What Are Nonqualified Plans?
Nonqualified plans are employer-sponsored benefit arrangements that provide a way for select employees, typically highly compensated employees and executives, to defer compensation beyond the limits of traditional tax-advantaged retirement vehicles. These plans fall under the broad financial category of retirement planning and executive compensation. Unlike "qualified plans," nonqualified plans are not subject to the extensive regulatory requirements of the Employee Retirement Income Security Act of 1974 (ERISA). This regulatory flexibility allows employers to design customized benefit structures tailored to specific individuals or small groups, making nonqualified plans a valuable tool for talent retention and recruitment. Participants in nonqualified plans typically defer a portion of their current income, with the intent of receiving it at a later date, often in retirement, potentially when they are in a lower income tax bracket.
History and Origin
The landscape of nonqualified deferred compensation plans underwent a significant transformation with the introduction of Section 409A of the Internal Revenue Code. Prior to this legislation, nonqualified plans offered greater flexibility regarding the timing of deferrals and distributions. However, perceived abuses, notably among executives at Enron who accelerated payments from their deferred compensation plans before the company's bankruptcy, prompted legislative action.12,11
The American Jobs Creation Act of 2004, which became effective on January 1, 2005, created Section 409A. This new section aimed to regulate nonqualified deferred compensation more strictly, imposing specific rules on when deferral elections could be made and when distributions could be taken. The intent was to prevent participants from accessing funds prematurely while still benefiting from tax-deferred treatment.10 The Internal Revenue Service (IRS) provides guidance on what constitutes a nonqualified deferred compensation plan and the rules for its taxation.9
Key Takeaways
- Nonqualified plans are employer-sponsored arrangements used to defer compensation for a select group of employees, often high earners.
- They are not subject to ERISA regulations, offering greater flexibility in design compared to qualified plans.
- Participants can defer current income, potentially delaying income tax liability until a later distribution date, often during retirement.
- These plans serve as a key tool for companies to attract, retain, and incentivize top talent.
- Compliance with IRS Section 409A is crucial to avoid significant penalties, including immediate taxation and additional excise taxes.
Interpreting Nonqualified Plans
Nonqualified plans are interpreted primarily as strategic compensation tools that bridge the gap between an employee's desired retirement savings and the contribution limits of qualified plans, such as 401(k)s or defined benefit plans. For employers, these plans are seen as a way to enhance loyalty and provide a competitive edge in recruiting skilled professionals. The flexibility in design means that each nonqualified plan can be uniquely structured to meet specific company goals and employee needs, rather than adhering to rigid, broad-based guidelines. The "unfunded" nature of many nonqualified arrangements, where the employee is essentially an unsecured creditor, also offers companies cash flow advantages since assets are not typically segregated.
Hypothetical Example
Consider Jane, a senior executive at Tech Solutions Inc., earning a substantial salary and already maximizing her contributions to her 401(k), a common type of defined contribution plan. Despite her substantial income, she recognizes a potential gap in her long-term financial security needs if she relies solely on her qualified plan.
Tech Solutions offers a nonqualified deferred compensation plan to its top management. Jane elects to defer an additional $100,000 of her annual bonus into this plan. This deferred amount is not immediately taxable as income to Jane, reducing her current year's taxable income. The deferred funds are notionally invested within the company's general assets, growing tax-deferred until distribution.
Jane and Tech Solutions agree that the deferred compensation will be paid out in five equal annual installments starting upon her separation from service. If Jane retires in 15 years, her accumulated deferred compensation, plus any notional earnings, will begin to pay out at that time. This strategy allows Jane to defer a larger portion of her compensation, manage her tax liability by potentially receiving payments in a lower tax bracket during retirement, and align her long-term financial interests with the company's success.
Practical Applications
Nonqualified plans are widely utilized across various sectors, particularly in public and private companies, as well as tax-exempt organizations. Their primary application is in tailoring compensation packages for executives, key employees, and board members.
- Executive Retention and Recruitment: Companies use nonqualified plans to attract and retain high-performing individuals who may have already maxed out their contributions to qualified retirement vehicles. Offering additional deferred compensation can be a powerful incentive.8
- Supplemental Retirement Income: For highly compensated employees, nonqualified plans provide a means to save beyond the limits imposed on qualified plans, ensuring a more comfortable retirement that aligns with their pre-retirement income levels.7
- Performance-Based Incentives: These plans can be structured to tie payouts to specific performance metrics or tenure, incentivizing long-term commitment and achievement of corporate goals.
