A deferred compensation plan is a benefit sometimes offered to highly compensated employees to help them defer some of their tax liability. It’s especially useful when someone is in their peak earning years, but still wants to earn and/or save more. It’s also a tool companies can use to attract and retain top talent.

If you’ve been offered deferred compensation from your employer, make sure you understand exactly what you’re signing up for. In this article, we’ll explain how deferred compensation works, the tax implications, risks to consider, and more.

What Is Deferred Compensation?

Definitions at a glance

Deferred compensation is what it sounds like. An employer will offer you the opportunity to defer a portion of your compensation for several years. Doing so defers taxes on any earnings until you withdraw. Examples include pensions, retirement plans, and stock options.

There are two types of deferred compensation plans:

• Qualified deferred compensation
• Non-qualified deferred compensation (NQDC)

Qualified deferred compensation plans include employer-sponsored retirement plans, including 401(k) and pensions. NQDCs, which are the ones we’ll primarily talk about in this article, are less common and work a bit differently.

Unlike 401(k) plans, NQDCs (also known as top-hat plans) aren’t subject to the Employee Retirement Income Security Act of 1974 (ERISA), which regulates employee benefit plans. This gives employees more flexibility in implementing them.

NQDCs have no limit on how much income you can defer each year. In fact, if you're in the top tax bracket, these plans can have significant tax benefits. That means you can defer a large enough portion of your income to drop down into a lower tax bracket, thus reducing the amount you must pay in income taxes.

Why employers offer it 

Often referred to as "golden handcuffs," NQDC plans are used to attract and retain top employees. The "golden" part refers to the potential tax benefit for the employee.

The handcuff refers to a penalty attached to any employer contributions to deferred compensation that kicks in if the employee leaves (especially for a competitor), retires early, or is terminated. That means the employee must stay with their company, or the deferred compensation is penalized, so the employer gets some extra assurance they will get to keep their valued employee for the long haul.[e1]

How NQDC Plans Work

When you sign up for your employer’s NQDC, you can elect how much to defer. While the IRS doesn’t impose contribution limits like it does for 401(k) plans and other plans regulated by ERISA, your employer may set plan limits.

You’ll also need to decide how long to defer – usually five years, ten years, or until you retire – and whether to receive one lump sum payment or a series of payments over multiple years.

The next choice you need to make with your NQDC is which investment option you want your returns to be indexed. This is just a bookkeeping mechanism, as your money isn't actually invested. 

Some companies offer options like what’s available in your 401(k) or may have options tethered to an actual asset (company stock) or a national index like the S&P 500. Occasionally, the company may choose for you by offering a guaranteed "rate of return" on the compensation, but this is rare.

It’s important to note that, unlike with a 401(k) or a similar account, the money you defer in your company’s NQDC isn’t actually sitting in an account for you. These accounts are generally unfunded, which means they’re promised, but not secured. Your employer will track your benefits in a bookkeeping account.

According to the IRS, this mechanism is necessary to ensure the deferred compensation isn’t includable in your income for the current tax year.

Distribution events under 409A 

Under Section 409A of the tax code, there are only six events that allow you to receive NQCD distributions. Those are:

• Specified time or fixed schedule (as determined at the time of the deferral)
• Separation from service (either voluntary or involuntary)
• Unforeseeable emergency
• Change in ownership or control of the company
• Disability
• Death 

If you violate Section 409A, the distribution is included in your gross income and subject to a 20% penalty. There will also be an additional interest charge for the year the amount was deferred or vested, rather than the current year. 

Changing your mind? The 12-month/5-year subsequent deferral rule

Once you’ve set your deferral and distribution options, they’re difficult to change. You can only change the timing of your distribution if it’s at least 12 months before your benefits were to be paid and that your new payment date is at least five years later than the original date.

Taxes: Income vs. FICA (What Hits When)

Income tax 

As with other income, you’ll pay taxes on your deferred compensation income in the year you “constructively receive” it, according to the IRS, rather than the year it’s deferred. However, any non-compliance with Section 409A could result in the compensation being included in your taxable income.

FICA/FUTA special timing rule

In most cases, you’ll pay payroll taxes on your deferred compensation in the year it’s deferred rather than the year you receive it. Payroll taxes include Federal Insurance Contributions Act (FICA) taxes like Medicare and Social Security, and Federal Unemployment Tax Act (FUTA) taxes.

