The Advantages of a Nonqualified Deferred Compensation Plan
A nonqualified deferred compensation plan (NDQP) is a salary-deferral arrangement whereby an employee, typically an executive or other highly compensated employee with limited access to 401k or other more conventional retirement savings vehicles, elects to defer receipt of a portion of her income. Instead, the company keeps control of the money and promises to pay the deferred compensation at a later date, such as retirement. The employee defers paying income tax on the money. In exchange for the tax deferral, the IRS generally requires that there be a "substantial risk of forfeiture" of the deferred amount.
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Qualified vs. Nonqualified
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A qualified retirement plan is any workplace retirement plan that falls under the Employee Retirement Income Security Act of 1974, or ERISA. Examples include traditional defined benefit pension plans as well as defined contribution plans such as 401ks, 403bs, SEP IRAs and SIMPLE IRAs. Congress requires sponsors of qualified plans to make benefits available to rank and file workers; it does not allow executives to discriminate based on class of employee or to restrict participation to executives. Nonqualified plans allow for discrimination and require fewer administrative burdens as well.
Advantages to the Employee
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In addition to tax deferral, nonqualified plans offer workers the following advantages: There is no requirement to wait until age 59 and a half to access the money, nor are there any required minimum distributions. Assets within NQDPs are not constructively received by the employee, and are therefore not considered part of the estate. If the employee dies without receiving the benefit, there is no estate tax due. Employers frequently use permanent life insurance to fund NQDPs, which pays a lump-sum, tax-free death benefit to the worker's heirs, so the family is taken care of without having to pay income or estate taxes. Furthermore, if the employee is sued, creditors cannot attach assets within a NQDP without also pursuing a claim against the company.
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Advantages to the Employer
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Employers have much more flexibility in designing a nonqualified plan than a qualified one. They can target certain classes of employees and even restrict participation, and any company match, to senior management if desired. They can also structure the plans to provide "golden handcuffs," or an incentive for the worker to stay with the company a certain amount of time. Further, NQDC plans are not subject to the IRS's requirement that pension contributions covered by ERISA be held in a trust: The company maintains control of the assets.
Types of NQDC Plans
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DQDC plans come in two basic types: elective and nonelective plans. Under an elective plan the worker chooses to defer income in advance. Generally, elective plans are not subject to the substantial risk of forfeiture requirement, and are generally payable when the employment arrangement is terminated. Note that if this amount is large enough and paid in a lump sum, the income could force the employee into a higher tax bracket. Nonelective plans are arrangements in which the employer holds funds on the employee's behalf. The employee does not make an election to defer income. These plans are frequently used as salary continuation plans, made available to the employee after a certain number of years of service.
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