A properly designed nonqualified deferred compensation plan (NDCP) can be a powerful tool for attracting and retaining key executive talent. However, unlike the benefits provided by qualified plans (e.g., 401(k) and defined benefit pension plans), NDCP benefits only remain tax-deferred until a future date if the underlying NDCP is structured to provide what is essentially an unfunded and unsecured promise to pay benefits in the future.

How an NDCP sponsor company chooses to set aside assets to "fund" these liabilities—or whether it funds them at all—has significant implications for its cash flow, taxes, and balance sheet health. Here is a summary of the primary methods used to manage these future obligations.

Unfunded ("pay-as-you-go")

In this model, the NDCP sponsor company does not set aside specific assets. Instead, it pays benefits directly out of general corporate cash flow when the participant retires or leaves the company.

• How it works: The contractual obligation to pay NDCP benefits exists only as a bookkeeping entry (a liability) on the balance sheet.

Benefits

• Upfront savings: There is no immediate cash outlay or administrative cost for asset management.
• Financial flexibility: The sponsor has maximum flexibility; capital can be used for business operations in the short term.
• Potential tax savings: There are no annual taxes on dividends, interest, and realized capital gains that may otherwise apply, depending on how set-aside assets were invested.

Considerations

• High risk for participants: As the benefits of one or more executives become payable, there are no guarantees that the NDCP sponsor company will have the cash available to meet its contractual obligation to pay.
• Future cash flow strain: Maintaining NDCP benefits creates a large, unpredictable on-hand cash requirement for the NDCP sponsor company in the future.
• Financial reporting: The NDCP sponsor company must record a liability for deferred amounts without being able to point to any pool of set-aside assets that could potentially be used to offset such future obligations.

Corporate-owned life insurance (COLI)

The NDCP sponsor company purchases COLI policies on the lives of participants that build cash value, with the company as the beneficiary.

• How it works: The cash value growth within the policy matches the NDCP’s liability to pay future benefits. When an executive’s benefit becomes due, the company uses COLI policy withdrawals or loans to pay such benefits.

Benefits

• Tax-deferred growth: Gains on the underlying investments are not taxed.
• Tax-free death benefits: COLI can help the NDCP sponsor company recover the total cost of the plan.
• Asset-liability matching: COLI policies can be structured to track the specific investment choices of the participants.

Considerations

• Complexity: Maintaining COLI requires specialized administration and compliance.
• Upfront costs: Commissions and insurance expenses can be high in early years.
• Surrender charges: There is a lack of liquidity if the NDCP sponsor needs to cancel policies early.

Taxable investment accounts (mutual funds/securities)

The NDCP sponsor company sets up a dedicated brokerage account and invests in a diversified portfolio of stocks, bonds, or mutual funds to offset the plan liability.

• How it works: The NDCP sponsor company manages a "mirror" portfolio that reflects the investment elections made by plan participants.

Benefits

• Simplicity: It is easy to set up and understand.
• High liquidity: Assets can be sold at any time if cash is needed.
• Asset-liability matching: Funds can be structured to track the specific investment choices of the participants.

Considerations

• Tax inefficiency: The NDCP sponsor company must pay annual taxes on dividends, interest, and realized capital gains.
• Administrative costs: Most NDCP sponsors need to engage a third-party administrator to assist in recordkeeping the individual participant’s account balances.
• Double taxation: The NDCP sponsor company pays tax on the growth, and then the executive pays ordinary income tax on the distribution.

Tax-exempt municipal bonds

The NDCP sponsor company typically purchases the municipal bonds or a municipal bond fund to "hedge" or "earmark" assets for the eventual payout.

• How it works: When the NDCP sponsor company buys the municipal bonds or a municipal bond fund, it receives the tax-exempt interest directly, which helps offset the future cost of paying the executive.

Benefits: In addition to the three benefits described in the “Mutual funds/securities” section above, this option also offers the following:

• Tax-free internal growth: The primary advantage is that interest income from most municipal bonds is exempt from federal taxes,¹ allowing the employer to accumulate funds for future payout liabilities without an annual tax drag on the earnings.
• Reduced after-tax funding cost: Because the corporation does not pay federal tax on the municipal bond interest, the after-tax return can be higher than taxable bonds with similar yields,² making it more efficient to match future liabilities.
• Simplicity and stability: Municipal bonds are generally considered lower-risk compared to equities, providing a more predictable cash flow to meet the NDCP’s future distribution requirements.³

Considerations

• Lower gross yields: Tax-exempt bonds generally offer lower interest rates than comparable corporate bonds because the tax benefit is already "priced in."⁴
• Interest rate risk: As with all fixed-income assets, the market value of municipal bonds declines when interest rates rise, which could leave the NDCP underfunded if assets must be liquidated early.
• Alternative Minimum Tax (AMT) exposure: Interest from certain "private activity" municipal bonds may be subject to the AMT, which can reduce the effective yield.
• Credit risk of the NDCP sponsor company: Although the bonds themselves have credit ratings, the assets in an NDCP remain part of the NDCP sponsor company's general assets; if the company goes bankrupt, participants have no superior claim to these municipal bonds over other unsecured creditors.

