The Basics of Nonqualified Deferred Compensation Plans
Consider bolstering your executive benefits program with a powerful tool that can help attract and retain key employees. Nonqualified Deferred Compensation (NQDC) Plans may be a valuable and flexible wealth planning tool for key executives and other highly compensated key employees. In this article, Morgan Stanley at Work helps demystify NQDC plans and discusses their potential advantages.
What Is an NQDC Plan?
In general, a NQDC plan is a workplace benefit offered by a plan sponsor to highly compensated employees (HCEs) and key executives that can allow for employer and employee contributions. Because most NQDC plans are unfunded, this article will focus on unfunded plan types. With a properly designed and operated unfunded NQDC plan, the amounts contributed to the plan are not includable in the employee’s income for income tax purposes until the amounts are paid or made available to the employee in a subsequent tax year, typically at retirement or upon separation from service. However, in general, an employer may not claim an income tax deduction for the amounts contributed to the plan until the year in which such amount is includible in the employee’s income for income tax purposes. As many as 80% of companies offer a NQDC plan, according to a study in 2020.1 So let’s take a deep dive into why these plans can be an attractive part of an executive benefits package.
What Are the Benefits?
NQDC plans continue to expand as companies compete to attract top executive talent. Unlike 401(k)s, NQDC plans generally are not subject to statutory contribution limits, which make them even more enticing to high-earning employees, who may easily max out an employer-sponsored qualified retirement plan. By understanding the advantages and potential risks of these plans, you can ensure you have what you need to decide if they are appropriate for your company’s needs.
Benefits for Companies:
- Helps employers stay competitive with a powerful recruitment and retention tool for executives
- May be used to reward certain employees for meeting specific performance metrics (either individual metrics or company metrics) and can provide for vesting over time or only on the occurrence of events stated in the plan
- Employers can create these plans at any time of the year
Benefits for Executives:
- May reduce current income taxes and provide tax-deferred savings opportunity
- Receive payouts while still employed (subject to certain requirements)
- Provides an additional tax-deferred savings vehicle for executives limited in 401(k) participation and company matching due to contribution limits and/or discrimination testing
|QUALIFIED 401(k) PLAN||NQDC PLAN|
|PARTICIPANT POPULATION||All employees||Highly compensated employees and key executives|
Generally, a plan cannot permit a distribution until a permissible triggering event has occurred, such as severance from employment (e.g., retirement), death, qualifying disability, attainment of age 59 ½, or qualifying hardship. The permissible triggering events may differ for different types of contributions (and the earnings attributable to such).
The form and timing of the distribution(s) is elected at the point of distribution.
Distributions are generally includable in the employee’s taxable income and, if made before age 59½, subject to a 10% penalty tax (unless an exception applies). Since the employer received an income tax deduction for the contribution to the plan, the employer is not entitled to a deduction for a distribution from the plan.
Required minimum distributions generally must begin once the participant (a) reaches RMD age (which is currently age 72) or (b) retires from employment with the plan sponsor, if later than RMD age and the participant is not considered a 5% owner.
Generally, amounts deferred under the plan must be payable only upon specific, permissible events stated in the plan, such as separation from service (e.g., retirement), qualifying disability, death, specified date or fixed schedule, qualifying change in control, or qualifying unforeseeable emergency.
The form and timing of the distribution(s) must be elected at the time of the deferral election. Distributions from the plan generally cannot be accelerated (subject to limited exceptions).
Distributions are generally includable in the employee’s taxable income but are not subject to the 10% penalty tax for pre-age 59½ distributions. The employer is entitled to a corresponding income tax deduction for the amount distributed from the plan that is includable in the employee’s taxable income.
No required minimum distributions.
Typically allows the participant to make the investment decisions for the assets held in the plan for them and to select from a menu of investment options.
Depending on the design of the plan, may allow participant to select from a menu of investment crediting options (which determines the amount payable to the employee in the future).
Funded – generally, must be irrevocably set aside by an employer in a qualified trust for the sole benefit of the participants and their beneficiaries. Not subject to the employer’s bankruptcy and insolvency creditors.
The assets within the qualified trust potentially grow on a tax deferred basis.
Unfunded – generally, a NQDC plan must be unfunded, meaning no assets of any kind being maintained in connection with the plan or if there are assets maintained in connection with the plan (informal funding), such assets must be subject to the claims of the employer’s bankruptcy and insolvency creditors.
To the extent there is informal funding of the plan, the employer is subject to income taxation on the taxable growth of the assets (e.g., dividends, interest, capital gains), unless a tax-favored asset (e.g., corporate-owned life insurance, which generally provides tax-deferred growth potential and may provide a fully or partially tax-free death benefit) is used.
Generally covered by ERISA, unless the plan is a governmental plan, a non-electing church plan or a plan that doesn’t cover any common law employees (i.e., a plan that only covers the owner of the plan sponsor or the owner and their spouse).
Generally, an unfunded NQDC plan is not subject to ERISA’s participation, funding, vesting or fiduciary provisions.
Upon bankruptcy/insolvency, participants are generally treated as general unsecured creditors of the employer.
Nonqualified Plan Considerations
There are many aspects of a NQDC plan benefit that make the option worth a second look for many companies and their higher-earning employees.
As your employees come to you and ask questions about their retirement planning needs, understanding options could help you to financially empower your workforce as well as retain and attract talent.
Our Morgan Stanley Financial Advisors are here to help answer questions you may have about NQDC plans and help you consider with your legal and tax advisor whether a NQDC plan is right for your organization.