Inherited Deferred Compensation Plan: Taxes, Payout, and Reporting

Money you receive from an inherited deferred compensation plan is taxed to you as ordinary income in the year you receive it, with no step-up in basis and no capital gains rate available. Nonqualified deferred compensation (NQDC) is a contractual promise the employer made to the deceased employee, and as the beneficiary you step into the income tax bill the employee deferred. Federal estate tax is a separate question, and for 2026 the $15 million per-person exemption keeps most estates out of it.¹ The income tax alone can still be large, and how you take the money changes what you owe.

What You Actually Inherited

You did not inherit an account. You inherited a contractual right to receive money from the employer. Unlike a 401(k) or IRA, the funds are not sitting in a trust with your name on them; they are commingled with the company’s general assets, and the arrangement is governed by the contract between the employer and the deceased employee together with Section 409A of the Internal Revenue Code.²

Two practical consequences follow. Your rights as a beneficiary are defined by the plan document, so get a copy from the employer’s HR or legal department before you make any decisions. It tells you who counts as a beneficiary, what the payment schedule is, and whether you have any choice in the matter. And because the promise is unsecured, you stand with the company’s general creditors if it goes bankrupt. Some employers use a rabbi trust to earmark the money, but by design those assets remain reachable by the employer’s creditors, which is what preserves the tax deferral in the first place. If the plan allows you to choose between a lump sum and installments, the employer’s financial health belongs in that decision alongside the tax math.

How Inherited NQDC Payments Are Taxed

Every dollar you receive is ordinary income in the year of receipt. The IRS classifies these payments as income in respect of a decedent (IRD) under Section 691 of the Internal Revenue Code, meaning income the deceased earned but never received and never paid tax on.³ When you collect it, you owe the tax the employee would have owed.

Most inherited property gets a stepped-up basis, so heirs who sell inherited stock or real estate only pay tax on appreciation after the date of death. IRD does not qualify. Section 1014(c) specifically excludes income in respect of a decedent from the step-up.⁴ The full amount is taxable.

The Section 691(c) Deduction if Estate Tax Was Paid

The value of future NQDC payments is included in the deceased’s gross estate for federal estate tax purposes, so the same dollars can be hit by estate tax and then again by your income tax. For 2026, the federal estate tax exemption is $15 million per person and indexed for inflation, so most estates will owe no federal estate tax at all.¹

When an estate does pay federal estate tax, Section 691(c) lets you deduct the portion of that tax attributable to the NQDC as you receive the income.³ The calculation compares the estate tax actually paid against the estate tax that would have been owed if the NQDC value were removed from the estate; the difference is allocated proportionally to the IRD income as it comes to you.⁵ You will need the estate’s Form 706 figures from the executor to run the numbers. If you take installments, you claim a slice of the deduction each year.

Claim the deduction on Schedule A of Form 1040, Line 16 (Other Itemized Deductions). It is not a miscellaneous itemized deduction, so it is not subject to those limits, but you have to itemize to use it.⁶ Take the standard deduction and you lose the benefit.

Lump Sum or Installments

Your choices are dictated by the plan document. Some plans let beneficiaries elect between a lump sum and installments, others lock in the payment schedule the employee originally elected, and a few force a specific payout at death regardless of prior elections. Read the plan before assuming you have a choice.

Where you do have a choice, the bracket math is often the decisive factor. A $500,000 lump sum lands in a single tax year and pushes much of the payment into the top federal brackets. The same $500,000 spread over five annual installments of $100,000 can sit in a much lower marginal bracket each year, and the federal tax savings over the full payout period can run into the tens of thousands.

Installments come with two costs. You do not have the money available for investment or other uses while you wait, and you are trusting the employer to stay solvent long enough to pay you. A company that may not survive the next five years changes the calculus even when installments look better on the tax return.

How the Payments Are Reported

Reporting depends on timing. Payments made in the same calendar year the employee died are reported on the deceased’s Form W-2 and may still carry FICA (Social Security and Medicare) tax. Payments made in later years go to you as the beneficiary on Form 1099-MISC, Box 3 (Other Income), and generally are not subject to FICA. Most NQDC that pays out at death was already vested, so the narrow FICA exceptions for unvested amounts rarely come into play; ask the employer’s payroll department to confirm.

Here is the piece that surprises people: the employer generally will not withhold federal income tax from a beneficiary payment. You receive the full gross amount and still owe income tax on every dollar. Report the income on Form 1040, typically on Schedule 1 as Other Income, and claim any Section 691(c) deduction on Schedule A, Line 16.⁶

Paying Estimated Tax to Avoid a Penalty

Because nothing is withheld, the IRS expects you to pay the tax as the money comes in. If you will owe $1,000 or more when you file, you generally need to make quarterly estimated payments on Form 1040-ES.⁷

You avoid the underpayment penalty by paying, over the year, the lesser of 90% of the current year’s tax or 100% of the prior year’s tax (110% if your prior-year adjusted gross income was over $150,000). For a large one-time distribution, the cleanest move is to send an estimated payment shortly after the money arrives rather than wait for the next quarterly due date. If the income lands unevenly during the year, Form 2210 lets you annualize your income and can reduce the penalty. If you also have wage income, an alternative is to file a new Form W-4 and increase withholding from your paycheck to cover the tax on the NQDC.

Medicare Premium Surcharges

A large payout can raise your Medicare Part B and Part D premiums through the income-related monthly adjustment amount (IRMAA). Medicare uses modified adjusted gross income from two years earlier, so a distribution received in 2026 shows up in your 2028 premiums.

For 2026, the surcharges start when modified adjusted gross income exceeds $109,000 for single filers or $218,000 for joint filers. At the top tier (above $500,000 single or $750,000 joint), the monthly Part B premium rises from $202.90 to $689.90, and Part D adds a surcharge of up to $91.00 per month.⁸ Spreading the income across years through installments can keep you under a threshold or drop you into a lower tier. If you are on Medicare or close to 65, model the IRMAA effect before you pick a payout method.

Foreign Employer Plans Add Reporting

If the deferred compensation comes from a foreign employer, the tax picture above still applies, and additional reporting stacks on top. An interest in a foreign deferred compensation plan is a specified foreign financial asset under FATCA, reportable on Form 8938 once your foreign financial assets cross the applicable threshold.⁹ You report the fair market value of your beneficial interest at year-end; if that value is not reasonably determinable, the IRS lets you use the total distributions received during the year, and if there were none and no value can be determined, you report zero but still disclose. A separate FBAR (FinCEN Form 114) may apply if the plan is held in a foreign financial account that exceeded $10,000 at any point during the year. Penalties for missing these filings are separate from any income tax on the payments, and they are steep. Get professional help before your first filing deadline.

1
Internal Revenue Service. Whats New – Estate and Gift Tax
2
Office of the Law Revision Counsel. 26 USC 409A – Inclusion in Gross Income of Deferred Compensation Under Nonqualified Deferred Compensation Plans
3
Office of the Law Revision Counsel. 26 USC 691 – Recipients of Income in Respect of Decedents
4
Office of the Law Revision Counsel. 26 USC 1014 – Basis of Property Acquired from a Decedent
5
eCFR. 26 CFR 1.691(c)-1 – Deduction for Estate Tax Attributable to Income in Respect of a Decedent
6
Internal Revenue Service. Instructions for Schedule A Form 1040
7
Internal Revenue Service. Estimated Taxes
8
Centers for Medicare & Medicaid Services. 2026 Medicare Parts A and B Premiums and Deductibles
9
Internal Revenue Service. Basic Questions and Answers on Form 8938