Non-Qualified Deferred Compensation

Non-qualified deferred compensation (NQDC) plans are arrangements that allow employers to provide retirement benefits beyond the limits imposed on qualified plans. For CFP exam purposes, understanding why these plans exist, the tax doctrines that govern them, Section 409A requirements, and the various funding arrangements is essential.

Why NQDC Plans Exist

The Qualified Plan Limitation Problem

Qualified retirement plans like 401(k)s and defined benefit pensions have strict limits on the compensation that can be considered:

For an executive earning $800,000 annually, a qualified plan contribution based on 25% of covered compensation would be limited to $87,500 (2025)—not $200,000 (25% of $800,000). This creates a significant "retirement gap" for highly compensated employees.

The Ability to Discriminate

Unlike qualified plans that must meet nondiscrimination tests covering all eligible employees, NQDC plans:

• Can be offered to select executives only
• Have no contribution or benefit limits
• Require no IRS approval
• Are exempt from most ERISA requirements (if offered to "top-hat" employees)

Trade-off: In exchange for this flexibility, NQDC plans receive no current tax deduction for the employer until benefits are actually paid, and executives face substantial risk of forfeiture.

Key Tax Doctrines

Constructive Receipt Doctrine

The constructive receipt doctrine states that income is taxable when it is made available to the taxpayer, even if not actually received. An NQDC plan must be structured so that executives:

• Cannot access deferred amounts before the specified distribution date
• Have no right to assign or pledge the deferred amounts
• Cannot accelerate payment except in limited circumstances

Example: If an executive can withdraw deferred compensation at any time, even with a 10% penalty, the entire amount is considered constructively received and immediately taxable.

Economic Benefit Doctrine

The economic benefit doctrine provides that if an employer sets aside assets in a fund that is:

1. Unrestricted (not subject to employer creditors), and
2. Nonforfeitable (the employee cannot lose the benefit)

...the employee has received an economic benefit and must include the value in current income, even without actual receipt.

Key Point: NQDC plans must maintain some element of risk to avoid immediate taxation—this is the "substantial risk of forfeiture" requirement.

Substantial Risk of Forfeiture

For deferred compensation to remain untaxed, there must be a substantial risk of forfeiture—meaning the employee's right to the benefit is conditioned on:

• Continued employment for a specified period
• Achievement of performance goals
• Other meaningful conditions

If the risk of forfeiture is eliminated (through vesting), the deferred amounts become taxable unless another deferral mechanism applies.

IRC Section 409A Requirements

Section 409A, enacted in 2004, provides comprehensive rules governing NQDC arrangements. Failure to comply results in severe penalties.

Timing of Deferral Elections

Example: In November 2025, an executive may elect to defer 20% of their 2026 base salary. After January 1, 2026, that election is irrevocable.

Permitted Distribution Triggers

Under Section 409A, distributions from NQDC plans are generally limited to:

1. Separation from service (6-month delay for "specified employees" of public companies)
2. Death or disability
3. Fixed date or schedule specified at deferral
4. Change in control of the company
5. Unforeseeable emergency (narrow circumstances)

Section 409A Penalties

Failure to comply with Section 409A results in immediate taxation of all deferred amounts PLUS:

• 20% additional excise tax on the deferred amount
• Premium interest tax calculated from the date of deferral

These penalties apply to the employee, not the employer.

Funding Arrangements

NQDC plans can be unfunded (merely a promise to pay) or use various trust arrangements. The choice affects creditor protection and tax treatment.

Unfunded Promise to Pay

The simplest NQDC arrangement is an unfunded promise:

• Employer maintains a bookkeeping entry only
• No assets are set aside
• Executive is an unsecured general creditor of the employer
• No current taxation; income recognized when paid

Risk: If the employer becomes insolvent, the executive may receive nothing.

Rabbi Trust

A rabbi trust is an irrevocable trust that:

• Holds assets designated for NQDC benefits
• Protects against employer "change of heart" (unwillingness to pay)
• Remains subject to claims of employer's general creditors in bankruptcy/insolvency

When to use: Rabbi trusts are appropriate when the executive's primary concern is a hostile takeover or employer's refusal to pay—not bankruptcy.

Secular Trust

A secular trust is an irrevocable trust that:

• Fully secures the employee's deferred compensation
• Assets are beyond reach of employer and employer's creditors
• Provides complete benefit security

Key Distinction: Because assets in a secular trust are fully secured, the employee has no substantial risk of forfeiture. This triggers immediate taxation under the economic benefit doctrine, eliminating the main advantage of NQDC.

Rabbi Trust vs. Secular Trust Comparison

Phantom Stock Plans

Phantom stock is a form of NQDC that tracks the value of employer stock without issuing actual shares:

1. Employer grants fictional "units" tied to stock value
2. At a specified date, the executive receives cash equal to the appreciation
3. No actual stock is transferred
4. No voting rights or dividends (unless plan provides dividend equivalents)

Tax treatment: Both employer deduction and executive income occur when payment is made—no mismatch in timing.

Advantage: Phantom stock provides equity-like incentives without diluting existing shareholders.

On the CFP Exam

Expect questions testing:

• Why executives need NQDC (covered compensation limits, discrimination ability)
• Constructive receipt vs. economic benefit doctrines
• Section 409A timing requirements and penalties
• Rabbi trust vs. secular trust differences
• Which arrangements maintain tax deferral vs. trigger immediate taxation