Non-Qualified Deferred Compensation (NQDC)

What is Non-Qualified Deferred Compensation (NQDC)?

A non-qualified deferred compensation (NQDC) plan is a type of non-qualifying plan that falls outside the Employment Retirement Security Income Act (ERISA). NQDC plans are also known as 409 (a) plans and golden handcuffs. Employers use such plans to attract and retain key executives and valuable employees.

As the name suggests, NQDC plans let employees defer a portion of their income to a later date (generally retirement). Employees can decide how much of their income they want to defer each year from their salary.

Deferring income provides a tax advantage to employees. Income that is deferred in a particular year is not subject to income or state tax until it is received by the employee. Depending on the plan, the income may be received in 5 years, 10 years, 15 years, or in retirement. Most employees tend to defer their income to retirement as they would presumably be in a lower tax bracket.

Types of Deferred Compensation Plans

The two types of deferred compensation plans include true deferred compensation plans and salary continuation plans. The goal of both plans is to supplement the retirement income of executives.

The difference between the two plans lies in the funding source. A true deferred compensation plan simply allows an employee to receive a portion of salary earned during retirement (or a later year) to receive tax benefits. In a salary-continuation plan, the employee continues to receive a lower salary from the employer during retirement.

How NQDC Plans Work: Key Conditions

A deferred compensation plan can be qualifying or non-qualifying. Qualifying plans are protected under the ERISA and must be drafted based on ERISA rules. While such rules do not apply to NQDC plans, tax laws require NQDC plans to meet the following conditions:

• The plan must be in writing.
• The written document must specify all the amounts and timings of the payments that will be deferred, the payment schedule of the deferred payments, and the triggering event that will need to occur before the deferred payments can be released.

There are six permissible triggering events – a specific date, separation from the company or retirement, a change in the ownership or control of the firm, disability, death, or an unforeseen emergency. Since NQDC plans provide a lot of flexibility, triggering events can differ depending on the agreement.

• The employee must make an irrevocable choice to defer compensation before the year in which the compensation is earned. Special deferral election rules may apply to commissions earned.

Usually, the deferred amount also earns a reasonable rate of return until the amount is paid out to the employee. The rate is not standardized but mutually agreed upon by the employer and employee.

Due to the flexibility available, the employer may also impose other restrictions on the employee. Commonly, NQDC plans come with a non-compete clause, which may prevent the employee from taking a job with a competitor or taking a client along in case the employee leaves the company.

Advantages of NQDC Plans

The key advantages for employees are:

1. Unlimited contributions and tax benefits

The U.S. Internal Revenue Service (IRS) imposes strict restrictions on the amount of money that can be contributed to qualifying plans. The 2021 annual limit for 401(k) contributions is $265,000. For highly paid executives, the amount may be a very small percentage of their income.

For example, for individuals earning around $5 million, the limit is only 5% of their annual income. At such a rate, they may not be able to save enough to make up the typical 70% income replacement goal for retirement.

NQDC plans don’t come with such limits on contributions. Moreover, NQDC plans allow employees to defer their taxes to the future and benefit from lower taxes in the near term (since deferring income reduces annual income and may put employees in a lower tax bracket). It can lead to significant tax savings for employees.

2. Investment options

Most NQDC plans offer the same investment options available in 401(k) plans. They include mutual funds and stock options. Since employees can invest a larger amount, they can grow their wealth significantly over time.

Disadvantages of NQDC Plans

Even though unlimited contributions and tax benefits are huge advantages, NQDC plans come with some disadvantages that employees must consider. They include:

1. No ERISA protections

The biggest disadvantage that employees need to consider is the lack of ERISA protections. The most significant implication is that NQDC plans are not protected from creditors in the event of bankruptcy.

Under such plans, the amount of income deferred represents a liability on the employer’s balance sheet, essentially making the NQDC plan an unsecured loan between the employee and the employer.

In the event of bankruptcy, creditors would not be obligated to pay this unsecured loan. Qualified plans come with ERISA protection, which protects employees from creditors in the event of bankruptcy. It is extremely important to consider bankruptcy risk before enrolling in such plans.

NQDC plans can either be funded or unfunded. If a plan is unfunded, the employee is relying on the company’s promise to pay them back. However, the firm has no obligation to pay (due to lack of ERISA protection). The company may not live up to its commitment if it is in financial distress. Therefore, funded plans are more secure than unfunded plans.

2. Strict distribution schedule and no early withdrawal provisions

NQDC plans adhere to a very strict distribution schedule that must be agreed upon in advance. They prevent employees from withdrawing funds at will after retirement. Unlike qualified plans that allow early withdrawals with a small penalty, NQDC plans do not allow any early withdrawals.

NQDC plans do not come with any notable disadvantages for employers but offer some key advantages. The main advantage is that they offer a great deal of flexibility to employers. NQDC plans are not subject to the discriminatory participation rules under ERISA, which allows companies to offer such plans to select employees.

NQDC plans also act as a key tool for retention. They are used as golden handcuffs for key employees, as leaving the company before retirement means forfeiting NQDC plans. Finally, the plans can boost the cash flow of the company since earned compensation is not payable until the future.

Related Readings

CFI is the official provider of the Capital Markets & Securities Analyst (CMSA)® certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

• 401(k) Contribution Limits
• Employee Stock Option (ESO)
• Golden Handcuffs
• Secured vs. Unsecured Loans
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