What is Non-Qualified Deferred Compensation (NQDC)?
Non-Qualified Deferred Compensation (NQDC) is a type of compensation arrangement where an employee defers a portion of their salary or bonus to a future date. Unlike qualified plans, such as 401(k) and pension plans, NQDC plans are not subject to the same legal requirements for participation and contribution limits.
NQDC plans are typically offered to highly compensated employees to defer taxes on their compensation and provide a retirement savings vehicle beyond the limits of qualified plans. The deferred compensation is subject to taxation when it is received by the employee rather than when it is earned.
How is Non-Qualified Deferred Compensation Taxed?
Non-Qualified Deferred Compensation (NQDC) is taxed when it is received by the employee rather than when it is earned.
Employees who participate in an NQDC plan defer a portion of their salary or bonus to a future date, typically after retirement. The deferred compensation is not subject to income tax when earned but is instead subject to income tax when the employee receives it.
When the deferred compensation is paid out to the employee, it is taxed as ordinary income and is subject to FICA taxes and any applicable state income tax and local taxes. Additionally, if the deferred compensation is paid out in a lump sum, it may be subject to higher tax rates, such as the highest marginal tax rate.
How to Set up a Non-Qualified Deferred Compensation Plan?
Setting up a Non-Qualified Deferred Compensation (NQDC) plan typically involves several steps:
- Consult with a financial advisor or tax professional to determine if an NQDC plan is right for your organization and to discuss the tax implications and regulatory requirements.
- Determine which employees will be eligible to participate and establish the plan’s terms, such as the contribution limits and vesting schedule.
- Create a plan document that outlines the terms of the NQDC plan, including the deferral election process, distribution options, and the timing of payments.
- Communicate the plan details to eligible employees and allow them to make deferral elections.
- Establish a funding mechanism for deferred compensation, such as an employer-owned life insurance policy or a rabbi trust, which can help protect the deferred compensation from creditors.
- Comply with regulatory requirements, such as the non-discrimination rules, which require that the NQDC plan does not favor highly compensated employees unfairly.
Also, See: After-Tax Contributions