NQDC plans are contracts that defer a certain amount of compensation to a future point in time, such as retirement. They don’t have to comply with the nondiscrimination rules or contribution limits that apply to qualified plans.
Because the promised compensation hasn’t been transferred to your executives, it’s not yet counted as earned income — and therefore it isn’t currently taxed. This reduces current taxes and allows the compensation to grow tax-deferred.
There’s a catch
Although NQDC plans aren’t subject to many of the qualified plan requirements, they are subject to Internal Revenue Code Sections 409A and 451 — which don’t apply to qualified plans.
Sec. 451 sets the parameters for income taxation of NQDC, and Sec. 409A imposes strict requirements on the timing and form of NQDC payments and of any subsequent change in their timing or form.
3 points to remember
Here are three specific compliance points to keep in mind:
- The timing must be right. Employees must make the initial deferral election before the year they perform the services for which the compensation is earned. So, for instance, an employee who wishes to defer part of his or her 2019 compensation to 2020 or beyond must have made the election by the end of 2018. There are exceptions for new employees and certain performance-based compensation.
- There must be an end point. Benefits must be paid on a permissible payment date specified at the time of the deferral. Common examples include death, disability, separation from service, change in ownership or control of the employer, or unforeseeable emergency.
- The money may come later, but probably not sooner. The timing of benefits may subsequently be delayed subject to specific rules within Sec. 409A, but it generally can’t be accelerated except in special circumstances — such as plan termination or compliance with legal requirements. Elections to change the timing or form of a payment must be made at least 12 months in advance of a scheduled payment, and the election may be effective no earlier than 12 months after it’s made.
An effective way
Penalties for noncompliance with NQDC plan rules are harsh for the recipient. They may include taxation of any vested benefits at the time of the deferral plus a 20% excise tax and a “bump-up” in the tax underpayment interest rate.
When the rules are followed, however, these plans allow executives to amass greater savings for later in life, while their employers continue to benefit from their leadership skills. Our firm can provide more information and help you design and implement the right NQDC plan.