What Is a Deferred Compensation Plan?
With a nonqualified deferred compensation (NQDC) plan, your employees can defer some of their pay until a later date. This type of deferred compensation plan typically pays out income after an employee leaves their job, like in retirement, for instance.
You can offer your employees two types of deferred compensation plans. Before you do, be sure you know the differences between qualified and nonqualified plans and how they work.
Qualified plans allow employees to put their money into a trust that’s separate from your business’ assets. An example would be 401(k) plans.
Nonqualified deferred compensation plans let your employees put a portion of their pay into a permanent trust, where it grows tax deferred. With this plan, your business promises to pay an employee at a future date. Unlike a qualified plan, however, your employee’s deferred money is a part of your company’s assets and can be used for business reasons.
How Do Nonqualified Deferred Compensation Plans Work?
There are laws you have to follow when setting up a NQDC plan with your employees. IRS Section 409A outlines the rules for nonqualified deferred compensation plans. You can’t just have a verbal agreement with your employees to defer their income until a later date. To set up a NQDC plan, you’ll have to:
Put the plan in writing: Think of it as a contract with your employee. Be sure to include the deferred amount and when your business will pay it.
Decide on the timing: You’ll need to choose the events that trigger when your business will pay an employee’s deferred income. Events include:
- A fixed date
- Change in business ownership
- Unforeseeable emergency
Note requirements or exclusions of the plan: Detail any qualifiers your employee has to follow to receive their pay. For example, your NQDC plan may state that your employee cannot work at a competing business after retiring.
Advantages of Nonqualified Deferred Compensation Plans
Nonqualified deferred compensation plans benefit both you and your employees. For employers like you, a NQDC plan offers:
- Flexibility: You can choose which executive or highly compensated employees can participate. Because there aren’t any non-discriminatory rules, you don’t have to offer this plan to every employee.
- Small management fees: There are small upfront costs to set up a NQDC plan, but you won’t have to deal with ongoing fees to manage it.
- Cash flow increases: The money your business brings in can be used for other things because it doesn’t have to go towards paying your employee right away.
For your employees, benefits for a nonqualified deferred compensation plan include:
- No maximum contribution amount: The IRS puts a limit to how much an employee can contribute to their 401(k) each year. With a NQDC plan, there is no limit.
- Tax advantages: When your employee makes their deferral election, they’ll have less taxable income, which can put them in a lower tax bracket.
Disadvantages of Nonqualified Deferred Compensation Plan
There may be some disadvantages for your employees if they participate in a nonqualified deferred compensation plan.
- Withdrawing funds: Your employee can only withdraw funds from a nonqualified deferred compensation plan on a pre-determined date. They can’t withdraw early, like they can with a 401(k) or other qualified retirement plans.
- Fund protection: Their money isn’t protected by the Employee Retirement Income Security Act (ERISA). When they defer their income, it becomes a part of your business’ assets. If you have to use the money, it could affect their retirement.
Are Nonqualified Deferred Compensation Plans Right for My Business?
Although there are tax and cash flow benefits for nonqualified deferred compensation plans, you should make sure it’s the right plan for your business and employees.
There are some key considerations for participating in a nonqualified plan. To determine if it would be good for you, ask yourself:
How are my business’ finances? You don’t want to risk having to use your employees’ deferred income if your business has money problems. That’s why it’s important to make sure your business is financially stable.
Can my employees afford to lose the deferred salary? It’s important your employees understand the risks with NQDC plans. Your business may have to use deferred income if it’s facing bankruptcy. If this happens, your employees should be comfortable with not getting their deferred salary.
Can I benefit from paying income taxes at a later date? Your business won’t have to pay income taxes until your employees get their deferred income. This can help your cash flow, which means you can use the money for business reasons in the meantime.
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