Deferred compensation is employee income that is paid out at a later date. There are two general categories of deferred compensation: qualified and nonqualified plans. In this blog post, we’ll focus on nonqualified deferred compensation (NQDC) plans.
NQDC Plans: Overview
For reference, qualified deferred compensation plans are subject to the Employee Retirement Income Security Act (ERISA), which is a set of retirement regulations implemented by the federal government. Perhaps the most well known qualified deferred compensation plan is the 401(k).
NQDC plans, on the other hand, are not subject to ERISA guidelines. They are called “nonqualified” because they don’t meet the IRS qualifications for favorable tax treatment like qualified retirement plans do. So while they are more flexible than qualified plans in terms of contributions and withdrawals, they don’t provide the same tax advantages. Taxes are paid when the employee actually receives the money in hand, as opposed to when a NQDC plan is drawn up.
Historically, NQDC plans have been associated with executive retention, though they can be used for any key employees that a company may want to retain, including contractors. Phantom stock is a type of NQDC plan, as are several other stock and bonus plans.
Key Features of NQDC Plans
Selective Awards:
Generally, qualified plans must be offered to all eligible employees at a given company. Non-discrimination rules do not apply to NQDC plans, however, meaning that employers can award specific individuals as they see fit.
No Contribution Limits:
Unlike 401(k) plans, there are no IRS-imposed limits on contributions to NQDC plans, which can be beneficial to high earners who want to save beyond what a 401(k) allows. This can be a huge boost to retirement savings, depending on the payout size.
Tax Treatment:
Qualified plans are taxed at the time of deferral; NQDC plans are taxed upon distribution. There are pros and cons that come with this tax treatment. For example, if an employee gets her deferred compensation upon retirement, she could benefit from years of tax-free growth and potentially plan to be in a lower tax bracket upon distribution. However, being taxed at ordinary income rates is not nearly as favorable as the tax treatment for qualified plans.
Highly Customizable:
The MARE Stock Plan is a great example of just how customizable NQDC plans can be. The value of the award, when it is paid out, and under what circumstances can be tailored per company and even per employee.
NQDC Plan Considerations
It’s important to familiarize yourself with the downsides of NQDC plans before implementing one at your company. For example, while 401(k) plans are federally protected against creditor claims should a company go bankrupt, for example, NQDC plans have no such legal protections.
In terms of plan design, NQDC plans are quite flexible. But once elections are made, they can be very difficult to change. For instance, an employee can withdraw money from their 401(k) (albeit with heavy penalties and tax consequences) but cannot deviate from a phantom stock distribution schedule.
Finally, NQDC plans must comply with IRC Section 409A, which imposes strict rules on payment triggers, schedules, and overall mechanics of the deferred award. Non-compliance can have serious tax consequences for participants.
A Reins Membership provides regular compliance checks for your MARE Stock Plan. To learn more about the MARE Stock Plan, create a free account and build your own customized phantom equity plan:
.jpg)
