Taxation of Nonqualified Deferred Compensation Plans

Some companies offer employees the opportunity to defer part of their wages until after retirement, using what’s called a nonqualified deferred compensation plan (NQDC). The plan may be offered in addition to or in place of a qualified retirement plan, such as a 401(k) plan.

The plans are typically offered as a type of bonus to top-level executives, who can maximize their allowable contributions to the company’s qualified retirement plan. Under an NQDC plan, both the compensation and the taxes due on it are deferred until a later date.

If you’re considering these types of retirement options, you need to understand how you’ll be taxed on that money and any profits it generates in coming years.

Key Takeaways

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

How NQDC plans are taxed

All salaries, bonuses, commissions and other compensation you receive under a NQDC plan are not taxed in the year in which you earn them. The deferral amount can be noted on the Form W-2 you receive for that year.

Beware of early withdrawals. The penalties are severe.

You will be taxed on the compensation when you actually receive it. This should be some time after you retire, unless you meet the rules for another trigger event allowed under the plan, such as a disability. The payment of the deferred compensation is reported on a Form W-2, even if you are no longer an employee at that time.

You will also be taxed on the income you receive from your deferral when it is paid out to you. The return is determined in the terms of the plan. For example, it may correspond to the return on the S&P 500 index.

Compensation in shares or options

When the fee is payable in stock and stock optionsspecial tax rules apply. In such cases, taxes are not due until you can sell or give away the shares or options at your own discretion.

However, you may want to report this compensation immediately. The IRS calls this a Section 83(b) election. This now allows the recipient to report the value of the property as income (unlike when the stock or options are). acquired), whereby all future increases in value grow into capital gains that can be taxed at a relatively favorable tax rate.

If you do not make the Section 83(b) election, you will owe taxes on the property and its appreciation when it is received. However, if you choose, you give up the ability to deduct any future losses if the asset declines in value.

The IRS has a sample Form 83(b). which can be used to report this compensation currently rather than deferring it.

Tax Penalties for Early Distributions

There are serious tax consequences if you withdraw money from an NQDC plan before retirement or if no other acceptable “trigger event” has occurred.

You will be taxed immediately on all deferred payments under the scheme, even if you have only received part of it.
The tax penalty for overpayments and underpayments is 8% for the fourth quarter of 2024, although companies must pay 7% for overpayments.

NQDC plans are sometimes called 409(a) plans, after the section of the U.S. tax code that regulates them.

How this affects FICA taxes

The Social Security and Medicare tax (FICA on your W-2) will be paid as compensation when it is earned, even if you choose to defer it.

This can be a good thing because of Social Security’s wage cap. Take this example: your compensation is €180,000 and you have chosen in a timely manner to defer another €25,000. For the 2024 tax year, income covered by the Social Security portion of FICA is limited to $168,600.

So $36,400 ($180,000 – $168,600 + $25,000) in total compensation for the year is not subject to the FICA tax. For the 2025 tax year, income covered by the Social Security portion of FICA is limited to $176,100, so $28,900 would be exempt if you don’t get a raise.

When the deferred compensation is paid out, such as upon retirement, no FICA tax is withheld.

NQDC Plans vs. 401(k)s

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

Another crucial difference lies in the contribution limits imposed on each plan. NQDC plans offer more flexibility because participants can defer a portion of their salaries or bonuses without the strict annual limits imposed on 401(k) plans.

This flexibility is intended to work with people who earn a lot and want to defer larger portions of what they earn. On the other hand, 401(k) plans adhere to the IRS set contribution limitsmeaning everyone has the same limit on how much they can contribute each year.

The tax treatment is another important difference between the two. NQDC plans allow participants to defer income taxes on their contributions. This can be a crucial advantage, as these high earners may have lower earnings tax brackets in the future.

Meanwhile, 401(k) plans offer immediate tax benefits by allowing participants to make pre-tax contributions. Keep in mind that you can create after-tax 401(k) plans to grow certain income tax-free.

Finally, there are some differences in supervision between the two. NQDC plans, without ERISA regulations, allow employers to be more flexible. Unfortunately, this provides less protection for participants. 401(k) plans are subject to ERISA regulations, so there are certain reporting and disclosure standards in place to protect the people who use the plan.

Is it worth it?

A non-qualified deferred compensation plan, if one is available to you, can provide a significant benefit in the long run. You invest money for your future while deferring taxes due on your income. That should give you greater profit accrual. However, the day of reckoning comes when you start collecting your deferred compensation. Just be prepared for the impact when it hits.

What is an example of a non-qualified compensation plan?

Nonqualified compensation plans pay deferred income, such as supplemental executive retirement plans and split-dollar plans, in addition to a regular salary. These types of plans are usually offered to upper management. They can be provided in addition to or instead of 401(k)s.

Are Non-Qualified Deferred Compensation Plans a Good Idea?

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

However, the deferred amount does not provide the benefits of qualified deferred compensation plans, such as the ability to take out loans against them or roll the money into an IRA.

There is also a risk that you could lose all of the amount you set aside without getting anything back. This could happen, for example, if the deferred compensation is in stock options and the company goes under.

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

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

Non-qualified plans are more restrictive. They are typically only offered to a few high-level employees. They are also tax efficient, but do not necessarily need to be invested immediately. There is a risk that you may lose the entire deferred amount.

The bottom line

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

The amount an employee chooses to defer reduces his taxable income, and the deferred amount is not taxed until he receives the money, usually in retirement. These types of plans are more complicated than traditional retirement plans, and the employees who offer them must carefully understand the terms before participating.