In today’s labor market, attracting and retaining top talent often requires thinking beyond traditional benefits offerings. In order to set your compensation and benefits package apart from your competitors, you may want to consider adding a nonqualified deferred compensation (NQDC) plan as a supplemental, tax-advantaged savings opportunity for these employees.
What is an NQDC plan?
Although a qualified retirement plan, such as a 401(k) plan, is often a fundamental component of a total rewards package, it may only provide a small fraction of the retirement income replacement needs of your more highly compensated leaders.
With an NQDC plan, unlike in a 401(k) plan, a participant may defer compensation on a pretax basis, irrespective of the IRS’ qualified plan limits. A participant may also elect to receive deferred payments at a specified future date (if the plan so permits), allowing a participant to save for certain life events (e.g., a child’s college education).
Key advantages for an employer offering an NQDC plan are that participation in such a plan is limited and the eligibility and nondiscrimination rules associated with 401(k) plans do not apply to NQDC plans. Therefore, adding an NQDC plan to provide an additional source for retirement income for key talent may provide you with an effective, and surprisingly affordable, tool in your overall benefits package.
How does an NQDC plan work?
Technically, a nonqualified plan is considered to provide for the deferral of compensation to the extent that a participant “has a legally binding right during a taxable year to compensation that, pursuant to the terms of the plan, is or may be payable to (or on behalf of) the participant in a later taxable year” (i.e., a NQDC plan permits eligible executives to set aside, on a tax-deferred basis, a portion of their salary or bonus each year, with the expectation that the amounts, plus earnings, will be paid to them at a later date). NQDC plans also allow employer contributions on a tax-deferred basis—with payment of these amounts and their associated earnings at a future date. This can be a valuable benefit for executives who are trying to:
- Minimize their current tax liability,
- Save to meet both short- and long-term goals, and/or
- Contribute more toward their retirement on a tax-deferred basis than the IRS’ 401(k) contribution limits will allow.
An NQDC plan must be designed to meet the specialized retirement needs of a select group of employees only—either select management personnel or select members of the highly compensated employee (HCE) group, known as the top hat group of employees. The U.S. Department of Labor (DOL) and various courts have generally upheld top hat status with plans that have a 4-5% employee coverage range. Consideration should also be given, however, to the difference between the average salary of participants otherwise eligible for the NQDC plan and the general employee population.
Are there different kinds of NQDC plans?
The most common types of NQDC plans include:
- Top hat plans
- Excess benefit plans
- Salary reduction/bonus deferral plans
Top hat and excess benefit plans are generally funded by employers, while salary reduction/bonus deferral plans are based on compensation deferred by each employee. NQDC plans may also include certain employment, severance, and/or reimbursement agreements, as well as some equity awards.
What are the differences between an NQDC and a 401(k) plan?
From the participant’s viewpoint, an NQDC plan can look a lot like a 401(k) plan. For example, with most NQDC plans, a participant must make both deferral and investment elections. The participant may also enroll and access plan information through the same website as their 401(k) plan. That, however, is where the similarities end.
An NQDC plan is governed by the rules under IRC Section 409A (409A). The 409A rules, which became effective January 1, 2005, place restrictions on deferral elections and the timing of distributions to avoid potential tax abuse. A deferral election must generally be made in the calendar year prior to the year in which services are to be performed (with an exception for newly eligible employees) and is irrevocable for the balance of the year.
A plan distribution is permitted:
- Upon separation from service
- Upon death or disability
- At a specified date or schedule—e.g., an in-service distribution
- In the event of an unforeseeable emergency
The acceleration of payment (once established) is prohibited, with two exceptions:
- A domestic relations order
- Plan terminations
A participant must make a distribution election during the initial enrollment period and/or the annual enrollment period, subject to 409A and plan rules (if the plan itself doesn’t specify any required distribution provisions). In addition, if the plan permits, a participant may change distribution elections, but any subsequent distribution deferral elections can't take effect until at least 12 months after the date of the new election. If the change is to a distribution that is scheduled to be paid as of a specified date, the election must be made at least 12 months prior to the scheduled payment date. Perhaps most challenging, the distribution must also be deferred/postponed for at least five years from the date the payment would otherwise have been made.
The above conditions also apply to:
- A change in the method of payments—e.g., lump sum to installments (if permitted by the plan)
- Any amendment by the employer changing the time or method of payment
There are several more key similarities and differences between the plan types that employers and eligible employees should be aware of.
|Assets subject to creditors||No||Yes|
|Required minimum distributions||Yes||No|
|Hardship/unforeseeable emergency distributions||Yes||Yes|
Tax considerations for NQDC plans
In general, contributions (and applicable earnings) accumulate on a tax-deferred basis. Participant deferrals, however, are subject to FICA and FUTA taxes when they are made to the plan, and employer contributions are subject to FICA and FUTA taxes when they vest. Participants owe federal income tax and state income tax, if applicable, on amounts when they're distributed from the plan.
Funding for NQDC plans
Although 409A requires that nonqualified plans be unfunded, assets may be informally maintained in a rabbi trust associated with the plan, subject to the following:
- Assets must remain assets of the employer, not the employee
- Assets must be subject to the claims of the employer’s general creditors
- A rabbi trust only protects assets from improper use by employer
There are also several funding options for employers:
- Pay as you go
- Taxable separate investment accounts or mutual funds
- Corporate-owned life insurance (COLI)
- Trust-owned life insurance (TOLI)
What reporting is required for NQDC plans?
An NQDC plan must file an annual Form 5500 unless a registration statement is filed with the DOL. The registration statement must be filed within 120 days of plan adoption. If the employer fails to file the registration statement in a timely manner, however, the defect may be corrected under the DOL’s Delinquent Filer Voluntary Compliance (DFVC) Program. An NQDC plan may also be subject to securities registration requirements.
Are NQDC plans becoming more widely used?
Despite their challenges and limitations when compared to qualified plans, NQDC plans may see greater use in the future, particularly in light of recently released retirement and tax proposals. For example, if individual tax rates go up, some employees will be looking for additional tax-deferred savings vehicles in order to reduce the impact to their annual compensation. Further, should pretax deferral opportunities eventually be limited in qualified retirement plans—e.g., by a shift to Roth contributions—some employees may want the ability to offset the lost deferral opportunity by contributing to an NQDC plan.
Deciding whether an NQDC plan is right for your organization
Adding a new benefit to your total rewards package can be a daunting consideration. Although offering an NQDC plan can enhance your overall benefits lineup, it comes with stringent rules regarding deferral and distribution elections and the prohibition of loan or rollover features. Perhaps more significantly, unlike a 401(k) plan, for which assets are segregated from the employer's general assets, deferred compensation amounts contributed to an NQDC plan are subject to potential loss, even when held in a rabbi trust.
Despite the limitations, however, offering an NQDC plan can be a key component of your total benefits package, enabling you to provide certain executives with an additional tax-deferred savings opportunity. Using an NQDC plan, this select group of employees may defer a much larger portion of their compensation than allowed in a qualified plan, as well as certain taxes on those amounts, until the compensation is paid. An NQDC plan may also allow these employees to schedule distributions during their careers, not just at retirement, providing them with greater financial flexibility. Given the ongoing changes in the retirement plan landscape, NQDC plans may become more popular in the future. Talk to your retirement plan partners to learn more if you think adding an NQDC plan might be right for your organization.