What is Non-Qualified Deferred Compensation?

Non-qualified deferred compensation (NQDC) is a type of retirement contribution that is earned by the employee but not yet paid by the employer. It is not counted in taxable income, as the compensation (monetary or otherwise) is earned but not received by the employee.

How Does Non-Qualified Deferred Compensation Work?

The non-qualified deferred compensation plan is created to allow the employees with high income to defer compensation that they have a legally binding right to receive. The upper-limits imposed on employee contribution to the retirement savings plans put restrictions on the contribution of the high salaried employees in their tax-deferred retirement savings. The non-qualified deferred compensation plan enables them to avoid income taxes on the earnings and enjoy the tax-deferred investment growth. They do not have to pay taxes on that earnings when deposited, as the transfer of ownership is deferred. For example, Christinas annual income is $900,000. According to US law, her maximum 401(k) contribution should be less than 2.5% of her annual income. So, her contribution should not cross $22,500. This rule makes it difficult for her to save enough in her retirement account to support her in retirement. The non-qualified deferred compensation will enable her to avoid paying income tax on her earning and save a higher percentage of her income in her retirement savings. The terms of the NQDC may vary by employer, it is often deferred up to 5 to 10 years or untill the retirement of the employee. The NQDCs are not restricted like the retirement plans and the employees can use the funds for fulfilling other savings goals. However, the earning of NQDC is not protected under the Employee Retirement Income Security Act. If the employer company declares bankruptcy or it faces legal action by the creditors, the NQDC would not be protected. The company's creditors may access this fund to get back what is owed by the company. The fund received NQDC cannot be rolled over into an IRA or other retirement accounts. Another disadvantage of NQDC is the tax on the fund is calculated according to the prevailing tax rate at the time of the access and if that rate is higher than the time it was earned the employee needs to pay a higher rate on the income.