How Non-Qualified Deferred Compensation Plans Work

A non-qualified deferred compensation (NQDC) plan is a contractual arrangement between an employer and an employee to pay compensation in a future year. These plans are a method for companies to attract, retain, and reward key employees, primarily executives and highly compensated individuals. An NQDC plan allows participants to set aside significant portions of their income, such as salary and bonuses, deferring the income tax liability until payment.

Unlike qualified retirement plans like a 401(k), NQDC plans are not required to follow the participation and non-discrimination rules of the Employee Retirement Income Security Act (ERISA). This allows employers to be selective in who they offer the plan to, tailoring benefits to specific individuals. The flexibility of NQDC plans provides a supplemental retirement savings vehicle beyond the contribution limits of qualified plans.

Core Mechanics of NQDC Plans

The operation of a non-qualified deferred compensation plan is defined in a formal plan document. It begins with a deferral election, where a participating employee makes an irrevocable decision to forgo receiving a portion of their future compensation. This election must be made before the compensation is earned, adhering to specific timing rules.

Once deferred, the employee’s account is credited with notional earnings as if the amount were invested. The employee selects investment options from a menu of choices that mirror publicly available mutual funds. These are phantom investments; the employer is not actually purchasing these securities on the employee’s behalf, but rather using them as a benchmark to calculate the growth of the deferred balance.

The final phase is the distribution of the accumulated funds. The total balance is paid out to the employee according to the terms established in the initial deferral agreement. The payment can be structured as a lump sum or as a series of installments over several years.

Common Types of NQDC Plans

Salary and bonus deferral plans function like a 401(k) without the contribution limits. In these arrangements, executives or key employees elect to defer a percentage of their base salary or annual bonus. This allows them to postpone income taxes and accumulate wealth on a tax-deferred basis.

Another form is the Supplemental Executive Retirement Plan, commonly known as a SERP. Unlike elective deferral plans, SERPs are funded entirely by the employer. They are designed to provide retirement benefits to executives above the limits imposed on qualified plans. The benefit formula for a SERP aims to replace a certain percentage of an executive’s final pay.

Phantom stock and Stock Appreciation Rights (SARs) are NQDC plans tied to company performance. A phantom stock plan grants an employee hypothetical shares of company stock, and after a vesting period, the employee receives a cash payment equal to the stock’s value. SARs provide a cash payment equal to the increase in the company’s stock price over a specified period, rewarding appreciation in value without diluting equity.

Key Regulatory Framework

The primary rules governing NQDC plans are in Internal Revenue Code Section 409A. This regulation imposes a strict framework on the timing of deferral elections and distributions to ensure the employee does not have undue control over the timing of compensation. Failure to comply with Section 409A results in severe tax consequences.

Section 409A regulates deferral elections. An employee must elect to defer compensation in the calendar year before the year the services are performed. For example, to defer a bonus earned in 2026, the election must be made by December 31, 2025. There are narrow exceptions for new participants or certain performance-based compensation.

Section 409A also defines the limited circumstances under which deferred compensation can be paid. The plan document must specify the payment timing and form at the time of deferral. Permissible distribution events are:

• Separation from service
• Disability
• Death
• A specified time or fixed schedule set at the time of deferral
• A change in control of the corporation
• An unforeseeable emergency

Once a payment schedule is established, Section 409A prohibits the acceleration of payments, with very few exceptions. Any violation of these rules—whether related to the initial election, the payment trigger, or the payment schedule—taints the plan. The consequence of a failure is immediate income taxation on all vested deferred amounts, plus an additional 20% penalty tax and potential interest penalties for the employee.

Taxation for Employees and Employers

For a compliant NQDC plan, the deferred amounts and any credited earnings are not included in the employee’s gross income until the year they are received. The employee pays federal and most state income taxes only when the money is paid out, which could be during retirement when their tax rate may be lower.

A special timing rule applies to Federal Insurance Contributions Act (FICA) taxes for Social Security and Medicare. FICA taxes are due when the services are performed or when the compensation vests, whichever is later. This means FICA taxes are often payable in the year an amount vests, even if the cash is not paid until years later, sometimes requiring a cash bonus to cover the tax liability.

The employer is entitled to claim a tax deduction for the compensation paid in the same year that the employee includes it in their taxable income. This creates a matching principle, as the employer cannot deduct the expense when it is earned or deferred, but only when it is paid.

Funding and Creditor Protection

NQDC plans are legally considered “unfunded,” meaning the employee has no right to any specific employer assets. The deferred compensation is a promise to pay from the company’s general assets, making the employee an unsecured general creditor. This structure is necessary to achieve tax deferral for the employee.

To provide employees with some security, many employers use a Rabbi Trust. The employer contributes to this trust to informally fund future NQDC obligations. The trust’s assets are segregated from the company’s general operating accounts and are protected from a change of heart by management or a change in company control.

The assets held within a Rabbi Trust remain subject to the claims of the employer’s general creditors in the event of insolvency or bankruptcy. This provision is what prevents the employee from being in constructive receipt of the income, preserving the plan’s tax-deferred status. While the trust offers security against the company’s unwillingness to pay, it offers no protection against its inability to pay, representing the fundamental risk an employee accepts in an NQDC arrangement.