How do nonqualified deferred compensation plans (NQDC) work?

What is a nonqualified deferred compensation (NQDC) plan?

A 409A nonqualified deferred compensation plan, or NQDC plan, is an arrangement between an employer and an employee that allows the employee to defer a portion of his or her income to a future date. The deferred amount grows tax-free until it is distributed, typically, at retirement.

These types of plan are referred to as nonqualified, because they are not regulated by the Employee Retirement Income Security Act (ERISA), like a 401(k) plan.

NQDC plans vs. 401(k) plans

NQDC plans and 401(k) plans are both great ways to save for retirement, but they are different. The key distinctions are summarized below.

Now that we better understand the key differences between NQDC plans and 401(k) plans, let’s take a deeper dive into the advantages that these non-qualified arrangements offer.

Benefits of NQDC plans

An NQDC plan offers more benefits than other workplace retirement plans. In certain situations, such a plan can help your business attract and retain top employees.

Tax advantages

Nonqualified deferred compensation plans are popular because they are generally highly rewarding and offer the prospect of tax-deferred growth – until the point of actual distribution. These plans make the most sense for highly compensated employees who presently face high levels of taxation, but are likely to be in lower tax brackets during retirement

Strategic savings opportunities

Another benefit of an NQDC plan is that it doesn’t have contribution limits, like a 401(k) plan. For 2025, the most you can put into a 401(k) plan is $23,500. If you are over 50, you can add catch-up contributions of $7,500 ($11,250, if you’re between 60 and 63). Given these limits, a 401(k) plan may restrict high earners from saving adequately for retirement.

For instance, assume you are a 50-year-old employee making $500,000 a year. The maximum you can put into a 401(k) plan is just 6.2% of pre-tax income — far from the 70% to 90% replacement income most aim for in retirement.

With an NQDC plan, an individual can save as much as he or she wants. This provides greater peace of mind and improves the probability of retiring comfortably.

Flexibility and customization

NQDC plans have fewer restrictions than other workplace retirement plans. They are not required to comply with ERISA rules that ensure all employees are treated equally (non-discrimination rules). As a result, with an NQDC plan, you can choose which employees are able to participate.

You can set up this type of plan whenever and however you want. You can even set up multiple plans that cater to different types of employees. Most plans are unfunded – to preserve tax deferral benefits for employees – but some plans are implemented via corporate-owned life insurance policies and trusts.

For employers, liquidity optimization is, perhaps, the greatest flexibility benefit of a NQDC plan. With this type of plan, a company is able to retain a big chunk of cash flow to fuel long-term growth, rather than distributing it via payroll. Essentially, with a NQDC plan, a company establishes an arrangement with highly compensated employees, whereby they agree to take less money upfront in exchange for significant deferred compensation — after the company has had a chance to grow and prosper.

Enhanced employee retention

Offering employee benefits via NQDC plans allows employers to attract and retain top talent. They reward high-performing employees and encourage them to stay for the long term. NQDC plans allow companies to offer extra benefits to their most essential workers.

Limitations and considerations

While NQDC plans offer plenty of advantages, they also have some disadvantages.

Lack of ERISA protections

ERISA does not protect NQDC plans, and businesses don’t have to set aside money for it. This means that if the company goes bankrupt or has financial trouble, any money employees have been promised and/or contributed is not guaranteed and could be lost. Moreover, unlike a qualified 401(k) plan, creditors can go after the money in NQDC plans.

No early withdrawals

The funds your employees contribute to a NQDC plan are generally not accessible before the designated distribution date. Participants must stick to the agreed-upon schedule, regardless of individual circumstances.

Business tax and cash flow implications

As a small business, you don’t receive a tax deduction for any contributions made to an NQDC plan until employees actually receive the funds. This could be a long time in the future. This, coupled with the fact that employees lose tax deferral benefits when a plan is funded, is why most NQDC plans are unfunded.

That said, when a plan is unfunded, the plan sponsor needs to plan carefully. You need to do everything necessary to make sure you have enough cash on hand to satisfy future obligations.

Now that we’ve discussed the various pros and cons of NQDC plans, let’s touch on how businesses can set get started with one.

Implementing NQDC plans for employers

NQDC plans may sound complex, but they are easier to implement and maintain than a qualified retirement plan.

1. Designing the plan

When designing an NQDC plan, you must decide who will be eligible to participate, whether or not to fund it, the types of employee contributions permitted, and the payout schedule.

Which classes of employees will benefit most from an NQDC plan? Is there any sense in funding the plan and forgoing valuable tax benefits for participating employees? What types of employee contributions are permitted (i.e., purely salaries, salaries and bonuses, other forms of compensation, etc.)? Will employees receive distributions at retirement or upon reaching a certain age?

2. Funding options

Businesses can fund a NQDC plan in a number of ways, including those outlined below.

• Unfunded structures: Employers do not have to fund NQDC plans. In fact, most plans are unfunded, largely due to the tax ramifications associated with funded plans. If a plan is unfunded, benefits are paid from the company’s general assets.
• Corporate-owned life insurance (COLI) policies: Employers can purchase life insurance policies on key employees to fund the plan. The employer pays the premiums and remains the policyowner and beneficiary. The policy’s cash value grows on a tax-deferred basis and can later be used to offset the cost of plan distributions.
• Trusts: An NQDC plan can be funded via a trust that invests in stock and bond mutual funds, whereby the assets are placed beyond the employer’s reach. Unfortunately, with a funded NQDC plan, the IRS generally treats the deferred compensation as immediately taxable to the employee.

3. Communicating with employees

NQDC plans can be complicated; therefore, it’s important to make sure your employees understand how they work and the associated benefits and risks. You should update your employees on any changes and be transparent about the company’s financial situation. This will help give your employees peace of mind.

Considerations for employees

Before jumping into an NQDC plan, your employees should thoroughly understand its ins and outs.

• Evaluating plan offerings: There are different types of plans. Examples of nonqualified deferred compensation plans are deferred savings plans and salary reduction plans. Work with your employees to make sure your offering best meets their needs.
• Understanding distribution triggers: NQDC plans have specific times when employees can withdraw money (i.e., retirement, disability, or a predetermined date). To avoid any unexpected tax consequences, employees must plan accordingly.
• Integration with other retirement plans: Participation in a NQDC plan should be evaluated within the context of a holistic financial plan. An employee needs to embrace a big picture perspective to determine whether participating in a NQDC plan makes sense.