- Tax Management: Both employers and employees can benefit from the timing of tax liabilities. For employees, income is generally not taxed until it is received, potentially at a lower future tax rate. For employers, contributions are typically not a tax deduction until the benefits are paid to the employee.6
- SEC Disclosure Requirements: Publicly traded companies must disclose details regarding executive compensation, including elements of nonqualified plans, under regulations set forth by the Securities and Exchange Commission (SEC). These disclosures aim to provide investors with a clear picture of how companies compensate their top executives and how this compensation aligns with company performance.5,4
Limitations and Criticisms
While offering significant flexibility and benefits, nonqualified plans come with notable limitations and risks. A primary concern for employees is that nonqualified plans are typically "unfunded" for tax purposes. This means the employer's promise to pay deferred compensation is a mere contractual obligation and not secured by dedicated assets. In the event of the employer's bankruptcy or insolvency, participants become general unsecured creditors, meaning their deferred compensation could be at significant risk of forfeiture or greatly reduced.
Another critical aspect is the stringent regulatory framework of Section 409A of the Internal Revenue Code. Failure to comply with the rules regarding deferral elections and distribution timing can lead to severe penalties for the employee, including immediate taxation of all deferred amounts (including prior years' deferrals), a 20% excise tax, and interest penalties.3,2 These penalties apply to the employee, not the employer, placing a considerable compliance burden on participants to ensure their nonqualified plans are correctly administered.
Furthermore, unlike qualified plans, nonqualified plans are exempt from ERISA's anti-discrimination rules, which means they can be offered to a select group of employees. This selectivity, while a benefit for employers seeking to reward specific talent, means they do not offer the broad-based employee protection and participation rights found in ERISA-governed plans.
Nonqualified Plans vs. Qualified Plans
The fundamental distinction between nonqualified plans and qualified plans lies in their adherence to the Employee Retirement Income Security Act (ERISA) and their associated tax treatments and regulations.
| Feature | Nonqualified Plans | Qualified Plans |
|---|---|---|
| ERISA Compliance | Generally exempt from ERISA's strict rules, except for a few limited provisions. | Subject to extensive ERISA regulations (e.g., funding, vesting, disclosure, non-discrimination). |
| Eligibility | Can be offered selectively to a "select group of management or highly compensated employees." | Must be offered to all eligible employees on a non-discriminatory basis. |
| Contribution Limits | No IRS-imposed limits on contributions, allowing for significant deferrals. | Subject to annual IRS contribution limits (e.g., 401(k) and IRA limits). |
| Tax Treatment (Employee) | Income tax deferred until distribution; FICA taxes often paid at deferral/vesting. | Contributions often tax-deductible or pre-tax; earnings grow tax-deferred; taxed upon withdrawal in retirement. |
| Tax Treatment (Employer) | Employer deduction generally deferred until benefits are paid to the employee. | Employer contributions are generally immediately tax-deductible. |
| Security of Funds | Unfunded; participants are unsecured creditors, funds are subject to employer's general creditors. | Funds held in a trust or custodial account, separate from employer's assets, offering protection from employer insolvency. |
| IRS Section 409A | Must comply with Section 409A rules for timing of elections and distributions. | Exempt from Section 409A (governed by other sections of the Internal Revenue Code). |
The confusion between the two often arises from their shared goal of providing retirement or deferred compensation benefits. However, the different regulatory frameworks lead to vastly different implications regarding employee protection, accessibility, and tax timing.
FAQs
Who benefits most from nonqualified plans?
Nonqualified plans primarily benefit highly compensated employees and executives who have already reached the contribution limits for traditional qualified plans like a 401(k). These plans allow them to defer additional income and save more for retirement or specific future financial goals.
Are contributions to nonqualified plans tax-deductible for the employee?
No, employee contributions to nonqualified plans are typically made with pre-tax dollars (through salary reduction agreements), meaning the income is not currently taxed. However, the income itself is not a separate tax deduction for the employee. Taxes are generally deferred until the compensation is actually paid out.
What happens if an employer goes bankrupt with a nonqualified plan?
If an employer goes bankrupt, participants in a nonqualified plan are generally considered general unsecured creditors. This means their deferred compensation is at risk and may not be fully paid out, as the funds are part of the company's general assets and are subject to the claims of other creditors. This is a significant difference from qualified plans, where assets are held in a separate trust.
Can nonqualified plans be changed or terminated by the employer?
Yes, employers typically retain more flexibility to amend or terminate nonqualified plans compared to qualified plans, though changes must generally comply with Section 409A rules regarding payment timing. Employees should understand the terms and conditions outlined in their specific nonqualified plan agreement.
How are nonqualified plan distributions taxed?
When distributions are received from a nonqualified plan, they are generally taxed as ordinary income at the participant's marginal income tax rate at the time of distribution. Social Security and Medicare (FICA) taxes may be withheld at an earlier point, usually when the right to the deferred compensation vests or when services are performed, rather than at distribution.1