Non qualified plans: Meaning, Criticisms & Real-World Uses

What Are Non-Qualified Plans?

Non-qualified plans are a type of contractual arrangement between an employer and an employee to defer current compensation until a future date, often retirement. Unlike their "qualified" counterparts, these plans do not meet the strict requirements of the Employee Retirement Income Security Act (ERISA) or specific sections of the Internal Revenue Code (IRC) like Section 401(a). This places them outside the typical framework of regulated retirement planning vehicles. Typically, non-qualified plans are offered to a select group of management or highly compensated employees, allowing them to defer a significant portion of their taxable income beyond the limits imposed on qualified plans.³⁷, ³⁸

History and Origin

The concept of deferred compensation has long existed as a means for employers to incentivize and retain key personnel. However, the specific regulatory framework distinguishing qualified and non-qualified plans evolved over time, primarily through various tax legislation in the United States. Non-qualified deferred compensation plans became particularly relevant as limitations were placed on the contributions and benefits for qualified plans like 401(k)s and pension plans. This led companies to seek alternative methods to provide additional benefits to their top executives. The Internal Revenue Code (IRC) Section 409A, enacted as part of the American Jobs Creation Act of 2004, significantly impacted how non-qualified plans are structured and administered to prevent abuses and ensure proper tax deferral treatment. Before Section 409A, there was less explicit guidance, and arrangements could be more informal, which sometimes led to issues with the timing of taxation.

Key Takeaways

Non-qualified plans allow employees, often executives, to defer compensation beyond limits set for qualified retirement plans.
They are not subject to most provisions of the Employee Retirement Income Security Act (ERISA)), which means they lack the same protections as qualified plans.
Taxes on deferred amounts in non-qualified plans are typically paid when the funds are received by the employee, usually in retirement.³⁶
These plans carry employer insolvency risk, as the deferred funds remain part of the company's general assets until distributed.³⁵
Distributions from non-qualified plans are generally subject to strict, pre-determined payout schedules.³⁴

Formula and Calculation

Non-qualified plans do not have a universal formula for calculating contributions or benefits, as they are highly customizable contractual agreements. The "formula" is essentially defined by the terms of the individual plan agreement between the employer and the employee. This can include:

Employee Deferral Amount: A percentage of salary, bonus, or other compensation that the employee elects to defer.
Employer Contribution: Discretionary or formula-based contributions made by the employer, which may be contingent on performance or other factors.
Notional Investment Growth: While the funds are technically part of the company's assets, the plan typically tracks a "notional" or hypothetical investment return based on chosen investment benchmarks. The calculation of this growth would follow standard investment return formulas:
$FV = PV \times (1 + r)^n$
Where:
- (FV) = Future Value of the deferred amount
- (PV) = Present Value of the deferred amount (initial deferral plus prior growth)
- (r) = Notional annual rate of return (e.g., tied to an index or specified interest rate)
- (n) = Number of periods (years) the amount is deferred

The "balance" in a non-qualified plan is a book-entry liability for the employer, representing their promise to pay the employee in the future. The growth of these deferred amounts is tax-deferred until distribution.³³

Interpreting Non-Qualified Plans

Interpreting non-qualified plans involves understanding their unique advantages and significant risks. For employees, the primary appeal is the ability to defer income taxes on compensation and its growth until a later date, potentially when they are in a lower tax bracket during retirement.³¹, ³² This can be particularly beneficial for highly compensated employees who have already maximized contributions to qualified plans like a 401(k)) or IRA. However, interpretation must also weigh the significant risks. Since the assets supporting these plans remain part of the employer's general assets, employees become unsecured creditors. This means that if the employer faces financial distress or bankruptcy, the employee's deferred compensation could be at risk.³⁰ Furthermore, these plans often come with rigid distribution schedules, meaning employees must receive payments at pre-determined times, regardless of their immediate financial needs or tax situation.²⁹

Hypothetical Example

Consider Sarah, a highly compensated executive earning a substantial salary and annual bonus. She has already contributed the maximum allowed to her company's 401(k) and her personal IRA, but still wishes to save more for retirement in a tax-efficient manner. Her company offers a non-qualified deferred compensation plan.

Sarah decides to defer $50,000 of her annual bonus into the non-qualified plan. The plan allows her to notionally invest these funds, and she chooses an option that tracks a market index. Over 10 years, assuming a hypothetical average annual growth rate of 7%, her initial $50,000 deferral, plus any subsequent deferrals and their growth, would accumulate without current taxation. If she continues to defer $50,000 annually for 10 years, and assuming a simple 7% annual growth on each year's deferral from the deferral date, her total accumulated (notional) balance would grow significantly.

Upon her pre-determined retirement date, specified years earlier in the plan document, Sarah begins to receive distributions from the non-qualified plan. For instance, she might elect to receive the accumulated balance in 10 annual installments. Each installment she receives will then be taxed as ordinary income in the year of receipt. This allows her to postpone paying taxes on the deferred income until a time when her overall income and tax rate may be lower.

