Integrating a nonqualified plan with a current 401(k) plan can assist an employer in resolving potential compliance testing issues and prevent testing failures, while allowing highly compensated employees (“HCEs”) to maximize their retirement savings. Adding a nonqualified plan also helps companies maintain a competitive benefit package that can recruit, reward, retain and retire key talent.
Unlike with a qualified plan, such as a 401(k) program, a nonqualified plan permits an employer to select which employees can participate. By doing so, an employer can make a nonqualified plan available for a select group of top executives, owners or key talent. Since the Department of Labor has not published definitions or any clarifying details of what constitutes the groups an employer can select to participate in a nonqualified plan, each employer can generally set the criteria. The benefit planning experts at the Cowart Group help employers establish the requirements of who can participate.
How Does a Nonqualified Plan Work?
The contributions made to nonqualified plans are not deductible for the employer. It means that employers must fund nonqualified plans using after-tax dollars. The contributions are also taxable for employees. However, participants can defer taxes until retirement and potentially benefit from receiving payments in a lower tax bracket. In addition, an employer can ‘gross up’ nonqualified plan contributions to cover immediate taxation, if any.
Since employers must use after-tax dollars to fund non-qualified plans, nonqualified plans are only offered to key executives, select senior employees and owners. The advantages of such plans lie in their flexibility. Nonqualified 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 talent is to allow them to contribute to another retirement plan after their qualified retirement plan contributions are maxed out – or if they can participate at all due to qualified plan compliance testing. The Cowart Group’s benefit team can calculate the shortfall from an employer’s qualified plan and explain how a nonqualified plan can fill this gap and provide the additional retirement income a HCE will need.
Major Types of Non-Qualified Plans
Supplemental Executive Retirement Plan (SERP)
In a SERP, the employer agrees to pay a certain sum to the employee in the future. Typically, during the annual open enrollment period, the executive can choose when and how to receive the following year’s SERP benefit – before retirement, after retirement, in a lump sum, or in a series of payments. The employer can decide the extent of the flexibility of the deferral and payout period and include restrictions on the benefit amount and qualifications to receive it.
Most companies choose to fund their SERP plans with cash value life insurance due to the tax benefits, ability to have liquidity for a lump-sum payment in the case of a death of the plan participant and the ability to re-coup a portion of or all of the costs of a SERP via a policy’s death benefit.
Deferred Compensation Plan
Similar to a SERP plan but instead of the annual benefit being offered by the employer, the employee is given an option to defer their compensation. The employer may also elect to match a part of or all of the employee’s deferral. As with the SERP, the deferral will grow tax-free and, at the employer’s choosing, the growth rate could be linked to a fixed rate, tied to a market index, tied to company performance or be based on any number of formulas. Restrictions to a deferred compensation plan are generally reserved for the employer’s contribution, if any. Companies generally elect to fund deferred compensation plans in the same manner as with SERP – using cash value life insurance.
Restricted Executive Bonus Arrangement (REBA)
In a REBA, selected employees are bonused money to pay for a cash value life insurance policy that the employee owns. Structurally, the policy is ‘maximum funded’ to keep insurance costs low while growing the policy’s cash value tax-free. In the future, the employee can access the policy’s cash value in the form of tax-free withdrawals and loans.
The employer may choose to gross up the bonus amount to cover an employee’s taxes on the bonus. In order to retain and incentivize a REBA participant, the employer places a restrictive endorsement on the plan, restricting the employee’s access to cash value for a period of time while encouraging performance and long-term employment in order to obtain additional bonuses.
Nonqualified Plans vs. Qualified Plans
The main difference between the two types of plans is the tax treatment of contributions. As noted, nonqualified 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 offer certain tax benefits to employees that nonqualified plans do not.
Another key difference between the two types of plans is participation. Non-qualified plans are only selectively offered to senior executives, owners and other key talent 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. Nonqualified plans are not subject to such restrictions and allow employers and employees to contribute as much as they like.
Qualified plans penalize participates for receiving a benefit before age 59 ½. Conversely, those with a nonqualified plan are not age-restricted when it comes to receiving plan benefits.
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