Does your organization offer a 401(k) plan to its employees? This is a common fringe benefit for the rank and file. However, some employers might want to take their benefits packages to the next level by offering special options to key employees. In such cases, a nonqualified deferred compensation (NQDC) plan could fit the bill.

Qualified vs. nonqualified

When it comes to understanding the concept of an NQDC plan, be sure to first know the difference between a qualified and nonqualified plan.

Under a qualified plan, so long as the employer follows various tax law requirements, its contributions are deductible when made and payments to participants are guaranteed. A 401(k) is a type of qualified deferred compensation plan.

With a nonqualified plan, participants rely on the employer’s promise to pay out the benefits at a specified date — but there are no guarantees. Participants run the risk that the organization might run out of money before any dollars are paid out.

This is because a key design component of most NQDC plans is that they’re “unfunded.” The employer can’t set aside money to fund the plan. A mitigating factor for participants, though, is that they’ll owe no tax on the deferred compensation until they receive it.

No more “haircuts”

Usually, employers intend to preserve tax deferral until payments are made to participants when they retire. That’s why NQDC plans are typically designed to be unfunded.

However, because of changes to tax law and accompanying regulations, certain restrictions now apply to the timing of NQDC plan distributions. If a plan doesn’t meet the requirements, the deferred compensation could become currently taxable. Specifically, funds can’t be distributed before:

  • Separation from service (plus an extra six months for key employees of publicly traded companies),
  • Death or disability,
  • A date specified by the participant at the time of deferral (or per a fixed schedule elected by the participant),
  • A change in control (subject to IRS guidance), or
  • The occurrence of an unforeseeable emergency.

Thus, subject to limited exceptions, NQDC plans can no longer include what are sometimes called “haircut” provisions that allow participants to receive accelerated distributions in exchange for paying a penalty.

Complex arrangements

As you can see, NQDC plans are complex. There are many potential tax pitfalls, so an employer considering one should first learn the rules and be prepared for compliance challenges.

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