Practical Applications

Non-qualified plans are primarily used by employers as a tool for executive compensation and retention, particularly for individuals whose contributions to qualified plans are limited by IRS regulations.²⁷, ²⁸

Executive Retention: Companies often use non-qualified plans to create "golden handcuffs," encouraging key executives to remain with the company by tying significant future payouts to continued employment or performance milestones.
Supplemental Retirement Savings: For highly compensated employees who have already maxed out their contributions to 401(k)) and other qualified retirement savings vehicles, non-qualified plans offer an additional avenue for tax-deferred accumulation.²⁵, ²⁶
Tax Planning: Participants can strategically defer income from high-earning years to future years when they anticipate being in a lower tax bracket, potentially reducing their overall income tax burden.²⁴
Performance Incentives: Some non-qualified plans are structured around performance awards or long-term incentives, aligning executive rewards with company success. For instance, companies may offer these plans to amplify benefits offerings and achieve strategic initiatives.²³

These plans are especially prevalent in publicly traded companies, private firms, and tax-exempt organizations looking to enhance their benefits for top talent.²² A deeper understanding of these plans and their integration into a total compensation strategy is often explored by financial consulting firms.²¹

Limitations and Criticisms

While beneficial for certain individuals, non-qualified plans come with distinct limitations and criticisms. A major concern for employees is the lack of protection under the Employee Retirement Income Security Act (ERISA)). Unlike qualified plans where assets are held in a separate trust, funds in non-qualified plans remain part of the company's general assets. This means that in the event of employer bankruptcy or financial distress, employees become unsecured creditors and may lose their deferred compensation.¹⁹, ²⁰

Another limitation is the rigidity of distribution rules. Once an employee elects to defer compensation and establishes a payout schedule (e.g., lump sum or installments), modifying this schedule can be difficult and may involve strict waiting periods or tax penalties under IRC Section 409A.¹⁷, ¹⁸ This lack of liquidity can be problematic if an unexpected financial need arises before the scheduled distribution date. Furthermore, while the intention is often to defer taxes to a lower bracket, poor planning or unforeseen circumstances (like a subsequent high-earning year in retirement) could result in the deferred income being taxed at a higher rate than anticipated.¹⁶

For employers, while non-qualified plans offer flexibility and retention benefits, the deferred compensation amounts represent a liability on their balance sheet. The company does not receive a tax deduction for the deferred compensation until it is paid out to the employee.¹⁵

Non-Qualified Plans vs. Qualified Plans

The fundamental difference between non-qualified plans and qualified plans lies in their compliance with the Employee Retirement Income Security Act (ERISA) and various sections of the Internal Revenue Code.

Feature	Non-Qualified Plans	Qualified Plans (e.g., 401(k), pension plans)
ERISA Protection	Generally exempt from most ERISA provisions.¹⁴ Funds are part of company assets.¹³	Subject to strict ERISA rules, including funding, vesting, and fiduciary responsibility. Assets held in a separate trust.¹²
Participant Scope	Typically offered only to a select group of management or highly compensated employees.¹¹	Must be offered to a broad base of employees and meet non-discrimination testing.¹⁰
Contribution Limits	No IRS-imposed limits on employee or employer contributions.⁹	Subject to annual IRS contribution limits.⁸
Taxation	Tax deferral until distribution. FICA/FUTA taxes often due at deferral or vesting.⁷	Contributions are often pre-tax, and growth is tax-deferred. Distributions are taxed as ordinary income.
Employer Risk	High. Deferred amounts are at risk if the employer faces bankruptcy.⁶	Low. Assets are protected from employer's creditors.
Flexibility	Highly flexible in design and customization for specific employees.⁵	Must adhere to strict IRS and DOL regulations in design and operation.

While qualified plans provide robust protections and broad accessibility for retirement savings, non-qualified plans serve as a supplementary tool, primarily for high-income earners seeking additional tax-deferred accumulation beyond regulatory limits.

FAQs

Q: Who can participate in non-qualified plans?

A: Non-qualified plans are typically offered by employers to a select group of management or highly compensated employees, such as executives, directors, or key personnel. They are not required to be offered to all employees, unlike qualified plans.⁴

Q: How are non-qualified plans taxed?

A: Participants in non-qualified plans typically defer paying federal income taxes on the deferred compensation and its earnings until the funds are distributed. However, Social Security and Medicare (FICA) taxes are generally assessed at the time the compensation is earned or when it vests, rather than when it's paid out.², ³

Q: Are non-qualified plans safe if my employer goes bankrupt?

A: No, non-qualified plans generally lack the same protections as qualified plans. Since the deferred funds remain part of the employer's general assets and are not held in a separate trust, if the employer experiences bankruptcy or financial insolvency, employees become unsecured creditors and risk losing their deferred amounts.¹