Non-qualified deferred compensation plans: Full guide for employers

Your CFO is hitting the 401(k) contribution cap next month. Your VP of Sales wants to delay part of her bonus until after her equity cliff. And your board wants a plan to keep top talent around through the next funding round. A non-qualified deferred compensation plan (NQDC) might help you do all three.

NQDCs aren’t just tax tools for high earners. They’re a way to fill gaps left by standard benefit plans and align incentives at the top of your org chart. But they’re also tightly regulated and easy to get wrong. This guide breaks down what you need to know as an employer—from how these plans work and who they’re for to tax treatment, compliance rules, and risks worth flagging early.

What is a non-qualified deferred compensation plan?

A non-qualified deferred compensation plan, sometimes called a non-qualified retirement plan, is an agreement between an employer and an employee to delay payment of part of the employee’s earnings to a future date, typically retirement, with the goal of deferring income tax. 

Example: Morgan is a senior executive with Acme Co. Morgan has already contributed the maximum to a standard 401(k) and isn’t eligible to participate in the company’s other qualified retirement plans. To keep saving for retirement, Morgan defers $100,000 of an annual bonus into Acme Co.’s deferred compensation plan. This strategy lowers Morgan’s current taxable income and delays income tax payments on that $100,000 until retirement, when Morgan will enter a lower tax bracket.

Unlike a 401(k), an NQDC has no IRS contribution limits, but it also comes with more restrictions. To preserve tax advantages, the plan must follow strict rules set out in Section 409(a) of the Internal Revenue Code and remain unfunded. That means the company doesn’t place the deferred money in a protected account. It stays on the employer’s books and can be used for other purposes until it’s time to pay out. This setup is what allows the employee to delay paying taxes, but it also means the funds are exposed. If the company ends up in financial trouble, employees may not receive what’s owed.

You might consider using a plan like this when standard retirement or savings plans don’t meet the needs of highly compensated employees, or when certain employees can’t participate due to plan limits or design. And for top performers, it can be an important component in a competitive total compensation package.

How NQDCs differ from qualified retirement plans

You might be tempted to think of NQDCs as a more complicated version of a 401(k) or other traditional retirement plan, but that overlooks some key structural differences. Qualified plans are heavily regulated, broadly accessible, and designed for the general workforce. NQDC plans are narrow by design, come with a higher risk profile, give you more latitude in design, and have far fewer limits.

Contribution limits 

Qualified plans have hard limits on how much an employee can contribute each year. NQDCs don’t. That makes them especially useful for high earners who want to set aside income above the 401(k) ceiling.

Tax treatment 

With both traditional retirement plans and NQDCs, your employee defers taxes. With NQDCs, however, the rules are tighter and the risk is higher. Noncompliance in the form of an early payout means an immediate tax, interest, and a potential penalty worth 20% of the deferred amount.

ERISA protection 

Qualified plans are protected under the Employee Retirement Income Security Act (ERISA), which imposes mandatory funding, reporting, and fiduciary responsibilities on employers to protect participants. NQDCs are exempt from ERISA, but the greater flexibility comes at the expense of regulatory protection if things go south. 

Funding 

A 401(k) holds real assets in trust. NQDCs do not. The company makes a bookkeeping entry and may choose to set aside money of its own accord, but those funds aren’t earmarked for the NQDC plan and may end up in the pockets of other creditors in the case of liquidation.

Flexibility in design and eligibility  

Qualified plans are subject to nondiscrimination testing and must meet broad eligibility requirements. NQDCs, on the other hand, deliberately limit who can participate, usually to high earners better able to handle the financial risk associated with an unfunded plan. Because they’re not subject to ERISA rules, you can offer them selectively in ways that align with your broader pay structure. Employers also have the option to customize an NQDC in ways that ERISA doesn’t allow for a traditional retirement savings plan.

Who typically uses non-qualified deferred compensation plans?

NQDC plans aren’t developed with your entire team in mind. They’re designed for the few employees whose compensation and influence make them difficult to replace. These are the people whose tax situations are more complex, and whose needs may go beyond what a standard retirement plan can support. If you’re thinking about offering an NQDC, here’s who it’s usually built for:

Executives with high income

When annual compensation outpaces the limits of a 401(k) or traditional IRA, deferring additional income becomes more appealing. NQDCs let high earners shift more of their pay into the future when their taxable income may be lower. 

