Non Qualified Deferred Comp Taxation Explained

Non qualified deferred compensation plans are taxed as ordinary income when you receive the money, which is typically when you leave your job or retire. This can increase your tax liability in the years you receive the funds.

You'll pay taxes on the entire amount, not just the interest or gains, as it's considered ordinary income. This is a key difference from qualified plans like 401(k)s and IRAs, where taxes are deferred until withdrawal.

The tax implications of non qualified deferred compensation plans can be significant, especially if you're in a high tax bracket when you receive the funds. This is because you'll be taxed on the entire amount, including the initial investment or contribution.

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The Deferred Compensation Program, or DCP, is a special type of savings program that helps you invest for the retirement lifestyle you want to achieve.

DCP is administered by the Washington State Department of Retirement Systems (DRS) and is similar to a 403b program.

It's an IRC Section 457 plan, which means it adheres to specific rules and regulations.

DCP adheres to administrative codes or rules adopted by Washington agencies, which can be found in the WAC (Washington Administrative Code).

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Non-qualified compensation plans are often used to pay deferred income, such as supplemental executive retirement plans.

These plans are typically offered to upper management and may be provided in addition to or instead of 401(k)s. They can include split-dollar arrangements, which are a type of deferred income payment.

Non-qualified compensation plans can pay regular salaries and deferred income, making them a flexible option for executives.

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When deciding on a DCP plan, you have the option to contribute to a pretax plan, a Roth plan, or both.

To make an informed decision, you can use a calculator to compare your savings options.

Contributing to a pretax plan means your contributions are made before taxes are taken out.

This can lower your taxable income, which may reduce your tax bill.

A Roth plan, on the other hand, allows you to contribute after taxes have been taken out.

You've already paid income tax on the money you contribute to a Roth plan, so you won't owe taxes when you withdraw the funds in retirement.

You can use a calculator to compare your savings options and determine whether contributing to a pretax plan, a Roth plan, or both is best for you.

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An excess benefit plan allows payments to be made after termination of employment to avoid taxes in the state where the income was earned. This type of plan can provide benefits only when statutory limits related to qualified retirement plans have been reached.

Under an excess benefit plan, you can contribute more than the limits of a qualified plan like a 401(k). For example, Company A provides a dollar-for-dollar 6% matching contribution, but the employer is only allowed to contribute 6% of the annual compensation limit of $345,000 in 2024.

The employer contribution limit for a highly compensated executive under a qualified plan is $20,700, which is 6% of the annual compensation limit. However, an excess benefit plan can provide more employer contributions, as seen in the example of Employee B, who received $39,300 from the NQDC plan.

Excess benefit plans don't require payments to be made over 10 years or more, but taking distributions over a number of years can help spread out federal tax liabilities and potentially reduce the effective tax rate.

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Non-qualified deferred compensation plans, or DCP plans, can be complex and have unique features. A common type of DCP plan is the supplemental executive retirement plan.

These plans pay deferred income, such as supplemental retirement plans, in addition to a regular salary. They're often offered to upper management.

DCP plans can provide a regular salary, plus deferred income from supplemental retirement plans or split-dollar arrangements. This can be a valuable benefit for executives.

Non-qualified compensation plans are most often offered to upper management. They may be provided in addition to or instead of 401(k)s.

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You're not taxed on the compensation you defer under an NQDC plan in the year you earn it, but you will be taxed when you receive it, which is usually after retirement.

The penalties for early withdrawals are severe, with the tax penalty for overpayments and underpayments for Q4 2024 being 8% for individuals, although corporations are charged 7% for overpayments.

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You're taxed immediately on all deferrals made under the plan if you withdraw money before retirement or a triggering event, and you'll have to pay the tax penalty on top of the taxes on the deferrals.

The tax penalty can be a significant burden, so it's essential to understand the rules and plan accordingly.

The tax rate on NQDC distributions can be affected by state and local taxes, depending on where you live, where you worked when the compensation was earned, the structure of your plan, and your distribution elections.

Here are some key tax implications to keep in mind:

You can name anyone as your beneficiary, including a spouse, child, domestic partner, friend, neighbor, or even a charity or trust. This allows for flexibility in planning for the future.

In the event of your death, your beneficiaries will receive payment from your DCP account, so it's essential to keep your beneficiaries updated. Your DCP beneficiaries must be declared separately from any other plan or program, like a pension.

If you die without a current beneficiary designation on file, a distribution will be made to your estate.

DCP emergency withdrawals can be a lifesaver in certain hardship situations. The IRS sets the criteria for what constitutes an unforeseeable emergency.

To qualify, the need must be outstanding, not something you could have planned for. This means that credit card debt, even if used to pay for a medical emergency, is not a qualified unforeseeable emergency.

You can withdraw DCP funds while still working, but only under specific hardship conditions. The DRS record keeper, Voya Financial, works with customers to process these claims and resulting DCP distributions.

Here are the key criteria for an unforeseeable emergency:

Emergency medical bills could be approved for distribution, but a credit card bill for those same bills would not. Knowing what an unforeseeable emergency is now could prevent some complications for you in the event a hardship occurs.

Your beneficiaries will receive payment from your DCP account in the event of your death, so it's essential to keep them updated.

You can name anyone as your beneficiary, including a spouse, child, domestic partner, friend, or neighbor.

A charity or trust can also be designated as a beneficiary.

If you die without a current beneficiary designation on file, a distribution will be made to your estate.

NQDC plans offer greater flexibility in contribution limits compared to 401(k) plans, allowing participants to defer a larger portion of their salary or bonuses without strict annual limits.

Contributions to NQDC plans can be made without the IRS-set limits that apply to 401(k) plans, making it a more attractive option for high earners who want to defer larger portions of their income.

However, 401(k) plans offer immediate tax benefits by allowing contributions to be made on a pre-tax basis, which can be beneficial for those who expect to be in a lower tax bracket in the future.

In contrast, NQDC plans provide tax-deferred treatment, allowing participants to delay income taxes on their contributions until they start collecting their deferred compensation.

This can result in a greater accrual of earnings over time, but it's essential to be prepared for the impact when taxes are finally owed on the deferred compensation.

401(k) plans, on the other hand, are subject to ERISA regulations, which provide certain standards of reporting and disclosure to protect participants, whereas NQDC plans lack this regulatory oversight.

Non-qualified deferred comp plans are typically offered to senior executives as an added incentive. These plans allow them to delay payment of a portion of their salary and the taxes due on it to a later date, typically after retirement.

You may be wondering who can participate in these plans. The answer is senior executives, who are often offered non-qualified compensation plans in addition to or instead of 401(k)s.

Here are some key takeaways about NQDC plans:

If you live in a state with high taxes, you may want to consider moving to a lower tax state or one without income tax. States like New York and California have high taxes, but states like Florida and Nevada do not.

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