Taxation on Non-Qualified Deferred Compensation Plans

Some firms provide workers the choice of suspending a part of their pay till after they retire by what is known as a non-qualified deferred compensation (NQDC) plan. The plan could also be supplied along with, or instead of, a professional retirement plan similar to a 401(okay) plan.

The plans are sometimes supplied as a sort of bonus to upper-level executives, who could max out their allowable contributions to the corporate’s certified retirement plan. In an NQDC plan, each the compensation and the taxes owed on it are delayed till a later date.

In case you are contemplating such an possibility, you need to perceive the way you’ll be taxed on that cash and any earnings it earns over time forward. 

Key Takeaways

How NQDC Plans Are Taxed

Any wage, bonuses, commissions, and different compensation you comply with defer beneath an NQDC plan will not be taxed within the 12 months through which you earn it. (The deferral quantity could also be recorded on the Type W-2 you obtain every year.)

Watch out for early withdrawals. The penalties are extreme.

You’ll be taxed on the compensation while you truly obtain it. This must be someday after you retire, until you meet the principles for an additional triggering occasion that’s allowed beneath the plan, similar to a incapacity. The fee of the deferred compensation will likely be reported on Type W-2 even if you’re now not an worker on the time.

You might be additionally taxed on the earnings you get in your deferrals when they’re paid to you. The speed of return is mounted by the phrases of the plan. It could, for instance, match the speed of return on the S&P 500 Index.

NQDC plans are generally known as 409(a) plans after the part of the U.S. Tax Code that regulates them.

Compensation in Inventory or Choices

When the compensation is payable in inventory and inventory choices, particular tax guidelines come into play. In such circumstances, the taxes is not going to be owed till the inventory shares or choices are yours to promote or give away as you select.

Nevertheless, you could wish to report this compensation instantly. The IRS calls this a Part 83(b) election. It permits the recipient to report the worth of the property as earnings now (versus when vested), with all future appreciation rising into capital positive aspects that could possibly be taxed at a good tax price.

For those who do not make the Part 83(b) election, you’ll owe taxes on the property and its appreciation on the time it’s acquired. Nevertheless, when you make the election you can be giving up the flexibility to deduct any losses sooner or later ought to the worth depreciate.

The IRS has a pattern 83(b) type that can be utilized to report this compensation at present somewhat than deferring it.

Tax Penalties for Early Distributions

There are heavy tax penalties when you withdraw cash from an NQDC plan earlier than you retire or when no different acceptable “set off occasion” has occurred.

  • You might be taxed instantly on the entire deferrals made beneath the plan, even when you’ve got solely acquired a portion of it.
  • The tax penalty for overpayments and underpayments for This fall 2022 is 6%.

How It Impacts FICA Taxes

The Social Safety and Medicare tax (FICA in your W-2) is paid on compensation when it’s earned, even when you choose to defer it.

This could be a good factor due to the Social Safety wage cap. Take this instance: In 2022, your compensation was $170,000 and also you made a well timed election to defer one other $25,000. For the 2023 tax 12 months, earnings topic to the Social Safety portion of FICA are capped at $160,200. Thus, $34,800 ($170,000 – $160,200 + $25,000) of complete compensation for the 12 months isn’t topic to the FICA tax.

When the deferred compensation is paid out, say in retirement, no FICA tax will likely be deducted.

Is It Value It?

A non-qualified deferred compensation plan, if one is on the market to you, could be a appreciable profit over the long term. You are investing cash in your future whereas delaying taxes owed on earnings. That ought to get you a larger accrual of earnings.

Nevertheless, the day of reckoning will come while you begin to accumulate your deferred compensation. Simply be ready for the affect when it hits.

What Is an Instance of a Non-qualified Compensation Plan?

Non-qualified compensation plans are deferred compensation plans similar to supplemental govt retirement plans and split-dollar preparations. These kinds of plans are most frequently supplied to higher administration. They stand in distinction to certified compensation plans, similar to 401(okay)s.

Are Non-qualified Deferred Compensation Plans a Good Concept?

Non-qualified deferred compensation plans will be a good suggestion for some people however do include dangers. A portion of an worker’s wage is deferred to a later date. This does cut back your taxes, which is a profit. The quantity deferred, nevertheless, doesn’t include a number of the advantages of certified deferred compensation plans, similar to taking out loans in opposition to them or rolling over the funds into an IRA. There may be additionally a threat of a complete lack of the quantity you’ve got put aside with no return.

What Is the Distinction Between Certified and Non-qualified plans?

Certified plans, similar to 401(okay)s, present buyers with a tax-advantaged retirement account. The cash is invested and grows over time. They arrive with different advantages and will be moved from employer to employer. Non-qualified plans are extra restrictive, supplied to just some workers, are additionally tax-advantaged however not essentially invested straight away, and there’s a threat of dropping your complete quantity deferred.

The Backside Line

Non-qualified deferred compensation plans are supplied to pick out workers for retention functions or for offering advantages along with conventional certified deferred compensation plans, similar to 401(okay)s.

The quantity an worker chooses to defer reduces their taxable earnings and the quantity deferred isn’t taxed till they obtain the funds, which is often in retirement. These kinds of plans are extra sophisticated than conventional retirement plans and people ought to rigorously perceive them earlier than participating.