Employers seeking to retain top talent

Tying part of an executive’s compensation to a future payout can strengthen retention. Deferred amounts tied to vesting schedules or retirement give employees a reason to think twice before walking away. 

Highly compensated professionals ineligible for qualified plans

In some cases, professionals may be excluded from participating in standard plans due to nondiscrimination testing or plan design. An NQDC offers another way to support long-term savings for those employees when qualified plans can’t.

Private equity-owned firms

Private equity-backed companies often use NQDCs as part of a long-term financial incentive strategy for leadership. These plans usually align payouts with exit events or performance milestones without requiring equity grants or changing ownership structure. 

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How a non-qualified deferred compensation plan works

At its core, a non-qualified deferred compensation plan is a structured delay: the employee agrees to postpone part of their pay, and the employer agrees to deliver it later under strict conditions. More than tax planning, it involves timing, trust, and commitment from both sides. Here’s how the process works, step by step.

1. Enrollment and eligibility

Most NQDC plans limit participation to a select group of executives or other highly compensated employees. Eligibility criteria are defined upfront by the employer, and often track with salary bands used to define executive tiers or key contributor roles. Enrollment usually happens during an annual window or upon hire into a qualifying position. 

Example: Avery receives a promotion to senior vice president at Big Co. Later that year, HR invites Avery to join the company’s NQDC plan during the open enrollment period. Previously, Avery’s role didn’t qualify.

2. Electing deferrals

Participants must choose which compensation to defer, and how much, before actually earning the base salary or bonus in question. That’s because, under Section 409A of the Internal Revenue Code, deferral elections must be made in the calendar year prior to the year the employee will earn the compensation.

Example: In November, Avery elects to defer 20% of their 2026 base salary and 50% of their performance bonus. After January 1, 2026, those numbers are locked in and Avery can’t change them.

3. Distribution options

Typically, employees will also choose when and how they want to receive their compensation at the same time as the deferral elections. Once made, this choice is usually locked in.

Example: Avery selects a five-year payout schedule that begins upon retirement. Revising it later will trigger taxes and penalties, so Avery double-checks her calculations with a financial planner before committing. 

4. Investment choices and account growth

Participants often choose from a set of hypothetical investment options, which the company tracks and uses to value the account. The balance goes up (or down) based on how these “investments” perform. 

Example: Avery allocates the deferred pay across a stock index benchmark and a conservative interest-based option. Their future payout will reflect the return of those benchmarks. 

5. Deferral of taxes until distribution

Provided the plan complies with Section 409A, employees won’t owe income tax until the money actually lands in their bank accounts. This allows them to defer the inevitable income taxes to a time when a lower rate may apply due to a change in brackets.

Example: Avery isn’t taxed on the deferred 20% of their salary in 2026. Instead, Avery will pay income tax on those funds when she starts receiving payments after retirement.  

6. Payout triggers 

A compliant plan needs to clearly define the events that trigger distribution, typically retirement, separation from service, disability, or death. Each trigger has its own specific rules under Section 409A, but particular plans may also have their own requirements for a given trigger.

Example: Avery retires in 2032. The following year, Big Co. issues the first payment, kicking off the five-year installment plan Avery selected back in 2025.

Key benefits of a non-qualified deferred compensation plan

They’re not for every business, but when used strategically, nonqualified deferred compensation plans offer real advantages for your business and your high-earning employees. These plans create additional space for tax planning, can improve retention, and allow you to customize compensation beyond what a qualified plan allows. 

Income tax deferral

NQDCs help your top employees plan for retirement by allowing them to defer income taxes on a portion of their compensation until they’ve entered a lower tax bracket. It’s an attractive benefit that doesn’t immediately increase your payroll tax burden and doesn’t require your business to come up with the cash upfront.

Customized retirement savings

Traditional retirement plans leave your highest-earning employees with limited options once they hit contribution caps. NQDCs let you offer something more strategic: the ability to delay compensation and plan future income on their own terms. That kind of control can appeal to executives, and it positions you as an employer who thinks beyond the basics.

