Deferred compensation (DC) plans are beneficial for employers and employees alike. From the perspective of an employer, DC plans are beneficial as it allows them to attract and retain valuable employees. From the employee’s perspective, DC plans are beneficial because it allows them to build wealth as a direct result of their performance on the job. For the purposes of the Certified Financial Planner® exam, many candidates have trouble differentiating between the many rules that exist around qualified and non-qualified plans. As long as you can differntiate between the basic differences betwenn qualified and non-qualified plans, you increase your odds of answering questions about these two general types of plans on the CFP® exam.
For starters, it’s important to understand that NQDC plans allow employers to offer various forms of compensation to employees and owners such as bonuses, salaries and equity. However, instead of granting compensation immediately, employers can hold off or defer compensation until a later date for the purpose of incentivizing valuable employees to remain with the employer, or to compensate the owner or owners. In addition to the potential benefit that DC plans provide to the employee, deferrment of taxation results as well, and the CFP® exam will test you in a number of ways about this important fact.
NQDCs also benefit employees who are already or will be maxing out contributions to their qualified plans, such as a 401(k). Remember that the CFP® exam will likely test you heavily not only on qualifed plan limites, but also on topics such as “catch-up” contributions and total contributions allowed by both the employee and employer.
Whereas qualified DC plans must adhere to strict ERISA rules, NQDC rules are far less stringent. Another key differentiator between qualified and non-qualified plans is that qualified plans have income and contribution limits, whereas NQDC plans, generally speaking, do not. This feature of NQDC plans is particularly beneficial to employees and owners with high income who want to save for retirement. The drawback, however, of NQDC plans is that the benefit is merely a promise to the employee, and not a guarantee. This obviously can cause some angst on the part of the employee since if the company declares bankruptcy, they could lose their benefits. There are remedies to this potential outcome which is addressed in other blog posts, and these remedies are sure to be tested on the Certified Financial Planner™ exam. Once such example is the Rabbi trust, which while still considered a NQDC plan, give the employee or owner some form of “guarantee” that they will receive their benefit in the future.
As for tax ramifications, taxation to an employee benefiting from a NQDC plan occurs when the benefit is constructively received or when there is no longer the threat of losing the benefit. At the time the employee or owner receives the benefit, the employer gets a corresponding tax deduction. This is in contrast to qualified DC plans where the employer gets an immediate tax deduction, even though the employee or owner will likely not access the funds until a later date, such as retirement or separation from service.
For purposes of the CFP® exam, it’s imperative that you differentiate between the rules that exist for NQDC and qualified DC plans. Of utmost importance is to understand when taxation occurs for the employee or owner, and when the employer is allowed the tax deduction for the benefit provided.