A nonqualified plan is a tax-deferred, employer-sponsored retirement plan that stands apart from traditional benefits adhering to standard guidelines. These plans, often structured to meet the sophisticated retirement requirements of key executives and select employees, are pivotal for recruitment and retention strategies. They are distinguished from qualified plans by their exemption from non-discriminatory and top-heavy testing.
Key Takeaways
- Nonqualified plans are specially designed retirement savings programs.
- Unlike qualified plans, they do not comply with standard Employee Retirement Income Security Act (ERISA) guidelines.
- They serve primarily for high-compensation executives, giving them additional retirement savings vehicles.
How Nonqualified Plans Operate
Nonqualified plans come in four main types:
- Deferred-compensation plans
- Executive bonus plans
- Split-dollar life insurance plans
- Group carve-out plans
Contributions to these plans generally do not qualify for employer tax deductions and are taxable for the employee. Yet, they allow taxes to be deferred until retirement, likely when the employee’s tax rate is lower. Additionally, they’re favored for complementing high earners’ savings once their contributions to qualified plans have maxed out.
Deferred Compensation as a Nonqualified Plan
Nonqualified deferred compensation plans can be categorized into two major types:
- True deferred compensation plans
- Salary-continuation plans
The primary distinction is in their funding sources. In true deferred compensation arrangements, the executive defers a part of their income, often their bonus income. Conversely, in salary-continuation plans, the employer funds future benefits targeting the executive’s retirement. Both facilitate tax-deferred growth until the point of disbursement when standard income tax rates apply.
Nonqualified Plan: Executive Bonus Plan
Executive bonus plans operate straightforwardly. Here, a company grants life insurance to an executive, where the premiums, treated as a bonus, are employer-paid. The premiums are deductible for employers but taxable for executives. Sometimes the employer additionally covers the executives’ tax expenses, in turn making their incoming somewhat transparent.
Nonqualified Plan: Split-Dollar Plan
Split-dollar plans come into play when employers seek to grant key employees permanent life insurance. The policy purchased by the employer is co-owned by the employer and the employee. Usually, the employee covers mortality costs while the employer finances the premium balance. In case of the employee’s demise, the death benefit is divided, with the beneficiaries and the employer receiving predetermined portions.
Nonqualified Plan: Group Carve-Out
In a group carve-out plan, the employer separates a key employee’s group life insurance beyond $50,000, substituting it with an individual policy. This switch helps the employee dodge imputed income taxes over the group insurance top threshold. The excess group’s premium is then directed to the individual policy managed by the employee.
Illustrative Example: Maximize Savings like a Financial Pro
Imagine a high-paid executive in the financial sector who has already maximized their 401(k) contributions, seeking additional retirement funds. Here, their employer presents nonqualified deferred compensation options, allowing the executive to defer additional income, thus extending their retirement savings and reducing immediate tax liability.
An employer and executive often concur on the deferral period, ranging from five years to retirement. This way, the deferred earnings accumulate tax deferred, and the withdrawal amount and regulations can adjust annually per the mutual agreement. Such agreements enable substantial flexibility and potential significant financial growth over time.
Related Terms: Deferred Compensation, Executive Bonus Plan, Split-Dollar Life Insurance Plan, Group Carve-Out Plan.
