Some companies offer employees the option to defer part of their salary until after they retire using what is called a non-qualified deferred compensation (NQDC) plan. The plan may be offered in addition to or instead of a qualified retirement plan, such as a 401(k) plan.

The plans are typically offered as a type of bonus to senior-level executives, who can maximize their allowable contributions to the company’s qualified retirement plan. In an NQDC plan, both compensation and taxes due are delayed until a later date.

If you are considering this type of retirement option, you need to understand how you will be taxed on that money and any earnings you make in the coming years.

How NQDC plans are taxed

Any salaries, bonuses, commissions and other compensation that you agree to defer under a NQDC Plan They are not taxable in the year they are earned. The deferral amount can be recorded on the W-2 form you receive for the year.

You will be taxed on the compensation when you actually receive it. This should be sometime after you retire, unless you meet the rules for another triggering event allowed under the plan, such as a disability. The deferred compensation payment will be reported on a Form W-2 even if you are no longer an employee at that time.

You are also taxed on the earnings you make from your deferrals when they are paid to you. The rate of return is set by the terms of the plan. It can, for example, equalize the rate of return of the S&P 500 Index.

Compensation in stocks or options

When compensation is payable in shares and stock optionsspecial tax rules come into play. In such cases, taxes will not be due until the shares or options are yours to sell or give away as you choose.

However, you may want to report this compensation immediately. The IRS calls this a Section 83(b) election. Allows the recipient to report the value of the property as income now (unlike when stocks or options are established), and any future appreciation will become capital gains that could be taxed at a relatively favorable tax rate.

If you do not elect Section 83(b), you will have to pay taxes on the property and its appreciation when you receive it. However, if you choose, you will give up the ability to deduct any future losses if the security depreciates.

The IRS has a sample Form 83(b) which can be used to report this compensation currently rather than deferring it.

Tax Penalties for Early Distributions

There are serious tax consequences if you withdraw money from an NQDC plan before you retire or when no other acceptable “triggering event” has occurred.

• You are taxed immediately on all deferrals made under the plan, even if you have only received a portion of it.
• The tax penalty for overpayments and underpayments for the fourth quarter of 2024 is 8%, although companies are charged 7% for overpayments.

How it affects FICA taxes

The Social Security and Medicare tax (FICA on your W-2) is paid as compensation when earned, even if you choose to defer it.

This may be a good thing because of the Social Security salary cap. Let’s take this example: your compensation is $180,000 and you made the timely decision to defer another $25,000. For tax year 2024, earnings subject to the Social Security portion of FICA are capped at $168,600.

Therefore, $36,400 ($180,000 – $168,600 + $25,000) of total compensation for the year is not subject to FICA tax. For the 2025 tax year, earnings subject to the Social Security portion of FICA are capped at $176,100, so $28,900 would be exempt if you don’t receive a raise.

When deferred compensation is paid, say during retirement, no FICA tax will be deducted.

NQDC Plans vs. 401(k)

You will most likely end up contributing to an NQDC plan or a 401(k) plan. These two plans differ significantly in terms of participant eligibility and contribution limits. NQDC plans are generally offered to a select group of highly compensated employees, while 401(k) plans are designed to be more inclusive and open to more employees.

Another fundamental difference lies in the contribution limits imposed on each plan. NQDC plans provide greater flexibility because participants can defer a portion of their salary or bonuses without the strict annual limits imposed on 401(k) plans.

This flexibility is intended to work in conjunction with people who have high incomes and want to defer larger portions of what they earn. On the other hand, 401(k) plans adhere to the rules set by the IRS. contribution limitsmeaning everyone has the same limit on how much they can contribute each year.

Tax treatment is another key difference between the two. In NQDC plans, participants can defer income taxes on their contributions. This can be a critical benefit, as these high-income earners can expect to be at lower levels. tax brackets in the future.

Meanwhile, 401(k) plans offer immediate tax benefits by allowing participants to contribute on a pre-tax basis. Keep in mind that you can create after-tax 401(k) plans so that certain earnings grow tax-free.

Finally, there are some differences in regulatory oversight between the two. NQDC plans, which lack ERISA regulation, mean employers can be more flexible. Unfortunately, this provides less protection to participants. 401(k) plans are subject to ERISA regulations, so certain reporting and disclosure standards exist to protect people who use the plan.

It’s worth it?

A non-qualified deferred compensation plan, if you have one available, can represent a considerable long-term benefit. You are investing money for your future while delaying taxes owed on the earnings. That should net you more profit accumulation. However, the day of reckoning will come when you start collecting your deferred compensation. Just prepare for the impact when it comes.

The conclusion

Nonqualified deferred compensation plans are offered to select employees as a benefit in addition to traditional qualified deferred compensation plans, such as 401(k)s.

The amount an employee elects to defer reduces his or her taxable income, and the deferred amount is not taxed until he or she receives the funds, usually in retirement. These types of plans are more complicated than traditional retirement plans, and employees who are offered them should carefully understand the terms before participating.