Unlike 401(k)s and similar workplace retirement plans, nonqualified retirement plans are not bound by the stringent guidelines of the Employee Retirement Income Security Act (ERISA). As a result, companies may use these plans to attract and retain top-tier talent by allowing high-earning executives and other key employees to defer a significant portion of their income and receive other benefits. Whether you have a nonqualified retirement plan, 401(k) or IRA, a financial advisor can help you plan and save for retirement.
Understanding Nonqualified Retirement Plans
Nonqualified retirement plans allow participants to defer a portion of their compensation to the future, potentially reducing their current income tax liability. These plans may be typically “unfunded,” as they are not backed by specific assets but rather by the employer’s promise to pay.
Companies adopt nonqualified retirement plans to gain flexibility in how they reward top executives. This flexibility serves as a powerful tool in the competitive landscape of executive recruitment and retention, offering benefits that extend beyond standard salary packages.
The timing of the payout of benefits is usually predetermined and may be aligned with specific events such as retirement, change in corporate control or other significant milestones. This planned timing helps both the employer and employee in managing finances more effectively – employers can plan their cash flow and tax implications while employees can optimize their tax liabilities and prepare for a steady income stream post-retirement.
For employers, contributions made to nonqualified plans are not tax-deductible until the employee actually receives the benefits, which can be strategically advantageous. For employees, the deferral of income through nonqualified plans means that taxes are not paid until the benefits are received, typically at a lower tax bracket in retirement.
Types of Nonqualified Retirement Plans
Here’s a look at the four primary types of nonqualified retirement plans.
- Deferred Compensation Plan: Employees defer a portion of their income (often in the form of bonuses) until a specified future date, which usually aligns with retirement. This delay in receiving income can provide tax benefits and savings growth over time.
- Executive Bonus Plan: This plan involves the employer paying premiums on a life insurance policy owned by the employee. The premiums are considered a taxable bonus to the employee but offer the benefit of life insurance protection and potential cash value growth.
- Split Dollar Plan: In this arrangement, the cost and benefits of a life insurance policy are split between the employer and employee. It can be structured in various ways, with the most common being either the employer recovers its cost from the policy’s death benefit or through cash value.
- Group Carve-Out Plan: Employers provide additional life insurance to selected employees by “carving out” these individuals from the group term life insurance plan. It is used primarily to offer additional benefits to key personnel beyond what is provided under standard group policies.
Qualified vs. Nonqualified Retirement Plans
Retirement plans are broadly categorized into two types: qualified and nonqualified plans. Qualified retirement plans meet specific requirements set by the IRS and the Employee Retirement Income Security Act of 1974 (ERISA), offering significant tax advantages such as tax-deferred growth on investments and tax-deductible contributions.
Qualified plans, which comprise both defined benefit and defined contributions plans, include:
- 401(k)s
- 403(b)s
- 457(b)s
- Simplified Employee Pensions (SEPs)
- Savings Incentive Match Plan for Employees (SIMPLEs)
- Employee stock ownership plans (ESOPs)
- Defined benefit plans
In contrast, nonqualified retirement plans do not meet these IRS specifications, thus not providing the same tax benefits. However, they offer more flexibility in terms of contributions and distributions. This fundamental distinction plays a pivotal role in shaping an individual’s retirement saving strategy.
One of the primary differences between these plans lies in their contribution limits. For the 2024 tax year, qualified plans like the 401(k) have set an annual contribution limit of $23,000 for individuals under 50, with an additional $7,500 allowed as catch-up contributions for people ages 50 and older. The IRS periodically adjusts these limits to keep pace with inflation.
Nonqualified plans, on the other hand, do not adhere to these statutory contribution limits, allowing for potentially large accumulations of wealth. This may make qualified plans an attractive option for low to moderate-income earners who benefit from the tax relief provided, whereas nonqualified plans may appeal more to high-income earners who prioritize flexibility over immediate tax advantages.
Nondiscrimination Testing
Nondiscrimination testing is a series of tests required for qualified retirement plans to ensure that the benefits provided do not favor highly compensated employees (HCEs) over non-highly compensated employees (NHCEs). The IRS mandates these tests to maintain the tax-advantaged status of qualified plans such as 401(k)s and 403(b)s.
These tests include, but are not limited to, the Actual Deferral Percentage (ADP) test, Actual Contribution Percentage (ACP) test, and the Top-Heavy test, all designed to ensure a fair and equitable distribution of contributions and benefits.
However, nonqualified retirement plans are generally exempt from the strict nondiscrimination testing that applies to qualified plans. Nonqualified plans do not provide the same tax benefits as qualified plans and are typically not tax-deductible for the company until the benefits are distributed. As result, the nondiscrimination testing requirements typically do not apply.
Pros and Cons of Nonqualified Retirement Plans
On one hand, these plans offer unmatched flexibility in design and implementation, significant tax deferral opportunities, and act as a potent tool for incentive and retention. Conversely, the drawbacks include the absence of ERISA protections, which places the security of the benefits at risk, potentially complex taxation issues upon vesting, and the high costs and complexities involved in plan administration.
Pros of Nonqualified Retirement Plans
- Flexibility: Employers can tailor plans to meet specific needs of select employees, which is not possible with qualified plans.
- Tax deferral opportunities: By deferring a portion of their income, participants in these plans can potentially reduce their immediate tax liability and benefit from lower tax rates in retirement.
- Incentive and retention tool: The flexibility inherent in nonqualified retirement plans is a significant advantage, allowing organizations to tailor the plans to meet the nuanced needs of their select employees. This customization can be crucial in sectors where competition for top talent is intense, and traditional compensation packages may not suffice.
Cons of Nonqualified Retirement Plans
- Strict distribution schedules. The distribution schedule is preset, so you have to take money according to schedule even if you don’t want it. Also, unlike early distributions, can’t take money whenever you want.
- Lack of ERISA protections: If a company faces financial difficulties, the benefits promised under these plans could be at risk, potentially leaving employees without the retirement funds they expected.
- Taxation upon vesting: In some plans, employees might find themselves liable for taxes on benefits before actually receiving them, which can lead to financial strain.
Bottom Line
Nonqualified retirement plans offer a strategic and flexible compensation tool for companies aiming to attract and retain top-tier executives. These plans, distinct from qualified plans, provide significant adaptability in terms of contributions, distributions, and tax deferral opportunities, tailored to meet the unique financial needs of high earners.
Retirement Planning Tips
- At its core, retirement planning is about ensuring that you have enough assets and streams of income to support yourself when you stop working. That’s why it’s important to track your savings throughout your working career and get a sense of how much your nest egg will allow you to spend in retirement. SmartAsset’s retirement calculator can help you estimate how much money you’ll have by time you retire, how much income your savings may generate and whether it will be enough to meet your projected expenses.
- A financial advisor can help you build a comprehensive retirement plan based on your needs. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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