If you have to perform substantial services for your deferred compensation to be vested, then you’ll pay FICA and FUTA taxes in the year your deferred compensation vests rather than the year it’s deferred.

Reasonable return limits

The IRS’s non-duplication rule excludes interest or earnings credited to your NQDC from your wages and, therefore, protects them from FICA taxes. However, this is only the case if the plan earns a reasonable rate of return. According to the IRS, a reasonable rate of interest could be Moody’s Average Corporate Bond Yield or the rate of return on the company’s stock, to name a few.

If earnings into the NQDC exceed what’s considered reasonable, they may be subject to FICA taxes.

State Taxes & the “10-Year Rule” If You Move

4 U.S.C. §114: When only your new resident state can tax “retirement income”

Federal law provides significant protection for retirees receiving retirement income. Under 4 U.S.C. §114, only your state of residence can tax your retirement income, as long as the following are true:

• You receive a series of substantially equal period payments at least once per year
• These period payments are made for your life (or life expectancy) or for at least 10 years

This provides unique protection for high-earning executives. If you live in a high-tax state, you could defer compensation, and then move to a low-tax (or no-tax) state for your retirement. Then you could avoid taxation on your NQDC altogether.

Scenario: 5-year vs. 10-year payout 

Let’s say you have $500,000 in deferred compensation and are moving from California (a state with a 13.3% top tax rate) to Texas (a state with no income taxes). If you plan to receive your deferred compensation over five years, you won’t be protected from state taxation in California. As a result, you could pay $66,500 in income taxes in California. 

On the other hand, let’s say you receive your deferred compensation over a period of 10 years. Now you’re covered under 4 U.S.C. §114 and will avoid income taxes from California. Because Texas doesn’t impose an income tax, you won’t pay any income taxes on those dollars at all.

Note: Make sure to consult a tax professional for your situation before making any big tax decisions.

Risks You Must Weigh

NQDCs have some clear benefits for employees, but there are also some risks. Here are some things to keep in mind before you sign up.

Employer credit risk & rabbi trust realities 

As we mentioned, your deferred compensation doesn’t sit in an account in your name like your 401(k) does. Instead, it sits in a trust, known as a rabbi trust, until it’s to be transferred to you. You put significant trust in your employer that they’ll have the money for you when you retire.

This leaves the money vulnerable to credit risks. If the company goes bankrupt, that money will likely go to its creditors rather than the account beneficiaries.

Liquidity & flexibility limits 

Unlike a 401(k), a deferred compensation plan doesn’t leave any of your money liquid. This means you can’t borrow from it like you would with a 401(k) loan. You also can’t roll it into an individual retirement account (IRA) or take early withdrawals.

The lack of flexibility can also cause issues. Once you set your distribution election, it’s difficult to change later on. There’s no way to change your distribution election to get your money early.

Concentration risk 

If your deferred compensation is invested in your company stock, then you’re vulnerable to concentration risk. If the company’s stock performs poorly, your retirement dollars could be at risk. However, you may not have to worry about this if your company offers more diverse investment choices for its NQDC.

NQDC vs. Qualified Plans (Quick Compare Table)

457(b) Plans: How They’re Different From NQDC

A non-governmental 457(b) is a type of deferred compensation plan that includes some features of an NQDC, while also sharing some features with governmental 457(b) plans.

Like NQDCs, non-governmental (also known as tax-exempt) 457(b) plans are generally reserved for highly-compensated employees and executives. They’re also unfunded – they use rabbi trusts just like NQDCs. Rather than being offered by government bodies, these plans are offered by tax-exempt entities.

However, similar to governmental 457(b)s, non-governmental plans have contribution limits set by the IRS. 

When Does Deferring Make Sense?

It can be difficult to know if an NQDC is the right option for you. And since these plans offer little flexibility, it’s important to be sure before you commit. The following checklist and case study should help make your decision easier.

