Introdcution to Non-Qualified Plans

Non-Qualified Deferred Compensation (NQDC) plans are powerful tools for business owners and high-earning employees looking to go beyond traditional retirement plan limits. This guide explains exactly how NQDC plans work, how they fit into a larger retirement strategy, and includes a detailed example of a plan for a 55-year-old executive using a 401(k), Cash Balance Plan, and NQDC together.

What is a Non-Qualified Deferred Compensation Plan?

An NQDC plan is an agreement between an employer and employee to defer a portion of the employee’s income to a future date—usually retirement. The deferred amount remains untaxed until paid, and there are no IRS-imposed contribution limits, unlike traditional retirement plans. However, the funds remain part of the employer’s assets and are subject to the company’s credit risk until distributed.

How It Works – Step by Step

‍

Let’s say an executive earns $500,000 a year. Under current IRS rules, the maximum they can contribute to their 401(k) is $23,500 in 2025, (with $7,500 catch up over 50), plus a company match or profit sharing up to a combined limit of $77,500. That leaves this employee with a large amount of income that cannot be sheltered in a traditional retirement plan.

‍

With an NQDC plan, the executive might elect to defer an additional $150,000 of their income. This election must be made before the beginning of the calendar year in which the income is earned. That $150,000 isn’t paid out in their regular paycheck—it’s held back and tracked on the company’s books in a separate account.

‍

Meanwhile, the company sets aside assets in a brokerage account to back that future obligation. The money is invested in a mix of individual stocks and ETFs, based on an agreed investment strategy. The account value fluctuates with the market, just like a regular investment portfolio.

‍

The deferred balance continues to grow, tax-deferred, and the employee doesn’t pay any income tax on it until it’s paid out—often years later, when they’ve retired and are in a lower tax bracket.

‍

When the agreed-upon payout date arrives (e.g., at age 65), the company begins distributing the deferred amount, either as a lump sum or in annual installments. At that point, it’s taxed as ordinary income.

‍

How It Works - Step by Step Example

1. The employee elects to defer a portion of their salary, bonus, or other income before the start of the calendar year.
2. The deferred compensation is not paid in the current year. It is tracked on the company’s books.
3. The employer may invest those funds in a taxable brokerage account usingstocks, ETFs, or model portfolios.
4. The value grows tax-deferred.
5. Distributions are made according to a predefined schedule (e.g., retirement,fixed dates, or separation) and taxed as ordinary income when received.

‍

Legal Framework: Section 409A

NQDC plans must comply with IRS Section 409A. This includes:
- Elections made before the start of the year the compensation is earned.
- Clear and unchangeable distribution schedules.
- Strict rules prohibiting early access to funds without penalties.
Violations of 409A can trigger immediate taxation, penalties, and interest.

‍

Case Study: 55-Year-Old Executive (2025)

Let’s say Sarah, a 55-year-old executive, earns $500,000 per year. Her company offers a full retirement package including a 401(k), Cash Balance Plan, and an NQDC plan.

• 401(k) Contribution (2025): Sarah contributes the maximum of $23,500 plus a$7,500 catch-up, totaling $31,000.
• Employer Match/Profit Sharing: Her company adds another $46,500, reaching the 2025 IRS total contribution limit of $77,500.

• Cash Balance Plan: Based on her age and income, Sarah contributes an additional $180,000 annually into a cash balance plan, which is tax-deductible to the business and tax-deferred for Sarah.

• NQDC Plan: Sarah defers an extra $150,000 of her salary into the NQDC plan. This election is made before the start of the calendar year. The deferred amount is not paid out currently but is instead recorded on the company’s books as a liability owed to Sarah. The company sets aside assets (typically in a brokerage account) to mirror this liability, investing the funds in public equities or ETFs.

• From a tax perspective, Sarah does not pay income tax on the $150,000 at the time of deferral. The company does not receive a tax deduction when the deferral is recorded—only when the compensation is actually paid to Sarah in the future. At the time of payout (e.g., starting at age 65), Sarah will pay ordinary income tax on the distributed amounts, and the company will receive a tax deduction in the year(s) the payments are made.

‍

Whencombined, Sarah is able to defer and invest a total of $407,500 annually in2025 across her 401(k), cash balance, and NQDC plans—far exceeding traditionalretirement limits. This structure significantly enhances her long-term taxdeferral and wealth accumulation potential, providing a highly strategicadvantage for both her and the sponsoring employer.

‍

Employer and Employee Perspectives

From the employer’s perspective:
- It’s a flexible tool for attracting and retaining top talent.
- Deferred comp is a liability on the books but does not require immediate cashoutlay.
- Contributions to the cash balance plan are tax-deductible when made.
- Non-qualified deferrals (NQDC) are not deductible until they are actually paid out to the employee, typically years later at retirement or separation.

From the employee’s perspective:
- The plan allows them to defer significantly more than the standard $77,500 cap.
- All deferrals grow tax-deferred until payout.
- Payouts can be scheduled to align with lower-income years, potentially reducing the tax burden.

Summary

For high-income earners and business owners, layering a non-qualified deferred compensation plan on top of a 401(k) and cash balance plan offers unmatched tax deferral and wealth accumulation potential. With proper design and compliance, these plans provide strategic benefits to both employer and employee.