Nonqualified retirement plan

What Is a Nonqualified Retirement Plan?

A nonqualified retirement plan is a type of deferred compensation arrangement between an employer and an employee, typically a highly compensated executive, that falls outside the strict guidelines of the Employee Retirement Income Security Act (ERISA) and most sections of the Internal Revenue Code (IRC) governing qualified retirement plans. These plans are a key component of executive compensation strategies, allowing select employees to defer a portion of their current income, such as salary or bonuses, until a future date, often retirement or separation from service. Unlike qualified plans, nonqualified retirement plans offer greater flexibility in design and contribution amounts but do not receive the same favorable tax treatment for the employer or asset protection for the employee.¹⁴

History and Origin

The concept of deferred compensation has long been a tool for employers to attract and retain key talent, predating the modern regulatory framework. However, the current landscape of nonqualified retirement plans was significantly shaped by the introduction of Internal Revenue Code Section 409A. Enacted as part of the American Jobs Creation Act of 2004, Section 409A brought a new layer of compliance requirements to nonqualified deferred compensation plans. Prior to this, rules governing these plans were primarily based on common law doctrines like constructive receipt and economic benefit. The Sarbanes-Oxley Act of 2002, following major corporate scandals, also influenced the push for greater transparency and stricter governance over executive pay practices, including deferred compensation arrangements.¹², ¹³ The IRS provides detailed guidance on the taxation and operation of these plans.¹¹

Key Takeaways

• Nonqualified retirement plans allow highly compensated employees to defer income beyond the limits of traditional qualified plans.
• These plans are not subject to many of the strict funding and non-discrimination rules of ERISA.
• Taxation of deferred amounts is typically postponed until the funds are distributed to the employee.
• Assets in a nonqualified plan generally remain part of the employer's general assets and are subject to the claims of the employer's general creditors.
• These plans often serve as "golden handcuffs" to incentivize long-term retention of key personnel.

Interpreting the Nonqualified Retirement Plan

A nonqualified retirement plan is primarily interpreted as a contractual promise from an employer to pay an employee deferred compensation at a future date. For the employee, it represents a significant opportunity for tax deferral on a substantial portion of their earnings, allowing the funds to potentially grow without immediate income tax liabilities. For the employer, it's a flexible tool to provide additional compensation to executives and senior management, bypassing the contribution limits imposed on qualified plans like 401(k)s. The value of a nonqualified plan is largely dependent on the employer's financial stability and the specific terms outlined in the plan document, which dictate payout events and forfeiture conditions.

Hypothetical Example

Consider Sarah, a 55-year-old executive earning $700,000 annually. She has already maximized her contributions to her company's 401(k) and other qualified retirement plans. Her company offers a nonqualified retirement plan allowing her to defer up to an additional 20% of her salary and bonus each year.

Sarah elects to defer $100,000 of her current year's income into the nonqualified plan. This $100,000 is not immediately subject to federal income tax, although FICA (Federal Insurance Contributions Act) taxes, comprising Social Security and Medicare taxes, are typically due at the time the compensation is deferred or when it is no longer subject to a substantial risk of forfeiture.¹⁰ The deferred amount is notionally invested based on her elected options, and its growth is also tax-deferred. When Sarah retires at 65, the accumulated balance, including any earnings, will be paid out to her according to the pre-determined schedule, at which point it will be subject to ordinary income tax.

Practical Applications

Nonqualified retirement plans are frequently used by corporations to supplement the retirement savings of their highly compensated employees and key executives. Because these plans are exempt from many ERISA regulations, they offer employers significant flexibility in tailoring benefits. This flexibility allows companies to design plans that serve specific business objectives, such as retaining critical talent through vesting schedules that act as "golden handcuffs."⁹ For instance, a company might implement a nonqualified plan that vests benefits only after a certain number of years of service or upon reaching specific performance targets, encouraging long-term loyalty. These arrangements are often utilized when qualified plans, due to their contribution limits, are insufficient for executives accustomed to higher levels of income and a certain standard of living in retirement. The plans can also incorporate various forms of equity compensation, further aligning executive interests with shareholder value.⁸ Many corporations provide detailed information on their nonqualified deferred compensation plans in their public filings.⁷

Limitations and Criticisms

Despite their advantages for high earners, nonqualified retirement plans come with notable limitations and risks. A primary concern is that these plans are generally "unfunded" for tax purposes. This means the assets held to cover future payouts often remain part of the employer's general assets, and the employee is merely an unsecured creditor of the company.⁶ In the event of the employer's bankruptcy or severe financial distress, the deferred compensation could be at risk or even lost. While some employers use a "rabbi trust" to hold the deferred funds, these trusts do not protect the assets from the employer's creditors.⁵

Furthermore, the stringent rules of IRC Section 409A impose strict requirements on election timing, distribution events, and permissible changes to deferral elections. Failure to comply with Section 409A can result in immediate taxation of all deferred amounts, plus a 20% penalty and interest for the employee, negating the intended tax advantages.³, ⁴ Unlike qualified plans, nonqualified plans do not permit plan loans or rollovers into an IRA or other tax-deferred retirement accounts upon distribution, limiting an employee's access to and flexibility with these funds.¹, ²

Nonqualified Retirement Plan vs. Qualified Retirement Plan

The fundamental distinction between a nonqualified retirement plan and a qualified retirement plan lies in their adherence to the stringent rules set forth by ERISA and the Internal Revenue Code.

While qualified plans offer significant tax benefits and strong asset protection for a broad range of employees, their strict rules and contribution limits can be restrictive for high earners. Nonqualified plans fill this gap by providing additional deferral opportunities and flexibility for a select group, albeit with less asset security and more complex tax compliance under IRC Section 409A.

FAQs

Who is eligible for a nonqualified retirement plan?

Eligibility for a nonqualified retirement plan is typically limited to a "select group of management or highly compensated employees" within a company. These plans are not subject to the broad participation rules of qualified plans, allowing employers to offer them strategically to key individuals.

Are contributions to a nonqualified retirement plan tax-deductible?

For the employee, contributions to a nonqualified retirement plan are made with pre-tax dollars (deferred income), meaning federal income tax is deferred until the money is paid out. However, Social Security and Medicare taxes (FICA) are generally due when the compensation is deferred or when it vests, whichever is later. For the employer, the deduction for the deferred compensation is typically taken when the employee recognizes the income, which is usually at the time of distribution.

What happens if my employer goes bankrupt?

If your employer goes bankrupt, the money you have deferred into a nonqualified retirement plan is generally at risk. Since these plans are typically "unfunded" and the assets remain part of the company's general assets, you become an unsecured creditor. This means your claim for the deferred compensation is on par with other general creditors, and you may lose some or all of your deferred funds.

Can I take a loan from my nonqualified retirement plan?

No, unlike some qualified plans such as a 401(k), nonqualified retirement plans generally do not permit participants to take loans against their deferred amounts. Distributions are typically restricted to specific events defined in the plan document, such as retirement, termination of employment, disability, death, or a specified date.