Definition
Non-Qualified Deferred Compensation (NQDC) refers to a contractual agreement between an employer and employee, where the employee voluntarily chooses to have part of their compensation withheld by the company, invested, and paid out at a future date. This deferred income is not subject to income taxes until it is disbursed. NQDC plans are nonqualified because they don’t meet Internal Revenue Code qualifications and thus don’t receive most tax benefits associated with qualified retirement plans.
Phonetic
Non-Qualified Deferred Compensation (NQDC): phonetics: /ˌnɒnˈkwɒlɪfaɪd dɪˈfɜ:rd kɒmpɛnˈseɪʃ(ə)n (en-kew-dee-see)/
Key Takeaways
- Deferred Tax Benefits: NQDC allows executives or employees to defer income taxes on their compensation until it’s actually distributed, which can provide a significant benefit in terms of tax planning and savings.
- Creditor Risk: NQDC plans involve a degree of risk as they are unsecured promises by an employer to pay future benefits. If a company goes into bankruptcy, participants in an NQDC plan become general creditors. There’s a risk that they may not receive the deferred compensation.
- Lack of Regulation: Unlike qualified plans such as 401(k)’s, NQDC plans are not subject to ERISA protections or requirements. This provides employers with more flexibility in how they can structure the plan, but it can also mean fewer protections for employees.
Importance
Non-Qualified Deferred Compensation (NQDC) plans are crucial business/finance tools, providing a superior route for enhancing corporate executives’ retirement income. Being ‘non-qualified,’ they aren’t subject to the stringent requirements of the Employee Retirement Income Security Act (ERISA), giving employers greater flexibility in choosing the beneficiaries of these plans. These plans also offer an effective avenue for deferring income tax payment because income tax on the deferred earnings isn’t payable until the funds are distributed, which could potentially reduce the beneficiary’s overall income tax liability if they fall into a lower tax bracket in retirement. Additionally, NQDC plans can act as a strategic retention tool, creating a financial incentive for the plan participant to remain with the company.
Explanation
The purpose of Non-Qualified Deferred Compensation (NQDC) plans is to provide a tool for employers to offer extra benefits to their key employees or executives. They work as a supplementary retirement savings plan over and above the regular retirement plans like 401(k) or IRAs, which have a limit on the contribution amount. NQDC plans offer the potential for tax savings, too, as the money put into them is not taxed until it is withdrawn. Non-Qualified Deferred Compensation (NQDC) is used to attract, motivate, and retain key talent within an organization, especially in highly competitive industries. From an employee perspective, they offer an avenue to defer income tax on more of their earnings, unlike standard retirement plans with contribution limits. This serves particularly well for key executives whose compensations significantly exceed the limits of standard retirement plans. Therefore, NQDC plays a significant role in both employee compensation strategy and personal financial planning.
Examples
1. Executive Retirement Packages: Often, corporations provide their chief executives with non-qualified deferred compensation plans as part of their retirement benefits. These benefits often consist of a portion of their salary and performance bonuses being deferred till their retirement. For example, a CEO could have a contract where they defer $1 million of their yearly pay until they retire. The benefit here is that the CEO can manage their present taxable income better and probably have lower income tax during retirement when they may fall in a lower tax bracket.2. Long-term Incentive Plans: A company might have a long-term incentive plan for crucial employees to retain them and align their interests with the company. For example, a technology startup could defer a portion of its key innovators’ salaries and provide it instead as deferred shares, which would be taxable only upon vesting after a long-term period.3. Bonus Deferral: A firm, especially investment banks or hedge funds, might compensate its investment professionals with a combination of immediate cash and deferred compensation. For instance, a Wall Street investment banker might receive half of their annual bonus in cash, while the remaining is deferred and paid out over several years. This deferral aligns the employees’ interests with the firm’s long-term performance and provides an incentive for them to remain with the company.
Frequently Asked Questions(FAQ)
What is Non-Qualified Deferred Compensation (NQDC)?
NQDC is an agreement between an employee and employer where the employee chooses to have part of their compensation paid out at a later date. This delay is often until retirement, essentially acting as an additional retirement plan.
How is NQDC different from a regular qualified deferred compensation plan?
A Qualified Deferred Compensation plan has certain restrictions and rules it must adhere to under the Employee Retirement Income Security Act (ERISA). NQDC plans are ‘non-qualified,’ meaning they aren’t subject to these rules, hence offering more flexibility for both the employer and employee.
Who typically participates in NQDC plans?
NQDC plans are most often offered to high earners or executives, as it allows them to defer the excess income and thus control their income tax exposure effectively.
When is Non-Qualified Deferred Compensation taxed?
NQDC is taxed when the income is actually paid to the employee. As such, the employee can strategically choose to receive the funds during a year when they expect to be in a lower tax bracket.
Are there any risks involved with Non-Qualified Deferred Compensation?
Yes, there are risks. NQDC plans are considered part of the employer’s general assets and can be seized by creditors if the company goes bankrupt.
Can employers contribute to NQDC plans?
Yes, employers can contribute to NQDC plans, and these contributions can be set up in a variety of ways, including matching the employee’s contribution or as a part of a broader incentive package.
Can an employee lose money they have put into an NQDC plan?
Yes, in the event of a company bankruptcy, NQDC plans are not protected by the ERISA and can be claimed by creditors.
Can the NQDC plan payout period be changed once selected?
Typically, it can be difficult to alter the payout period after it has been set. IRS rules states that changes can only be made under specific circumstances, and even then, the payout must be deferred by an additional five years.
Related Finance Terms
- Vesting Schedule
- Deferred Compensation
- Tax Deferral
- Distribution Plan
- Funding Methods
