NON-QUALIFIED DEFERRED COMPENSATION PLANS
NQDC plans enable the executive to postpone a portion of their present income and any revenue made thereon until one or more predetermined future dates. Additionally, these programs are governed by complex regulations, which an executive should discuss with their tax expert. For instance, choosing a payout term is one of the most crucial factors for an executive to think about because the payout cannot be changed without negative effects.
The timing of the payout, which is set at the employee’s choice, can be either spread out over time or as one lump sum. These plans are subject to the creditors of the firm and are not shielded if the company goes bankrupt. The payouts are subject to standard tax rates when paid. When setting them up, state income taxes should also be taken into account. Moving to a state that doesn’t tax income after deferring revenue earned while residing in one won’t always stop the taxing state from taxing the income. Once more, when establishing these plans and managing these challenges, a tax expert should be consulted.
How NQDC Plans Are Taxed
The year in which you earn any salary, bonuses, commissions, or other remuneration that you agree to defer under a NQDC plan is tax-free. (The deferred amount can be shown on the annual Form W-2 you receive.)
When you actually receive the compensation, taxes will be due on it. Unless you fulfill the criteria for another triggering event that is permitted by the plan, such as a disability, this should happen after you retire. Even if you are not an employee at the time of payment, Form W-2 will still reflect the deferred compensation payment.
The earnings you receive from your deferrals when they are paid to you are also subject to tax. The conditions of the plan set the return rate.
For instance, it might be comparable to the S&P 500 Index’s return percentage.
Watch out for early withdrawals. The consequences are harsh.
Compensation in Stock or Options
Special tax regulations apply when compensation is paid in stock and stock options. Taxes won’t be due in these situations until you may sell or give away the stock shares or options as you see fit.
You might want to disclose this compensation right away, though. This is referred to by the IRS as an 83(b) election. It enables the receiver to report the property’s value as income right away (instead of when it becomes vested), with all future appreciation turning into capital gains that may be subject to advantageous tax treatment.
You will be required to pay taxes on the asset and its appreciation at the time it is received if you don’t make the Section 83(b) option. If you choose to do so, you will forfeit your right to claim any future damages in the event that the value declines.
Instead of deferring reporting of this compensation, one can disclose it immediately using a sample 83(b) form provided by the IRS.
Tax Penalties for Early Distributions
If you take money out of a NQDC plan before retirement or when no other suitable “trigger event” has happened, there are severe tax repercussions.
- Even if you have only received a portion of the deferrals made under the plan, you are still subject to immediate taxation on the entire amount.
- The tax rate on interest is one percentage point more than the underpayment penalty. The rate of underpayments for Q4 2021 was 3%, so the taxable interest rate would be 4%.
- A 20% penalty applies to the deferrals for you.
How FICA Taxes Are Affected
Even if you want to defer it, the Social Security and Medicare tax (FICA on your W-2) is paid on earnings at the time they are made.
As a result of the Social Security pay cap, this may be advantageous. Use this illustration: Your salary was $150,000 in 2019 and you made a timely decision to defer an additional $25,000 in remuneration. Earnings subject to the Social Security part of FICA were restricted at $142,800 for the 2021 tax year. The amount of total compensation for the year that is not subject to the FICA tax is $32,200 ($150,000 – $142,800 + $25,000.)
No FICA tax will be taken out of the deferred compensation when it is paid out, like in retirement.
Retirement Planning Strategies for NQDCs
If you have a NQDC, you might wish to collaborate with an advisor like our team at Credo to develop a financial strategy for your retirement needs and objectives. Finding a competent financial advisor need not be difficult.
Remember to factor in Social Security when estimating how much you will need to save for retirement. Despite the fact that it’s practically difficult to survive only on Social Security, these payments can fill in the gaps if your savings fall just short.
One of the simplest ways to save for retirement is via a 401(k) plan. In actuality, your employer will typically offer them. You can designate a certain sum of money to be deducted from each paycheck. Even better, your company might match your donations.