to the retirement plan. On the other hand, the 401 (k) plan limits the contribution amount, so highly paid employees like executives do not use it.

For example, John is the CEO of a company with an annual salary of $700,000. John will like to avoid 401 (k) plans as the maximum contribution for 2022 is 20,500 of the annual salary. This is 2.92% of John’s annual salary, which is a very minimal contribution.

So John would like to go with Non-Qualified Deferred Compensation as it doesn’t set limits on contributions and hence has a better retirement plan, which means that NQDC is an attractive option for high-paid employees because NDCP isn’t subject to limitations in contribution and participation.

However, The risks associated with NQDC plans are often higher than those of 401 (k). A 401(k) plan's trust account is safe against creditors.

These compensation plans typically contain an unfunded, unsecured promise to pay benefits later, with the promise's fulfillment occasionally relying on the company's performance.

The money in this trust (NQDC) is a part of the business's overall assets, which means it would be vulnerable to creditors' demands in bankruptcy.

Non-qualified plans aren't just about retirement savings. For shorter-term goals like financing a child's college tuition, you can delay compensation by scheduling distributions throughout your career rather than just when you retire.

Researched and authored by Khadega Bazarah | Linkedin

Reviewed and edited by Parul Gupta | LinkedIn

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