When structuring a compensation package, companies should understand the various compensation choices available: base salary, annual bonuses, nonqualified deferred compensation, equity compensation and fringe benefits. Nonqualified deferred compensation NQDC is a general term that includes plans that provide equity compensation, plans that provide additional retirement benefits and plans that provide mid-term and long-term incentive payments.
Failing to understand these rules breeds expensive and painful situations for an employer and employees. Within the limitations, the NQDC plan rules provide employers with a number of fairly flexible and useful choices for attracting, retaining and motivating top employees.
Some NQDC plans only provide for employee elective contributions, permitting employees to elect to defer compensation earned in one year until a later time or event as stated in the plan. Other NQDC plans provide for employer-only or employee and employer contributions.
NQDC plans can provide for a single benefit such as payment in a lump sum after retirement, on reaching a stated event, or at a specified date or can allow the employee to choose among various payment choices such as an employee choice between benefit payments after three, five or seven years and employee choices between lump sum payments or payments over a stated period of time.
Employers typically offer NQDC plans only to top management or other highly compensated employees and generally should not cover nonhighly compensated employees. As a tool for attracting and retaining top talent, a NQDC plan offers several advantages compared to qualified deferred programs.
Also, a NQDC plan can discriminate in favor of higher compensated employees and amongst employees in various compensation levels, which becomes problematic in a qualified retirement plan. For companies experiencing temporary cash flow issues, NQDC plans offer convenient opportunities when the company expects an improvement in cash flow in later years and wants to continue with promised benefits but cannot currently pay the benefits.
Further, by design, NQDC plans can reward 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. This gives a company flexible methods for awarding the type of behavior that is likely to bring about desired company results such as increasing stock value or selling for a good price. An employer can design a plan to vest over time, vest at the time of grant, or without vesting conditions.
Like other compensation, employers report the distributed amount as taxable compensation. Under a qualified retirement plan such as a k plan , employers deduct expenses in the year they remit payments to the trust, even though employees will not recognize income until the later years upon receipt of distributions from the plan.
Under a NQDC plan, employers can only deduct the benefit as the employee includes the benefit in taxable income. NQDC plans rules impose federal and generally state income tax withholding requirements in each year in which employers distribute and include amounts in employee compensation.
For payroll tax purposes, employers generally take into account NQDC amounts as FICA wages at the later of 1 when the employee performs services, or 2 when the employee vests in the right to receive the deferred amounts.
As a result, payroll taxes typically apply to NQDC before the employee receives payment, and before income tax applies. As an added benefit, any earnings accruing under the plan after the vesting dates will not be subject to payroll taxes.
The funds then grow tax-deferred until withdrawals are made at retirement. If you retire in a lower tax bracket or lower-tax jurisdiction you will benefit from the tax deferral upon retirement. Income Tax. Life Insurance. Retirement Planning. Retirement Savings Accounts. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page.
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I Accept Show Purposes. Your Money. Personal Finance. Your Practice. Popular Courses. Retirement Planning Retirement Savings Accounts. What Is Deferred Compensation? Key Takeaways Deferred compensation plans are an incentive that employers use to hold onto key employees. Deferred compensation can be structured as either qualified or non-qualified. The attractiveness of deferred compensation is dependent on the employee's personal tax situation. These plans are best suited for high earners.
The main risk of deferred compensation is if the company goes bankrupt you may lose everything put away in the plan. Pros No contribution limits Tax-deferred asset growth Current-period tax deduction. Cons Can lose money if the company goes bankrupt Illiquid Only intended for high earners No way to borrow against. Home retirement. February 14, At what age do anticipate retiring? When do you plan to take Social Security?
We often advise clients to take deferred compensation distributions upon retirement and defer commencing Social Security. Should you ladder annual lump sum distributions or take equal distributions over a period of years?
This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. About the Author. Most Popular. Tax Breaks. February 25, By entering, you certify that you are a resident of one of these states. All information herein has been prepared solely for information purposes, and it is not an offer to buy or sell, or a solicitation of an offer to buy or sell any security.
Hear about us on Radio or TV? Client Access. Request a Meeting. Resource Library Search. Share This. What is deferred compensation? How does deferred compensation work? How is deferred compensation taxed? What are some risks associated with taking NQDCs? Is a deferred compensation plan right for me? Here are some questions to consider: Are you maximizing your traditional retirement plan contributions? Do you plan to be with your company until retirement?
Will you be in a lower tax bracket when the deferred compensation payments start? Are you comfortable with the distribution options?
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