Some companies give employees the option to defer a portion of their salary until after they retire using what’s called a non-qualified deferred compensation (NQDC) plan. The plan may be offered in addition to, or in lieu of, a qualified retirement plan such as a 401(k) plan.

The plans are typically offered as a type of bonus to senior executives who can maximize their allowable contributions to the company’s qualified retirement plan. In an NQDC plan, both compensation and taxes due on it are deferred until a later date.

If you’re considering this type of retirement option, you should understand how you’ll be taxed on that money and any gains it makes in future years.

How NQDC plans are taxed

Any salary, bonuses, commissions and other compensation you agree to defer pursuant to a the NQDC plan they are not taxed in the year you earn it. The amount of the deferral can be recorded on the Form W-2 you receive for the year.

You will be taxed on the compensation when you actually receive it. This should happen sometime after you retire, unless you meet the rules for another trigger event that is allowed under the plan, such as a disability. The payment of deferred compensation will be reported on a Form W-2 even if you are no longer employed at that time.

You are also taxed on the earnings you get from deferrals when they are paid to you. The rate of return is set by the terms of the plan. It can, for example, match the rate of return a S&P 500 Index.

Stock or Option Compensation

When compensation is paid in stock and stock optionsspecial tax rules come into play. In such cases, no taxes will be due until the shares or stock options are sold or donated as you wish.

However, you may want to report this compensation immediately. The IRS calls this a Section 83(b) election. It allows the beneficiary to report the value of the property as income now (as opposed to when the stock or options are vested), with all future appreciation growing into capital gains that could be taxed at a relatively favorable tax rate.

If you do not elect Section 83(b), you will owe taxes on the property and its appreciation at the time it is received. However, if you make an election, you will give up the ability to deduct any future losses should the value depreciate.

The IRS has a sample Form 83(b). which can be used to report this compensation now instead of deferring it.

Tax penalties for early distributions

There are tough tax consequences if you withdraw money from an NQDC plan before you retire or when no other acceptable ‘trigger event’ has occurred.

• You are taxed immediately on all deferrals made under the plan, even if you only received part of it.
• The tax penalty for overpayments and underpayments for Q4 2024 is 8%, although corporations are charged 7% for overpayments.

How it affects FICA taxes

Social Security and Medicare Tax (daughter on the W-2) is paid on compensation when earned, even if you choose to defer it.

This can be a good thing because of Social Security’s wage cap. Take this example: Your compensation is $180,000 and you made a timely election to defer another $25,000. For tax year 2024, earnings subject to the Social Security portion of FICA are limited to $168,600.

Thus, $36,400 ($180,000 – $168,600 + $25,000) of total compensation for the year is not subject to FICA tax. For tax year 2025, earnings subject to the Social Security portion of FICA are capped at $176,100, so $28,900 would be exempt if you don’t get a raise.

When the deferred compensation is paid out, say at retirement, no FICA tax will be deducted.

NQDC plans vs. 401(k)s

Chances are you’ll end up contributing to an NQDC plan or a 401(k) plan. These two plans differ significantly in participant eligibility and contribution limits. NQDC plans are typically offered to a select group of highly compensated employees, while 401(k) plans are designed to be more inclusive and open to more employees.

Another critical difference lies in the contribution limits imposed by each plan. NQDC plans offer greater flexibility because participants can defer a portion of their salary or bonuses without the strict annual limits imposed on 401(k) plans.

This flexibility is meant to work in tandem with people who have high incomes and want to defer larger portions of what they make. On the other hand, 401(k) plans adhere to the IRS set contribution limitsmeaning everyone has the same limit on how much they can contribute each year.

Tax treatment is another key difference between the two. In NQDC plans, participants can defer income taxes on their contributions. This can be a key benefit as these high earners can expect to be lower tax brackets in the future.

Meanwhile, 401(k) plans offer immediate tax benefits by allowing participants to contribute before taxes. Note that you can make after-tax 401(k) plans so that certain income can grow tax-free.

Finally, there are some differences in regulatory oversight between the two. NQDC plans, without ERISA regulations, mean employers can be more flexible. Unfortunately, this provides less protection for participants. 401(k) plans are subject to ERISA regulations, so there are certain reporting and disclosure standards to protect people using the plan.

Deserve?

A non-qualified deferred compensation plan, if you have one, can be a considerable long-term benefit. Invest money for your future while deferring taxes due on earnings. This should bring you a bigger accumulation of earnings. However, the day of reckoning will come when you start collecting your deferred compensation. Just be ready for the impact when it hits.

conclusion

Non-qualified deferred compensation plans are offered to selected employees as a benefit in addition to traditional qualified deferred compensation plans such as 401(k)s.

The amount an employee chooses to defer reduces their taxable income, and the deferred amount is not taxed until they receive the funds, usually in retirement. These types of plans are more complicated than traditional retirement plans, and employees who are offered them should carefully understand the terms before participating.