Executive retention and loyalty

Because payouts are delayed and often tied to vesting, NQDCs create a built-in reason for participating employees to stick around. They turn standard compensation into a forward-looking incentive: the longer your top earners stay, the more they stand to gain. That’s a powerful hedge against expensive leadership turnover. 

Flexible plan design options

Unlike ERISA-governed plans, NQDCs give you broad freedom in how you structure contributions, vesting, and distributions. You can align incentives with performance, retention, or retirement, depending on what best fits your business strategy. As long as you stay within the Section 409A rules, you have space to build a plan that works for your business’s overall compensation plan.  

No contribution limits like 401(k)s

Standard plan caps can sometimes fall short or become restrictive for employees with more complex compensation. NQDCs let you offer additional deferral opportunities well beyond the limits of a typical 401(k) or Roth IRA, which can make a meaningful difference for executives looking to manage income over time. It’s a way to stay competitive in the market when top talent expects more than just the basics.

Investment growth potential

Even though NQDCs stay unfunded, you can still offer participants a way to track growth over time. Most plans let employees pick from a set of notional investments that operate like performance benchmarks. You don’t actually invest the money, but you do credit the accounts based on how those benchmarks perform. It’s a way to add long-term value without locking up real funds on your balance sheet.

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Risks and challenges of NQDC plans

Nonqualified deferred compensation can be a smart move for both employers and high earners, but it does come with tradeoffs. These plans require careful handling, and the risks aren’t always obvious until something goes awry, so it’s worth understanding the potential pitfalls before you start designing your own NQDC.

Assets remain employer property (unsecured)

Because NQDC plans are unfunded, the assets are part of your company’s general funds (vs. held in trust for your employees). This setup gives you more control, but it also means you’re making a long-term promise to pay without setting the money you’ll need aside in a protected account. If your financials take a hit, those obligations stay on the books. 

This creates a potential trust issue; if your business starts to seem less than healthy, executives may question whether those deferred amounts will ever materialize, which can lead to turnover. 

Plans must strictly follow Section 409A rules 

The IRS isn’t known for taking a generous interpretation of the regulations that govern NQDC plans. If your version doesn’t follow Section 409A down to the letter, your participants could be hit with immediate income tax, a penalty of up to 20% of the deferred amount, and interest. One mistake can unravel years of planning.

Complex administration and legal compliance

From tracking deferrals and distributions to W-2 reporting and FICA timing, NQDCs come with a lot of moving parts. For HR and finance teams, that means staying in sync with legal counsel, payroll, and plan administrators to avoid expensive compliance gaps.

How employers can set up a compliant NQDC plan

Setting up a nonqualified deferred compensation plan isn’t the time to improvise. It takes planning, thoughtful design, and the right tools to keep it compliant. While NQDCs can strengthen both retention and tax strategy, they carry real risks for you and your employees if you don’t devote time to managing them. Below are the key steps to build a plan that holds up under IRS scrutiny and supports your leadership team.

1. Determine executive eligibility criteria

Start by deciding who the plan is actually for. NQDCs are typically reserved for highly compensated employees or executives, since opening them up more broadly risks crossing into qualified plan territory. Draw your eligibility criteria from your compensation philosophy and apply them consistently. 

2. Define deferral and distribution rules

Lay out when and how participants can defer income and under what circumstances they’ll receive it. IRS Rules under Section 409A require that deferral elections happen before the compensation is earned and that distribution events, like separation from service, are clearly set out up front. NQDCs require tight coordination with your broader compensation management strategy, especially when aligning incentives across salary, bonuses, and deferred pay.

3. Draft plan documents and comply with Section 409A

Getting the legal framework right upfront is worth it, so work with legal counsel to draft a written deferred compensation plan that meets Section 409A requirements. The rules are strict, and even small mistakes can lead to immediate taxation, a 20% penalty, and added interest. It’s one of those areas where cutting corners will cost you more in the long run. 

4. Choose an administration platform

Administering NQDC plans in-house can lead to manual errors, missed deadlines, and other compliance risks. The best compensation management software can help manage deferral elections, track vesting schedules, manage W-2 reporting, and monitor compliance. Look for a solution that integrates natively with your existing payroll and HRIS systems.

