Deferred Compensation

The Basics of Nonqualified Deferred Compensation Plans

Consider bolstering your executive benefits program with a powerful tool that can help attract and retain key employees. Nonqualified Deferred Compensation (NQDC) Plans may be a valuable and flexible wealth planning tool for key executives and other highly compensated key employees. In this article, Morgan Stanley at Work helps demystify NQDC plans and discusses their potential advantages.

 

What Is an NQDC Plan?

In general, a NQDC plan is a workplace benefit offered by a plan sponsor to highly compensated employees (HCEs) and key executives that can allow for employer and employee contributions. Because most NQDC plans are unfunded, this article will focus on unfunded plan types. With a properly designed and operated unfunded NQDC plan, the amounts contributed to the plan are not includable in the employee’s income for income tax purposes until the amounts are paid or made available to the employee in a subsequent tax year, .  However, in general, an employer may not claim an income tax deduction for the amounts contributed to the plan until the year in which such amount is includible in the employee’s income for income tax purposes. So let’s take a deep dive into why these plans can be an attractive part of an executive benefits package.

 

What Are the Benefits?

NQDC plans continue to expand as companies compete to attract top executive talent. Unlike 401(k)s, NQDC plans generally are not subject to statutory contribution limits, which make them even more enticing to high-earning employees, who may easily max out an employer-sponsored qualified retirement plan. By understanding the advantages and potential risks of these plans, you can ensure you have what you need to decide if they are appropriate for your company’s needs.

Benefits for Companies:

  • Helps employers stay competitive with a powerful recruitment and retention tool for executives.
  • May be used to reward certain employees for meeting specific performance metrics (either individual metrics or company metrics) and can provide for vesting over time or only on the occurrence of events stated in the plan.
  • Employers can create these plans at any time of the year.

Benefits for Executives:

  • May reduce current income taxes and provide tax-deferred savings opportunity​.
  • Receive payouts while still employed (subject to certain requirements).
  • Provides an additional tax-deferred savings vehicle for executives limited in 401(k) participation and company matching due to contribution limits and/or discrimination testing.

Qualified 401(k) Plan vs. Nonqualified Plan

  QUALIFIED 401(k) PLAN NQDC PLAN
PARTICIPANT POPULATION Generally All employees Highly compensated employees and key executives
CONTRIBUTIONS
  • The plan can generally be designed to allow:
  • employee salary deferral contributions of (a) up to $23,000 for 2024, or (b) $30,500 for those age 50 and over for 2024; and/or
  • employer contributions up to the lesser of 25% (or, for self-employed individuals, 20%) of the employee’s compensation (subject to $345,000 limit for 2024) or $69,000 (for 2024).
  • Note: the $69,000 limit applies to employer contributions and salary deferral contributions combined (but does not apply to catch-up contributions for those who are age 50 or older). Other limitations may reduce the amount that can be contributed for, or on behalf of, a participant, depending on the type of contribution and the design of the plan.
  • Deferral Election: The deferral election generally must be made by the employee before the compensation is paid to the employee or otherwise considered “currently available” to the employee. Additional timing restrictions may apply under the terms of the plan.
  • The contributions to the plan are generally income-tax deductible by the employer and not includable in the employee’s taxable income. However, salary deferral contributions are subject to Social Security and Medicare (FICA), and federal unemployment (FUTA) taxes; employer contributions are not subject to FICA and FUTA taxes.
  • The plan can generally be designed to allow:
  • employee salary deferral contributions and/or
  • employer contributions, with no statutory maximum for either type of contribution. The maximum contribution amount depends on terms of the plan.
  • Deferral Election: The election generally must be made by the employee prior to the tax year in which the compensation to be deferred is earned (subject to certain limited exceptions). Additional timing restrictions may apply under the terms of the plan.
  • The contributions (salary deferral and employer) to the plan are neither income tax deductible by the employer nor includable in the employee’s taxable income. However, contributions to, and earnings under, the plan are generally subject to FICA and FUTA taxes to the extent not subject to a substantial risk of forfeiture (e.g., vested). If the contributions and/or earnings are initially subject to a substantial risk of forfeiture, then they are generally not subject to FICA or FUTA taxes until they are no longer subject to a substantial risk of forfeiture.
DISTRIBUTIONS

Generally, a plan cannot permit a distribution until a permissible triggering event has occurred, such as severance from employment (e.g., retirement), death, qualifying disability, attainment of age 59 ½, or qualifying hardship. The permissible triggering events may differ for different types of contributions (and the earnings attributable to such).

The form and timing of the distribution(s) is elected at the point of distribution.

Distributions are generally includable in the employee’s taxable income and, if made before age 59½, subject to a 10% penalty tax (unless an exception applies). Since the employer received an income tax deduction for the contribution to the plan, the employer is not entitled to a deduction for a distribution from the plan.

