Many companies use nonqualified deferred compensation plans to reward, retain, and attract executives and other highly compensated employees. These key employees are typically highly compensated and already contributing the maximum amount to the more traditional deferred compensation plans, for example their 401K plans and traditional IRAs. These Nonqualified Deferred Compensation Plans, or NQDC plans, aren’t like other workplace savings vehicles, which typically let employees defer a portion of their salary into a segregated account held in trust, and then invest these funds in a selection of investment options.
A nonqualified deferred compensation program is an unfunded, unsecured promise by the employer to a key employee to pay compensation at a specific time or upon a specific event in the future. The program is a contract between the employer and the key employee for the payment of these future benefits. The term “nonqualified” means that the plan is not required to meet most of the requirements of the Employee Retirement Income Security Act (ERISA) or the Internal Revenue Code that are imposed on tax-favored, or qualified, plans.
Often an NQDC plan is more like an agreement between you and your employer to defer a portion of your annual income until a specific date in the future. Depending on the plan, that date could be in 5 years, 10 years, or in retirement. Deferring this income provides one tax advantage: You don’t pay federal income tax on that portion of your compensation in the year you defer it (you pay only Social Security and Medicare taxes), so it has the potential to grow tax-deferred until you receive it.
There are four general types of nonqualified plans:
1.) Salary Reduction Arrangements
Employees choosing this type of NQDC plan choose to receive a portion of their earnings at a future time, reducing their current salary.
2.) Bonus deferral Plans
Employees participating in this type of NQDC defer income from bonuses to a future time.
3.) Supplemental Executive Retirement Plans
Covers a wide range of income deferring options that are typically used by a company’s upper level management or higher paid employees.
4.) Excess Benefit Plans
Employees participating in this type of NQDC plan are employees whose benefits are limited by their employer’s qualified plan.
These general descriptions encompass a litany of options for deferred compensation arrangements.
Nonqualified Top Hat Plans (THPs)
Employers offer THPs as a perk to certain employees who, in the words of the IRS, are “highly compensated.” The IRS defines this type of employee as one who owned more than 5 percent of a business in the current or preceding year, regardless of the employee’s actual compensation; or an employee who received more than $120,000 of compensation from the business during the preceding years of 2015 through 2018 (more than $125,000 if 2019 is the preceding year). There are generally three types of THPs:
1.) Golden Parachute Plan
In the event a company is taken over by another company, or merged with another company, a “golden parachute plan” offers top-level executives a lucrative benefits package if they’re terminated by the owners or managers of the newly formed company. Although it’s not specifically designated as a retirement plan, benefits from the golden parachute plan can certainly help fund an employee’s retirement, particularly if the employee is at or near retirement age.
2.) Golden Handshake Plan
A “golden handshake plan” is similar to the golden parachute plan, with a notable difference. Golden handshake plans do include specific retirement benefits in an executive’s severance package.
3.) Golden Handcuffs Plan
A company may want to hold on to a valuable, highly compensated employee for a long time. The “golden handcuffs plan” offers incentives to the employee that often carry a time constraint. For example, the employee benefits from stock options that vest only after the employee remains with the company for a certain number of years.
Tax consequences to the employer
The tax consequences to the employer are substantially different from qualified plans. Unlike qualified plans, contributions to a nonqualified deferred compensation plan are not a currently deductible expense to the corporation. Corporations may only obtain a deduction from the plan at the point when the key employee is subject to tax on the benefits due to actual or constructive receipt. What’s more, if any funding amounts are informally set aside, the employer is generally subject to taxation on any investment earnings generated by those assets. Thus, interest, dividends, and realized gains or losses on any investments would generally be taxable income to the employer.
Rules and Risks of an NQDC
Employees face one major risk when accepting deferred compensation via an NQDC. Unlike with a 401k or other items where the funds are held in a separate trust, NQDCs are held in the general assets of the company. The means that if the company is sued or goes out of business, this compensation may not ultimately be paid. NQDCs have a strict distribution schedule rather than at will as with qualified plans, and have no early withdrawal provisions.
A deferred compensation plan for key employees is often a cost-effective, flexible, and powerful tool to provide appropriate incentives and rewards and encourage the retention of valuable leaders within the organization. With the right design and careful implementation, a nonqualified deferred compensation arrangement can help achieve many organization objectives.