Non-Qualified Deferred Compensation (NQDC)

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Non‑Qualified Deferred Compensation (NQDC) and 409A Plans

Overview

Non‑qualified deferred compensation (NQDC) plans let employees defer receipt of earned compensation to a future date. For for‑profit employers, these arrangements are governed by Internal Revenue Code Section 409A (commonly called “409A plans”); similar arrangements for nonprofits or government employers fall under IRC Section 457(b) or 457(f). NQDCs are often used by highly compensated employees who want to save more on a tax‑deferred basis than allowed by qualified plans like 401(k)s.

How NQDC/409A Plans Work

  • An employee elects to defer a portion of current compensation (salary, bonus, etc.) into the NQDC plan.
  • The deferred amounts remain part of the employer’s general assets (not placed in a separate trust for the employee) until paid.
  • The plan specifies distribution timing or triggering events (for example: a set future date, retirement, separation from service, disability, or unforeseeable emergency).
  • Investment options vary by employer and can resemble 401(k) options, but rules and protections differ.

Example: An executive earning $750,000 might be limited by 401(k) contribution caps to a small percentage of pay. By deferring additional income into an NQDC, the executive can postpone taxation and increase savings beyond qualified‑plan limits.

Taxation and Reporting

  • Deferred compensation is taxed when it is actually received, not when earned. Taxes are based on the recipient’s income tax bracket at distribution.
  • Employers report paid distributions as wages on Form W‑2 (or in some cases on Form 1099‑MISC), even if the employee no longer works for the company.
  • Because taxation is tied to receipt, changes in future tax rates can affect the after‑tax value of distributions.

Limitations and Risks

  • Lack of ERISA protection: NQDC assets are generally not protected under the Employee Retirement Income Security Act (ERISA). If the employer becomes insolvent or is sued, plan participants are treated like unsecured creditors and may lose some or all deferred amounts.
  • No rollover to IRAs: Once distributed, funds from an NQDC cannot be rolled into an IRA or other tax‑advantaged retirement accounts.
  • Tax‑rate risk: If tax rates are higher at distribution than when income was earned, the participant’s tax burden may increase.

When Employers and Employees Use NQDCs

  • To supplement retirement savings for high earners who reach contribution limits in qualified plans.
  • To provide flexible payout timing for executives and other key employees.
  • To align compensation with future liquidity events or retirement timing.

Key Takeaways

  • NQDC plans allow deferral of earned compensation until a future date, postponing income tax until distribution.
  • For-profit employer plans fall under IRC Section 409A; nonprofit and governmental plans may be covered by IRC Section 457.
  • NQDCs offer higher deferral flexibility than qualified plans but carry greater solvency and rollover risks because they are not ERISA‑protected and cannot be rolled into IRAs.
  • Distributions are taxed as wages when received and reported by the employer.

Conclusion

NQDC/409A plans are useful tools for highly compensated employees seeking additional tax‑deferred savings and flexible payout timing. However, participants should weigh the advantages against the lack of creditor protection, rollover limitations, and potential changes in future tax liability before electing deferrals.