Non-Qualified Deferred Compensation

Non-Qualified for what? A Qualified plan, such as a 401(k), Profit-Sharing, or Defined Benefit Pension Plan, must fulfill certain requirements under ERISA and other legislation to "qualify" for tax deductibility and deferral. They must satisfy nondiscrimination rules (equal benefits for all employees regardless of position or class), participation rules (must include all eligible employees), and funding limits (maximum contribution limits) to "qualify" for tax deductibility.

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Non-Qualified Deferred Compensation Plans (NQDC) are not designed to satisfy these requirements, consequently, plan contributions are not tax deductible, but they are also not subject to these rules or limitations. They can accommodate much larger employer contributions and salary deferrals to offer more flexibility and meaningful benefits to highly compensated executives and owner employees. NQDC plans serve as an incentive to attract, reward, and retain key employees; also known as "golden handcuffs." 

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One caveat regarding these plans is that the assets must be subject to a "substantial risk of forfeiture" to avoid inclusion in the employee's taxable income. This is accomplished by holding them as general assets of the company subject to the claims of the company's creditors. This becomes much less of a concern for larger, more stable entity, governmental, or institutional plans.

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In a low tax environment, or for entities that are tax exempt, they may elect to use taxable investments, such as mutual funds, as a funding vehicle. A common practice for taxable entities and in high tax environments is to use specialized institutional life insurance policies to fund these arrangements. The cash accumulation, distributions, and death benefits are generally income tax free and the internal costs tend to be much lower than retail policies. In addition, many of these policies offer a platform of self-directed investment options similar to a 401(k) plan.

 

Although the contributions or premiums are not deductible, the distributions or withdrawals and low interest policy loans are generally tax free to the entity. The entity can then deduct the distributions payable to the employee and can elect to enhance the benefits by factoring in their deduction based on their tax bracket. The policies serve a dual purpose by also providing valuable Key Person Life Insurance protection for the employer.