Why you might consider an NQDC plan
An NQDC plan may be a valuable addition to your benefits package if you have select employees you want to reward or motivate. You may simply want to help them increase their income, or you may want to provide them with an incentive by aligning their activities to your business objectives. Employees may benefit by receiving:
- Higher income-tax deferral opportunities than qualified plans allow
- The ability to defer taxes on bonuses, incentive compensation, stock options, and other types of non-salary income
- Fewer restrictions than qualified plans for distributable events
- The opportunity to increase their income replacement in retirement
These plans may also offer you greater flexibility compared with their qualified plan counterparts, including:
- Control over plan eligibility and who can participate, considering best practices and the Internal Revenue Code (IRC) Section 409A
- The option to match employee deferrals
- How to informally fund, if at all, and invest plan assets
- Being exempt for many reporting obligations required by the Employee Retirement Income Security Act of 1974 (ERISA); NQDC plans must comply with the rules of IRC Section 409A
Types of contributions executives can make
Tax deferral is a primary benefit to employees participating in NQDC plans. And unlike qualified plans, NQDC plans may offer more flexibility in the type and amount of compensation that participants can defer.
High salaries—Many NQDC plans allow participants to defer their income beyond the IRC Section 415 limits. The same applies to plan sponsor contributions that would otherwise be limited in qualified plans. This feature helps highly paid individuals achieve a higher income replacement ratio in retirement.
Performance or incentive bonuses—Executives or highly compensated employees (HCEs) with large bonus targets can decide each year whether they want to defer part, or all, of their bonus to a future date. The same applies to salespeople or other commission-oriented roles. This option can help reduce current income and spread the tax burden of one-time or large, infrequent payments over multiple years.
Your business entity affects your NQDC plan structure
The type of business you run factors into the decision to offer an NQDC plan, or at least how you might structure it. Are you one of several pass-through entities, a C corporation, or something else?
S corporations, sole proprietorships, partnerships, LLCs, and tax-exempt nongovernmental employers—Business profits are passed through to partners to report the gain or loss on their personal tax filings. This pass-through feature makes NQDC plans less effective for owners/partners—their income deferrals are considered revenue to the company and immediately taxable to the partners of the company (i.e., themselves). Non-partner participants are unaffected.
C corporations—All participants can defer taxes from their income, regardless of their ownership stake, unlike pass-through entities.
Employers take tax deductions only when benefit payments are made to employees, regardless of the business entity.
How to determine eligibility
The makeup of your employee base can influence who you elect to be eligible for your NQDC plan. Here are some questions to answer:
- How many total employees work for your company?
- How many workers are considered HCEs—greater than 5% ownership or paid more than $135,000?
- How many employees are owners of the company?
NQDC plans usually cover a small fraction of total employees, limited to HCEs and select management. There isn’t a regulatory limitation, but a smaller percentage of employees covered in the plan can help avoid IRS audits and a violation of IRC Section 409A.
Company performance affects confidence in the plan
NQDC plans are a promise by plan sponsors to pay employee benefits in the future. Assets set aside to informally fund the plan are subject to general creditors in the event of bankruptcy. If the company goes bankrupt, participants’ benefits can be unlikely to be paid, unlike qualified plan accounts, which are owned by the participants and not subject to creditors.
Cultivate participants’ confidence by focusing on your business results—positive and increasing cash flows, revenue, and profit—to help reduce the risk of asset forfeiture due to bankruptcy. Combine strong business results with informal funding to create an NQDC your select group of employees will want to participate in.
Your nonqualified plan questionnaire
Create a questionnaire for yourself if you’re contemplating whether you should offer an NQDC plan or how you should go about designing it. Consider why you want to offer it in the first place—what are your goals of the plan? See how eligible employees get paid and consider if it may make sense to revise their compensation structures to make the plan more enticing. Deliver strong business results to help boost plan participation and create an effective retention and talent acquisition tool.
Consider consulting with a financial professional before implementing a new NQDC plan to ensure it’s the right decision for your business and your employees.
This information is general in nature and is provided solely for educational and informational purposes. John Hancock does not provide legal, accounting, or tax advice. Participants should obtain advice specific to their circumstances from independent legal, accounting, investment, and tax advisors, including specific advice as to the applicability of the Employee Retirement Income Security Act of 1974 (ERISA) to a nonqualified plan.