Non-Qualified Deferred Compensation (NQDC)

Non-Qualified Deferred Compensation (NQDC) plans are contractual agreements under which an employee agrees to defer receipt of a portion of their compensation until a specified future date. Unlike qualified plans, such as 401(k)s which must adhere to ERISA (Employee Retirement Income Security Act) regulations and IRS limits, NQDC plans do not have to meet these stringent rules. Consequently, they are often utilized by high-earning executives and highly compensated employees.

Basic Concepts

NQDC plans allow employees to delay income taxation on portions of their earnings until the funds are actually paid out. This can provide a number of strategic financial and tax planning advantages for both the employee and the employer:

• Employee Advantages:
  • Tax Deferral: Employees defer tax on compensation until it is received in the future, potentially when they may be in a lower tax bracket.
  • Customized Deferral Options: Plans can be tailored to meet the specific deferred compensation needs of employees.
  • Investment Flexibility: Some plans allow the deferred amounts to be invested, potentially providing substantial gains.
• Employer Advantages:
  • Attract and Retain Talent: NQDC plans can be a pivotal factor in attracting and retaining top-tier talent, particularly in competitive industries.
  • Customization: NQDC plans can be designed to meet diverse needs without the constraints that are applicable to qualified plans.

Types of NQDC Plans

NQDC plans come in various forms, each with its own set of rules, benefits, and disadvantages:

Salary Reduction Arrangements

• Advance Arrangements: Employees agree to defer a portion of their salary pre-tax, to be paid at a future date.
• Investments: These funds are often invested in selections that mimic the company’s 401(k) offerings or other specified investment vehicles.

Bonus Deferral Plans

• Mature Arrangements: Executives and other high-earners may elect to defer bonus earnings, delaying tax liabilities.
• Long-term Incentives: This allows employees to tie the bonus to future company performance.

Supplemental Executive Retirement Plans (SERPs)

• Company-funded: Offers additional retirement benefits beyond the qualified plan limits.
• Retention Tool: Often partially vested over time to encourage long-term employment.

Excess Benefit Plans

• Compensation Limit Surplus: Designed to provide benefits beyond what is permissible under qualified plans.
• Dollar Limit Exceeding Contributions: Relevant for employees who would otherwise exceed the defined contribution or benefit limits.

Key Considerations

Tax Treatment

• Income Tax: Deferred compensation is not taxed until it is received.
• Payroll Taxes: Social Security and Medicare taxes are due when the income is earned, not when it is paid.
• Section 409A Compliance: Adherence to IRS rules is essential to avoid tax penalties.

Risk and Investment Options

• Company Solvency Risk: Funds deferred are typically unsecured obligations of the company; if the company faces bankruptcy, these funds could be at risk.
• Investment Options: Depending on the plan, employees may have a variety of investment choices, or the employer may predetermine these.

Timing and Distribution

• Specified Payment Dates: Payouts usually occur at retirement, termination, or other specified times.
• Hardship Withdrawals: Plans may allow for early withdrawal under specific and severe circumstances.

Creating and Managing NQDC Plans

Setting up an NQDC plan involves multiple steps and crucial managerial decisions:

Plan Design

• Customization: The plan should meet the unique requirements of both the employee and the employer.
• Flexibility: Should provide options for changes based on life events and economic conditions.

Funding and Investments

• Rabbi Trust: Employers often use a rabbi trust to hold deferred amounts, offering some protection against company insolvency.
• Investment Diversity: Offering a range of investment options similar to a 401(k) helps employees grow their deferred earnings.

Legal and Compliance

• Section 409A: Ensures the plan complies with deferral elections, distributions, and funding rules to avoid penalties.
• ERISA Exemptions: NQDC plans are generally exempt from ERISA, simplifying compliance.

Employee Communication

• Clear Explanations: Provide detailed explanations about plan benefits, risks, and tax implications.
• Annual Reviews: Regular updates on account performance, changes in tax law, and other relevant information.

Real-world Examples

Here are a few real-world entities that offer or manage NQDC plans:

• Vanguard: Vanguard provides various investment options for managing deferred compensation plans.
• Fidelity Investments: Fidelity offers NQDC administrative services, including recordkeeping and plan compliance.
• Merrill Lynch: Bank of America - Merrill specializes in administering executive compensation programs, including NQDC plans.

Conclusion

Non-Qualified Deferred Compensation plans are a versatile tool used primarily by high-earners to defer tax liabilities and align company performance with individual compensation. Their flexibility in terms of design and investment, coupled with potential risks associated with company solvency, necessitates sophisticated planning and management. The rise of sophisticated administration and recordkeeping services, provided by companies like Vanguard, Fidelity, and Merrill Lynch, ensure these plans remain an attractive option for both employers and employees.

Understanding the nuances of NQDC plans can unlock significant financial benefits, making it imperative for all high-earning executives to consider deferring part of their compensation strategically.