Nonqualified versus ERISA-qualified plans
Unlike qualified retirement plans, nonqualified plans aren’t subject to ERISA’s funding, reporting, disclosure, and legal (fiduciary) obligation rules. And nonqualified employee benefits aren’t protected. If your business goes under, employees become general creditors.
How nonqualified plans work
Like qualified retirement plans, these types of nonqualified plans allow an employee to delay income and its related taxes in exchange for a future benefit (although Federal Insurance Contributions Act taxes for Social Security and Medicare may apply to employee deferrals). While you may choose to define a nonqualified plan benefit (e.g. $100,000 payable over five years at retirement), unlike with a qualified pension, you aren’t liable for it and you don’t have to put anything aside now to pay it in the future (they’re unfunded). And unlike with a qualified defined contribution plan, the employee has no account balance—nonqualified deferred compensation (NQDC) benefits exist only on paper.
A 401(k) plan allows an employee to defer a portion of their income, invest it, and receive the deferred amount, plus earnings and reduced for taxes, at a later date when the employee is potentially in a lower tax bracket. An NQDC plan provides a similar opportunity for employees, but subject to a much different set of rules. One key difference is that NQDC plans are unfunded—the benefits only exist on paper. Typically, a participant will defer a portion of their income and it will “earn” a reasonable rate of return until the benefit is distributed; however, unlike a qualified plan, the money isn’t actually invested—it’s simply a bookkeeping item.
NQDC plans are typically structured to avoid conferring any economic benefit on, or constructive receipt of income to, covered employees. (Income is constructively received when it’s credited to an account, or made available to an employee. An economic benefit occurs when the right to a payment is guaranteed. This is because guaranteeing a benefit or giving an employee control over nonqualified assets may result in income taxes.)
Because nonqualified benefits aren’t secured, there are no federal nonqualified plan rules regarding:
- Eligible employees—Nonqualified plans are often offered to key executives and other select employees.
- Discrimination—You can skew benefits to an employee or to a category of employees.
- Funding—There are no funding requirements.
This gives you the flexibility to design a nonqualified plan to meet the particular needs of your business.
IRS Internal Revenue Code, Section 409A, applies to NQDC plans
Prior to Section 409A being adopted in 2004, NQDC plan practices varied, with some plans improperly allowing employees to both defer income and have control over their benefits. Internal Revenue Code (IRC), Section 409A, formalizes the constructive receipt and economic benefit prohibitions by forbidding employees from accelerating NQDC plan payments or otherwise exercising control over nonqualified plan benefits prior to receiving their payment. Section 409A requires NQDC agreements to be agreed to in writing. Failure of a NQDC plan to comply with Section 409A can result in taxes and penalties to an employee.
Types of nonqualified plans
Nonqualified plans have no set features that you have to adopt. There are, however, four broad types of nonqualified agreements.
- Salary reduction arrangements allow employees to delay receipt of income.
- Bonus deferral plans allow employees to delay receipt of bonuses.
- Top-hat plans, or supplemental executive retirement plans (SERPs), are nonqualified plans created for the benefit of a particular group of employees—generally, management or executives.
- Excess benefit plans promise benefits to employees who are limited by IRS restrictions on retirement plan contributions and benefits. Because IRS IRC, Section 415, lists these limits, excess benefit plans are sometimes called Section 415 nonqualified plans.
ERISA’s contribution limits can be restrictive. In 2021, 401(k) plan contributions can’t exceed $58,000 from all sources and $19,500 on salary deferrals, plus an additional $6,500 catch up, for participants over the age of 50. Defined benefit pension contributions are limited to the amount necessary to fund annual benefits, which, in 2021, can’t exceed the lesser of 100% of the beneficiary’s average compensation for their highest three consecutive calendar years or $230,000. Since nonqualified plans have few rules, these features can be combined to meet your needs.
Why you might want an NQDC plan for your business
There are several reasons to consider sponsoring a nonqualified plan:
- NQDC plans can help improve employee retention and results by tying benefits to future service and performance.
- You can help highly compensated employees save more than the IRS IRC, Section 415, limits allow.
- Payments can be of any amount, making it an effective way to offer significant rewards to select employees.
- You don’t have to fund the benefit, freeing cash up to meet the current needs of your business.
- Administration costs are modest, since, at most, you might want to provide eligible employees with a periodic benefits statement—although this isn’t mandatory.
- You have freedom in nonqualified plan design.
Is a nonqualified plan right for your business?
A nonqualified plan is a set of unsecured financial promises you make to an employee. Because they operate outside of ERISA, nonqualified plans can meet the needs of your business and your employees without regard to funding, fairness, or eligibility mandates. But they have to comply with IRS IRC, Section 409A, which can be complex. A benefits or financial professional can help you consider and construct a nonqualified plan that meets the needs of both your business and your employees.
This content is for general information only and is believed to be accurate and reliable as of the posting date but may be subject to change. It is not intended to provide investment, tax, plan design, or legal advice (unless otherwise indicated). Please consult your own independent advisor as to any investment, tax, or legal statements made herein.
MGTS-P44199-GE 11/21 46226 MGR1110211909245