Checklist 

Before enrolling in an NQDC plan, ask yourself the following questions:

• Maximize qualified accounts: Are you maxing out other tax-advantaged plans available to you, including your 401(k), IRA, and health savings account (HSA)?
• Years to retirement: Do you have enough time before retirement to benefit from the tax deferral?
• Employer health: Is your employer in good financial health, making your deferred compensation less vulnerable to creditors?
• Moving plans: Do you plan to move to a different state during retirement? How do the state income taxes in that state compare to those in your current state?
• Large one-time income: Are you expecting a large, one-time income this year that will increase your tax bill?
• Liquidity needs: Is there any possibility you’ll need to access this money before retirement?

Case study

Consider a case study of a 60-year-old executive who currently earns $750,000 and gets a $250,000 annual bonus. She’s planning to retire at 65 and move from California to Texas. She’s trying to decide whether to defer her bonus.

As we mentioned, California has a 13.3% maximum tax rate, while Texas has no state income taxes. If she chooses not to defer any of her bonus, she’ll pay $33,250 in state income taxes. And that’s on top of the federal income tax bill she’ll owe.

However, she could choose to defer her $250,000 and receive it over 10 years of payments starting at age 65. Because Texas doesn’t have a state income tax, she would only have to worry about federal income taxes. 

Not only will she save herself the $33,250 in state taxes, but she could also save herself money in federal income taxes, assuming she’s in a lower tax bracket during retirement than she is during her highest-earning years. 

Of course, there are plenty of other factors at play here. What if she’s not planning to move to a no-income-tax state? What if she doesn’t trust her company’s credit risk? She’d have to ask herself these questions and more to decide if an NQDC is really right for her.

Frequently Asked Questions (FAQ’s) About Deferred Compensation 

Is deferred compensation earned income? 

Deferred compensation isn’t considered income in the year it’s earned. Instead, it’s taxed as income in the year it’s distributed. However, some retirement accounts, including Roth 401(k)s, are considered earned income in the year the contribution is made.

Can I change my payout after electing? 

You can change your NQDC payout after the election, but with strict limitations. It has to be at least one year before you’re scheduled to receive distributions, and your new distribution date must be at least five years later than the original one.

When are FICA taxes due on NQDC? 

In most cases, FICA taxes are due on deferred compensation in the year it’s deferred. There are exceptions for plans that require you to complete certain actions before your deferred compensation is fully vested.

What happens if I quit or get laid off? 

If you quit your job or are laid off, you likely forfeit your unvested dollars to your NQDC. You should still get distributions for your vested funds, but those are subject to credit risk.

Will a rabbi trust protect me in bankruptcy? 

No, rabbi trusts don’t offer any creditor protection during bankruptcy. This lack of protection is part of the reason you don’t pay taxes on your deferred compensation until it’s distributed.

If I move states, where is my NQDC taxed? 

Assuming you elect substantially equal periodic payments over at least 10 years, your NQDC is taxed in your state of residence rather than the state you lived in when the funds were deferred.

How is a 457(b) different from NQDC? 

Non-governmental 457(b)s differ from NQDC in that they’re generally offered by tax-exempt entities and they have contribution limits. They also allow for hardship withdrawals, which NQDCs don’t. However, similar to NQDCs, they’re usually unfunded and aren’t eligible for loans or IRA rollovers.

Related Reading & Next Steps

If you’d like to learn more about your retirement saving options, tax planning, executive benefits, and more, visit these related articles.

• How Incentive Stock Options (ISOs) Work
• Non-Qualified Stock Options Taxation
• What Are the Best Tax Planning Strategies?
• Tax Implications of a Roth Conversion
• Catch-Up Contributions: Why They Matter & 2026 Changes

Every executive’s situation is unique, so it’s important to get personalized advice from a financial professional. Our experienced advisors can help with various financial needs, including compensation planning for high-earning professionals. Schedule your complimentary consultation today to discuss your specific questions and needs.

Disclosures and Sources

1. IRS. “Nonqualified Deferred Compensation Audit Technique Guide.”
2. Cornell Law School. “26 CFR § 1.409A-2 – Deferral elections.”
3. Cornell Law School. “4 U.S. Code §114 – Limitation on State income taxation of certain pension income.”
4. IRS. “Non-governmental 457(b) deferred compensation plans.”

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. 

Current as of 09/23/2025. Subject to legislative changes and not intended to be legal or tax advice. Consult a qualified tax advisor regarding specific circumstances. Accuracy is not guaranteed.