1. Nonqualified deferred compensation plans (NQDC) allow pretax compensation to be deferred by an employee, thereby lowering his or her current taxable compensation and delaying payment to a later year (e.g., retirement).

  • Plans can also be designed to have employer-paid contributions without the employee deferring his or her own compensation, or a combination of both salary deferrals and employer contributions
  • NQDC plans often supplement an employer’s tax-qualified plan, particularly if highly paid employees are unable to defer the maximum allowed by law into their qualified retirement plan due to nondiscrimination testing failures

2. NQDC plans are pension benefit plans under ERISA; however, most of the substantive provisions of the law will not apply to a plan which is unfunded and is maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees. This is often referred to as the top-hat retirement.

  • The ERISA provisions that will not apply to such a plan are:
    • Participation and vesting1
    • Funding2
    • Fiduciary responsibility3

3. Internal Revenue Code section 409A governs NQDC arrangements.

  • If an NQDC plan fails to meet the requirement of IRC Section 409A, all compensation deferred under the plan for the taxable year and all preceding years will be included in the gross income of the employee along with late payment interest and an additional amount equal to 20% of the compensation which is required to be included in gross income4

4. There are 4 basic requirements for NQDC arrangements.

  • The plan must be unfunded
  • The plan must be provided for select management and highly compensated employees
  • There must be a written agreement setting forth the substantive provisions of the plan5
  • The arrangement must comply with IRC Section 409A6

5. IRC Section 409A requires that deferral elections must be made in the tax year prior to the tax year in which compensation subject to the election is earned.

  • An exception to the rule: If an employee has “performance-based compensation,” the employee may make the deferral election no later than 6 months before the end of the performance period7

6. IRC Section 409A specifies these distribution triggers for NQDC arrangements:

  • Death
  • Disability
  • Separation from service
  • Change in control
  • Unforeseeable emergency
  • Specified date/event8

7. When informally funding an NQDC, employers will want to consider both taxable assets (mutual funds and annuities) as well as tax-deferred assets (corporate-owned life insurance) as potential funding vehicles for their arrangements. These considerations include:

  • The employer’s liquidity needs
  • The taxation of the asset
  • The assets’ impact on the employer’s earnings

Key differences between tax-qualified and NQDC plans

Participation Must include all eligible employees The employer selects the employees, who must be management or highly paid
Vesting Statutory vesting schedules The employer can design the vesting schedule, with no restrictions
Funding Contributions/deferrals must be deposited into the qualified plan trust in a timely manner No assets/funds can be held in employees' names; otherwise, those amounts will be taxable income to employees
Creditor access to assets Amounts in the trust are not subject to claims of creditors of the employer or employee
Employer assets that are "earmarked" for an NQDC plan are subject to claims of unsecured creditors, even if held by a rabbi trust
Fiduciary Subject to ERISA fiduciary rules Not subject to ERISA fiduciary rules
Reporting and disclosure Depending on the type of plan, might need to file annual report (Form 5500) and provide summary plan description (SPD), funding and/or fee disclosures, and other mandatory disclosures
One-time notice to the U.S. Department of Labor of the plan's existence; no SPD is required
Tax deduction for employer The employer can deduct contributions (within limits) when made, including elective deferrals by employees The employer cannot deduct contributions (including employees' elective deferrals) until they are paid out of the plan to employees
Contribution amount The amount that can be credited to a participant’s account is limited; the benefit is limited in a defined benefit plan There’s no limit on the amount that can be credited or paid to employees (subject to being "reasonable compensation")
Employee recognition of taxable income Generally, employees recognize taxable income when amounts are paid Employees recognize taxable income when amounts are paid or made available to them
Distributions Depending on the type of plan design, employees might be able to take out loans and hardship distributions, and can elect when, after retirement, to begin distributions
Must begin distributions no later than age 70½, if no longer employed
Distributions can occur only upon events defined in statute: separation from service, death, disability, unforeseeable emergency, change in control, or fixed date or event
Elective deferrals Employees can change, begin or stop deferrals to 401(k) plan at any time Employees must make irrevocable deferral election in the year before the year before the year in which the amount is earned, and can stop deferrals due to unforeseeable emergency or disability
Rollovers Employees can elect to roll over amounts into another qualified plan or IRA, thereby delaying the taxation of those amounts No rollovers are allowed; once an amount becomes payable, it is taxable to the employee
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[1] ERISA Section 201(2).
[2] ERISA Section 301(a)(3).
[3] ERISA Section 401(a)(1).
[4] Code Section 409A(a)(1).
[5] Treasury Regulation Section 1.409A-1(c)(3)(i).
[6] IRS Nonqualified Deferred Compensation Audit Techniques Guide (June 2015).
[7] Code Section 409A(a)(4)(B)(iii).
[8] Treasury Regulation IRC Section 1.409A-3(a).

This material is not a recommendation to buy or sell a financial product or to adopt an investment strategy. Investors should discuss their specific situation with their financial professional.
Federal income tax laws are complex and subject to change. The information in this memorandum is based on current interpretations of the law and is not guaranteed. Neither Nationwide, nor its employees, its agents, brokers or registered representatives gives legal or tax advice. Please have your clients consult with their attorney or tax advisor for answers to their specific tax questions.