Taxation on Non-Qualified Deferred Compensation Plans

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Taxation on Non-Qualified Deferred Compensation Plans

Through a non-qualified deferred compensation (NQDC) plan, some employers allow workers to delay a portion of their income until after they retire. The plan might be provided in addition to, or instead of, a qualifying retirement plan like a 401(k).

The programs are often presented as a sort of incentive to upper-level executives who may contribute to the company’s qualifying retirement plan to the full extent of their ability. Both the compensation and the taxes owing on it are postponed under a NQDC arrangement.

Key Takeaways

  • An NQDC plan postpones payment of a part of salary and the associated taxes to a later period, usually after retirement.
  • Such programs are often given as an additional incentive to top executives.
  • FICA taxes, unlike income taxes, are payable in the year the money is earned.

If you’re thinking about it, you should know how you’ll be taxed on that money and any earnings it makes in the future.

How NQDC Plans Are Taxed

Salary, bonuses, commissions, and other remuneration deferred under a NQDC plan are not taxed in the year earned. (The amount of the deferral may be reported on the Form W-2 you get each year.)

Beware of early withdrawals. The penalties are severe.

When you get the compensation, you will be taxed on it. Unless you fulfill the conditions for another triggering event authorized under the plan, such as incapacity, this should be anytime after you retire. Even if you are no longer an employee at the time, the payment of deferred compensation will be recorded on Form W-2.

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You are also taxed on your deferred earnings when they are paid to you. The plan’s parameters determine the rate of return. It might, for example, replicate the S&P 500 Index’s rate of return.

NQDC plans are also known as 409(a) plans, after the part of the United States Tax Code that governs them.

Compensation in Stock or Options

When remuneration is paid in stock and stock options, additional tax regulations apply. Taxes will not be due in such circumstances until the stock shares or options are yours to sell or give away as you see fit.

However, you should disclose this compensation as soon as possible. The IRS refers to this as a Section 83(b) election. It permits the receiver to report the property’s worth as income now (rather than when it is vested), with any future appreciation growing into capital gains that may be taxed at a lower rate.

You will owe taxes on the property and its appreciation if you do not make the Section 83(b) option. However, if you make the choice, you will forfeit the right to deduct any future losses if the value falls.

The IRS provides an example 83(b) form that may be used to record this remuneration now rather than later.

Tax Penalties for Early Distributions

If you remove money from a NQDC plan before retiring or when no other suitable “trigger event” has happened, you may face significant tax repercussions.

  • You are taxed on all deferrals made under the plan, even if you only received a fraction of them.
  • Interest is levied at a rate one percentage point greater than the penalty for late payments. Underpayments were 3% in Q4 2021, thus the taxable interest rate would be 4%.
  • The deferrals are subject to a 20% penalty.
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How It Effects FICA Taxes

Even if you want to delay it, the Social Security and Medicare tax (FICA on your W-2) is paid on pay when it is received.

Because of the Social Security pay ceiling, this may be a positive thing. Consider the following: Your salary in 2019 was $150,000, and you made a timely option to postpone another $25,000. Earnings subject to the Social Security part of FICA were restricted at $142,800 for the 2021 tax year. As a result, $32,200 ($150,000 – $142,800 + $25,000) of total remuneration for the year is exempt from FICA tax.

When the deferred pay is distributed, such as in retirement, no FICA tax is deducted.

Is It Worth It?

If you have access to a non-qualified deferred compensation plan, it may be a significant advantage in the long term. You’re putting money down for the future while deferring income taxes. This should result in a higher earnings accrual.

However, the day will come when you begin to get your delayed salary. Just be ready for the impact when it arrives.

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