These plans allow top performers and highly paid executives to receive bonuses and other forms of compensation when it may be more tax efficient for them—usually in retirement.
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Why businesses should use nonqualified deferred compensation plans
A nonqualified deferred compensation plan (NQDC) can be a valuable tool for companies that want to retain top performers and improve cash flow. That’s because these plans allow you to delay the payment of bonuses or other forms of compensation until your employees need them most (usually in retirement).
Payroll, taxes, expenses, and corporate-owned life insurance are only a few buckets of a company’s finances. It’s essential to have deferred compensation plans in place to help provide stability.
A quick look at nonqualified deferred compensation plans (or nonqualified deferment compensation plans)
A nonqualified deferred compensation (NQDC) plan is an agreement that gives a business permission to set aside some of the money an employee is owed and pay it in the future. The money, which can be distributed in a lump sum or allocated over time, is usually deferred until retirement—when the employee’s tax burden may be lower.
What’s the difference between qualified and nonqualified plans?
In general, qualified plans are funded with pretax money—like a 401(k)—and nonqualified plans use after-tax dollars. Another major distinction is that any money put into a nonqualified plan becomes a business asset and is controlled by the company until paid. Any contributions paid into a qualified plan are held separately and considered the employee’s personal assets.
How nonqualified deferred compensation plans can help owners and employees
For business owners, nonqualified deferred compensation plans can offer the following advantages:
Better cash management—Since payroll is often a business’s largest expense, deferred compensation can help you keep more cash on hand during slower periods.
Improved recruiting and retention—By adding an NQDC plan, your benefits package will become even more attractive.
Greater selectivity—Unlike 401(k)s or other tax-qualified plans, you can choose which employees are eligible. You are not required to offer this benefit to every employee.
For employees, an NQDC can be a powerful benefit:
Tax advantages—By deferring some of their compensation, workers can postpone any federal income taxes that would normally be due on this money. This can be especially helpful if the employee expects to be in a lower tax bracket when they finally accept payment.
Unlimited contributions—Unlike most tax-qualified plans, there is no cap on how much income employees can defer.
Control and flexibility—With an NQDC, your employees get to decide when they would like to receive their money, and how (a lump sum or incremental payments).
Yes, there are some drawbacks
While nonqualified deferred compensation plans have lots of advantages, there are a few negatives your employees need to consider:
No early withdrawals—Unlike a 401(k) or other qualified plans, your employees cannot access this money before the specified date.
No protection from loss—Since this money becomes a business asset, it could disappear if something happens to the company before your employee receives payment.
No investment options—With an NQDC, there is no investment component, so employees do not have the opportunity to diversify their holdings or pursue market returns.
How to handle payroll taxes and withholding
In most cases, federal income taxes are paid by the employee when the money is actually received. Deferrals should be reported on Form W-2 annually, but they are not subject to income tax withholding at the time of the deferral. Conversely, FICA taxes (Social Security and Medicare) are due when the compensation is earned, not when it is paid.
Using life insurance to fund a nonqualified deferred compensation plan
Some businesses use a supplemental executive retirement plan (SERP) to defer compensation, which can provide an employee with supplemental retirement income at a date that is agreed on in advance. If you are looking for an easy and effective way to fund a nonqualified deferred compensation plan, you may want to consider corporate-owned life insurance (COLI). In this case, the business purchases a life insurance policy for an employee and uses the benefits to compensate the employee at a later date. A COLI policy can be included in a business’s general asset reserve for nonqualified deferred compensation plans, complying with generally accepted accounting principles (GAAP).
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New York Life offers a range of diverse and innovative small-business solutions. Connect with our team of trained professionals today and learn how they can help you set up your business for a secure and successful future.
Nonqualified deferred compensation plan FAQs
Absolutely not. While nonqualified deferred compensation plans are sometimes called “executive deferred compensation plans” because they are often used to pay executive bonuses, you can use them to reward any of your top-performing employees.
A 401(k) is a retirement savings vehicle that lets employees invest pretax dollars and capitalize on tax-deferred growth. 401(k)s are generally available to all employees; however, there are limits to how much they can contribute annually. In contrast, nonqualified deferred compensation plans are paid by the employer and are usually offered to select employees as a bonus. While there are no limits to how much compensation can be deferred, employees do not receive any pretax benefits from these plans.
It does, but not right away. Federal income taxes are due only when the funds are received.
In some cases, yes. If your state has an income tax, it’s important to check with your accountant or tax advisor to see how these plans are treated.
Neither New York Life Insurance Company, nor its agents, provides tax, legal, or accounting advice. Please consult your own tax, legal, or accounting professional before making any decisions.
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