Non-Qualified Plan

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21 Aug, 2024

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A Non-qualified Plan, also called a non-qualified retirement plan or non-qualified benefit plan, is an employer-sponsored retirement plan that does not fall under the purview of the Employee Retirement Income Security Act (ERISA). These plans are typically offered to C-level executives to present them with an additional avenue for building a retirement corpus.

These plans help companies hire and retain top talent across industries. When key personnel receive such enhanced, non-qualified retirement benefits, their inclination to remain associated with the company increases. Such arrangements foster loyalty and ensure employees pledge their affinity to the organization with a long-term commitment toward contributing to its success.

What Is A Non-Qualified Plan?

Non-qualified plan is an employer-sponsored compensation or retirement plan that does not adhere to the specific criteria and tax advantages of qualified plans like 401(k)s or traditional pension plans.
The benefit of a non-qualified plan is that it provides an opportunity for employees to save more for retirement, especially when they have already reached the contribution limits of qualified plans like 401(k)s. This supplementary source of retirement income can significantly enhance their financial security and stability in retirement.
Deferred-compensation plans, executive bonus plans, split-dollar life insurance plans, and group carve-out plans are the four types of plans available under this category.

How Does A Non-Qualified Plan Work?

Non-qualified plans operate as unique employer-sponsored retirement or compensation packages primarily designed for key executives and select senior employees. In contrast to qualified retirement plans, such as 401(K)s, non-qualified plans stand out due to their distinctive tax treatment.

These plans are not subject to the nondiscrimination rules that apply to qualified plans, which enables employers to offer them to a select group of individuals. The tax treatment of non-qualified plans depends on the contributions from employers. They are not tax-deductible for employers, and employers must use after-tax dollars to fund these plans.

For employees, contributions are taxable when deferred, but they can defer these taxes until their retirement years, when they may potentially fall into a lower tax bracket. This tax flexibility is a key feature of these plans.

Another key advantage of such plans is the flexibility related to contributions. There are no maximum contribution limits as opposed to qualified plans. For qualified plans, the Internal Revenue Service (IRS) has defined annual contribution limits. This flexibility allows both employers and employees to contribute as much as they want to these plans, making them attractive for executives with high compensation packages.

To ensure every employee contributing to qualified plans in the corporate ecosystem receives fair treatment, the IRS imposes certain restrictions on the contributions of Highly Compensated Employees (HCEs) to qualified retirement plans. Hence, non-qualified plans offer a valuable solution to HCEs, who can continue to save for retirement beyond the standard contribution limits that apply to qualified plans.

In essence, non-qualified plans serve as a supplementary retirement savings tool for HCEs, filling the gaps left by qualified plans and offering a prosperous retirement.

Types

There are four major types of non-qualified plans.

Deferred Compensation Plans: These allow employees to defer a portion of their current compensation to receive at a later date, typically in retirement. In addition, these plans supplement an employee’s retirement income and offer tax advantages, as employees are required to pay taxes on the deferred amount only when they receive the funds. The compensation portion so deferred is invested in a trust or other investment vehicles until it is used.
Executive Bonus Plans: Also called Section 162 Bonus Plans, it is a way for employers to provide additional compensation to key employees. Companies pay bonuses to these employees, and they can choose to use the bonus to purchase a life insurance policy or invest in other investment vehicles. This allows employees to receive the funds at a later date and pay taxes only upon the realization of such money. For instance, they can enjoy life insurance benefits while still being able to control the policy's cash value.
Split-dollar Life Insurance Plans: They are a form of life insurance arrangement where the costs and benefits of a life insurance policy are shared between the employer and the employee. These plans offer key employees life insurance coverage while serving as a form of compensation or retirement benefit. Employers usually pay the premium applicable to the death benefit, while employees pay the premium for the cash value of the life insurance plan. This arrangement allows employees to fund their retirement by borrowing against the plan’s cash value component.
Group Carve-out Plans: Group carve-out plans are a type of life insurance plan that allows an employer to offer life insurance coverage to a select group of employees, often key executives. The employer separates this group from the general employee population and provides life insurance coverage tailored to their needs. Employers may pay the premiums or contribute to the policy's funding.

Examples

Let us study some examples to understand the concept better.

Example #1

Suppose a tech company offers its top software engineer, Sarah, a compensation plan. Sarah can choose to defer 20% of her annual salary to the plan, which is invested in a diversified portfolio. By doing so, she reduces her taxable income for the current year and allows her investments to grow with a tax-deferred clause.

