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Nonqualified Benefit Plans

What is a Nonqualified Benefit Plan?

Nonqualified benefit plans are executive benefit programs whose primary purpose is to provide supplemental benefits to a company's key executives. The term supplemental refers to additional benefits over and above the benefits provided by the company's qualified benefit plans (retirement, group life insurance, disability).

Nonqualified Deferral Plans (NQDP's) are a particular form of nonqualified benefit plan that permits a company's key executives to defer substantial portions of their compensation, thereby delaying taxation on both the deferral amount, and subsequent growth until the balance is distributed, as long as some basic rules are followed (See ERISA, Constructive Receipt Doctrine, Economic Benefit Doctrine).

Qualified Plan Limitations vs. Nonqualified Plan
Qualified plans are plans that qualify under Section 400 of the IRS Code, and therefore enjoy significant tax advantages for both the employee and employer. Some examples of these advantages are:

  • The employer receives a current tax deduction for contributions to the plan.
  • The employee is not taxed when contributions are made, but only when benefits are received.
  • Plan assets accumulate free of taxes until distributed.
  • Plan assets are secure - they are placed in trust beyond the reach of creditors, providing a high level of security for employees.

However, in exchange for these tax advantages, IRS rules and regulations must be strictly followed. These restrictions have the most severe impact on highly compensated executives. Some of the more restrictive rules are:

Benefits are Limited

  • A qualified Defined Benefit Pension Plan must limit the annual benefit to $160,000 per year (for calendar year 2003).
  • A qualified 401(k) plan may not permit employee deferrals in excess of $12,000 per year (for calendar year 2003), with a maximum combined employee/employer contribution of $40,000 per year (for calendar year 2003). 
  • A qualified plan must limit the amount of compensation when calculating benefits to $200,000 (for calendar year 2003).
  • Qualified plan benefits must be non-discriminatory - there are strict rules with regard to the level of benefits that may be provided to a "highly compensated employee" in relation to the benefit provided to a rank and file employee.

A nonqualified plan has no statutory restrictions on the magnitude of the benefit that may be provided.

Coverage
Qualified plans must comply with strict coverage rules regarding which employees are permitted to enter the plan. For all practical purposes, all company employees are usually made participants in the plan after they meet a basic participation requirement, such as attaining age 21 and completing one year of service.

A nonqualified plan may cover as few as one employee, and generally must cover only a "select group of highly compensated employees" (See ERISA).

Reporting
Qualified plans are required to provide a series of reports to the IRS, Department of Labor (DOL) and the participant. These reports include, but are not limited to: (a) IRS Annual Report (5500), (b) Summary Annual Report to the participant, (c) Summary Plan Description to the participant and the DOL. The labor involved in fulfilling these reporting requirement can be quite intense, and usually requires the services of a third party administrator.

A nonqualified plan has virtually no statutory reporting requirements, other that a short form to be filed with the DOL.

Disadvantages of Nonqualified Plans
While nonqualified plans have no maximum benefit amount and the freedom to pick and choose plan participants, there are some limitations and drawbacks:

  • The employer does not receive a tax deduction for contributions until the year the income is taxable to the covered employee. This can be a substantial number of years.
  • The employee's benefit is not as secure as under a qualified plan. The employee must rely on the employer's unsecured promise to pay the benefits. Placing the assets in trust beyond the reach of creditors would incur adverse taxation (See Rabbi Trusts and Secular Trusts for methods of increased security).
  • Not all companies are suited for a nonqualified plan. Non-profit organizations and governmental organizations are subject to special, highly restrictive rules. Partnership or S Corporation tax structure would not allow for the full benefits of a nonqualified plan.

When is a Nonqualified Plan Indicated?

Restore Lost Benefits
Many executives face the prospect of retiring on an income significantly lower, as a percentage of compensation, than that of the average employee. In part, this happens because the regulations governing qualified retirement plans often favor non-highly compensated employees. An NQDP would be an appropriate tool to restore the lost benefits due to the statutory limitations of a qualified 401(k) plan, to use a common example.

Consider the following comparison between a manager with a current salary of $50,000 and a senior executive with a current salary of $250,000. Both are expected to work 20 more years until retirement at age 65; both are making maximum contributions to their company's 401(k) plan each year. The company matches the deferral at $.50 on the dollar, up to 6% of salary.

Income Source

Manager, age 45

Senior Executive, age 45

Current Salary

$50,000

$250,000

Final Salary at 65

$126,348

$631,738

401(k) Account Value at Retirement (assumes an 8% annual rate of growth)

$743,290

$952,315

Annual Post-Retirement Income from 401(k) Plan

$74,390

$95,231

Post-Retirement Annual Income as Percentage of  Final Salary

59%

15%

As you can see there is quite a disparity in the results. In summary, one could state that qualified plans by themselves appear to be inadequate as a retirement planning tool for highly compensated executives.

Reward or Recruit Key Executives
A nonqualified plan is often used to reward a key executive with a special benefit which is not available to other employees. It may also be effectively used as a recruiting tool to attract talented executives to the company, without offering company equity.

What are the roadblocks to installing a Nonqualified Deferral Plan?

The main objectives of an NQDP are to provide a select group of executives with the ability to defer substantial sums of money while delaying taxation on the deferral and growth. In order to accomplish this, the plan must be designed to prevent current income taxation under:

The plan should also be designed to bypass the severe implications of having to comply with ERISA.

 

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