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
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 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
- 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.
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).
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
- 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
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.
Manager, age 45
Final Salary at 65
401(k) Account Value
at Retirement (assumes an 8% annual rate of growth)
Income from 401(k) Plan
Annual Income as Percentage of Final Salary
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.