The Taxation of Executive Compensation: Part 2

Tax News You Can Use | The Northern Trust Institute

Jane G. Ditelberg, Chief Tax Strategist and
Nancy Nauheimer, Senior Wealth Advisor

March 16, 2026

This is the second of two articles discussing the taxation of executive compensation. This article covers tax implications of employee benefit plans. Part I, addresses tax insights on stock options, stock grants and bonuses.

Executive compensation packages can be complex, and decisions about these plans have unique tax implications that impact their net after tax value to the recipient. This guide provides an overview of the tax treatment for common forms of employee benefit plans used for executive compensation, including defined contribution plans, defined benefit plans and non-qualified employee benefit plans. Understanding the tax treatment and timing of these forms of compensation is critical to maximizing the value of executive benefits.

Defined Contribution Plans

Executives often participate in qualified plans offered by their employers, including 401(k), 403(b), profit sharing and employee stock ownership plans — all of which are types of defined contribution (DC) plans. DC plans are governed by the Employee Retirement Income Security Act (ERISA), which provides protections for the employee participants. Under a DC plan, the employee is eligible to make elective contributions to the plan. In addition, the employer may contribute to the plan, including matching contributions. The contributions, together with investment growth over time, remain in the plan and are available to the employee at a later date, typically upon retirement or separation from service, when the executive is entitled to withdraw them. The amount ultimately received is driven by the investment performance of the assets while they are in the plan.

In some cases, the employee funds all the contributions to their account via payroll withholding. In other cases, there are both employee contributions and employer matching contributions. And then there are plans, like most profit-sharing plans, where all the contributions come from the employer. To receive the portion of the DC plan’s account consisting of employer contributions, there may be requirements for the employee to fulfill before the contributions vest, such as remaining an employee for a period of time.

Employer contributions to a traditional (non-Roth) qualified DC plan are not income to the employee at the time of contribution to the plan and are deductible by the employer. Assets, including earnings and growth, are taxed to the recipient as ordinary income when withdrawn from the plan. Employees who make contributions to a DC plan may deduct their contributions from income at the time of contribution up to an annual cap. This cap is set by regulations and is indexed for inflation. Additional deductible contributions are allowed for older employees, referred to as “catch up” contributions for those age 50 and over, and super-catch-up contributions for those between ages 60 and 64. When DC plan assets are withdrawn, including the earnings and growth on the original contributions, they are also taxed as ordinary income. The plan essentially lets the employee defer the tax on the contributions, earnings and growth, which increases the potential for the account to grow more rapidly than investments outside of a DC plan.

Some DC plans allow participants to make contributions in excess of the cap on deductible contributions. These amounts are treated as having basis equal to the amount of the contribution and are subtracted from the total when the amount of ordinary income is computed upon withdrawal of assets from the plan. These are the type of contributions used for a Mega Backdoor Roth Conversion. Other plans allow DC accounts that are treated as Roth plans, where there is no deduction for the contribution, no income tax on earnings and accumulation and typically no income tax on any of the “qualified” amounts when they are withdrawn by the participant or the participant’s beneficiary.¹ Beginning in 2026, catch-up and super-catch-up employee contributions can only be made to Roth accounts if the employee’s wages exceed $150,000 for the prior year.

Defined Benefit Pension Plans

Defined benefit (DB) plans, or pension plans, are another type of ERISA-protected employee benefit. These plans provide the employee with a fixed benefit payable at retirement, typically based upon a formula based on the employee’s compensation during certain working years. The employer funds the plan based on actuarial projections and holds those assets in the pension plan. All investing is done by the employer or its agents, and the DB plan’s obligation to pay the employee remains the same regardless of how the investments perform. Upon retirement, the employee may have the option to elect a lifetime annuity, a joint annuity with the employee’s spouse or a lump sum payout. There may also be a payout to a beneficiary at the employee’s death. These payments, when received, will constitute ordinary income for tax purposes.

Non-Qualified Employee Benefit Plans

Non-qualified plans are typically deferred compensation plans that withhold payment of a part of an employee’s compensation until a later date. These are not governed by ERISA. The plan may be mandatory (the employee only gets the funds if they defer) or elective (employee determines whether and how much to defer). The employee may be able to make an upfront deferral election for future contributions, for example, to defer a fixed percentage of all variable cash performance-based incentives earned in the future. Non-qualified deferrals do not need to be tied to retirement dates, so they can be used to save for other goals such as funding education or buying a vacation home. Note that these payout dates need to be established before the income is deferred. Amounts deferred are taxed as ordinary income when received.

In some cases, the plan is merely an unsecured, unfunded promise to pay the employee on a future date, while others have funding mechanisms. Some are available only to specific individuals as part of an employment agreement, while others have a plan document that determines which employees are eligible to participate.

A rabbi trust is one type of non-qualified retirement plan where the employer deposits assets in an irrevocable trust for the executive. These assets are subject to the claims of the employer’s creditors. Other plans, called secular plans to distinguish them from rabbi trusts, keep employee assets separate from the company’s assets, which protects them from the claims by the employer’s creditors.

¹ The basic requirements for a qualified distribution from a Roth account are that the account be open at least five years before the withdrawal and that the withdrawal be after the owner reaches age 59 ½, or after the death or disability of the owner. There are also certain limited permitted withdrawals related to the purchase or renovation of a first home.

² The state taxation of distributions varies widely.