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.
Characteristics
- 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
Deferral and Distribution Timing Rules
The IRC imposes strict rules on NQDC plans:
- Deferral elections must be made before the beginning of the year in which services are performed
- Distribution triggers are limited to: separation from service, disability, death, change in control, unforeseeable emergency, or a fixed date/schedule
- Violations result in immediate taxation plus a 20% additional tax and interest
Exam Tip: Gotchas
NQDC timing-rule penalties are severe: immediate taxation + 20% penalty + interest. If a question describes an NQDC plan that lets the executive change distribution timing after the deferral year, that violates the deferral-election rules.
Rabbi Trusts
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
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.
NQDC vs. Qualified Plans
| Feature | NQDC | Qualified Plan |
|---|---|---|
| Contribution limits | None | IRC annual-contribution limits |
| Tax deduction for employer | At distribution (not contribution) | At contribution |
| Creditor protection | No | Yes (Employee Retirement Income Security Act (ERISA) trust) |
| Discrimination allowed | Yes | No |
| IRS approval required | No | Yes |
| Taxation of distributions | Ordinary income | Ordinary income (or tax-free for Roth) |
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.