Tax Qualified & Non-qualified Deferred Compensation Plans

What is deferred compensation? Deferred compensation generally refers to an arrangement whereby an employer pays income to an employee in a year following the year in which such income is earned. Essentially, deferred compensation is the employer’s promise to pay income to the employee at a later date. The Internal Revenue Code generally segregates deferred compensation plans into two categories: tax-qualified plans and non-qualified plans.

The starting point: understanding the nature of qualified plans. Qualified plans must adhere to limitations on the amount of compensation that may be deferred as well as strict requirements imposed by the Internal Revenue Code and overseen by the Internal Revenue Service. Qualified plans are generally established to provide deferred compensation in the form of retirement benefits such as defined benefit plans or defined contribution plans (401(k) plans, profit-sharing, etc).

Why the non-qualified plan has a unique nature. As their name suggests, non-qualified plans are not subject to the rules and limitations applicable to qualified plans. There is generally more flexibility in the structure and design of non-qualified plans, although Congress has recently provided specific rules for the tax treatment of non-qualified plans through the enactment of Code Section 409A.

Understand the key differences between qualified and non-qualified plans. Qualified and non-qualified differ in many key respects related to the degree of security underlying the employer’s promise including: funding, the employee’s absolute right to receive the deferred compensation (vesting), the timing of the employer’s tax deduction, whether tax is paid on earnings received on deferred assets, and the scope of employees that must be covered and under what terms (coverage). The following is a chart generally outlining these different characteristics:

Characteristic Tax-Qualified Plans Non-Qualified Deferred Compensation Plans
Funding Must be funded and held in trust for exclusive purpose of
benefit payment.
Must not be funded to achieve tax consequences (with
exception for certain forms of trusts) and subject to employer’s creditors.
Vesting/Spousal Consent Required vesting schedules and spousal consent may be
required for payment of benefit.
Flexible vesting schedules and spousal consent not
generally required for distribution.
Time of employer deduction At time of contribution to the trust. Generally matched to employee’s inclusion in income.
Tax of earnings on assets during build up period Tax free to employee. Generally taxed to employer who retains assets (with
certain exception).
Coverage Must not discriminate based on compensation; detailed
limitations on age and service eligibility requirements.
Flexible coverage and eligibility requirements, but must
be top hat or excess benefit or not a pension plan.

Understand how the law treats qualified and non-qualified plans differently? Employees living within the qualified plan world are protected by a comprehensive legal framework. Nevertheless, there are many complex and detailed regulations governing qualified plans that are subject to interpretation and therefore issues do arise under qualified plans. This was illustrated in a recent case addressing an everyday set of facts involving a divorce where a 401(k) plan mistakenly paid a participant doctor’s million dollar account balance to his ex-spouse.

Employees entering into or participating in non-qualified plans need to be particularly diligent and pro-active to protect their interests and expectations as the law does not provide them with an automatic degree of security. Furthermore, many of the benefit terms and design features of non-qualified plans are subject to negotiation.

Blitman and King provides cutting edge, practical advice for clients in the Albany, Buffalo, Manhattan, Long Island, Rochester and Syracuse NY areas.