Non-qualified deferred compensation (NQDC) plan?

What is it?

A non-qualified deferred compensation (NQDC) plan enables a service provider (e.g., a worker ) to make salary, bonuses, or other compensation in 1 year but get the earnings–and defer the income tax on them–in a subsequent year. Doing so provides income in the future (often after they have left the workforce), and might reduce the tax payable on the income if the man is in a lower tax bracket when the deferred compensation is obtained.

Key Takeaways

• The tax law requires that the plan to be in writing; the program document(s) to define the amount to be paid, the payment schedule, and the triggering event which will lead to payment; and for the worker to make an irrevocable election to defer compensation prior to the year in which the compensation is earned.

• The tax benefits of NQDC plans are realized only if the plan conforms to tax law requirements, and other limitations may get onerous.

The non-qualified type is produced by an employer to allow employees to defer compensation they have a legally binding right to receive. There are lots of kinds of NQDC plans (also referred to as 409A plans following the section in the tax code governing them, introduced in 2004); the one discussed here is the fundamental unfunded plan for deferring part of annual compensation (the most common type).

Tax laws

The tax law requires that the plan to fulfill all of the following requirements:

• The strategy is in writing.

There are six permissible triggering events: a predetermined date, separation from service (e.g., retirement), a change in ownership or management of the business, disability, death, or an unforeseen crisis. Other events, like the requirement to pay tuition for a child, a change in the financial status of the business, or a hefty tax bill, aren’t permissible triggering events.

• The worker makes an irrevocable election to defer compensation prior to the year in which the compensation is earned. However, a unique deferral election rule applies to commission payments.

The NQDC plan may also impose conditions, including refraining from competing with the company or providing advisory services after retirement.1

The deferred amount earns a fair rate of return determined by the company at the time that the deferral is made. This may be the rate of return on a genuine asset or index –say, the yield on the Standard & Poor’s 500 Index. Thus, when distributions are made, they include both the compensation and what numbers to earnings on this reimbursement (though there are no real earnings; it is merely a bookkeeping entry).

Violating the strict conditions in the law causes harsh results. All the deferred settlement becomes immediately taxable.

Advantages for Employers

Because NQDC plans aren’t qualified, meaning they are not covered under the Employee Retirement Income Security Act (ERISA), they give a greater amount of flexibility for employers and employees. Unlike ERISA plans, companies can elect to provide NQDC plans only to executives and key employees who are most likely to utilize and gain from them. The programs can also be used as”golden handcuffs” to keep valued staff on board, as leaving the company before retirement could lead to forfeiting deferred benefits.

An NQDC plan can be a blessing to cash flow, because now earned compensation isn’t payable before the future. However, the compensation isn’t tax-deductible for the company until it’s truly paid.1

The costs of establishing and administering an NQDC plan are minimal. Once first legal and accounting fees are paid, there are no unique yearly expenses, and there are not any necessary filings with the Internal Revenue Service (IRS) or other government agencies.

Advantages for Employees

Endless Savings and Tax Benefit

Deferred compensation plans don’t have any such federally mandated limits, though companies may specify a donation limit based on your reimbursement.

The ability to defer any quantity of compensation also reduces your annual gross income. This can, in turn, put you into a lower tax bracket, further decreasing your tax liability every year. However, deferred compensation remains subject to FICA and FUTA taxes in the year it’s earned.1

Investment Options

Many NQDC plans provide investment options like 401(k) plans, such as mutual funds and stock choices. NQDC plans are not just fancy deposit accounts for high rollers. Instead, they let you increase your wealth over time. However, you are able to invest in a larger scale as your contributions are unlimited, raising the possibility of more substantial gains.

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