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Nonqualified Deferral Plans

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The Nonqualified Deferral Plan (NQDP) is one of the most popular nonqualified benefits offered to company executives today. The main reason for its popularity is the ever-growing popularity of qualified 401(k) plans. Since the early 1990's, 401(k) plans have become a standard benefit in most businesses for the following reasons:


oEmployees participate in accumulating funds for their own retirement, thereby reducing the moral and financial burden on the employer.

o401(k) plans allow employees to actively participate in the equity market.

o401(k) plans are easy to understand.


Most NQDP's (but not all) follow the format of a qualified 401(k) plan. These plans allow key executives to defer a significant portion of their compensation, over and above the dollar limit set for elective deferrals under a qualified 401(k) plan, and allocate it across a set of hypothetical investments.


The terms hypothetical investment or phantom investment are used because the executive's contributions are not actually invested in the funds shown on the participant statement. In fact, the contributions remain the property of the company (or a trust). Due to tax and legal restrictions (see ERISA, Constructive Receipt Doctrine, Economic Benefit Doctrine), the plan document is structured so that the contributions invested will be paid to the executive, along with investment earnings, as if such contributions were actually invested in the funds selected. In other words, the company is obligated to pay the hypothetical accumulated amounts to the executive, but must have the freedom to invest the contributions at their discretion, possibly not investing them at all. Please refer to Designing a Plan and Funding a Plan for a more detailed explanation.


Some NQDP's will allow large deferrals, but will not offer a variety of investments. For simplicity, these plans will credit a rate of interest, usually based on the performance of an outside index, to deferral account balances.


Irrespective of the investment crediting method, NQDP's generally take one of three forms:


401(k) Mirror Plan


A 401(k) mirror plan is set up to look and feel just like the company's qualified 401(k) plan. Key executives will be invited to participate in a plan that allows the same investment options as the qualified 401(k) plan. These plans mirror the features of the qualified plan with respect to options such as changing elections and transferring balances.


401(k) Excess Plan


Also known as an overlay plan, this type of plan allows the executives to allocate deferrals to the NQDP, over and above their maximum contribution to the qualified 401(k) plan. The range of hypothetical investment options may be as broad as the mirror plan, or limited to a basic interest rate crediting. The key here is that the excess plan is coordinated with the qualified 401(k) plan.


A common coordination is to deny the right to make contributions to the NQDP plan until the executive has made the maximum elective deferrals under the qualified 401(k) plan. The IRS has ruled favorably on this type of coordination.


401(k) Wraparound Plan


Another type of coordination involves the restrictions applicable to qualified 401(k) plans. As stated above, an executive may not defer more than a statutory dollar amount into a 401(k) plan each year. However, the maximum amount may be less in any particular year, if the 401(k) plan violates the statutory ADP (Actual Deferral Percentage) test. In essence, this test is a discrimination test which is designed to limit the extent to which elective contributions of highly compensated employees exceed those of lower paid employees.


The coordination works as follows: The executive defers a specified percentage of compensation under the NQDP plan, and specifies that from this deferred amount, the maximum contribution would be made to the qualified 401(k) plan, after the 401(k) ADP testing is completed.


Typical Plan Structure


Flexibility is the operative term when it comes to structuring an NQDP.


Deferrable Compensation


The majority of plans will permit the deferral of a portion of the participant's base salary. Many plans also permit the deferral of a portion of bonus compensation, and other compensation components, such as director's fees, retainers, etc.




Most plans will offer a choice of accounts for investment of deferrals. The accounts will be earmarked for variety of purposes, such as:


oA retirement account for retirement savings.

oA post-retirement medical account for accumulating funds for health insurance after retirement.

oAn education account to accumulate funds for dependents' education.


An account is a repository, or container for investments. Each account may contain a variety of investments - basically, any of the investments that the plan makes available (stocks, bonds, insurance, mutual funds, etc.).


oA participant may elect to split his deferral across the accounts in any proportion desired.

oEach account may or may not contain matching contributions (i.e., the employer will match a portion of the participant's deferrals), with its own vesting schedule.

oThe participant may choose the same or different investments for each account.

oEach Account will have its own distribution options (time and method of payout).


Investment Options


Most plans offer a variety of investment options, with the majority of plans offering investments that mirror the return of the company's 401(k) investment options. A number of plans simply offer a competitive interest rate credit on the participant's deferral (i.e., Moody's Corporate Bond Index Rate + 5%).


Money Management


A plan that offers more than one investment choice will generally allow the participant to manage their account(s) by permitting the transfer of balances from one investment to another.


Distribution Options


The participant may select the time and method of payment for each year's deferral election, from a list of available choices for each applicable event, such as retirement, death, or in-service withdrawal. For example, a plan will generally allow funds to be distributed upon retirement to be paid out in lump sum, or as annual installments over 5, 10, or 15 years. In-service withdrawals could be paid out in four installments (i.e., funds for a child's education).


What is Needed to Set Up a Plan


Please refer to the Implementing a Plan page for additional information and sample forms. Implementation of a plan requires the following:


Sponsor - The plan needs an official sponsor. The sponsor is the employer.


Agreement - The plan needs an agreement. This will be the plan document, which will outline the specifics of the plan design, including:


oPlan purpose


oPlan benefits

oParticipant rights

oSponsor and Employer obligations

oThe choice of hypothetical investments available to participants

oHow earnings are credited to a participant's account


Trust - The sponsor may desire to set up a trust. The sponsor establishes the trust as a vehicle to accumulate assets to support the payment of benefit obligations under the plan. The trust receives contributions, makes investments, and makes distributions according to the terms of the plan.


One form of trust, a Rabbi Trust, protects plan participants from being denied payment due to a change in management or hostile takeover. Another form of trust, a Secular Trust , will further secure the benefits for the participant, but will potentially result in some undesirable tax consequences.


Department of Labor (DOL) Letter - A letter must be filed with the Department of Labor within 120 days of establishing the plan.


Announcement Letter - potential participants must be informed of the benefits of joining the plan.


Election Form and Beneficiary Form - Each potential participant must complete a form which will state the amount of the deferral to be made, along with a selection of desired investment options, and the time and form of distribution. The participant may also elect a beneficiary or beneficiaries, who will receive the participant's account balances upon his death.


Insurance Consent Form - If life insurance is to be used as an informal funding vehicle, then the consent form must be completed. This form will give permission to the sponsor to purchase life insurance on the life of a plan participant.


Administrative Services - NQDP plans require sophisticated systems to record and track the activity of the participants' deferral account balances. Such activities might include:


oAllocation of participant contributions across investments

oTransfer of funds from one investment to another

oDistribution processing

oGeneration of benefit statements and management reports



The information contained on this Site is general in nature and should not be considered legal, tax or investment advice. This information is provided for general educational purposes in connection with your use of our site and services. The facts of your particular situation, and developments in applicable laws, rules and regulations or the interpretation thereof, may affect the information as it pertains to you. You should consult with your attorney or tax advisor regarding your specific legal or tax situation and with your investment advisor regarding the risks and advisability of sponsoring or participating in a nonqualified plan.

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