Retirement Meditation #37: What is a non-qualified deferred compensation plan?

Insights | Retirement Meditation #37: What is a non-qualified deferred compensation plan?

Author: Paul A. Carl, CHSA, CPFA Vice President, Retirement Plan Consulting, Registered Representative

Did you know that July 1st is considered “Bobby Bonilla Day?” Now, you may ask: “Who is Bobby Bonilla and why does he have a dedicated day?” Bobby Bonilla played major league baseball from 1986 through 2001 for 8 different teams, including the New York Mets twice. An above average player, Bonilla appeared in six all-star games during his career and placed second and third for the National League’s Most Valuable Player award in 1990 and 1991, respectively. For 2000, the Mets and Bonilla agreed to a $5.9 million contract. The Mets, however, released him in January and the two parties contractually agreed to defer Bonilla’s salary with 8% interest spread across 25 years. Beginning with July 1, 2011, the Mets began annual payments to Bonilla of $1,193,248.20 in deferred compensation through 2035.

Non-qualified deferred compensation (NQDC) plans are also often known as non-qualified retirement plans. They must conform to specific tax law but not to the extent of a qualified retirement plan. The NQDC plan is also not subject to ERISA. In a NQDC plan, typically the employer and employee have reached a customizable contractual agreement whereby a portion of the employee’s compensation earned in a particular time-period is deferred into the future and paid pursuant to an agreed-upon schedule, often beginning with retirement. Types of NQDC plans include supplemental executive retirement plans (aka SERPs), voluntary deferral plans, top-hat plans, and excess benefit plans. Not-for-profits may sponsor NQDC plans through Internal Revenue Code sections 457(b) and 457(f).

Similar to qualified plans, the NQDC must be in writing and carry certain specific terms. Often NQDC plans allow for both employer and employee contributions. They may allow the employee to choose among a menu of investment options and direct the investments according to the employee’s preferred asset allocation, or they may be invested as the employer deems appropriate. The funds are often held in a Rabbi Trust; so-named because the first known use followed an IRS Private Letter Ruling approving the use of a trust to hold a Rabbi’s deferred compensation.

While the employee does not recognize the income immediately for tax purposes, the employer does not receive an immediate tax deduction either. In fact, all contributions made to the NQDC plan, whether by the employee or the employer, are considered to be assets of the employer, subject to risk of substantial forfeiture by the employee, and subject to the claims of unsecured creditors in the event of the employer’s bankruptcy. 

Employees covered by a NQDC plan incurring a triggering event - ordinarily retirement but can also include events such as a change in ownership, death or disability, and financial hardship - are paid pursuant to a pre-arranged schedule. It’s normally at the time of payment that the employee pays ordinary income tax and the employer receives its tax deduction.

Distributions from a NQDC plan are not eligible for rollover to a qualified plan or IRA.

Would a non-qualified deferred compensation plan benefit some of your employees?

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