Taxation on Non-Qualified Deferred Compensation Plans

Some companies offer employees the option of postponing part of their pay until after they retire using what is called a non-qualified deferred compensation (NQDC) plan. The plan may be offered in addition to, or in place of, a qualified retirement plan such as a 401(k) plan.

The plans are typically offered as a type of bonus to upper-level executives, who may max out their allowable contributions to the company's qualified retirement plan. In an NQDC plan, both the compensation and the taxes owed on it are delayed until a later date. If you are considering this type of retirement option, you should understand how you’ll be taxed on that money and any profits it earns over the years ahead. 

How NQDC Plans Are Taxed

Any salary, bonuses, commissions, and other compensation you agree to defer under an NQDC plan are not taxed in the year in which you earn it. The deferral amount may be recorded on the Form W-2 you receive for the year.

You will be taxed on the compensation when you actually receive it. This should be sometime after you retire, unless you meet the rules for another triggering event that is allowed under the plan, such as a disability. The payment of the deferred compensation will be reported on a Form W-2 even if you are no longer an employee at the time.

You are also taxed on the earnings you get on your deferrals when they are paid to you. The rate of return is fixed by the terms of the plan. It may, for example, match the rate of return on the S&P 500 Index.

Compensation in Stock or Options

When the compensation is payable in stock and stock options, special tax rules come into play. In such cases, the taxes will not be owed until the stock shares or options are yours to sell or give away as you choose.

However, you may want to report this compensation immediately. The IRS calls this a Section 83(b) election. It allows the recipient to report the value of the property as income now (as opposed to when the stock or options are vested), with all future appreciation growing into capital gains that could be taxed at a relatively favorable tax rate.

If you don't make the Section 83(b) election, you will owe taxes on the property and its appreciation at the time it is received. However, if you make the election you will be giving up the ability to deduct any losses in the future should the value depreciate.

The IRS has a sample 83(b) form that can be used to report this compensation currently rather than deferring it.

Tax Penalties for Early Distributions

There are heavy tax consequences if you withdraw money from an NQDC plan before you retire or when no other acceptable "trigger event" has occurred.

• You are taxed immediately on all of the deferrals made under the plan, even if you have only received a portion of it.
• The tax penalty for overpayments and underpayments for Q3 2023 is 7%, though corporations are charged 6%.

How It Affects FICA Taxes

The Social Security and Medicare tax (FICA on your W-2) is paid on compensation when it is earned, even if you opt to defer it.

This can be a good thing because of the Social Security wage cap. Take this example: your compensation is $170,000 and you made a timely election to defer another $25,000. For the 2023 tax year, earnings subject to the Social Security portion of FICA are capped at $160,200. Thus, $34,800 ($170,000 - $160,200 + $25,000) of total compensation for the year is not subject to the FICA tax. For the 2024 tax year, earnings subject to the Social Security portion of FICA are capped at $168,600, so $26,400 would be exempt if you don't get a raise.

When the deferred compensation is paid out, say in retirement, no FICA tax will be deducted.

NQDC Plans vs. 401(k)s

Chances are, you'll end up contributing to a NQDC plan or a 401(k) plan. These two plans differ significantly in terms of participant eligibility and contribution limits. NQDC plans are typically offered to a select group of highly compensated employees, while 401(k) plans are designed to be more inclusive and open to more employees.

Another critical difference lies in the contribution limits imposed on each plan. NQDC plans provide greater flexibility because participants can defer a portion of their salary or bonuses without the strict annual limits imposed on 401(k) plans. This flexibility is meant to work in tandem with people who are high earners and want to defer larger portions of what they're making. On the other hand, 401(k) plans adhere to IRS-set contribution limits, meaning that everyone has the same limit on how much they can contribute each year.

Tax treatment is another key difference between the two. In NQDC plans, participants can defer income taxes on their contributions. This can be a critical benefit, as these high earners may expect to be in lower tax brackets in the future. Meanwhile, 401(k) plans offer immediate tax benefits by allowing participants to contribute on a pre-tax basis. Note that you can make after-tax 401(k) plans to have certain earnings grow tax-free.

Last, there's some differences in regulatory oversight between the two. NQDC plans, lacking ERISA regulation, mean employers can be more flexible. Unfortunately, this gives less protection for participants. 401(k) plans are subject to ERISA regulations, so there are certain standards of reporting and disclosure to protect the people using the plan.

Is It Worth It?

A non-qualified deferred compensation plan, if one is available to you, can be a considerable benefit over the long run. You're investing money for your future while delaying taxes owed on earnings. That should get you a greater accrual of earnings. However, the day of reckoning will come when you start to collect your deferred compensation. Just be prepared for the impact when it hits.

The Bottom Line

Non-qualified deferred compensation plans are offered to select employees as a benefit in addition to traditional qualified deferred compensation plans, such as 401(k)s.

The amount an employee chooses to defer reduces their taxable income and the amount deferred is not taxed until they receive the funds, usually in retirement. These types of plans are more complicated than traditional retirement plans and employees offered them should carefully understand the terms before taking part.