What Is a Nonqualified Deferred Compensation Plan?
Like a 401k, Nonqualified Deferred Compensation plans operate on classic "now and later" savings principles. An NQDC plan allows an employee delay a portion of her wages until a later date, usually retirement. This serves to lower current income tax and fund retirement. NQCD plans differ from 401k plans because they are not tax-preferred savings plans as outlined by Section 401a of the tax code.
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Preferred Employees
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Unlike 410(k) plans, IRAs and other tax-preferred savings plans, NQDC plans do not qualify for special tax treatment because they are not subject to the rules of Section 401a. Qualified plans are required to contribute an equal percentage of compensation for everyone and cannot be "top heavy," that is, higher paid employees cannot defer more on average than those who receive lower wages. NQDC plans can be discriminatory---everyone in a company is not entitled to an NQDC, and employees may have different deferral arrangements. Because of this, these plans are often used to reward top performers or to provide additional tax deferred compensation in offices with large wage differences between employees, such as nurses and doctors.
Funded vs. Unfunded
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NQDC plans are either funded or unfunded. A plan is funded when the employer sets aside funds in a trust or other protected account with the employee as a beneficiary. An unfunded account is simply a promise to pay. An employer may set aside funds, often in a Rabbi trust, but they are not protected from creditors and the employee has no claim to them.
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Tax Deferral
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Most employers structure NQDC plans so that they are not included in the employee's taxable income. This usually involves reducing the employee's claim to deferred wages or leaving the plan unfunded. In some cases, contributions to the NQDC plan may be counted as current wages. If so, they become taxable as employee income, but are deductible from employer income.
Types of Plans
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Excess benefit plans are designed to make up for limitations on tax-deferred contributions into 401k or other qualified plans when discrimination testing limits the contributions of higher paid workers. Top hat plans provide special benefits for select groups of employees, usually top-tier management. Depending on the plan, employees may defer regular wages, bonuses, special compensation or some combination of the three.
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