Required minimum distributions generally must begin once the participant (a) reaches RMD age (which is currently age 73) or (b) retires from employment with the plan sponsor, if later than RMD age and the participant is not considered a 5% owner.

Generally, amounts deferred under the plan must be payable only upon specific, permissible events stated in the plan, such as separation from service (e.g., retirement), qualifying disability, death, specified date or fixed schedule, qualifying change in control, or qualifying unforeseeable emergency.

The form and timing of the distribution(s) must be elected at the time of the deferral election. Distributions from the plan generally cannot be accelerated (subject to limited exceptions).

Distributions are generally includable in the employee’s taxable income but are not subject to the 10% penalty tax for pre-age 59½ distributions. The employer is entitled to a corresponding income tax deduction for the amount distributed from the plan that is includable in the employee’s taxable income.

No required minimum distributions.
INVESTMENTS

Typically allows the participant to make the investment decisions for the assets held in the plan for them and to select from a menu of investment options.

Depending on the design of the plan, may allow participant to select from a menu of investment crediting options (which determines the amount payable to the employee in the future).
FUNDING

Funded – generally, must be irrevocably set aside by an employer in a qualified trust for the sole benefit of the participants and their beneficiaries. Not subject to the employer’s bankruptcy and insolvency creditors.

The assets within the qualified trust potentially grow on a tax deferred basis.

Unfunded – generally, a NQDC plan must be unfunded, meaning no assets of any kind being maintained in connection with the plan or if there are assets maintained in connection with the plan (informal funding), such assets must be subject to the claims of the employer’s bankruptcy and insolvency creditors.

To the extent there is informal funding of the plan, the employer is subject to income taxation on the taxable growth of the assets (e.g., dividends, interest, capital gains), unless a tax-favored asset (e.g., corporate-owned life insurance, which generally provides tax-deferred growth potential and may provide a fully or partially tax-free death benefit) is used.
ERISA PROVISIONS

Generally covered by ERISA, unless the plan is a governmental plan, a non-electing church plan or a plan that doesn’t cover any common law employees (i.e., a plan that only covers the owner of the plan sponsor or the owner and their spouse).

Generally, an unfunded NQDC plan is not subject to ERISA’s participation, funding, vesting or fiduciary provisions.

Upon bankruptcy/insolvency, participants are generally treated as general unsecured creditors of the employer.

Nonqualified Plan Considerations

There are many aspects of a NQDC plan benefit that make the option worth a second look for many companies and their higher-earning employees. In fact, 82% of business leaders are now offering NQDC plans to retain top talent.1

 

Our Morgan Stanley Financial Advisors are here to help answer questions you may have about NQDC plans and help you consider with your legal and tax advisor whether a NQDC plan is right for your organization.

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1 https://webfiles2.nfp.com/webfiles/public/Web/Exec-Ben/NFP-Exec-Ben-Report-2022-2023.pdf

 

Disclosures

This material does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it.

The strategies and/or investments discussed in this material may not be appropriate for all investors. Morgan Stanley recommends that investors independently evaluate particular investments and strategies and encourages investors to seek the advice of a Financial Advisor. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.

Nonqualified deferred compensation plans established by private sector employers are generally designed to comply with an exemption under ERISA, which exempts such plans from most (or potentially all) of ERISA’s requirements for employee benefit plans. Failure to comply with an available exemption under ERISA will generally cause the plan to be subject to potentially onerous ERISA requirements and may result in adverse consequences if those ERISA requirements are not met.

Nonqualified deferred compensation plans are generally subject to section 409A of the Internal Revenue Code, along with other federal tax rules, which impose specific requirements on such plans (including, but not limited to, specific requirements concerning deferral elections and the time and form of distributions under the plan). Failure to satisfy these requirements can result in significant adverse consequences, including (but not limited to) inclusion in the employee’s taxable income of all vested compensation deferred under the plan, plus interest and a 20% penalty tax. 

This material does not reflect the impact of state and local income taxes. The state and local income tax treatment of a qualified retirement plan and/or a nonqualified deferred compensation plan may differ from the federal tax treatment. You should consult with and rely on your own independent tax advisor.

Tax laws are complex and subject to change. Morgan Stanley and its affiliates, employees and agents do not provide tax or legal advice. Employers (and other service recipients) should consult their own tax and legal advisors before establishing a nonqualified deferred compensation plan, and regarding any potential legal, tax, and other consequences of any investments or other transactions made with respect to a nonqualified deferred compensation plan. Eligible employees (and other eligible service providers) should consult their own tax and legal advisors before deciding to participate in, or making any elections with respect to, a nonqualified deferred compensation plan

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