What Is a Nonqualified Plan?
A nonqualified plan is an employer-sponsored arrangement for deferred compensation that falls outside the stringent regulations of the Employee Retirement Income Security Act (ERISA). Unlike traditional retirement plans, which adhere to broad participation and nondiscrimination rules set by the Internal Revenue Service (IRS), nonqualified plans are specifically designed to provide supplemental benefits to a select group of management or highly compensated employees. These plans are a critical component within the realm of executive compensation, offering a flexible means to attract, retain, and incentivize top talent by allowing them to defer a portion of their current income taxable earnings until a future date, often retirement.34
History and Origin
The landscape of employer-sponsored retirement benefits in the United States underwent a significant transformation with the enactment of the Employee Retirement Income Security Act (ERISA) in 1974. Prior to ERISA, a patchwork of state and federal regulations governed pension plans, often leading to issues of underfunded plans and employees losing benefits due to employer insolvencies or job changes. ERISA was designed to protect the rights of plan participants and their beneficiaries by setting minimum standards for most voluntarily established pension and health plans in private industry. However, the comprehensive nature of ERISA also introduced complexities and compliance burdens for employers.33
In response to these regulations, and recognizing the need to offer additional benefits to key executives beyond the limits imposed on "qualified" plans (those fully compliant with ERISA and IRS rules), nonqualified plans emerged. These plans leverage specific exemptions within ERISA, allowing them to provide benefits without adhering to the extensive reporting, disclosure, and fiduciary duty requirements that apply to broad-based retirement plans. The development of nonqualified plans provided companies with a tool to create customized retirement savings strategies for their most valuable personnel, enabling greater flexibility in plan design and contribution amounts.
Key Takeaways
- A nonqualified plan is an employer-sponsored arrangement that defers compensation and is exempt from most ERISA requirements.32
- They are primarily used to provide additional benefits to highly compensated employees and executives.31
- Contributions to a nonqualified plan typically allow for tax deferral for the employee until distributions are received.30
- Unlike qualified plans, nonqualified plans are generally "unfunded" for ERISA purposes, meaning the deferred amounts are subject to the claims of the employer's general creditors in the event of bankruptcy.29
- These plans offer significant flexibility in design, contribution amounts, and payout options, as they are not subject to the same IRS contribution limits as qualified plans.28
Interpreting the Nonqualified Plan
A nonqualified plan should be interpreted primarily as a contractual promise from an employer to an employee, rather than a funded trust account. For an employee, participation in a nonqualified plan signifies an agreement to receive compensation at a future date, typically upon retirement, separation from service, or a specified time. This arrangement allows for potential tax deferral until the funds are distributed, which can be advantageous if the employee anticipates being in a lower income tax bracket during retirement.27
However, a critical aspect of interpreting these plans is understanding their "unfunded" nature for tax purposes. While an employer may informally set aside assets to cover future nonqualified plan obligations, these assets remain subject to the claims of the company's general creditors. This means that in the event of the employer's bankruptcy or insolvency, the employee's deferred compensation is not protected in the same way that assets in a 401(k) or other qualified plans would be. Employees participating in a nonqualified plan essentially become unsecured general creditors of the company.26
Hypothetical Example
Consider Sarah, a CEO earning a substantial salary and annual bonus. She has already maximized her contributions to her company's 401(k) plan, a standard qualified plan. To further incentivize her and provide additional retirement savings, her company offers a nonqualified deferred compensation plan.
Sarah elects to defer $100,000 of her annual bonus into this nonqualified plan. This means she does not receive the $100,000 now, and she does not pay income tax on it in the current year. The company agrees to pay this deferred amount, plus any notional earnings, when she retires in 15 years. The agreement specifies the payment terms, such as a lump sum or installments over five years.
During the 15 years, the deferred amount is not held in a separate, protected account for Sarah's sole benefit. Instead, it remains a general asset of the company, subject to the company's financial health and claims from its creditors. When Sarah retires, the company will pay her the deferred $100,000 plus accumulated earnings. At that point, the entire amount will be subject to her ordinary income tax rate. This illustrates the tax deferral benefit and the inherent risk of the unfunded nature of a nonqualified plan.
