Non-Qualified Retirement Plans
Many workers are familiar with the concept of retirement plans such as Roth IRAs, 401(k)s, and other forms of tax sheltered retirement accounts. For high level executives and other certain highly compensated employees, there are additional plan options available in the event they no longer qualify for typical retirement plans. Let's take a look at what exactly a non-qualified retirement plan is and review examples of different types of plans.
Definition
A non-qualified retirement plan is a retirement program that doesn't meet Employer Retirement Income Security Act (ERISA) standards. An ERISA qualified account would include a typical retirement account like a 401(k). A non-qualified plan is used to accommodate high level employees who may be excluded from other plans by law, or to provide a retirement benefit option that the company doesn't want to make available to every employee. For example, qualified plans might not allow as much money to be invested as a high income earner would need to put in to meet his retirement goals.
Types
Non-qualified retirement plans describe a class of investment strategies. There are four major types which we will review.
Deferred Compensation
In a deferred compensation plan, an employee elects to wait until a later date to receive his wages. If Bill, a corporate Chief Operations Officer earns $200,000 a year, but elects to defer $25,000, he will actually take home $175,000 before taxes. That $25,000 can then be invested in an account similar to a 401(k) where Bill can invest the money in mutual funds. When he pulls the money out many years later in retirement, he will pay income taxes on the compensation he has delayed, taking any earnings that have accrued. The benefit for Bill is lower taxes now, in his high income earning years, and that the growth of that money in the investment account is tax free.
Executive Bonus Plans
An executive bonus plan allows a company to provide additional compensation beyond regular wages to an employee. One option is for the company to pay the premiums on a cash-value life insurance plan that belongs to Bill. Bill can then access this money as he could with any other life insurance policy that can be surrendered for a cash sum. The company can even include an additional amount to make up for the taxes Bill will have to pay when he takes the money. This is one of the most common options, but executive bonuses can also include perks such as a car purchased by the company and given to Bill, or outright cash payments.
Group Carve-Out Plans
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nonqualified deferred compensation plan. This design flexibility gives the employer the ability to customize their plan to be unique to their organization and their key employees, and accomplishes a wide variety of objectives:
• Toattractkeyemployeesthroughsignificantbenefitsthatare deferred to a future date, which can also ensure a long-term commitment by the new hire. In fact, offering a nonqualified deferred compensation program can level the playing field by tailoring a benefits package that is equal to or better than that of larger companies;
• To retain key employees through “golden handcuffs” by offering deferred benefits that are subject to forfeiture unless certain conditions are met;
• Tomakeupbenefitsthatcannotbeprovidedunderthequalified plan due to various limitations of law;
• Toavoidnondiscriminationrulesandissuesthatwould otherwise apply if benefits were provided through the employer’s qualified plan. Providing benefits to only a select group of management or highly compensated employees can also be a more cost-effective approach for providing benefits than under a qualified plan;
• Toprovidesupplementalbenefitsinadditiontoaqualifiedplan that would allow the key employee to retire with the same total pay replacement that staff employees receive;
• Toprovidekeyemployeeswithincentivesandrewardswithout creating an immediate corresponding tax burden to the individual;
• Toprovidefuturebenefitswithoutthelegalrequirementtofund those benefits.
Key employee objectives
High-earning key employees with substantial discretionary income find these plans attractive due to their favorable tax treatment. Typical objectives are:
• Avoidanceofcurrenttaxationonregularorincentivepay;
Avoidanceofcurrenttaxationonanygrowthofaccounts or benefits;
• Managingpersonalcashflowandtaxesbydeferringcompensation until a future date when there may be a lower tax rate applied and when the money may be better used;
• Accumulationoftax-favoredsavingsandwealthbeyondthat allowed by their qualified plans and personal savings.
Disadvantages — for the individual
Key employees covered by these plans should know that the amounts they and the company defer and their earnings are at all times unsecured contractual obligations of the employer. Therefore, any amounts set aside in the key employee’s name are not protected from the claims of general creditors of the company. The key employee is an unsecured general creditor of the employer.
The rules for the timing of elections to defer compensation and the ability to change deferral rates in a nonqualified deferred compensation program are much less flexible than the typical 401(k) plan. Elections to defer compensation must occur before the compensation is earned, and the election timing rules differ depending upon whether the compensation is considered base pay, performance-based, or some other form of compensation. Also, Internal Revenue Code Section 409A is clear that any key employee who chooses to defer compensation is generally not allowed to change their deferral election during the year. As a result, the timing of the election to defer can often be well in advance of the actual deferral of compensation from that key employee’s paycheck, and the key employee must plan carefully when making their election to defer.
Elections to defer compensation must occur before the compensation is earned, and the election timing rules differ depending upon whether the compensation is considered base pay, performance-based, or some other form of compensation.
Further, unless dictated by the plan language, the key employee must determine when and in what form the deferred compensation is to be paid at the time of the election to defer.
Thus, key employees who choose to defer compensation under the program commonly choose to defer compensation for periods that correspond to major life events such as retirement, college education for children, or for other personal needs. Since the election of the timing and form of distribution is generally made in advance of such payment(s), financial and other circumstances
maychangeforthekeyemployeeduringtheperiodofdeferment. Once an election has been made, there are limited ways in which the distribution election can be changed. So the key employee must also plan carefully for the timing and the form of distribution well in advance of those events.
Disadvantages — for the employer
The almost complete flexibility to determine who is eligible
and what benefits are provided under a nonqualified deferred compensation program comes with a price. There is no current tax deduction to the employer for any amounts that may be
set aside to pay future benefits from the plan. Further, if funds
are set aside, any investment earnings on those funds can be taxable income to the employer. Finally, the requirements of Internal Revenue Code Section 409A raise the risk of adverse tax consequences to the key employee as a result of an error in the design, the written plan documentation, or the administration of the program.
Unlike qualified plans, contributions to a nonqualified deferred compensation plan are not a currently deductible expense to the corporation.