5. Educate participants and HR teams

This isn’t a passive benefit. NQDC plans require ongoing attention and maintenance to work properly, and HR needs to understand the mechanics well enough to guide employees. Participants should have a good grasp of the risks and conditions that impact their payout, especially around tax treatment, payout timing, and what happens if they leave or your business falters. When communication falls short, even a well-designed plan can do more harm than good by eroding trust or creating confusion. 

6. Monitor compliance and reporting

Once your plan is active, keep a close watch on tax reporting, FICA timings, and any changes in employment status that could trigger a payout. You’ll also need to track plan assets, even if you hold them in a rabbi trust, and follow the IRS instructions for Form W-2.

7. Evaluate funding options (e.g., corporate-owned life insurance)

Even though NQDC plans need to stay unfunded to keep their tax-deferred status, many companies still set aside money to cover future payouts. One approach involves using corporate-owned life insurance (COLI). It doesn’t belong to the employee, so you stay on the right side of compliance rules, but it does give your business a tool to manage long-term liabilities. The key is making sure any funding strategy stays within IRS limits and doesn’t accidentally trigger taxes.

8. Plan for plan amendments or terminations

NQDC plans shouldn’t be static. Business needs change, and you may need to amend or terminate the plan down the line. Section 409A places strict limits on how and when this can happen, especially regarding payout acceleration, so be sure to build in flexibility and document any changes. 

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What does that mean for you and your team? For starters, you have a single source of truth for up-to-the-minute employee information. It also means that your team doesn’t have to reenter information across systems when an employee gets promoted or moves to a different city to work remotely. From changing security permissions to updating PTO policies, Rippling triggers automatic updates to employee information in a single flow. It’s infrastructure that frees you to think bigger—and offer the benefits your employees need, compliantly and efficiently.

Non-qualified deferred compensation plan FAQs 

What is non-qualified deferred compensation?

Non-qualified deferred compensation is pay that an employer promises to deliver in the future in exchange for work done now. It’s typically offered as an incentive to high earners like executives. Unlike a qualified retirement plan, it doesn’t follow ERISA rules, has no contribution limits, and carries more risk. The deferral lets employees delay income tax until payout, often in a lower tax bracket. But because these plans are unfunded, the money isn’t protected if the company fails. Section 409A of the Internal Revenue Code sets strict rules to prevent abuse and impose penalties if companies misuse the funds.

Does non-qualified deferred compensation count as earned income?

Non-qualified deferred compensation counts as earned income when it’s paid out, not when it’s deferred. Until then, it’s considered deferred income and isn’t included in your taxable income or subject to income tax, as long as the plan complies with the requirements at Section 409A of the Internal Revenue Code. Once distributed, it’s treated like salary or a bonus on the employee’s W-2 and taxed accordingly. At that point, it qualifies as earned for purposes like IRA contributions and income thresholds.

How is NQDC taxed at payout?

When an NQDC plan pays out, the amount is taxed as ordinary income, not capital gains. It’s included in the employee’s W-2 and subject to income tax, plus FICA and Medicare taxes if not already withheld. There’s no special tax rate, even for large payouts. The IRS treats it like regular compensation once the payout is no longer subject to a substantial risk of forfeiture.

Can an employee lose their deferred compensation?

Yes, employees can lose their deferred compensation under certain conditions. If the company goes bankrupt, they may not get paid at all since the NQDC plans are subject to creditor claims. They can also lose the payout if they violate plan terms, like leaving early or failing to meet performance targets tied to the deferral. Under Section 409A of the Internal Revenue Code, early access or noncompliance can also trigger taxes and penalties.

What happens to an NQDC plan if the company goes bankrupt?

If a company goes bankrupt, NQDC plan participants become unsecured creditors. That means they stand in line with other creditors seeking compensation, and risk losing some or all of their deferred compensation depending on who has priority. Because NQDCs are intentionally unfunded to avoid early income tax, there’s no protected account holding the money. 

Are NQDCs reported on W-2 or 1099?

NQDCs are reported on the employee’s W-2, not a 1099. Amounts become taxable once the employee has a right to receive them, typically when there’s no longer a substantial risk of forfeiture under Section 409A of the Internal Revenue Code. Employers are required to report these amounts as wages in Box 1 and again in Box 11 with code “Y” for tracking purposes.