Rabbi trusts (the semi-security layer)

A rabbi trust is established by an NDCP sponsor company as a source of funds that can be used to satisfy its future obligations to pay NDCP benefits to participants. The name stems from the first IRS letter ruling involving such a trust that a congregation established for the benefit of a rabbi. It is important to note that a rabbi trust is not an investment vehicle itself, but a legal "wrapper" that can hold any of the assets mentioned above.

• Purpose: It protects assets from a "change of heart" (e.g., a new management team refusing to pay or a hostile takeover).
• Key restriction: To maintain tax-deferred status for the executive, the assets in the rabbi trust must remain subject to the claims of the NDCP sponsor company's general creditors—including the NDCP participants—in the event of the company’s bankruptcy or insolvency.
• Potential 409A limitation: Under certain circumstances, Internal Revenue Code Section 409A imposes restrictions on a company’s ability to fund a rabbi trust if its defined benefit pension plan is in financial distress. A complete summary of this limitation is beyond the scope of this article; however, since NDCP plan sponsors in this situation may face adverse tax consequences for violating this rule, they should consult their benefits counsel before transferring funds to a rabbi trust.

Dealing with the deferred deduction

Regardless of the investment type used to fund the NDCP, the NDCP sponsor company cannot take a tax deduction for contributions until the year the executive actually receives the payment and recognizes the income—often years or decades later.⁵

NDCP sponsors should consider the following tax factors when determining contribution levels:

Tax factors

• Future corporate tax rates: NDCP sponsors should weigh whether their marginal tax rate is likely to be higher or lower in the future when the deduction is finally taken. A higher future rate makes the deferred deduction more valuable.
• Book-to-tax differences: For financial accounting, the benefit expense is recorded as it accrues, reducing net income on financial statements. However, for tax purposes, the deduction is disallowed until payment is made. This creates a deferred tax asset that must be managed on the balance sheet.
• Investment income taxation: If the NDCP is informally funded (e.g., using a rabbi trust), the employer remains the owner of the assets and must pay taxes on any annual earnings or realized gains from those investments.
• Employment tax timing (FICA/FUTA): Unlike income tax, payroll taxes are generally due when the compensation is earned or vested, rather than when it is paid. Employers must have cash available to cover these current tax obligations, even if the income tax deduction is years away.

Which method is right for your organization?

The "best" method usually depends on the NDCP sponsor company's tax bracket and cash position. For example,

• High-growth startups may prefer pay-as-you-go to keep cash in the business.
• Mature, profitable corporations may prefer COLI for the tax-advantaged growth and the ability to eventually recover the NDCP's costs via death benefits.

Financial factors

• Cost of capital and liquidity: Since there is no immediate tax relief, the "net cost" of a contribution is higher than a qualified plan contribution in the first year. NDCP sponsors must evaluate their current liquidity and whether those funds could earn a higher return if reinvested in business operations.
• Cash flow volatility: NDCP sponsors must plan for the eventual cash outflow when distributions occur. If many executives retire or reach distribution dates simultaneously, it can create a sudden, large cash outlay requirement.
• Earnings impact: The accrual of NDCP liabilities reduces current year accounting earnings, which may affect financial covenants or executive performance metrics tied to net income.
• Informal funding vehicles: To mitigate the lack of an immediate deduction, many NDCP sponsor companies use COLI. COLI allows assets to grow tax-deferred, helping to offset the eventual cost of the payout and the taxable nature of other traditional investments.

To fund or not to fund, and, if yes, how?

As described above, there are a multitude of complex factors for NDCP sponsors to consider before deciding upon the funding approach they wish to adopt for their NDCP(s). Since there is no “one size fits all” solution, prudent NDCP sponsor companies should be wary of product-based recommendations. They should instead consult an independent third party with NDCP expertise that can objectively analyze the factors applicable to both their business (e.g., financials, cash flow, tax outlook) and the NDCP's covered group (e.g., age/salary demographics, turnover). Engaging with such an expert partner will ensure that they find the right funding fit for their NDCP(s).

¹ Stifel, Nicolaus, & Company, Inc. (n.d.). The preferential tax treatment of municipal bonds. Retrieved May 27, 2026, from https://www.stifel.com/newsletters/adgraphics/pdf/wp/The-Preferential-Tax-Treatment-of-Municipal-Bonds.pdf.

² Walker, D.I. (2019, February 19). The practice and tax consequences of nonqualified deferred compensation. Washington and Lee Law Review. Retrieved May 27, 2026, from https://scholarlycommons.law.wlu.edu/cgi/viewcontent.cgi?article=4629&context=wlulr.

³ Farther. (n.d.). Municipal bond income for retirement: Pros and cons. Retrieved May 27, 2026, from https://www.farther.com/foundations/municipal-bond-income-for-retirement-pros-and-cons.

⁴ Tracy, T. (2026, April 4). Are tax-free municipal bonds really worth it? Key considerations. Investopedia. Retrieved 27 May, 2026, from https://www.investopedia.com/articles/investing-strategy/090116/think-twice-buying-taxfree-municipal-bonds.asp.

⁵ Internal Revenue Code Section 404(a)(5) and Treas. Reg. 1.404(a)-12.