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Deferred compensation plan (NQDC) and 409A: defer or take it now?

A deferred compensation plan delays income tax on part of your pay until it is paid. Here is how it is taxed, and whether to defer before December 31.

Vishant Mehta, CPA, Ex-Big 4

Published

  • deferred compensation
  • Section 409A
  • executive pay
  • high earners

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A deferred compensation plan lets you postpone part of your salary or bonus to a later year. Most are nonqualified deferred compensation (NQDC) plans, governed by Section 409A. Income tax waits until you are paid, but Social Security and Medicare tax does not.

The choice has a deadline. Most plans need your election to defer 2027 pay by December 31, 2026. Defer when your tax rate will be lower at payout and you trust your employer to pay.

What it isYour employer's promise to pay part of your pay later
Election for 2027 payUsually due by December 31, 2026
Income taxWhen the plan pays you
Social Security and MedicareWhen you earn the pay, or when it vests if later
Dollar limitNone in the tax code; your plan sets its own
If the plan breaks 409ATaxed at once, plus 20% and interest
Rules checkedOctober 9, 2026

How are nonqualified deferred compensation plans taxed?

A nonqualified deferred compensation plan is taxed in two stages: payroll tax when you earn the pay, and income tax when you receive it.

  1. When you elect. Nothing is taxed. Your W-2 for that year leaves the deferred pay out of box 1, your taxable wages.
  2. When the pay vests. Social Security and Medicare tax is due. Once your wages pass the 2026 Social Security wage base of $184,500, only Medicare tax applies.
  3. While it grows. Earnings the plan credits are not taxed until you are paid.
  4. When you are paid. The payout is ordinary income, taxed at federal rates of 10% to 37% for 2026.
  5. If the plan breaks Section 409A. Your vested deferrals under it become taxable at once. You also owe an extra 20%, plus interest at the IRS underpayment rate plus one percentage point.

A state or local government's 457(b) plan is also called a deferred compensation plan. It has its own rules and a $24,500 limit for 2026.

Should you defer your pay or take it now?

Defer only if you expect a lower tax rate at payout and trust your employer to pay. Four questions decide it, and the next section covers your state.

  1. Will your federal rate be lower at payout? For 2026, the 37% rate starts above $768,700 of taxable income on a joint return, or $640,600 for a single filer. If you stay in the top bracket, deferral mainly buys years of growth before tax.
  2. Can your employer pay? Plan money stays your employer's asset, open to its creditors if it becomes insolvent. A rabbi trust does not change that.
  3. When will you need the cash? The plan pays only on the dates or events you chose. A later change must delay the payment at least five years.
  4. Is your 401(k) full? Use it first, up to $24,500 for 2026.

Can moving to another state cut the tax on deferred pay?

Yes, if the plan pays you in substantially equal installments over at least 10 years, or for life. Federal law (4 U.S.C. 114) then bars your former state from taxing them once you live elsewhere. The payments must come at least once a year.

A lump sum or a shorter schedule gets no such protection, so the state where you earned the pay may tax it. See how California treats income after you leave.

You choose the payout schedule when you elect, so it belongs on this December's form. Changing it later delays the payment by at least five years.

Do I need to report deferred compensation on my taxes?

Not in the year you defer, because your employer leaves the deferral out of box 1 of your Form W-2. Once it vests, it is included in boxes 3 and 5, your Social Security and Medicare wages.

You report the money in the year it is paid. Your employer puts the payout in box 1 of that year's W-2, even after you leave, and usually in box 11 too. For a pension or annuity from the plan, the 2025 Form 1040 instructions move it from line 1a to Schedule 1, line 8t.

Code Z in box 12 means the plan failed Section 409A. The extra 20% tax and interest then go on Schedule 2.

How are NQDC distributions taxed?

NQDC distributions are taxed as wages, at your ordinary income tax rate for the year you receive them. They are not capital gains, even when the plan tracked investment funds.

Your employer withholds on them as supplemental wages, like a bonus. It can withhold a flat 22%, and must use 37% on supplemental wages above $1 million in the year. If your rate is higher than 22%, the gap comes due with your return. Social Security and Medicare are not taken again if they were paid at vesting.

When do you have to decide?

Most plans need your election by December 31 of the year before you earn the pay.

WhenWhat happens
December 31, 2026Usual last day to defer 2027 salary and bonus
Within 30 days of first becoming eligibleFirst election, for pay earned after it
Six months before a 12-month performance period endsLatest election for performance pay, if the plan allows
Six months after you leaveEarliest payout on leaving for a public company key employee

A performance pay election also needs the amount to be uncertain when you make it.

What should you do now?

  • Find your plan's election form and deadline. For 2027 pay, most close on December 31, 2026.
  • Choose the payout schedule with care. Installments over 10 years or more can help if you may retire to another state.
  • Fill your 401(k) first, and defer only money you will not need before the payout date.
  • Check each W-2 when it arrives. Box 1 should be lower by the amount you deferred.

For more, see our guides to executive tax planning and tax planning for high earners.

Sources.