When Sarah retires, she receives regular payments from the plan, providing her with an additional stream of retirement income beyond her 401(k). Thus, the non-qualified plan helps Sarah save more for retirement and manage her tax liability effectively at a later date.

Example #2

A 2023 WTW survey revealed that 37% of US employers who offer non-qualified retirement plans primarily do so to onboard and retain top talent. Around 400 employers representing over 7.5 million employees were surveyed. Of these, 55% said they have already modified their non-qualified defined benefit plans in the last 2 years or plan to modify them in the coming 2 years. About 75% of the surveyed employers said they have already updated their non-qualified defined contribution plans in the past 2 years or planned to modify them within 2 years.

A majority of respondents (56%) exclusively offer non-qualified defined contribution plans, while 35% provide both defined contribution plan and defined benefit plans. Employers are placing a strong emphasis on enhancing employee experience for both types of plans, focusing particularly on better communication and finance education. The survey also highlighted the popularity of mutual funds as a preferred investment vehicle to contain or reduce the risks associated with these plans.

In summary, US employers are increasingly adopting non-qualified plans as a means to draw talent to their companies and retain them for long periods.

Taxation

Non-qualified plans have unique tax implications. Here's a breakdown of how taxes are typically calculated on such plans:

FICA Taxes: FICA taxes (Medicare and Social Security) pertaining to non-qualified plan contributions are withheld from an employee's paycheck, similar to other earnings.
Federal Income Tax: The federal income tax withholding relevant to non-qualified plans is not computed or withheld until the money is paid to an employee. Hence, employees pay taxes on these amounts only when they are credited to their accounts.
Future Tax Rates: This refers to the tax rate that becomes applicable when the money from the non-qualified plan is released or paid. The employee will be required to pay taxes per the rates applicable at the time of release. This usually creates uncertainty because it is challenging to predict future tax rates. Since tax rates at the time of distribution may be higher or lower than the rate applicable during an employee's working years, most employees prefer to hedge the risks using varied investment options.
Potential Tax Benefit: This is connected to the point above. The uncertainty in future tax rates might work to an employee's advantage. If an employee falls in a lower tax bracket during retirement, they pay a lower amount in taxes on the distributed income from the non-qualified plan.

Qualified Plan vs Non-Qualified Plan

The key differences between qualified plans and non-qualified plans are enumerated in the table below.

Basis	Qualified Plan	Non Qualified Plan
Employee perspective	Contributions to qualified plans, such as 401(k)s or traditional IRAs, are tax-deferred. When an employee contributes to their qualified plan, the contribution is deducted from their current taxable income, reducing their immediate tax liability. The contributions grow tax-deferred until withdrawal.	Employees do not get a current tax deduction for their contributions to such plans. They enjoy the flexibility associated with making the plan work according to their needs.
Employer perspective	Contributions to qualified plans from employers are generally invested in stocks, bonds, or mutual funds.	Contributions to non-qualified plans are made with after-tax dollars. Employers cannot deduct these contributions as a business expense.
Tax Treatment	When employees withdraw funds from their qualified plans, during retirement, the withdrawals are treated as taxable income at the income tax rate applicable to the individual.	When employees receive distributions from non-qualified plans, they are taxed only on the earnings (interest, dividends, capital gains) portion of the distribution. The original after-tax contributions are not taxed again.

Frequently Asked Questions (FAQs)

1. Why is a 457 plan non-qualified?

Non-qualified 457 plan is a specific retirement savings plan offered to employees of state and local governments, as well as certain nonprofit organizations. It is considered “non-qualified” because it does not comply with the requirements of a qualified retirement plan, such as a 401(k) or a traditional pension plan. 401(k) or traditional pension plans are governed by the Employee Retirement Income Security Act (ERISA) and have certain tax benefits and regulatory protections.

2. Who is eligible for a non-qualified deferred compensation plan?

Eligibility for a non-qualified deferred compensation plan, often referred to as an NQDC plan, depends on an employer's discretion and the specific terms of a plan. These plans are usually offered to a select group of employees, such as key executives and Highly Compensated Employees (HCEs).

3. Is military retired pay a non-qualified plan?

Military retired pay, which is the retirement income received by retired members of the US military, is generally not considered a non-qualified plan. Military retired pay is provided through the Department of Defense and is based on a formula that takes into account an individual's length of service and final pay grade.