A non-qualified deferred compensation plan is a program used by employers to compensate employees for services rendered, typically executives or other high-level employees, without paying taxes on the income until it’s received. It’s also known as a non-ERISA plan because it doesn’t fall under the Employee Retirement Income Security Act (ERISA). The Internal Revenue Service (IRS) regulates these types of plans, but they aren’t subject to the same rules as qualified plans like 401(k)s and 403(b)s.
Deferred compensation plans are an essential part of the compensation package for highly paid employees. They may receive additional income in a non-qualified deferred compensation plan (NQDC), which aims to defer payment until after retirement when it is taxed at lower rates. This article will help you learn how NDQC plans work.
Conditions of NQDC Plans
Here are some of the critical features or conditions of non-qualified deferred compensation plans:
The plan is in writing
A non-qualified deferred compensation plan must be written and meet certain specific requirements; otherwise, it will not be considered a plan for tax purposes. In addition, the plan must be approved by the company’s board of directors or equivalent governing body. The plan must be in writing and include the following:
- A description of the employer’s qualified NQDC plan, including the names of all employees covered by the plan.
- Each employee’s rights to benefits under the plan, including any vesting requirements.
- The terms governing payment or distribution of benefits (including any death or disability benefits).
The plan is funded
NQDC plans require contributions from both employer and employee. The number varies depending on which type of NQDC plan you choose. You may make a lump-sum contribution at the beginning of employment or make regular contributions throughout your employment. These contributions will be invested until you retire or leave employment.
The money goes into an account that an outside party manages
Non-qualified deferred compensation plans are usually operated by an outside financial institution such as a mutual fund or trust company. These institutions manage accounts for many companies and individuals, so they have experience managing these accounts consistently and adequately meet all government regulations and requirements.
The plan document(s) specifies the triggering event that will result in payment
An NQDC plan is an unfunded, nonqualified deferred compensation arrangement with a qualified employer. The employee’s account balance is not invested in any investments; it is simply a record of their right to receive future payments. The employee may not have actual access to the cash until retirement. For an employee’s NQDC to be paid out, there must be a triggering event that causes the money to be withdrawn from their account. These events are often related to specific events like termination or retirement, but some companies allow employees to take distributions at other times (such as when they become disabled).
The plan document(s) specifies the payment schedule
NQDC plans typically specify that payments will be made at specified intervals over time, such as monthly or annually. This can allow for more frequent distributions if you plan on early retirement or if your employer offers this as a benefits package option. Most plans require that distribution start no earlier than age 59½ and no later than age 65 (or later if you work past age 65). When an employee leaves an employer, they must receive their entire account balance before they can begin making withdrawals. The plan document specifies how much money an employee needs to have in their account before they are eligible for a distribution.
The plan document(s) specifies that at the time an amount is deferred
The maximum number of years that the amount may be deferred. Deferrals must be payable no later than two and one-half months after the close of the taxable year in which the employee dies, becomes disabled, or separates from service before age 65 with five or more years of service (or age 70 with 20 years of service). The minimum number of years that the amount must remain in the plan without regard to any other restrictions on withdrawals.
Separation from service
Employees can receive their accrued benefits under an NQDC plan upon separation from service. These may include interest or other earnings that have been credited on cash amounts deferred during employment. The timing of the distribution depends on whether there is a vesting schedule.
If there is no vesting schedule, the employee must wait until age 59 1/2 (or another specified age) before receiving any benefits. If there is a vesting schedule, employees may receive benefits before age 59 1/2 if they have met all vesting requirements (e.g., ten years of service). Suppose an employer makes distributions that are not permitted under law. In that case, they may face a penalty tax equal to 20% of the amount distributed plus interest on that amount at a rate equal to 110% of the federal short-term rate.
The plan document(s) specifies the amount to be paid
A company may decide to pay its executives in stock options or other forms of equity instead of salaries, but this is not considered deferred compensation. The amount must be stated to be identified as part of the agreement between the two parties.
A change in ownership or control of the company
For an arrangement to qualify as non-qualified deferred compensation, it must be established before any change in ownership or control occurs at your company (such as through acquisition). If a new owner comes on board and decides not to honor an existing deferred compensation arrangement, they could incur substantial penalties under Internal Revenue Code 409A (the “409A rules”).
