Due to the limitations imposed on qualified plans, such as 401(k) plans, under the Internal Revenue Code and Employee Retirement Income Security Act (ERISA), executives are often not given the opportunity to fully participate in an employer's tax-deferred savings plans. Nonqualified plans give an organization the flexibility to design an arrangement to compensate a select group of managers and highly compensated individuals. These nonqualified plans give executives the opportunity to defer taxation of compensation and investment earnings until retirement or some future date.
NQDC plans are one of the most popular nonqualified compensation options. These plans allow executives to defer part or all of their compensation until a time in the future, thus significantly reducing their tax liability in some cases. However, for the plan to retain a tax-deferred status, it must meet the following criteria:
The employee is not in constructive receipt of the amount promised, which means the employee has no right to receive or turn down the benefit.
The employee does not receive an economic benefit from the compensation; for example, the employee cannot use the promised benefit as security for a loan.
A substantial risk of forfeiture must exist; that is, the executive's ownership is contingent on meeting certain conditions and goals, and ownership is forfeited if those goals or conditions are not met.
The plan usually credits interest to the deferrals, which allows executives to maximize tax-deferred growth and take their total earnings over an extended period of time. Executives can choose to defer a significant amount of their salary or bonus and write their own pre- and post-retirement options. As executives' needs change, so can the amount of deferrals and future payout arrangements.