Taxation of Nonqualified Deferred Compensation Plans

Some companies offer employees the opportunity to defer a portion of their salary until retirement using what is called a non-qualified deferred compensation (NQDC) plan. The plan may be offered in addition to or instead of a qualified retirement plan, such as a pension plan. 401(k) plan.

The plans are typically offered as a bonus to senior executives who can maximize their allowable contributions to a company pension plan. With an NQDC plan, both compensation and taxes due on it are deferred to a later date.

If you’re considering this type of retirement, you need to understand how you’ll be taxed on that money and any profits it generates in the years ahead.

Key Findings

An NQDC plan defers a portion of your salary and the taxes due on it until a later date, usually after retirement.
Such plans are usually offered to senior executives as an additional incentive.
Unlike income taxes, FICA taxes are paid in the year the money is earned.

How NQDC plans are taxed

Any salary, bonuses, commissions and other compensation that you agree to defer in accordance with NQDC plan are not taxed in the year in which you earn it. The deferral amount can be recorded on the W-2 form you receive for the year.

Beware of early withdrawals. The punishments are severe.

You will be taxed on compensation when you actually receive it. This must occur some time after your retirement, unless you meet the rules for another trigger event allowed by the plan, such as disability. Payment of deferred compensation will be reported on Form W-2, even if you are no longer an employee at that time.

You are also taxed on the earnings you receive from deferments when they are paid out to you. The level of profitability is fixed by the terms of the plan. For example, it may correspond to the rate of return on S&P 500 Index.

Compensation by shares or options

When compensation is paid in the form of shares and stock optionsspecial tax rules come into force. In such cases, taxes will not be due until you are able to sell or surrender the shares or options at your option.

However, you can report this compensation immediately. The IRS calls this a Section 83(b) election. This allows the recipient to report the value of the property as income now (as opposed to when the shares or options are sold). endowed), with all future appreciation being converted into capital gains, which may be taxed at a relatively favorable tax rate.

Unless you make a Section 83(b) election, you will be required to pay property taxes and assessments on the property when you receive it. However, if you make the election, you will give up the ability to deduct any future losses if the value declines.

The IRS has a sample Form 83(b). this can be used to communicate this compensation now rather than delaying it.

Tax penalties for early distribution

If you withdraw money from an NQDC plan before retirement or when no other eligible “trigger event” has occurred, there may be severe tax consequences.

You are immediately taxed on all deferrals taken under the plan, even if you only took part of it.
The tax penalty for overpayments and underpayments for the fourth quarter of 2024 is 8%, although corporations are charged 7% for overpayments.

NQDC plans are sometimes called 409(a) plans, named after the section of the Internal Revenue Code that governs them.

How does this affect FICA taxes?

Social Security and Medicare tax (FICA on your Form W-2) is paid as compensation as it is received, even if you choose to defer it.

This may be a good thing because of the Social Security wage cap. Let’s take this example: Your compensation is $180,000, and you make a timely decision to set aside another $25,000. For the 2024 tax year, income eligible for the Social Security portion of FICA is limited to $168,600.

Therefore, $36,400 ($180,000 – $168,600 + $25,000) of total compensation for the year is not subject to FICA tax. For the 2025 tax year, income eligible for the Social Security portion of FICA is capped at $176,100, so $28,900 will be tax-free unless you get a raise.

When deferred compensation is paid, say at retirement, no FICA tax will be deducted.

NQDC Plans vs. 401(k)s

You’ll likely end up contributing to an NQDC plan or 401(k) plan. The two plans differ significantly in terms of participant eligibility and contribution limits. NQDC plans are typically offered to a select group of highly compensated employees, while 401(k) plans are designed to be more inclusive and open to more employees.

Another important difference is the contribution limits imposed on each plan. NQDC plans provide greater flexibility because participants can defer a portion of their salary or bonuses without the strict annual limits imposed on 401(k) plans.

This flexibility is designed to work in tandem with high-income individuals who want to save more of what they earn. On the other hand, 401(k) plans are IRS compliant. contribution limitsThis means everyone has the same limit on how much they can contribute each year.

Tax treatment is another key difference between the two. In NQDC plans, participants can defer income taxes on their contributions. This can be a decisive advantage as these high-income people can expect to be in lower strata of the population. tax categories in the future.

Meanwhile, 401(k) plans offer immediate tax benefits by allowing participants to make pre-tax contributions. Note that you can set up an after-tax 401(k) plan to allow certain earnings to grow tax-free.

Finally, there are some differences in regulatory oversight between them. NQDC plans, which are free of ERISA regulation, mean employers can have more flexibility. Unfortunately, this provides less protection to participants. 401(k) plans are subject to ERISA rules, so there are certain reporting and disclosure standards to protect people using the plan.

Is it worth it?

A non-qualified deferred compensation plan, if available to you, can provide significant benefits in the long run. You’re investing in your future while deferring taxes on your income. This should bring you more income. However, the day of reckoning will come when you start receiving deferred compensation. Just be ready to hit when it hits.

What is an example of a compensation plan for unskilled workers?

Non-qualified compensation plans pay deferred income, such as supplemental executive pension plans and dollar-sharing agreements, in addition to regular salary. These types of plans are most often offered to senior management. They may be provided in addition to or instead of a 401(k).

Are non-qualified deferred compensation plans a good idea?

Non-qualified deferred compensation plans are a great bonus, but they come with risks. Part of an employee’s salary salary is postponed to a later date. This reduces the taxes paid that year, which is a benefit.

However, the deferred amount does not provide some of the benefits of qualified deferred compensation plans, such as the ability to borrow against them or roll over funds into an IRA.

There is also a risk that the amount you have set aside will be completely lost without repayment. This could happen, say, if deferred compensation is granted in the form of stock options and the company goes bankrupt.

What is the difference between qualified and non-qualified plans?

Qualified plans, such as 401(k)s, provide investors with a tax-advantaged retirement account. Money is invested and grows over time. The account can be transferred from employer to employer.

Non-qualified plans are more restrictive. They are usually only offered to certain senior employees. They also have tax advantages, but don’t necessarily invest right away. There is a risk of losing the entire deferred amount.

Bottom line

Nonqualified deferred compensation plans are offered to individual employees as a benefit in addition to traditional qualified deferred compensation plans such as 401(k)s.

The amount a worker chooses to save reduces his taxable income, and the amount deferred is not taxed until he receives the funds, usually in retirement. These types of plans are more complex than traditional pension plans, and employees offered them should carefully review their terms and conditions before participating.