Deferred compensation is a standard part of senior pay at energy, healthcare and financial services companies across Houston. An executive may defer salary or bonus for years, or earn a supplemental executive retirement plan (SERP) benefit on top of a 401(k). By the time a divorce is filed, those balances can be among the largest items in the marital estate, and among the riskiest.
This guide explains how Texas divides qualified and nonqualified deferred compensation, why nonqualified plans need different handling, and what executives and spouses in River Oaks, the Energy Corridor, Katy and Sugar Land should look for before signing a settlement.
Qualified plans and nonqualified plans are different assets
Qualified plans include 401(k)s, 403(b)s, pensions and profit sharing plans. They are held in trust, protected from the employer’s creditors, and can be divided through a qualified domestic relations order (QDRO) under the Internal Revenue Code and ERISA. A properly drafted QDRO lets the plan pay the former spouse directly, as an alternate payee. Our post on QDROs and tax planning in a Texas divorce covers these in detail.
Nonqualified deferred compensation (NQDC) includes elective deferral plans, SERPs, excess benefit plans and deferred bonus arrangements. These are generally unfunded promises by the employer to pay later. Even when the company sets money aside in a “rabbi trust,” those assets remain reachable by the company’s general creditors. NQDC is also governed by Internal Revenue Code section 409A, which tightly restricts when and how benefits can be paid.
How Texas characterizes deferred compensation
Compensation earned during the marriage is community property, even if it is paid years later. The method for measuring the community share depends on how the plan works:
- Account based plans (elective deferrals, many deferred bonus plans). The community portion is generally the amounts deferred during the marriage plus the growth on those amounts. Texas Family Code section 3.007(c) allows separate property in a defined contribution plan to be traced like any other asset, so premarital balances and their growth can be proven separate with good records.
- Formula benefit plans (many SERPs). Like a traditional pension, the benefit is tied to years of service and pay. Texas courts generally apportion these by comparing service during the marriage with total service, and value the community interest as of the divorce rather than counting post divorce raises.
Records matter. Deferral elections, annual statements and the plan document are what allow a spouse to prove what was deferred, when, and from which pay.
Why NQDC is harder to divide
No QDRO. A QDRO is a creature of qualified plan law. For NQDC, the order is usually a domestic relations order (DRO) directed to the plan, or an obligation in the decree for the employee to pay the former spouse’s share when payments arrive.
The plan may or may not pay a former spouse. Treasury regulations under section 409A (Treas. Reg. 1.409A-3(j)(4)(ii)) permit a plan to make payments to a former spouse under a domestic relations order, including on an accelerated basis. That is an option, not a requirement. Many plans have been amended to allow it; some have not. Read the plan document before choosing a structure.
Creditor risk. If the employer later fails, NQDC participants generally stand as unsecured creditors. For companies in cyclical industries, that risk is worth pricing into any settlement that leaves a spouse waiting on future payments.
Fixed payment timing. Section 409A generally locks in when benefits are paid, often on separation from service or a set date. A former spouse may wait years, and the executive cannot simply cash out to fund a buyout.
Settlement options
- Offset. The executive keeps the NQDC and the other spouse takes other assets of comparable after tax value. This is often the cleanest answer when the employer’s credit or the payment schedule is uncertain.
- Direct payment under a DRO. If the plan allows it, the plan pays the former spouse’s share directly. This removes the executive as a middleman.
- Pass through obligation. The executive receives each payment and remits the former spouse’s share within a set number of days. This needs strong notice, reporting and enforcement terms, and ideally security such as life insurance.
NQDC is often only one piece of a larger package that may include stock options, RSUs, golden parachute benefits and terms in an employment agreement. Change in control provisions can also accelerate deferred pay.
Tax treatment
Under IRS Revenue Ruling 2002-22, transferring an interest in nonqualified deferred compensation to a former spouse incident to divorce does not create income for the employee at the time of transfer. The former spouse includes the payments in income when they are paid or made available to him or her. Those payments are ordinary income, not capital gains.
That means a dollar of NQDC is not worth a dollar of brokerage account or home equity. Compare after tax values before agreeing to an offset. Our post on the tax implications of dividing executive compensation goes further.
Deferred compensation and support
Deferred amounts can also matter for spousal maintenance and child support, because Texas support rules look at income broadly. If a spouse increases deferrals during a divorce, the court may be asked to look past the reduced paycheck. See how bonuses and variable compensation affect alimony.
Talk with a Houston divorce lawyer for executives
Chidi Anunobi is Board Certified by the Texas Board of Legal Specialization, holds an M.B.A. from Carnegie Mellon University, and spent a decade consulting for large corporations at KPMG before practicing law. We represent executives and their spouses in high net worth divorces from our Houston office at 1415 North Loop West.
Clients come to us from River Oaks, the Houston Heights, Katy, Fulshear, Sugar Land, Missouri City, The Woodlands, Cypress and across Harris, Fort Bend and Montgomery Counties. Call 832-538-0833 or contact us. Bring your plan document, deferral elections and latest statement. For the full compensation picture, see our executive compensation guide.
Frequently asked questions
Is deferred compensation community property in Texas? The portion earned during the marriage generally is, even if it is paid after the divorce.
Can a QDRO divide a nonqualified deferred compensation plan? No. QDROs apply to qualified plans. NQDC is divided by a domestic relations order if the plan allows direct payment, by a pass through obligation in the decree, or by an offset.
Who pays tax on NQDC paid to a former spouse? Under Revenue Ruling 2002-22, the former spouse includes the payments in income when they are paid or made available.
What happens if the employer goes bankrupt? NQDC is generally an unsecured promise, so both the executive and the former spouse may recover little. That risk is a reason to consider an offset.
This article is general information, not legal or tax advice.