Nonqualified deferred compensation (NQDC) plans are used by business owners, executives, and highly-compensated employees as a way to save for retirement while reducing their income tax liability.
IRS code 409A is the tax law that regulates NQDC plans. In today’s post, I’ll outline the important requirements in 409A and help you decide if a NQDC plan is a smart option for you.
What is a nonqualified deferred compensation (NQDC) plan?
NQDC plans allow employees and contractors to defer some of their compensation to a later date, which is usually retirement. Typical NQDC plans include:
- Salary Reduction Arrangements: This is when an employer and employee or a service provider and recipient agree that a portion of the salary owed won’t be paid out until a later date.
- Bonus Deferral Plans: This allows the employee or recipient to agree to defer receiving bonus money to a later date.
- Top-Hat Plans or Supplemental Executive Retirement Plans (SERPs): These compensation deferral plans are specific to a select group of management or highly-compensated employees.
- Excess Benefit Plans: These plans are created to defer the payment of benefits that would exceed the annual amount for contribution limits for other types of retirement plans.
- Stock Options and Equity Awards: These plans are typically created to defer the payment of compensation coming from stocks and may include certain timing provisions.
- Severance Packages: A severance agreement can also allow for deferred compensation such as a continuation of salary or bonuses.
NQDC plans are usually only offered to high-earners and they can be used in place of or in addition to another retirement plan, such as a 401(k). Typically, businesses use NQDC plans as a bonus to attract or retain executives who have maxed out their contributions to other retirement accounts.
An NQDC plan can also have a distribution schedule that allows you to pick deferral dates that make sense for you. For instance, you might schedule a distribution date around the same time you know you’ll be paying for your child’s college tuition.
How does a NQDC save tax money?
An NQDC plan allows you to hold off on paying income taxes owed on the deferred compensation. In other words, when you take your distributions out of your account at retirement or other agreed upon date, you’ll pay income taxes on that money. You’ll also pay taxes on any earnings you have on that money. Since you’ll likely be in a lower tax bracket when you retire than you are during your working years, delaying income taxes until that time can account for a huge tax-savings.
One thing to note is that you will pay FICA (Social Security and Medicare) taxes on the deferred compensation amount in the tax year that you earned the income. However, even though it’s usually better to hold off on paying income taxes until you’re retired, it’s actually better to pay FICA taxes now because there is a cap on how much income is used to calculate the tax. Translation: If you’re a high earner, you probably won’t pay any more in FICA taxes than you already are.
What’s the difference between a NQDC plan and a 401(k) plan?
Although both a NQDC plan and a traditional 401(k) plan are funded with pre-tax dollars (you don’t pay income tax until you take distributions), there are some differences between the two types of plans:
- NQDC plans do not have annual contribution limits.
- You can’t take early distributions or loans from NQDC plans.
- You can’t roll NQDC plan money into an IRA or other retirement account.
- 401(k) plans have more regulations that act as safeguards for plan participants (IRS code 409A serves to protect the government’s tax dollars and not necessarily safeguard your money).
What does IRS code 409A say?
The Internal Revenue Code that deals with NQDC plans is section 409A. This tax code was enacted in 2004 to help regulate the way deferred compensation is structured, reported, and taxed. The main requirements laid out in the code are:
- Timing of Election: Code 409A generally requires that deferral elections must be made prior to the tax year when the compensation will be earned. In other words, they don’t want people waiting until the end of the year and deciding on deferring the money at that point.
- Timing of Distribution: The code also outlines when deferred compensation should be distributed. Basically, you need to choose a fixed date(s) or event, such as retirement. The code also allows for unforeseen circumstances to trigger the distribution, such as disability or losing your job.
- Noncompliance Penalties: The code also states that if you aren’t in compliance with the other requirements laid out in 409A, the IRS is allowed to impose significant penalties. These can include immediate taxation of any deferred amount plus an additional 20% federal income tax and possible interest charges on that amount.
- Exemptions and Exceptions: There are certain types of compensation arrangements that are exempt from code 409A, such as certain types of retirement plans and certain short-term deferrals. There are also exceptions for some types of emergency distributions and some equity-based stock compensation.
What are the risks of an NQDC plan?
The biggest risk associated with having an NQDC plan is that the compensation amount that you’ve deferred basically belongs to the company or employer while you’re waiting for the agreed upon deferral date. This means that if the company goes bankrupt, that money can be claimed by creditors. It also means that you’re putting a lot of trust into the company. You’re trusting that they will take care of your money and abide by their agreement now and in the future.
Abridged by Amy
A nonqualified deferred compensation arrangement can be a smart way for high-earners to plan for their retirement while maximizing their tax savings. However, before agreeing to a NQDC plan, it’s wise to consult a certified public accountant who can ensure that the plan agreement doesn’t violate IRS code 409A. Remember that the tax penalties for 409A violations can be very costly!
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