What is a Non-Qualified Plan?
A non-qualified plan is an employer-sponsored, tax-deferred retirement savings plan that falls outside the Employment Retirement Income Security Act (ERISA). Unlike qualified plans, non-qualified plans are exempt from the regulations and testing that apply to qualified plans.
Non-qualified plans are used as a recruitment and retention tool for key executives and select senior management employees. The plans are designed to meet the specialized retirement needs of key employees.
- Non-qualified plans fall outside the Employment Retirement Income Security Act (ERISA) and are exempt from discriminatory participation and contribution rules.
- The plans are used as a key tool to recruit and retain key executives and select senior employees.
- The four major types of non-qualified plans include deferred compensation plans, executive bonus plans, group carve-out plans, and split-dollar life insurance plans.
How Does a Non-Qualified Plan Work?
The contributions made to non-qualified plans are not deductible for the employer. It means that employers must fund non-qualified plans using after-tax dollars. The contributions are also taxable for employees. However, employees can defer taxes until retirement to benefit from a lower tax bracket.
Since employers must use after-tax dollars to fund non-qualified plans, non-qualified plans are only offered to key executives and select senior employees. The advantages of such plans lie in their flexibility. Non-qualified plans do not come with maximum contribution amounts and allow employees and employers to contribute as much as they like.
The major reason such plans are offered to senior executives is to allow them to contribute to another retirement plan after their qualified retirement plan contributions are maxed out. It is reached quickly since senior executives are very well compensated.
Senior executives are subject to much lower maximum contribution limits (as a percentage of their income) due to the Internal Revenue Service (IRS) regulations surrounding highly compensated employees.
Major Types of Non-Qualified Plans
1. Deferred Compensation Plans
Deferred compensation plans include true deferred compensation plans and salary-continuation plans. The goal of both plans is to supplement the retirement income of executives.
The difference between the two plans lies in the funding source. A true-deferred compensation plan simply allows an employee to receive a portion of salary earned during retirement (or a later year) to receive tax benefits. In a salary-continuation plan, the employee continues to receive a lower salary from the employer during retirement.
2. Executive Bonus Plans
Executive bonus plans provide supplemental benefits to select executives and employees. Most commonly, employees under such plans receive a life insurance policy with employer-paid premiums. The expenses are reported as executive bonus compensation and can be treated as tax-deductible by the employer.
3. Group Carve-out Plans
A group carve-out plan provides another life insurance arrangement. The employer carves out the group life insurance of a key executive and replaces it with an individual policy. It allows the employee to avoid excess costs associated with a group plan.
4. Split-dollar Life Insurance Plans
A split-dollar life insurance plan is used when the employer wants to provide a key executive or employee with a new and permanent life insurance policy. Under this plan, the employer purchases a life insurance policy for the employee, and they split the ownership of the policy. Such a type of arrangement tends to be less regulated, and the details of such arrangements may differ depending on the contract and situation.
Non-Qualified Plans vs. Qualified Plans
The main difference between the two types of plans is the tax treatment of contributions. As mentioned earlier, non-qualified plan contributions are not tax-deductible for the employer and must be funded using after-tax dollars. Qualified plans allow employers to treat contributions as tax-deductible and also offer certain tax benefits to employees that non-qualified plans do not.
Another key difference between the two types of plans is participation. Non-qualified plans are only selectively offered to senior executives, while all employees who meet the eligibility criteria must be allowed to participate in qualified plans.
Finally, qualified plans prevent excessive contributions that would favor higher-paid employees by limiting contributions through various caps, rules, and restrictions set by the IRS. Non-qualified plans are not subject to such restrictions and allow employers and employees to contribute as much as they like.
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