A nonqualified retirement plan, also known as a nonqualified deferred compensation plan (NQDC), is a type of retirement benefit employers offer to selected executives, too ranking employees, or highly compensated individuals. Unlike qualified retirement plans such as 401(k)s or IRAs, nonqualified plans do not meet specific tax code requirements and are not subject to the same contribution limits or employee protections.
Features of Nonqualified Retirement Plans
Eligibility: Not all employees are qualified for nonqualified retirement plans, rather it’s offered to a few selected of employees, usually high-level executives or key employees. Employers are at liberty to determine the eligibility criteria.
Deferred Compensation: Participants in nonqualified plans can defer a portion of their compensation (e.g., salary, bonuses) into the plan, allowing them to delay receiving taxable income until retirement. The major benefit of deferred compensation is that provides a tax advantage by potentially deferring tax payments until retirement when beneficiaries would be in a lower tax bracket.
Contribution Limits: Unlike qualified plans, nonqualified plans do not have the same contribution limits imposed by the Internal Revenue Service (IRS). Employers and employees have more flexibility in determining the amount of compensation to defer, subject to any company-imposed limits.
Tax Treatment: Contributions to nonqualified plans are not tax-deductible for the employer at the time of contribution, unlike qualified plans. However, the deferred compensation is not included in the participant's taxable income until it is distributed, providing potential tax advantages if the participant's tax rate is lower in retirement.
Vesting and Distribution: Nonqualified plans often have vesting schedules that determine when participants become entitled to the deferred compensation. The plan document will specify the conditions for distribution, such as retirement, termination, disability, or a predetermined date. Upon distribution, the deferred compensation is typically subject to ordinary income tax.
Investment Options: Participants may have some control over the investment options within the nonqualified plan, similar to a qualified retirement plan. The available investment options may vary depending on the plan design.
Risk of Employer Insolvency: It's important to consider the risk of employer insolvency when participating in a nonqualified plan. Since these plans are not subject to the same regulatory protections as qualified plans, participants may be at higher risk of losing their deferred compensation if the employer faces financial difficulties.
Types of Nonqualified Retirement Plans
There are basically four types of Nonqualified Retirement Plans:
- Deferred compensation plan
- Executive bonus plan
- Split-dollar life insurance plan
- Group carved-out plan
Nonqualified retirement plans can be complex, and it is advisable for employees considering such plans to consult with financial advisors or tax professionals to fully understand the implications, risks, and potential benefits of participating in these plans.