What it means
A qualified retirement plan, such as a 401(k), follows strict government rules about who can join, how much can be contributed and how the funds are protected. In return it receives tax benefits.
A nonqualified plan sits outside those rules, so employers can offer it to a select group and let participants defer far more than the qualified plan limits would allow. The participant chooses to postpone some salary or bonus, and the employer records the amount in an account that usually grows with notional investment returns.
Tax on the deferred amount is generally delayed until it is paid out, which may be when the executive is in a lower tax bracket. The arrangements must follow specific timing rules, and in the United States Section 409A of the tax code sets out strict requirements for when elections are made and when money can be paid.
The big trade-off is security. Because the money is not held in a protected trust for the employee, the participant is usually an unsecured creditor of the company.
If the employer goes bankrupt, the executive may lose some or all of the deferred amount, which is why some companies use a rabbi trust, a type of trust that sets money aside but remains reachable by creditors in a bankruptcy. For the employer, NQDC is both a retention tool and a financial liability.
The company usually cannot deduct the compensation until it is actually paid, and it needs to track the growing obligation on its balance sheet. Many employers invest in life insurance or other assets to help fund the future payments, although these remain company assets.
Failing to follow the timing rules can be costly. In the United States, a plan that breaches Section 409A can trigger immediate taxation of the deferred amount plus an additional tax and interest on the participant, so careful drafting and administration are essential.
In practice
Real-world examples.
Example
A chief financial officer earns a $400,000 salary and defers $150,000 of her bonus each year into the company's NQDC plan. She will receive it in instalments after retirement, which spreads the income over several lower-earning years.
Example
A technology company wants to keep a star engineering director and offers an NQDC plan in which the company adds $50,000 a year that vests after five years. If he leaves early, he forfeits the unvested amount.
Example
A private hospital group sets up a rabbi trust to hold assets for its executives' deferred pay. The trust gives executives some comfort, but the assets remain available to creditors if the hospital group becomes insolvent.
Formula
Calculation
Future value of deferred amount = Amount deferred x (1 + Annual growth rate) ^ Number of years
Suppose an executive defers a $100,000 bonus into an NQDC plan whose notional investments grow at 6% a year, and the plan pays out after 10 years. Growth factor = 1.06 ^ 10 = 1.7908 (rounded). Future value = $100,000 x 1.7908 = about $179,085. The executive then pays ordinary income tax on the $179,085 when it is received, rather than on the $100,000 in the year it was earned.Case study
Seen in the real world.
Falconridge Industries is a fictional manufacturer that wanted to retain its eight most senior managers. Its qualified retirement plan limited how much each could save, so the board introduced an NQDC plan allowing them to defer up to half of their annual bonus. The company promised a fixed interest rate of 5% on balances.
After three years, the finance team noticed that the liability had grown to $6,500,000 and was not matched by any assets. The chief financial officer arranged for the company to buy life insurance policies on participating managers and to invest part of the funds in a rabbi trust, so there would be money to pay at retirement.
In this illustrative story, a market downturn then hit the company's profits, and several managers asked whether their deferred pay was safe. The finance director explained that they were unsecured creditors, which prompted two managers to reduce their deferrals. The episode showed that retention tools have to be paired with honest conversations about risk.
Watch out
Common mistakes.
- Treating NQDC as risk-free savings. The money is typically an unsecured promise from the employer, and it can be lost if the company fails.
- Changing payout dates casually. Rules such as Section 409A restrict when deferrals can be made and paid, and breaches carry heavy tax penalties.
- Forgetting payroll taxes. Social security and Medicare taxes may apply when amounts vest, even though income tax is deferred.
Questions
People also ask.
Who typically takes part in an NQDC plan?
Usually a select group of executives or highly paid employees, because the plans are designed for people who reach the limits of qualified plans.
Can the employer deduct the deferred pay straight away?
Generally no; the deduction usually comes only when the employee includes the payment in income.
How is NQDC different from a 401(k)?
A 401(k) has contribution limits and protected assets, while NQDC has no set limits but depends on the employer's ability to pay.
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