Legal Definitions - nonqualified deferred-compensation plan

A nonqualified deferred-compensation plan is an agreement between an employer and an employee where a portion of the employee's compensation is earned in the present but paid out at a future date, such as retirement, termination of employment, or a specific milestone. Unlike "qualified" plans (like 401(k)s or traditional pension plans), these arrangements do not have to meet the strict rules set by the Employee Retirement Income Security Act (ERISA) or the Internal Revenue Service (IRS) regarding broad employee participation and non-discrimination.

This flexibility allows employers to offer tailored benefits, often to a select group of highly compensated employees or executives, without the same regulatory burdens. However, because these plans are "nonqualified," the employee's deferred funds are typically not held in a protected trust and may be subject to the claims of the company's general creditors if the company faces financial difficulties. The compensation is generally taxed to the employee only when it is actually received, rather than when it is earned.

• Example 1: Executive Bonus Deferral

  The CEO of a successful software company, Maria, is due a substantial annual performance bonus. Instead of receiving the entire bonus this year and paying immediate income tax on it, she agrees with the company to defer half of the bonus. This deferred amount will be paid out to her in three equal installments over the first three years of her retirement from the company. The company records this as a liability on its books, but the funds remain part of the company's general assets until paid.

  This illustrates a nonqualified deferred-compensation plan because it's a specific arrangement for a single executive, not a plan offered to all employees under ERISA rules. The bonus is earned now but the payment is deferred until a future event (retirement), and the funds are not held in a separate, protected account.

• Example 2: Retention Plan for Key Scientists

  A biotechnology startup wants to ensure its lead research and development team stays with the company for at least five years to complete a critical drug trial. The company offers its five most senior scientists a "long-term incentive plan" that promises a significant cash payout based on the company's stock performance over the next five years, but only if they remain employed for the entire period. This plan is not available to other employees, such as administrative staff or junior researchers.

  This is a nonqualified deferred-compensation plan because it's a selective benefit offered only to a small group of key employees, not subject to the broad participation and non-discrimination rules of qualified plans. The compensation (cash payout) is earned over time but deferred until a future condition (five years of service) is met.

• Example 3: Supplemental Executive Retirement Plan (SERP)

  A large financial institution offers its senior vice presidents a Supplemental Executive Retirement Plan (SERP). This plan promises to pay them an additional annual pension amount for 10 years after they retire, supplementing their regular 401(k) and company-sponsored pension. The SERP is "unfunded," meaning the company promises to pay these benefits from its general operating funds when the executives retire, rather than setting aside money in a separate, protected trust fund specifically for the SERP.

  This demonstrates a nonqualified deferred-compensation plan because it's exclusively for a select group of senior executives and does not adhere to the strict funding and participation rules of ERISA-qualified pension plans. The promise of future retirement income is a form of compensation earned during their working years but paid out much later, during retirement.