What is a nonqualified deferred compensation plan?
A nonqualified deferred compensation plan (NQDC) typically refers to an agreement in which an employee consents to receive a withheld portion of salary as payments at a later point in time. The employee can decide how much to defer each year from salary, bonuses or other forms of compensation. Income tax is not paid on that portion of compensation until the employee receives that income. The payments made by the employer are not tax-deductible until distributed to the employee at a future date and are not limited to caps imposed on qualified (ERISA compliant) defined contribution or defined benefit plans.
Deferred compensation plans are typically available to senior management and highly compensated employees when the contribution limits on 401(k) plans are not adequate for those higher earners. It is also used as an employer contribution to reward employees if they remain with the Company for a period of time. The primary goal of most NQDC plans is to recruit, reward and retain top executive talent.
Provisions
- Eligibility – NQDC plans are not subject to discrimination and participation rules, so employers can decide to allow a few or even just one employee to participate in the plan.
- Contributions – NQDC plans are not subject to contribution limits, so employers can provide unlimited benefits to employees (subject to the IRS reasonable compensation requirement).
- Vesting – Matching contributions and discretionary employer contributions may be subject to a vesting schedule and can also be subject to forfeiture in certain cases of termination. This is often referred to as a “golden handcuff”.
- Distributions – Distributions are received as a lump-sum payment or annuity. NQDC plans can allow for in-service distributions.
- Earnings – Earnings in NQDC plans are generally credited based on (1) a flat interest rate (2) the earnings linked to a prime rate or other index or (3) the earnings reflecting the performance of specific investments selected by the employer and/or participant.
Plan Design Options
Plans can utilize designs and formulas that are available in company qualified retirement plans such as defined contribution or defined benefit and cash balance plans.
Establishing the NQDC Plan
Funded vs Unfunded
In a funded arrangement, assets are set aside in a trust or escrow account. In an unfunded arrangement, the employee simply has an employer’s “mere promise to pay” the deferred compensation benefits at a future time. Companies often fund their NQDC plans with a rabbi trust which protects the assets for the employees other than from creditors in a company bankruptcy.
The provisions in a nonqualified deferred compensation plan can allow for employer and/or employee contributions. Employer contributions can be established using a matching formula or on a discretionary basis.
Participant Directed vs Trustee Directed
In a participant directed account, the employees can direct the investments of their individual accounts. In a trustee directed account, the employer directs the investments for the plan and earnings are allocated pro rata based on participant account balances.
Valuation Mode: Daily, Quarterly, Annually
NQDC plan accounts can be valued on a daily, quarterly or annual basis to report the account balances of individual employees based on contributions, earnings, allocation formulas or benefit formulas as determined by the plan design and provisions.
Benefits of NQDC Plans
- Attract and retain top talent by offering key executives an employer-paid deferred compensation arrangement
- Provide deferred benefits beyond the limits allowed under qualified plans
- Provide an incentive for early retirement through participation in both a qualified retirement plan and nonqualified plan
- Avoid ERISA requirements (participation, vesting, funding, fiduciary responsibilities, distribution and reporting rules) that apply to qualified plans.
Disadvantages of NQDC Plans
- You can’t take loans from NQDC plans.
- The money from NQDC plans can’t be rolled over into an IRA or other retirement account when the compensation is paid.
- Assets in NQDC Plans may be subject to creditor claims if the Plan Sponsor files for bankruptcy. Other than a bankruptcy, all other claims to the assets can generally be protected thru the drafting of a Rabbi Trust to ‘hold’ the assets of the Plan.