Nonqualified deferred compensation plans for your key employees

A nonqualified plan is a type of retirement plan that falls outside of ERISA (Employee Retirement Income Security Act) guidelines and requirements. These plans are often used as a way to recruit and retain key employees, allowing them to save additional money for retirement.

A nonqualified deferred compensation plan is an arrangement between an employer and key employee that allows the key employee to postpone receiving a portion of their compensation until a later date, typically retirement. Unlike qualified plans (i.e., 401(k)), nonqualified deferred compensation plans:

• Are not subject to ERISA participation and vesting requirements
• Don’t have IRS contribution limits
• Generally, are only available to select employees (often executives or high earners)
• Are typically unfunded, meaning the deferred money remains part of the company’s general assets
• Offer potential tax advantages by deferring income to years when the employee may be in a lower tax bracket

Unlike 401(k) plans, deferred compensation plans generally don’t have strict IRS contribution limits. The amount key employees can contribute usually depends on the specific terms of the deferred compensation agreement.

• Provide key employees a way to save more than in a qualified plan.
• Give key employees more control over the timing of benefits payments (and income taxes).
• Offer an exclusive benefit to help employers recruit and reward key employees.

• Typically offered to select, highly compensated employees or executives
• No IRS contribution limits
• More flexibility in plan design and structure
• Complement the tax benefits of a qualified plan
• Unfunded agreement between the employer and employee, meaning the assets remain part of the company’s general assets
• Carry some risk to participants, since any company assets set aside to pay benefits are subject to company creditors

A deferred compensation plan provides investment options that act like mirrors of real investments, though the key employees don’t actually own the underlying assets. These are called “reference” or “phantom” investments because they track the performance of actual investment funds without direct ownership.

While the earnings grow tax-deferred, just like in a 401(k) plan, the investment menu may be more limited. Key employees can typically change their investment choices periodically, and how well these investments perform will directly impact how much money they receive when they take distributions.

Unlike 401(k)s and IRAs, deferred compensation plans don’t have required minimum distribution (RMD) ages. Instead, key employees receive their money based on the choices made when they first enroll in the plan and according to specific triggering events. These events typically include retirement, leaving their job, death, disability, or a future date they selected.

Key employees must decide when to receive distributions before they start deferring money into the plan. Once made, these choices are difficult to change due to IRS rules under Section 409A and usually can’t speed up the payment schedule. The plan document and the key employee’s initial elections determine when they receive distributions, rather than age.

A nonqualified deferred compensation plan offers tax-deferred growth, so key employees don’t pay income taxes on the money they contribute or earn. When distributions are received, they’re taxed as ordinary income.

Unlike 401(k)s, key employees cannot roll these funds into an IRA or another retirement plan, and the employer can’t take a tax deduction until benefits are paid out.

The money remains part of the employer’s general assets, which means it could be at risk if the company faces financial difficulties. Additionally, the specific IRS rules under Section 409A need to be followed to avoid tax penalties. State tax treatment may vary.