Meaning
Financial agreement between an employer and an employee permits the deferral of income tax on salary, bonuses, or equity to a future date. This arrangement, known as nonqualified deferred compensation, is typically reserved for highly compensated executives because it does not have to meet the non-discrimination rules of qualified plans. It carries a risk of loss if the company faces insolvency, as the deferred assets remain part of the employer’s general creditor pool.
Tax Deferral
The employee elects to defer a portion of their earnings before the start of the calendar year. This nonqualified deferred compensation grows on a tax-deferred basis until it is distributed according to a predetermined schedule. Distribution usually occurs at retirement, separation from service, or a specified date.
Funding Mechanism
Unlike qualified plans, these arrangements are often unfunded or informally funded using corporate-owned life insurance or rabbi trusts. The employer does not receive a tax deduction until the employee receives the distribution. This tax treatment distinguishes nonqualified deferred compensation from standard pension schemes.
Financial Security
Participating executives must evaluate the creditworthiness of their employer before committing to these plans. In the event of bankruptcy, the deferred compensation may be lost to secured creditors. This risk makes the arrangement less secure than a qualified retirement plan.
