Non-Qualified Deferred Compensation: Part I

This is the first part of the non-qualified deferred compensation plans Q&A. Here, we introduce NQDC plans and summarize their basic feature. In the second part, we outline the critical difference between 401(k) and NQDC plans. You can read the second non-qualified deferred compensation post here.

 

What is a non-qualified deferred compensation (NQDC) plan?

An NQDC plan, or a non-qualified deferred compensation plan, is a type of retirement savings plan offered to key company employees or executives. This plan allows these employees to set aside a portion of their income for retirement on a tax-deferred basis, meaning that they do not have to pay taxes on the contributions or investment earnings until they withdraw the money in retirement.

While companies make efforts to design NQDC plans to be similar to 401(k) plans, by their nature, non-qualified plans are nonstandard and are not allowed the same tax privileges as qualified plans.
So, while each company has flexibility in designing its own plan, this makes it difficult to give a definitive answer that applies in every case. Please keep that in mind while reading this Q&A.

 

Who are the primary users of NQDC plans?

NQDC plans are typically offered to key employees or executives of a company. Companies often determine employee eligibility annually based on pay and send invitations to participate when an employee becomes eligible. This plan allows these employees to set aside a portion of their income in addition to what qualified plans such as 401k plans offer.

The main advantage of NQDC plans is that they can provide a way for high-income earners to save more for retirement than they would be able to with traditional retirement savings vehicles, like 401(k) plans, which have contribution limits. While non-qualified plans may also limit the pay eligible for participation, these limits are generally higher than the IRS limits set on other plans.

For example, in 2022, the IRS limits the maximum 401k(k) contribution to $20,500 and the maximum eligible pay to $305,000. But a company creating a non-qualified plan has no such limitations. For example, it could set any limit to, say, 25% of the excess of eligible pay for up to $500,000. That is an additional $48,750 [25% * ($500,000 – $305,000)] on top of the IRS limits.

However, there are also some risks and drawbacks to NQDC plans. So, if you are an employee being offered one of these plans, it is essential to carefully consider your options before deciding whether this is the right option for you.

 

How are NQDC plans taxed?

Non-qualified deferred compensation (NQDC) plans are typically structured as pre-tax plans. The deferred compensation is not subject to income tax until it is distributed to the participant.

Like 401(k) plans, non-qualified deferred compensation (NQDC) plans are generally taxed when the employee receives deferred compensation rather than earned. This means that there’s a chance the recipient will pay less tax on the compensation—if they are in a lower tax bracket when they get the money than when they earned the compensation.

The specific tax treatment of NQDC plans may vary depending on the specific terms of the plan and the individual circumstances of the employee, but, in general, they are taxed similarly to 401(k) plans.

 

Can I roll my non-qualified deferred compensation into a traditional IRA account?

A rollover is a tax-free way to move funds from one retirement account to another. This process is typically allowed only if the two accounts are of the same type—e.g., 401(k) to 401(k), IRA to IRA, etc.

Non-qualified deferred compensation (NQDC) plans are not subject to the same rules as qualified retirement plans such as 401(k) plans. It is generally not possible to roll over funds from an NQDC plan directly to one of these accounts. Therefore, it’s essential to carefully consider the potential tax implications of an NQDC plan before you start participating in one.

 

Do companies make matching contributions to NQDC plans?

Some companies may offer matching contributions to their employees’ non-qualified deferred compensation (NQDC) plans. A matching contribution is an employer-funded contribution to an employee’s retirement savings plan, typically based on a certain percentage of the employee’s contributions to the plan. For example, an employer might offer to match 50% of an employee’s contributions to an NQDC plan up to a maximum amount.

Offering matching contributions can be a way for employers to encourage employees to save for retirement and to help them build their retirement savings faster. However, not all employers offer matching contributions to their employees’ NQDC plans, and the specific terms and conditions of any matching contributions will depend on the employer and the plan’s provisions.

 

Do companies make additional non-matching contributions to NQDC plans?

Your company may also make non-matching contributions to your NQDC plan. These employer-funded contributions to an employee’s retirement savings plan are not based on the employee’s contributions. In other words, the employer contributes to the employee’s plan regardless of whether the employee makes any contributions.

Non-matching contributions can be a way for employers to provide additional support for their employees’ retirement savings. The terms and conditions of non-matching contributions will vary depending on the employer and the plan’s provisions. For example, an employer might offer a non-matching contribution of 2% of an employee’s non-qualified deferred compensation (NQDC) plan on an annual basis, or they might provide a one-time contribution as a bonus or incentive.

Once again, all NQDC plans are different. It’s always a good idea to carefully review the provisions of your NQDC plan and consult with your employer or a financial advisor to understand the details of any non-matching contributions that may be available. This can help you make informed decisions about your retirement savings and ensure that you take advantage of all available opportunities to build your nest egg.

 

What is vesting, and how does it work with NQDC plans?

Vesting refers to the ownership of employer-provided benefits, such as contributions to a retirement savings plan. Vesting determines when an employee can keep the employer’s contributions, even if they leave the company.

In general, companies try to match the vesting rules of their NQDC plans to their 401(k) plan rules, but there may be some differences.

For example, matching company contributions to an NQDC plan may be immediately vested, while non-matching contributions may be vested based on years of service. An example is vesting on non-matching contributions after three years; vesting can be cliff or graded.

Employees’ contributions are always vested.