Non-Qualified Deferred Compensation Programs

While qualified plans have strict contribution limits and non-discrimination requirements, non-qualified deferred compensation (NQDC) programs allow executives and highly compensated employees to defer compensation beyond those limits. The tradeoff: far less protection.

What Are the Key Characteristics of NQDC?

• Allow executives and highly compensated employees to defer compensation beyond qualified plan limits
• Subject to strict Internal Revenue Code (IRC) rules governing the timing of deferrals and distributions
• Assets remain part of the employer's general assets (the employee is an unsecured creditor)
• No contribution limits (unlike qualified plans)
• Distributions are taxed as ordinary income when received
• Can be offered selectively: no non-discrimination requirements
• Deferral elections must generally be made before the year in which the compensation is earned

What Are the Deferral and Distribution Timing Rules?

The IRC imposes strict rules on NQDC plans:

• Deferral elections generally must be made and become irrevocable before the beginning of the year in which services are performed
• Regular distribution triggers are limited to: separation from service, disability, death, change in control, unforeseeable emergency, or a fixed date/schedule
• Violations can bring vested deferred amounts not previously taxed into current income, with a 20% additional tax and interest

A separate acceleration exception applies to domestic relations orders. Payment to someone other than the participant, such as a former spouse, may be accelerated to the extent necessary to fulfill the order. The federal payment-timing rules do not require the exception to be written into the plan. Divorce itself is not a regular distribution trigger and does not automatically establish an unforeseeable emergency.

Exam Tip: Gotchas

NQDC timing-rule penalties can be severe: current taxation of affected vested deferrals, a 20% additional tax, and interest. A participant cannot revoke a valid deferral election mid-year merely because the deferred compensation has not yet been paid. Later elections to delay payment must meet separate subsequent-election requirements; permitted acceleration exceptions are distinct.

What Is a Rabbi Trust?

A rabbi trust is an irrevocable trust used to hold NQDC plan assets:

• Named "rabbi trust" because first approved by the Internal Revenue Service (IRS) for a rabbi's deferred compensation arrangement
• Assets are protected from the employer changing its mind about paying the deferred compensation
• Assets are NOT protected from the employer's creditors in bankruptcy
• Provides some security to the employee while maintaining non-qualified tax status

A rabbi trust concerns assets still held for the deferred arrangement. Once an NQDC distribution is paid to the participant, it is ordinary cash, not a protected retirement-plan interest. In the participant's own bankruptcy, it does not receive the special exclusion generally available to a qualified plan covered by the Employee Retirement Income Security Act (ERISA) with an enforceable transfer restriction; ordinary cash exemptions are a separate question.

Exam Tip: Gotchas

A rabbi trust does NOT protect assets from the employer's creditors. If the employer goes bankrupt, the rabbi trust assets are available to satisfy creditor claims. This is what keeps the plan "non-qualified." Full creditor protection would make it a funded plan subject to immediate taxation.

How Does NQDC Compare to a Qualified Plan?

Exam Tip: Gotchas

The employer gets no tax deduction when NQDC contributions are made. The deduction comes only when the employee receives the distribution and pays tax on it. This is the opposite of qualified plans, where the employer deducts at contribution time.

What Should You Check on Exam Day?

• Confirmed the deferral election was made before the year compensation is earned; a late or mid-year change violates IRC timing rules.
• Remembered a rabbi trust protects assets from the employer changing its mind, but NOT from the employer's creditors in bankruptcy.
• Checked that the employer's tax deduction is deferred until the employee receives and reports the distribution, not taken at contribution.
• Distinguished NQDC (no contribution limits, can discriminate) from a qualified plan (IRC limits apply, must be non-discriminatory).