Deferred Compensation Plan (Individual)

A non-qualified deferred compensation (NQDC) plan is an agreement between you and your employer to pay some portion of your compensation in the future. NQDC plans provide employers and employees with different tax benefits than qualified plans, such as 401(k)s and defined contribution plans. Under a non-qualified plan, your employer agrees to pay you some type of compensation at a future time. It may be dependent on you completing certain requirements — such as years of service or honoring the terms of a non-competition agreement — or it may simply be an agreement to pay some of your current salary at a future time.

The advantage to you is that you are not taxed on the income until you actually receive it. The disadvantage is that you will have a very low priority behind most of your employer’s creditors in the event your employer cannot pay its debts.

Types of deferred compensation plans

NQDC plans typically fall into four categories:

• Salary Reduction Arrangements allow you to defer receipt of some portion of your salary that would otherwise be included in your current compensation.
• Bonus Deferral Plans resemble salary reduction arrangements, except they apply specifically to deferring receipt of bonuses.
• Top-Hat Plans (aka Supplemental Executive Retirement Plans or SERPs) are NQDC plans maintained primarily for a select group of management or highly compensated employees. These plans are usually some form of additional compensation that your employer agrees to pay you in the future, not a deferral of salary that the employer would otherwise pay you in the current year.
• Excess Benefit Plans provide benefits solely to employees whose benefits under the employer's qualified plan are limited by the tax law.

NQDC plans may be formal or informal, but they must be in writing. While many plans are very detailed, some are mentioned only in a few provisions of an employment contract.

What is an unfunded NQDC plan?

NQDC plans can be either funded or unfunded, but most are unfunded in order to gain the tax advantages they offer employees.

An unfunded arrangement is one where you get only an unsecured promise from your employer to pay the deferred compensation benefits in the future. Your employer may:

• Keep track of the benefit in a bookkeeping account.
• Voluntarily choose to invest amounts intended to help fulfill its promise to pay you.
• Transfer amounts to a trust that remains a part of its general assets, with the intention of using those assets to fund the future payments owed to you.

These arrangements are still considered “unfunded” because your employer isn't required by law to hold that money for your benefit, and the assets would be subject to the claims of your employer's creditors in the event they cannot pay their debts.

For you to get the benefit of income tax deferral, it is important that the amounts are not set aside from the employer's creditors for your exclusive benefit. If they are, you may have currently includible compensation, meaning you may have to pay taxes on the assets after all.