Non-qualifying deferred compensation (NQDC) is an additional form of reward for highly compensated executives, where a qualified plan is considered too limited. A portion of earnings is withheld until a later point in time, usually upon retirement, in order to reduce tax exposure by reducing current taxable income.
NQDCs are becoming more popular. In 2012, 83 percent of Fortune 1000 companies offered non-qualifying deferred compensation, according to the Newport Group's survey, with 47 percent of eligible employees electing to participate.
Types of plan In the United States, two types of deferred compensation plans for executives are common. The first type is traditional non-qualifying deferred compensation. The second is called a Supplemental Executive Retirement Plan (SERP), or a "top hat" plan. The difference between the two is that the executive can choose to pay into the former, whereas the latter is typically provided entirely by the company as a benefit.
How do they work? If funded, Non-qualified plans tend to be funded with cash value of life insurance policies or "permanent" insurance, which are useful because there are no annual or total contribution limits, unlike the 401(k) contribution cap. Typically assets are placed inside one of the following types of irrevocable trust:
1. A rabbi trust, where the assets are segregated while allowing creditors access to the funds in the event of insolvency. Tax is deferred until the plan is distributed.
2. A secular trust, where assets are protected from creditors but subject to taxation.
3. A hybrid of the two — a rabbicular trust — where a rabbi trust is only converted to a secular trust when the employer experiences financial difficulties, resulting in immediate taxation of plan assets but protecting the assets from creditors.
The IRS has imposed two rules: (1) Assets in a plan must be kept separate from an employees other assets; (2) As assets in a deferred compensation plan are part of a company’s balance sheet, it is important for employees to understand that if the company fails the plan assets could be seized. From a tax point of view there must be a "substantial risk of forfeiture," in order for the plan to be considered as tax deferred for the employee.
The company's contributions are not tax deductible, and employees pay taxes on deferred compensation when this compensation is eligible to be received rather than when it is actually drawn out.
Why would an employer defer compensation?
1. Key employees can demand or deserve additional compensation, and a deferred compensation plan is a way for a company to do this while still retaining the assets.
2. SERP deferred compensation tends to be used by companies as an incentive or "golden handcuff" arrangement to encourage an employee to stay until retirement rather than move over to a competitor. Unlike traditional employee elected deferred comp, the employee’s rights to benefit from the plan may be forfeited if they left the company.
3. Such a plan could also be used to lessen the blow of termination in a takeover, merger, or buyout situation, referred to as a “golden parachute” plan.
4. An NQDC plan offers a degree of flexibility to employers. The employer can choose who can participate in the plan, including independent contractors, and vary the amounts and vesting schedules and other details in a tailored agreement.
5. Compared to qualified plans, NQDCs are less regulated, require minimal reporting and filing and so tend to be cheaper to set up and manage. Contributions are also offset against current-year tax.
Benefits for the employee
1. A traditional NQDC offers the employee flexibility in that he or she can choose to defer a portion of income to a future time in order to reduce tax exposure while likely in higher earning time periods.
2. Most plans provide investment options allowing for potential growth of deferred income.
3. Ability to structure income for retirement income planning.
4. No income limits unlike 401k plans.
5. The employee can choose how this income is paid out after retirement. Linked life insurance policies can be cashed in for a versatile lump sum, and options traded gradually to give a more regular income stream.
6. If the assets are held in insurance policies, this can be a useful extra package of employee benefits, including disability, critical illness, and long-term care as well as substantial death benefits.
7. By deferring the point at which tax is paid to retirement when the individual may well be moving to a lower income bracket or physically moving to a lower income tax state, the overall tax exposure will be reduced, which of course maximizes the deferred compensation. Also, rising state taxes will not have such an effect on later income.
The flexibility of NQDCs is part of their appeal, to employers and employees alike; however, this very flexibility and reliance on multiple factors requires close monitoring of the related tax rules, which could change over time.
When considering a NQDC, employees should consider the length of the deferral period as the longer it is the more valuable the effect of the tax shield. Also, assumed rates of investment return can have a large impact on the final value. Personal circumstances like these can cause the results to vary greatly, so advice should always be taken. Another point to consider is the individual's attitude to risk and investment strategy, which an independent advisor will always explore.
Ultimately, whether you choose to use a deferred compensation plan or one is automatically provided for you, they can be both a fantastic opportunity and risk to your wealth. Evaluate the benefits and risks carefully and leverage these great platforms to maximize your long-term results.
*Please consult a financial professional prior to making an investment decision.