What Is Nonqualified Deferred Compensation?
A nonqualified deferred compensation plan (NQDCP), sometimes referred to as a Section 409A Plan, allows highly compensated employees to earn their salary one year and receive it at a future date. The advantage of this is that the employee does not pay income tax on the compensation until it’s received.A nonqualified plan differs from a qualified plan in that it does not need to be offered to the entire company. Typically, a company only offers nonqualified plans to its key executives. An NQDCP is a contractual agreement between employers and executives that can be formal or informal, but it must be in writing. In many plans, the agreement is in the form of an extensive plan document, but in some cases the plan details are included in the employment contract. These details include what triggering events cause the benefit payment, the payment terms and the requirements the executive must meet in order to be paid.
Nonqualified deferred compensation arrangements typically fall into three categories:
- Salary Reduction / Bonus Deferral Plans
These arrangements allow employees to defer part of their salary or a bonus to a different year. For example, an employee earns $250,000 in the current year and wants to defer $50,000 until retirement. The employee would receive and only owe taxes on $200,000 in the current year. They would not owe taxes on the $50,000 that they defer, or on the earnings, until they receive it later.
- Supplemental Executive Retirement Plans
These arrangements allow companies to contribute an amount to a nonqualified retirement plan for the benefit of a key executive. When the executive retires, they can access their deferred compensation if they have fulfilled certain conditions mapped out in the agreement.
- Excess Benefit / Restoration Plans
These arrangements are designed for employees who participate in a qualified benefit plan, with their contributions or benefits affected by qualified plan limits. Examples of these limits include the compensation limit, annual contribution limit, deferral limit, limits due to nondiscrimination testing and other limits that affect the amounts that the executive or the company may contribute to a qualified plan or the benefit the executive will receive. These nonqualified plans restore the limits imposed on the qualified plan and can allow the company or the executive to contribute more than their qualified plans would allow.
Advantages of a Nonqualified Benefit Plan
In our first issue of the 2018 SilverLink, we covered the Tax Cuts and Jobs Act (enacted by Congress on December 20, 2017) and how it will impact nonqualified deferred compensation. The article, “Tax Cuts and Jobs Act’s Effect on Nonqualified Deferred Compensation,” discusses the advantages of nonqualified deferred compensation for both employees and employers. It explains that many people will continue to pay high tax rates, so it can be advantageous to defer compensation and delay income taxes on that money. The cost of offering an NQDCP is less due to the maximum corporate tax rates dropping from 35% to 21%, making it a more attractive option for employers. The article ultimately conveys that in light of the Tax Cuts and Jobs Act, NQDCPs are a win-win for both the employer and the employee.
While keeping this SilverLink article in mind, we’d like to discuss some additional reasons why nonqualified deferred compensation can be beneficial to both employers and employees.
For the Executive
As previously stated, one of the more attractive benefits to the executive is that deferring compensation also defers the income tax obligation until they receive it in the future. This allows the full amount of the deferred compensation and earnings on it to grow on a tax-deferred basis. This helps the executive accumulate more wealth than they could have had they paid tax on the income and invested the after-tax amount.
Another benefit is the use of NQDCPs as a retirement planning tool. The company may contribute to a nonqualified plan or the executive may defer additional compensation. The contributions and earnings can grow tax deferred until retirement, and the executive can use this to supplement their retirement income.
For the Employer
An NQDCP can help with employee retention. Depending on the plan design, it can act as a “golden handcuff.” When a company contributes to an NQDCP, they can limit the executive’s access to the compensation until a triggering event occurs (as specified in the written agreement). If the employee breaks any condition in the agreement or leaves the business prior to a triggering event, they forfeit the deferred compensation that is attributable to the company’s contribution.
In today’s competitive employment market, executives are looking beyond the salary and focusing on total compensation, which includes benefits such as health and welfare plans, vacation / time off and qualifiednonq retirement benefits. An NQDCP is an additional benefit that an employer can offer to an employee for a low cost (especially with the change in corporate tax rates), which could provide a competitive edge in the hiring market.
This article originally appeared in the 2018 | ISSUE TWO of the SilverLink magazine, under the title “More Appealing Than Ever Before? | Nonqualified Deferred Compensation” To receive a complimentary subscription to the SilverLink magazine, sign up here.