What Kind of an Investment Is a Deferred Compensation Plan?

ERISA - Qualified Plans

An ERISA-qualified plan, or simply "qualified plan," is a plan that is covered under the Employee Retirement Income Security Act of 1974, or ERISA. Common examples of these plans are traditional pension plans, 401(k) plans, and 403(b) plans, or tax-sheltered annuities. In a 401(k) plan, assets are withheld and invested on the employee's behalf by an investment company retained by the plan sponsor.

Qualified plans such as 401(k)s and pensions are popular with employees, and in the case of 401(k) and 403(b) plans, and other qualified plans such as SIMPLE IRAs help encourage the rank and file employee to save for his own retirement security. However, qualified plans come with restrictions. Employers cannot discriminate, meaning they cannot select key employees for the benefits of a qualified plan. Qualified plans also impose significant burdens on a company to administer.

Non-qualified deferred compensation plans, or NQDC, refers to deferred compensation arrangements that are not regulated under ERISA. To qualify for tax deferral, assets in these plans must come with a substantial risk of forfeiture. This could be the possibility that the firm could go bankrupt--assets in these plans are generally subject to the claims of creditors. Other forfeiture risks include a requirement that the employee remain with the company a certain number of years. If the money does not have a substantial risk of forfeiture, the IRS could deem all amounts in the plan immediately taxable as income, plus an additional 20 percent penalty.

NQDC plans may not distribute income unless the employee leaves the company, retires, dies or is disabled. Alternatively, the employee can take income according to a fixed schedule defined by the plan. This is to prevent company executives from raiding the plan when it becomes apparent that creditors will soon seize the assets in the plan. Key employees of publicly traded companies may not take income from these plans for at least six months after retiring.