What is a Non-Qualified Deferred Compensation?

Arin V., EA , MBA

Arin is an Enrolled Agent (EA), authorized to represent taxpayers in front of the IRS, and holds a BA and MBA (Management) degree from California State University, Northridge.

Recently, our blog articles have focused on topics that are relevant to both ex-pats and entrepreneurs, in particular those who hold overseas assets and/or have started a startup company. Today, however, it is time for a slight detour, to discuss a topic that is less familiar to our audience but is important nonetheless, especially for founders of startup companies who are looking to bring in high-earning executives in the future.

Non-qualified deferred compensation (NQDC) is one way to reward high-earning employees, who, due to the various restrictions and limits of traditional retirement plans, are unable to contribute more money to their retirement accounts. Deferred compensation, just as it sounds, is compensation that has been earned by an employee, but not yet paid by the employer; non-qualified in this case means that the contributions made to the plan are not deductible to the employer until the employee receives the money.

Because compensation that has not yet been transferred to the employee is not part of the employee’s income, this is one way for high-earners to defer ownership of part of their income, avoid income taxes on those earnings not yet received, and enjoy tax-deferred investment growth.

A typical use case for an NQDC plan is as follows. Suppose you are the CEO of a multinational company and you hire an executive on a pay package of $2,000,000 per year. In this scenario, the executive could contribute only $19,500 to their 401(k) plan; this $19,500 amount is equal to less than one percent of the executive’s annual pay. By deferring some of their earnings to an NQDC plan, the executive could postpone paying taxes on that tranche of income and save a higher percentage of their income for retirement than would be allowable under the 401(k) plan. At first glance, this makes perfect sense, as if someone who is accustomed to the lifestyle that higher earnings bring, would probably be unsatisfied with only being able to put away a very small amount of their earnings toward retirement.

What’s especially nice about an NQDC plan is that it isn’t as restrictive as traditional retirement accounts; you can use those savings for purposes other than retirements, such as education or travel. Additionally, it is free of the contribution limits that plague traditional retirement plans. However, along with this greater flexibility comes increased risk, as NQDC plans are not protected against claims made by creditors, which means that an employee could potentially lose their investment in an NQDC plan if the company goes bankrupt or gets sued. With a 401(k) plan, on the other hand, contributions to the plan are held in a trust account that is protected against creditors and bankruptcy. Additionally, with an NQDC plan, you would be unable to roll the money into an IRA or other traditional retirement plan when the compensation is paid to you.

However, despite the few drawbacks, NQDC plans are a powerful way for high-earning executives to take advantage of tax laws and defer income and taxes to a later date while saving more money for retirement.

If you are the founder of a startup, an executive looking to change jobs, or a high-earning ex-pat, please get in touch today to discuss your options for contributing to an NQDC plan, and the tax implications of doing so. Indeed, in today’s highly competitive job market, you want to make sure you are attracting the best and brightest minds to your company, to ensure its long-term success. One of the ways you can do that is through an NQDC plan, whereby you reward your employees for their competency, execution, and dedication to the company.