What are the pros and cons of nonqualified deferred compensation plans?


If you are an independent contractor, a freelancer or a key employee in a company, your employer might offer you to do work under a non-qualified deferred compensation plan. You might be asked to sign a contractual arrangement in which the employer will make an unsecured promise to pay benefits in a future tax year in exchange of current services.

There are generally two types of nonqualified deferred compensation plans: the so-called "addition plans" provide retirement benefits to a select group of executives, whereas under "elective plans" employees might choose to defer a share of their pay in order to save some money on a tax-deferred basis.

Advantages of Nonqualified Deferred Compensation Plans

  • Employers who use life insurance to finance nonqualified deferred compensation plans, are not taxed on the earnings, since the accumulation of cash value is not subject to tax until distribution.
  • Employees, who are covered under a nonqualified deferred compensation plan, do not owe taxes on the benefits until they receive a distribution.
  • Nonqualified deferred compensation plans provide great flexibility, compared to qualified plans. Employers have the freedom to name the people who will be covered, choose the levels and conditions of coverage, specify the forfeiture options and place any restrictions.

Nonqualified Deferred Compensation Plans - Disadvantages

  • The employer's income tax deduction is deferred until the year in which income is taxable to the covered employee.
  • The employee covered under a nonqualified deferred compensation plan, has little security, being left in a position in which they have to rely on the employer's promise to pay.
  • To use and take advantage of the nonqualified deferred compensation plans, an employer has to meet certain status requirements: generally, only C corporations can effectively use these plans. A partnership or an S corporation cannot use a nonqualified plan for its key employees. Non-profit and governmental organizations are subject to restrictive rules of utilizing the nonqualified deferred compensation plans.
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