You know employees like employer-sponsored benefits. As an employer, offering benefits is advantageous for your business, too. A nonqualified deferred compensation plan is one type of benefit that both you and your employees can enjoy.
Find out what a nonqualified deferred compensation plan is, why you might consider offering it, and how to set it up.
What is a nonqualified deferred compensation plan?
A nonqualified deferred compensation plan, also called an NQDC plan or a Section 409A, allows employees to earn compensation in one year but receive it in a specified future year. Employees might decide to defer compensation like bonus payments or part of their wages. If an employee defers compensation, they also defer the taxes they owe on it. And, the deferred funds accrue interest.
NQDC plans are agreements made between employees and employers. And, you can make agreements with independent contractors. Although they can be flexible, you still must follow rules to avoid IRS penalties. The agreements should detail the conditions the employee must meet to access their money (e.g., when they can access it).
Nonqualified deferred compensation plans can be either elective, meaning employees choose to contribute, or non-elective, meaning you contribute. You do not need to separate an employee’s contributions from the rest of your business funds. And, an employee can contribute as much as they want to their nonqualified deferred compensation plan.
There are no laws stating that you must make NQDC plans available to all your employees. You can choose to provide this plan to only key employees if you want.
Nonqualified vs. qualified deferred compensation plans
Another deferred compensation agreement is known as a qualified deferred compensation plan. A 401(k) plan is an example of a qualified deferred compensation plan. Unlike NQDC plans, qualified deferred compensation plans are only for employees, and they have contribution limits. Qualified plans are also protected, meaning you must separate the funds from the rest of your business money. And, you must conduct nondiscrimination tests.
Types of nonqualified deferred compensation plans
According to the IRS, there are a few types of Section 409A plans.
Salary Reduction Arrangements: An employee can defer part of their salary to a different year. Let’s say an employee earns $75,000 in a year and wants to defer $25,000 to a later year. They would only receive $50,000 in the current year, and they would only owe taxes on the money they receive.
Bonus Deferral Plans: An employee can defer the amount of their bonus to a different year. For example, an employee earns a $10,000 bonus. They can choose not to pay the bonus tax rate on that $10,000 bonus until a future year.
Supplemental Executive Retirement Plans (SERPs): A company might decide to contribute to a highly compensated or key employee’s nonqualified retirement plan. When the employee retires, and if they fulfilled certain conditions (e.g., vesting schedule), they can access their funds.
Excess Benefit Plans: This type of NQDC plan is for employees who are enrolled in qualified benefit plans with contribution limitations. This way, employees can contribute more to their benefit plans (e.g., retirement plans for employees).
Benefits of nonqualified deferred compensation plan
Why would you want to offer employees NQDC plans, and why would employees want to opt into a plan?
As an employer, offering NQDC plans has many benefits. Nonqualified deferred compensation plans are inexpensive to establish, and they can increase cash flow and help you retain top talent.
Without healthy cash flow, you will have more money leaving your business than coming in. If employees choose to defer compensation, you don’t need to pay them that amount immediately. And, you don’t need to place it in a separate fund. This could help you with managing small business cash flow.
Offering nonqualified deferred compensation plans can also help you to retain top talent. Employees who enroll in NQDC plans can’t access their funds for a certain amount of time, and they lose access to their funds if they break one of the conditions in the agreement or leave your business prematurely.
NQDC plans are also beneficial to employees. Employees can save up money beyond the contribution limits of a qualified deferred compensation plan. And, the employee could walk away with a high rate of return on the money they defer.
Disadvantages of nonqualified deferred comp plan
Although there are many benefits to NQDC plans, there are also disadvantages for employers and employees.
You can deduct business expenses like employee pay and the money you contribute to their benefit plans. However, you cannot claim business tax deductions for deferred compensation until you actually give employees that money.
With only 36% of small businesses surviving after 10 years, enrolling in a nonqualified deferred compensation plan can be risky for employees. Because their contributions are not separated from your business funds, contributions are not secure. If your business were to go under, creditors could claim the employee’s deferred compensation.
Rules for setting up a nonqualified deferred compensation plan
Although NQDC plans can be informal, you still need to follow tax rules. Here are some of your responsibilities.
- Get the plan in writing.
- Make sure you detail your plan (when the compensation is deferred, when the employee will receive the payment, how much the payment will be, etc.).
- Credit the deferred compensation in your accounting books for small business so you know how much you still owe the employee.
Nonqualified deferred compensation plan and taxes
Figuring out employment taxes (income tax, FICA tax, and FUTA tax) on nonqualified deferred compensation plans can be difficult. But, failing to withhold properly can result in an IRS audit.
You only withhold income tax from the employee’s compensation when they actually receive it.
FICA and FUTA taxes are a little more complicated than income tax. Generally, you must withhold and contribute FICA tax and pay FUTA tax when the employee defers the income. However, if the employee is required to perform future services to receive their payment, FICA and FUTA taxes are not due until those services have been performed.
For more information on taxes and nonqualified deferred compensation plans, check out the IRS’s website.
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This article has been updated from its original publication date of July 18, 2013.This is not intended as legal advice; for more information, please click here.