- Nonqualified deferred compensation plans provide a way for high-income earners to set money aside above the IRS’s annual limit.
- Qualified plans follow ERISA regulations, while nonqualified plans use an agreement drafted by the plan issuer.
- Both nonqualified and qualified plans must meet IRS regulations.
If you’ve ever done your own income taxes, you may have noticed the term “deferred compensation plan” on the W-2 form your employer provides. Maybe you haven’t even noticed it, especially if it’s never applied to you.
In case you’ve ever wondered, “What is deferred compensation?,” it’s a tax term. It refers to an agreement between an employer and an employee or service provider that puts payment off, or defers it, to a future date. This allows the employee or service provider to delay paying taxes until the next year. Here are some basics to help you determine if a nonqualified deferred compensation plan is right for you.
Understanding Nonqualified Deferred Compensation (NQDC)
You’ve probably participated in a deferred compensation program without even realizing it. A 401(k) plan is what’s known as a qualified deferred compensation program. Some types of IRA plans, salary agreements, and excess benefits programs are considered qualified deferred compensation plans.
Although a nonqualified deferred compensation plan (NQDC) operates similarly, qualified plans fall under the Employee Retirement Income Security Act of 1974 (ERISA), while nonqualified plans do not. Typically, NQDCs are offered to executives and other key employees when qualified plans can’t satisfy their needs. In addition, some public NQDC plans are available for certain state government, local government and non-governmental tax-exempt entities under IRC Section 501 such as religious institutions and charitable organizations.
NQDCs, sometimes referred to as 409(a) plans, can be in the form of a retirement savings plan or stock options. It can also simply be an agreement to pay you at a later date. In many cases, employees participate in both a qualified and nonqualified plan, putting the maximum amount into a 401(k) each year while setting an additional amount aside in a nonqualified plan. For an employer, it’s important to have documentation on every plan issued, qualified or nonqualified, and assign at least one plan administrator to act as fiduciary and ensure you’re compliant with IRS regulations.
One thing both types of plans have in common, though, is their tax treatment. Both are deferred compensation plans, which means taxes are delayed until the money is taken out. This gives the plan holder an opportunity to set money aside for the future, which often means retirement. In either case, the plan holder will pay taxes when the money is withdrawn.
Nonqualified Plans vs. 401(k) Plans
Nonqualified retirement plans are typically offered as part of an executive benefits package, giving higher-earning employees an opportunity to save for retirement. For other employees, a qualified retirement plan is often the primary part of a retirement benefit package.
One of the most common types of qualified plans is a 401(k), which holds more than $5.7 trillion in assets for American workers. By participating in these plans, employers have to follow ERISA regulations, including setting participation standards and maintaining accountability of the plan administrators. Here are some key differences between NQRPs and the most popular employer-provided qualified plan, the 401(k).
|NQDC Plans||401(k) Plans|
|Participation Requirements||Employers can offer at their own discretion.||Must be offered to every employee who meets minimum requirements.|
|Tax Deductibility||Employers cannot deduct costs.||Employers can deduct costs.|
|Contribution Requirements||No annual contribution limit.||Annual limits on contribution. In 2020, an employee under the age of 50 can only contribute up to $19,500.|
|Minimum Distribution Age||Funds not available until date outlined in the agreement.||Funds cannot be taken before age 59½ without penalty.|
Limits of NQDC plans
Nonqualified deferred compensation plans may not fall under ERISA, but employers still have guidelines to follow. The plan terms will need to be outlined in writing, in the form of an agreement signed by the participant. An NQDC is also subject to audit by the IRS, so it’s important that employers keep careful documentation and have fiduciaries in place to make sure the plan is administered properly.
One major problem with a nonqualified deferred compensation plan is that funds aren’t guaranteed. You’ve signed an agreement, but if the business files for bankruptcy, the funds aren’t protected as they are with a 401(k). However, the agreement should outline what the payment schedule will be, as well as what requirements the plan holder will have to satisfy before accessing the funds.
For some, it may make sense to participate in a non-qualified plan once your qualified plan is fully funded. You may find that you want to contribute more than $19,500 in 2020 (or $26,000 for employees over the age of 50), for instance, at which point a non-qualified plan can take over the excess. You’ll have the protections that come with a qualified plan for part of your money without the contribution limits.
NQDC plans have their benefits, but they also lack the guarantees you get with a qualified deferred compensation plan. If you're saving for retirement, make sure you are aware of the options provided by your employer and the associated risk involved. A qualified plan is a great place for most of your savings but a NQDC might be a valuable complement long-term if offered by your employer.