The Basics of Nonqualified Deferred Compensation Plans

  QUALIFIED 401(k) PLAN NQDC PLAN
PARTICIPANT POPULATION Generally All employees Highly compensated employees and key executives
CONTRIBUTIONS
  • The plan can generally be designed to allow:
  • employee salary deferral contributions of (a) up to $23,000 for 2024, or (b) $30,500 for those age 50 and over for 2024; and/or
  • employer contributions up to the lesser of 25% (or, for self-employed individuals, 20%) of the employee’s compensation (subject to $345,000 limit for 2024) or $69,000 (for 2024).
  • Note: the $69,000 limit applies to employer contributions and salary deferral contributions combined (but does not apply to catch-up contributions for those who are age 50 or older). Other limitations may reduce the amount that can be contributed for, or on behalf of, a participant, depending on the type of contribution and the design of the plan.
  • Deferral Election: The deferral election generally must be made by the employee before the compensation is paid to the employee or otherwise considered “currently available” to the employee. Additional timing restrictions may apply under the terms of the plan.
  • The contributions to the plan are generally income-tax deductible by the employer and not includable in the employee’s taxable income. However, salary deferral contributions are subject to Social Security and Medicare (FICA), and federal unemployment (FUTA) taxes; employer contributions are not subject to FICA and FUTA taxes.
  • The plan can generally be designed to allow:
  • employee salary deferral contributions and/or
  • employer contributions, with no statutory maximum for either type of contribution. The maximum contribution amount depends on terms of the plan.
  • Deferral Election: The election generally must be made by the employee prior to the tax year in which the compensation to be deferred is earned (subject to certain limited exceptions). Additional timing restrictions may apply under the terms of the plan.
  • The contributions (salary deferral and employer) to the plan are neither income tax deductible by the employer nor includable in the employee’s taxable income. However, contributions to, and earnings under, the plan are generally subject to FICA and FUTA taxes to the extent not subject to a substantial risk of forfeiture (e.g., vested). If the contributions and/or earnings are initially subject to a substantial risk of forfeiture, then they are generally not subject to FICA or FUTA taxes until they are no longer subject to a substantial risk of forfeiture.
DISTRIBUTIONS

Generally, a plan cannot permit a distribution until a permissible triggering event has occurred, such as severance from employment (e.g., retirement), death, qualifying disability, attainment of age 59 ½, or qualifying hardship. The permissible triggering events may differ for different types of contributions (and the earnings attributable to such).

The form and timing of the distribution(s) is elected at the point of distribution.

Distributions are generally includable in the employee’s taxable income and, if made before age 59½, subject to a 10% penalty tax (unless an exception applies). Since the employer received an income tax deduction for the contribution to the plan, the employer is not entitled to a deduction for a distribution from the plan.

Required minimum distributions generally must begin once the participant (a) reaches RMD age (which is currently age 73) or (b) retires from employment with the plan sponsor, if later than RMD age and the participant is not considered a 5% owner.

Generally, amounts deferred under the plan must be payable only upon specific, permissible events stated in the plan, such as separation from service (e.g., retirement), qualifying disability, death, specified date or fixed schedule, qualifying change in control, or qualifying unforeseeable emergency.

The form and timing of the distribution(s) must be elected at the time of the deferral election. Distributions from the plan generally cannot be accelerated (subject to limited exceptions).

Distributions are generally includable in the employee’s taxable income but are not subject to the 10% penalty tax for pre-age 59½ distributions. The employer is entitled to a corresponding income tax deduction for the amount distributed from the plan that is includable in the employee’s taxable income.

No required minimum distributions.

INVESTMENTS

Typically allows the participant to make the investment decisions for the assets held in the plan for them and to select from a menu of investment options.

Depending on the design of the plan, may allow participant to select from a menu of investment crediting options (which determines the amount payable to the employee in the future).

FUNDING

Funded – generally, must be irrevocably set aside by an employer in a qualified trust for the sole benefit of the participants and their beneficiaries. Not subject to the employer’s bankruptcy and insolvency creditors.

The assets within the qualified trust potentially grow on a tax deferred basis.

Unfunded – generally, a NQDC plan must be unfunded, meaning no assets of any kind being maintained in connection with the plan or if there are assets maintained in connection with the plan (informal funding), such assets must be subject to the claims of the employer’s bankruptcy and insolvency creditors.

To the extent there is informal funding of the plan, the employer is subject to income taxation on the taxable growth of the assets (e.g., dividends, interest, capital gains), unless a tax-favored asset (e.g., corporate-owned life insurance, which generally provides tax-deferred growth potential and may provide a fully or partially tax-free death benefit) is used.

ERISA PROVISIONS

Generally covered by ERISA, unless the plan is a governmental plan, a non-electing church plan or a plan that doesn’t cover any common law employees (i.e., a plan that only covers the owner of the plan sponsor or the owner and their spouse).

Generally, an unfunded NQDC plan is not subject to ERISA’s participation, funding, vesting or fiduciary provisions.

Upon bankruptcy/insolvency, participants are generally treated as general unsecured creditors of the employer.

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