What’s a nonqualified deferred compensation plan?
A nonqualified plan is a deferred compensation arrangement between employers and employees that allows the employees to defer income—and income taxes—to a future date. Unlike the IRC Section 415 limits for qualified plans, there are no limits on how much income participants can defer in nonqualified deferred compensation (NQDC) plans. Plan sponsors can also target certain employees they want to include in the plan; there are no nondiscrimination requirements. These features and benefits can give you a competitive edge in attracting and retaining key talent by offering an NQDC plan.
|Qualified plan||Nonqualified plan|
|Subject to ERISA||Yes||No|
|Eligibility and participation||Maximum age and service limits before required eligibility||Can be offered to a select group of management and/or highly compensated employees|
|Nondiscrimination testing||Required||Not required|
|Coverage testing||Required to ensure equitable benefits||Not required|
|Funding||Required by certain annual dates||Technically unfunded|
|Vesting||Maximum vesting schedule terms before becoming fully vested||No requirements|
|Employer taxation||Immediate deduction when money is contributed||Deferred until paid to the employee|
|Employee taxation||Deferred until withdrawn, unless using Roth¹||Deferred until constructively received|
How are nonqualified plans funded?
An NQDC plan isn’t technically funded, so there aren’t participant or custodial accounts to hold plan assets. You decide how to manage participant benefits, which are liabilities to your company. You can informally fund the plan or not fund the plan at all.
Whether the NQDC plan is informally or not funded, the assets intended for NQDC benefit payments are subject to your company’s general creditors, should the company declare bankruptcy.
Not funding your plan means you’re responsible for paying employee benefits from the company’s general assets when they’re due. You aren’t required to set aside or invest assets along the way to keep up with the growing benefits. Unfunded plans operate on a pay-as-you-go approach.
Informally funded plans
Informal funding means you set assets aside in a rabbi trust so the money will be available to pay your employees when their benefits come due. One of the reasons to informally fund your plan is to align your growing liabilities (benefits owed to participants) with a similarly growing asset.
A rabbi trust is an irrevocable trust designed for NQDC plans. Irrevocable trusts don’t allow the grantor—the trust owner—to withdraw assets unless they’re going to pay benefits. Informal funding protects plan assets against employer change of control or change of heart, but not from general creditors in the event of the company’s bankruptcy.
Informally funding your NQDC plan can include benefits such as:
- Greater confidence for participants who see that money is available to pay them in the future versus a simple promise to pay
- Potential tax advantages, including deferred taxes on investment gains for participants or tax-free death benefits
What investments are available for informally funded plans?
You have a few options for investing your assets in an informally funded plan.
Cash or cash equivalents tend to maintain low levels of risk and high liquidity. Cash, or similar short-term duration investments, can be considered as a benefit-paying asset since it’s generally stable in value and easy to liquidate.
Taxable investments, such as mutual funds and similar taxable investments, may offer growth opportunities. This potential growth can be a hedge against your—likely—growing benefit liabilities. Investment sales are taxable events, but you can offset investment gains with company net operating losses or loss carry forwards (if applicable). Plan sponsors should weigh this tax treatment, especially for larger NQDC plans, which may have significant taxable gains over time.2
Corporate-owned life insurance (COLI) can be an effective tax strategy for managing benefit liabilities. The company purchases life insurance policies on participants in the plan and is typically the owner and beneficiary of the policies. The company can invest or earn interest on the cash value—on a tax-deferred basis—and can use it to make benefit payments when due. If the participant dies, the remaining benefit can be paid tax free to beneficiaries from the insurance death benefit.
COLI also has a few downside considerations:
- Potentially firmer cash flow commitment to making regular premium payments
- Potential complexity
- Added oversight of your policy portfolio
How do you decide on your funding strategy?
Informally funding your NQDC plan (or not) largely comes down to:
- Company performance and financial flexibility
- Matching your assets and liabilities
- Plan participant sentiment and trust in the plan
Know that you have options to align plan funding with your business objectives. If you decide to informally fund your plan, there are a few ways to invest plan assets to help maximize liquidity, growth opportunities, and tax advantages. Consult with a financial professional to learn how you can set up a plan and funding arrangements (or not).
1 Ordinary income taxes are due on withdrawal. Withdrawals before the age of 59½ may be subject to an early distribution penalty of 10%. 2 There is no guarantee that any investment strategy will achieve its objectives.
Any tax-related discussion contained in this publication, including any attachments, is not intended or written to be used, and cannot be used, for the purpose of avoiding any tax penalties or promoting, marketing, or recommending to any other party any transaction or matter addressed. Please consult your independent legal counsel and/or professional tax advisor regarding any legal or tax issues raised in this publication.
The content of this document is for general information only and is believed to be accurate and reliable as of the posting date, but may be subject to change. It is not intended to provide investment, tax, plan design, or legal advice (unless otherwise indicated). Please consult your own independent advisor as to any investment, tax, or legal statements made.
John Hancock Retirement Plan Services LLC provides nondiscretionary administrative and/or recordkeeping services to sponsors or administrators of retirement plans, as well as a platform of investment alternatives for actual or hypothetical investing that is made available without regard to the individualized needs of any plan. Unless otherwise specifically stated in writing, John Hancock Retirement Plan Services LLC does not, and is not undertaking to, provide impartial investment advice or give advice in a fiduciary capacity.