Nonqualified deferred compensation

How it works

Before the year begins, the worker elects how much salary or bonus to defer and when it will be paid, such as at separation or in a set year, and federal law under Section 409A makes those elections hard to change later. There is no dollar cap set by law, which is the appeal for people who already fill a 401(k). The deferred pay is not taxed as income until paid, though Social Security and Medicare tax usually apply when it is earned. The money is not held in a trust for the worker; it stays on the employer's books, and if the employer goes bankrupt the worker stands in line with other unsecured creditors. A plan that breaks the 409A rules can trigger immediate tax on all vested deferrals plus a 20 percent addition.

What it gives

Deferrals above the 401(k) cap are allowed, with no yearly dollar limit set by law.

Tax is delayed to a year the worker chose, which may be a lower income year after retirement.

Many plans credit the deferred amount with earnings tied to a fund menu.

What it costs, or where the catch is

The money can be lost entirely if the employer becomes insolvent.

Payout dates are locked in, and changing them requires a five year delay under the rules.

A lump sum payout at separation can land all the deferred years of income into one tax year.

A worked example

Rafael earns $300,000 and defers $50,000 of his bonus into a plan paying out five years after he leaves. His taxable income this year drops to $250,000, which at a 35 percent marginal rate saves $50,000 times 0.35, or $17,500 now. If the company fails in year three, the $50,000 is an unsecured claim and he may receive $0 of it.

Where it goes wrong

The common miss is deferring a large sum without reading the payout election closely, and then getting all of it in a single year at the highest bracket.

Who confirms it for you

For your own numbers, a CPA or enrolled agent. This page explains how the rule works for people in general; it does not know your situation and does not tell you what to do.

The official source

IRS Publication 525, Taxable and Nontaxable Income. Every figure that changes by year comes from the site's rules table, which the watcher checks against the official page on a schedule; where a figure is not yet verified, this page says so instead of printing a number.