Practical Applications
Nonqualified plans serve several practical applications, primarily as a tool for executive compensation and talent management. For employers, these plans offer a highly flexible mechanism to attract and retain key individuals without being constrained by the broad participation, nondiscrimination, and contribution limits of qualified plans. This flexibility allows companies to tailor benefit packages to specific roles, performance incentives, or retention goals.25
Many large companies utilize nonqualified deferred compensation plans. As of a recent survey, the majority of large companies offer such plans as part of their compensation strategy.24 They are particularly useful when compensating highly compensated employees who may have already maxed out their contributions to standard qualified plans like a 401(k). By offering a nonqualified plan, employers can provide an additional avenue for significant wealth accumulation on a tax-deferred basis, strengthening employee loyalty and incentivizing long-term commitment.23
These plans can be structured in various ways, including deferred salary or bonuses, supplemental executive retirement plans (SERPs), and equity-based deferral arrangements. They allow companies to manage their cash flow more effectively by deferring the payout of compensation until a future date when the company may be in a better financial position.22
Limitations and Criticisms
Despite their flexibility and benefits, nonqualified plans come with significant limitations and criticisms, primarily concerning employee security and tax implications. The most notable drawback for employees is that nonqualified plans are generally "unfunded" for ERISA purposes. This means that unlike assets in a qualified plan, which are typically held in a trust and protected from the employer's creditors, the deferred compensation in a nonqualified plan remains a general, unsecured obligation of the employer.21 Should the employer face financial distress or bankruptcy, employees with nonqualified deferred compensation are treated as general creditors and may lose some or all of their deferred funds.20
Another limitation is the lack of portability. Unlike qualified plans, which often allow for rollovers to an Individual Retirement Account (IRA) or another employer's plan upon changing jobs, nonqualified plans typically do not offer this flexibility.19 Employees may forfeit benefits or face unfavorable distribution terms if they leave their employer before the vesting schedule is met or a specified event occurs.18 The deferral election for a nonqualified plan is generally irrevocable once made, limiting an employee's access to funds before the designated payout event.
Furthermore, while nonqualified plans offer income tax deferral, participants are generally still subject to FICA taxes (Social Security and Medicare) on the deferred amounts when the services are performed or when the benefits become vested, even if the income has not yet been received.17 The rules governing nonqualified deferred compensation, particularly IRS Section 409A, are complex, and non-compliance can lead to severe penalties, including immediate taxation and an additional 20% penalty tax for the employee.16
Nonqualified Plan vs. Qualified Plan
The fundamental distinction between a nonqualified plan and a qualified plan lies in their adherence to the stringent rules set forth by the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Service (IRS).
| Feature | Qualified Plan (e.g., 401(k), traditional pension) | Nonqualified Plan (e.g., NQDC, SERP) |
|---|---|---|
| ERISA Compliance | Must comply with most ERISA provisions (participation, vesting, funding, fiduciary). | Largely exempt from most ERISA requirements (especially for "top-hat" plans).15 |
| Eligibility | Must be offered broadly to all eligible employees without discrimination.14 | Can be selective, offered only to a select group of management or highly compensated employees.13 |
| Contribution Limits | Subject to annual IRS-imposed contribution limits.12 | Generally, no IRS-imposed contribution limits.11 |
| Tax Deduction | Employer contributions are generally tax-deductible when made. | Employer contributions are typically deductible only when paid to the employee.10 |
| Employee Tax | Contributions are often tax-deferred; earnings grow tax-deferred. | Compensation is tax-deferred until distribution; earnings grow tax-deferred.9 |
| Asset Protection | Assets held in trust, protected from employer's creditors in bankruptcy.8 | Unfunded promise, assets subject to employer's general creditors.7 |
| Portability | Generally allows rollovers to IRAs or other qualified plans.6 | Typically lacks portability and rollover options.5 |
| Distribution Rules | Strict rules for withdrawals (e.g., 59½ age rule, RMDs). | More flexible payout options, but election is often irrevocable. |
The choice between a nonqualified plan and a qualified plan often depends on an employer's objectives (broad employee benefits vs. executive retention) and an employee's income level and risk tolerance.
FAQs
Who is typically offered a nonqualified plan?
Nonqualified plans are typically offered to a select group of management or highly compensated employees because they are exempt from the broad participation rules that apply to qualified retirement plans. They are a tool for executive compensation.
Are contributions to a nonqualified plan tax-deductible for the employee?
No, employee contributions (deferrals) to a nonqualified plan are not tax-deductible in the year they are earned. However, the taxation of the deferred income is postponed until the employee actually receives the payout, typically in retirement. This is known as tax deferral.
4
Is my money safe in a nonqualified plan if my employer goes bankrupt?
In most cases, no. A nonqualified plan is generally an "unfunded" promise by the employer. This means the assets set aside to pay future benefits are not held in a separate trust for the employee's benefit and remain subject to the claims of the employer's general creditors if the company faces bankruptcy or insolvency.
3
What is the main advantage of a nonqualified plan for an employee?
The primary advantage for an employee is the ability to defer a significant portion of their income tax until a later date, often retirement, when they may be in a lower tax bracket. Additionally, there are typically no IRS limits on the amount an employee can defer into a nonqualified plan, unlike a 401(k).
2
Can I roll over funds from a nonqualified plan to an IRA?
Generally, no. Unlike qualified plans like a 401(k), nonqualified plans typically do not allow for direct rollovers of distributions into an IRA or another qualified retirement plan.1