What Is a Non-Qualified Deferred Compensation Plan?

Non-qualified deferred compensation (NQDC) plans are contractual agreements between an employer and an employee. They stipulate that a portion of current income (e.g., salary or bonuses) will be paid at a future date or event. NQDC plans offer a flexible, tax-efficient method for highly compensated individuals to accumulate wealth beyond traditional qualified retirement plan limits. Employers use these plans to attract, retain, and incentivize key talent.

Defining Characteristics

Non-qualified deferred compensation plans are distinct from qualified plans (e.g., 401(k)s) as they are not subject to the regulatory framework of ERISA. This exemption allows employers flexibility in designing these plans. Unlike qualified plans, NQDC plans can be selectively offered to executives or highly compensated employees.

NQDC plans are “unfunded” for tax purposes. Assets set aside by an employer remain subject to general creditors’ claims. The employee is an unsecured general creditor, meaning deferred compensation might not be paid if the employer faces financial distress or bankruptcy. This impacts fund security compared to qualified plans, where assets are protected.

NQDC plans do not have federally mandated contribution limits. This allows high-income earners to defer more compensation than permissible in 401(k)s or similar qualified vehicles. While employers may impose their own limits, NQDC plans attract individuals who have maximized qualified retirement account contributions. Deferred compensation forms include voluntary salary, bonus, stock plan, and employer discretionary deferrals.

How Deferral Operates

A non-qualified deferred compensation plan begins with an employee’s deferral election. This election must occur before compensation is earned. For example, an employee might elect in December to defer salary or bonus earned the following year. This timing ensures tax-effective deferral and avoids “constructive receipt.”

Deferred compensation often becomes subject to a “substantial risk of forfeiture.” This means the employee’s right to funds is conditioned upon future services. For example, compensation might be forfeited if the employee leaves before a specified vesting period. A substantial risk of forfeiture prevents immediate taxation.

NQDC plan distributions are triggered by pre-determined events in the plan document. Common triggers include separation from service (e.g., retirement or termination) or a fixed date. Other events include a change in company control, death, or qualifying disability. The plan document binds the employer to pay deferred compensation upon these events, ensuring a structured payout.

Taxation Considerations

Taxation of NQDC plans differs for employees and employers compared to qualified plans. For employees, deferred compensation is generally not subject to federal income tax until received. This allows compensation to grow tax-deferred, beneficial if the employee anticipates a lower tax bracket at distribution (e.g., retirement). Social Security and Medicare taxes (FICA and FUTA) are typically due when compensation is earned, not when paid out.

To maintain tax-deferred status, NQDC plans must avoid “constructive receipt.” This occurs if an individual has an unrestricted right to income but chooses not to receive it, making it immediately taxable. NQDC plans prevent this by ensuring the employee lacks current access or control over funds until a specified future event or date. Plan terms must define payment schedule and triggering events to align with IRS regulations.

Internal Revenue Code Section 409A governs NQDC plans. It provides rules for deferral and distribution timing. It imposes strict requirements on deferral elections, distribution triggers, and payment acceleration. Failure to comply can result in immediate taxation of deferred amounts, plus penalties and interest for the employee.

For employers, the tax deduction for NQDC is generally allowed only when the employee includes compensation in their gross income. This means the employer’s deduction is often delayed until compensation is paid out. This timing difference impacts the employer, as they cannot deduct the expense in the year earned or deferred, but in a subsequent tax year when payment occurs. This requires careful tax planning, affecting their current taxable income and cash flow.

Common Plan Structures

NQDC plans manifest in various structures, designed to meet employer and employee objectives. One common form is the Supplemental Executive Retirement Plan (SERP), providing additional retirement income for executives beyond qualified plans. SERPs often promise a specific benefit at retirement, such as a percentage of final average salary, ensuring an income stream for executives facing qualified plan contribution limitations. These plans are customized and serve as a tool for executive retention.

Another NQDC structure is the Excess Benefit Plan. This plan provides benefits exceeding qualified plan limits under the Internal Revenue Code. For instance, if an executive’s compensation is too high for maximum 401(k) contributions, an Excess Benefit Plan can make up the difference, addressing statutory caps. These plans bridge the gap between what a highly compensated employee could save in a qualified plan and their desired savings.

NQDC plans can also incorporate equity-based compensation. Phantom stock plans grant employees hypothetical company shares, with payments (cash or shares) equivalent to their value at a future date or event. Stock Appreciation Rights (SARs) allow employees to receive cash equal to the appreciation in value of company shares over a set period. These equity-linked arrangements align employee interests with company performance, tying benefits to business growth.