If you’re an executive or key employee, you may be eligible to participate in your company’s nonqualified deferred compensation (NQDC) plan, along with receiving grants of stock options or restricted stock. For NQDC plan participants, year-end is the time to make like an autumn squirrel and decide how much to store for the future.
In November and December, NQDC participants at many companies must decide how much of next year’s salary to defer. Factors in this decision about nonqualified plans include the IRS limits that apply to qualified retirement plans (and this year also the outlook for future tax rates under legislation in Congress). The IRS just set the qualified plan limits for 2022.
The contribution limits of qualified plans are a major reason for the existence of nonqualified plans: to allow executives and other highly compensated employees to squirrel away substantial extra amounts for retirement with an elective nonqualified plan or an excess 401(k) plan.
What Is Nonqualified Deferred Comp?
The combination of the terms “nonqualified” and “deferred” may seem odd. Deferred compensation is pay earned in one year that is not distributed to you until a future year. The deferred income is “nonqualified” because it does not meet the rules in the Internal Revenue Code that permit tax-qualified plans (e.g. 401(k) plans).
NQDC allows you to put away unlimited amounts of money beyond the permissible contribution amounts of standard qualified retirement plans. For retirement planning, NQDC can thus fill the gap that often arises between the amount of income that you will actually need in retirement and the amount of income that can be provided via your 401(k) plans and Social Security.
While retirement is a frequent goal for NQDC, the time of distribution need not be your retirement. Depending on the plan’s design, you can instead defer income to some nearer point in the future to meet shorter-term financial goals (e.g. college tuition or a vacation home).
Here’s how it works. With NQDC, you elect to delay receiving salary, a bonus, or other compensation. This will reduce your taxable income in the year of deferral. For salary, the deferral election (which is not changeable) must be made prior to that year. The ordinary income that you would have received, any company match, and the earnings from your NQDC account are all tax-deferred until distribution.
The complex rules under Section 409A of the US tax code must be followed in the deferral and distribution elections. The amount that you defer can only be informally funded by your company and is at risk should the company enter bankruptcy proceedings.
The website myNQDC.com is a comprehensive resource on NQDC plans, including the basics, the deferral/distribution process, the risks, and the related financial and tax planning.
2022 IRS Qualified Plan Limits Affect NQDC Deferrals
Generally, you defer income via nonqualified plans only when you know you will max out your yearly contributions to qualified plans, such as your 401(k). Therefore, the contribution limits set by the IRS on qualified plans, adjusted annually for inflation, are important for NQDC planning.
The IRS changes in these limits from 2021 to 2022 are relatively small. If you’ve already maxed out your qualified plan contributions for 2021, you will probably do the same in 2022, so you will need NQDC plans to defer any salary and bonus increases you expect in 2022. Also, depending on tax legislation in Congress, there may be higher tax rates in 2022 and/or beyond, increasing the need to defer income.
For a table comparing the features of 401(k) plans and NQDC plans, and their relative advantages and disadvantages, see an FAQ at myNQDC.com.
Social Security Tax Wage Cap Grows In 2022
Meanwhile, set by the Social Security Administration, the Social Security wage cap will also rise in 2022 to $147,000, a slight increase from $142,800 in 2021. With the 6.2% rate of Social Security tax, the maximum possible Social Security withholding is $8,853.60 in 2021 and will rise to $9,114 in 2022. Social Security tax (up to the yearly limit) and Medicare tax (uncapped) are withheld at the time of deferral.
What this means is that after you’re above the $147,000 mark in 2022, you can defer yearly income without paying Social Security tax on it at the time of deferral (though you will pay Medicare tax).