What Is a Nonqualified Plan and How Does It Work?

Nonqualified plans are a specialized category of compensation arrangements employers use to offer deferred income or additional benefits to certain employees. They serve as a flexible tool for attracting, retaining, and incentivizing key talent.

Defining Nonqualified Plans

A nonqualified plan is an employer-sponsored arrangement that falls outside the regulations of the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code (IRC) that apply to qualified plans. These plans are designed for a select group of management or highly compensated employees. Unlike broad-based plans, nonqualified plans do not adhere to the extensive participation, funding, and vesting rules that protect most employees.

Employers offer nonqualified plans to achieve strategic objectives. They are powerful tools for executive retention, providing incentives for key personnel to remain with the company long-term. These plans also offer supplemental retirement income beyond what qualified plans allow, benefiting highly compensated employees who may reach contribution limits in traditional retirement accounts. Their core characteristic is flexibility, allowing customized benefits for specific individuals or small groups, rather than being uniformly applied across the entire workforce.

Distinguishing from Qualified Plans

The primary distinction between qualified and nonqualified plans lies in their adherence to ERISA and IRS regulations. Qualified plans, such as 401(k)s, must comply with ERISA’s stringent requirements concerning participation, funding, vesting, and fiduciary responsibilities, ensuring broad employee coverage and protection. Nonqualified plans are exempt from most of these comprehensive rules.

Qualified plans require IRS approval and must pass non-discrimination testing to ensure they do not disproportionately favor highly compensated employees. In contrast, nonqualified plans are not subject to these non-discrimination rules, allowing employers to offer benefits selectively to a chosen group of executives or key employees. This selective nature is a hallmark of nonqualified arrangements.

Qualified plans have strict contribution limits set annually by the IRS, which can restrict the amount high-earning individuals can save on a tax-deferred basis. Nonqualified plans, however, do not have these statutory contribution limits, enabling greater deferral opportunities for participants. Qualified plans are typically available to a broad base of employees who meet eligibility criteria, while nonqualified plans are specifically designed and offered only to a targeted group of high-earning or key personnel.

Common Nonqualified Plan Structures

Nonqualified plans encompass various structures, each tailored to specific compensation and deferral objectives. One common type is a deferred compensation plan, which allows an employee to postpone receiving a portion of their salary, bonus, or other compensation until a future date, often at retirement or separation from service. This arrangement enables income deferral and can be structured as either true deferred compensation, where the employee defers their own earnings, or a salary continuation plan, where the employer funds the future benefit.

Supplemental Executive Retirement Plans (SERPs) represent another prevalent nonqualified structure. A SERP is an employer’s promise to pay a specified retirement benefit to an executive, typically in addition to the benefits received from qualified retirement plans. These plans aim to provide a more robust retirement income stream for executives.

Excess Benefit Plans are designed to provide benefits to employees that would otherwise exceed the limitations imposed by the Internal Revenue Code on qualified plans. This allows employers to offer a full benefit package without being constrained by the federal caps on qualified plan contributions and payouts. Other nonqualified arrangements include equity-based incentives like Stock Appreciation Rights (SARs) and Phantom Stock. SARs provide a cash payment equal to the appreciation in the value of a company’s stock over a set period, without requiring actual stock ownership, while phantom stock plans provide participants with a hypothetical ownership interest that tracks the value of the company’s shares.

Tax Implications

The tax treatment of nonqualified plans differs significantly from qualified plans for both employers and employees. Generally, employees are not taxed on deferred amounts until the income is “constructively received” or when their right to the funds is no longer subject to a “substantial risk of forfeiture.” This means that income and any earnings grow tax-deferred until a specified payout event occurs, such as retirement or termination.

Constructive receipt occurs when income is made available to an individual without restriction, even if they choose not to take possession of it. A substantial risk of forfeiture exists if the right to receive the compensation is conditioned upon the performance of substantial future services or the occurrence of a condition related to the purpose of the compensation. When this risk lapses, the deferred compensation may become taxable, even if not yet received.

For employers, contributions or deferred amounts in nonqualified plans are generally not tax-deductible until the employee includes the income in their taxable income. This contrasts with qualified plans, where employer contributions are typically deductible when made. Regarding payroll taxes, specifically Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) taxes, special rules apply to deferred compensation. These taxes often apply at the later of when the services are performed or when the employee’s right to the deferred amounts vests, which can be before the income tax is due.

Funding and Security Considerations

Nonqualified plans are typically “unfunded” from the employee’s perspective to achieve tax deferral. This means that the assets intended to pay future benefits remain part of the employer’s general assets and are subject to the claims of the employer’s general creditors. While an employer might informally set aside assets, these assets are not legally separated from the company’s other holdings.

To informally secure these future obligations without triggering immediate taxation for the employee, employers often use a “rabbi trust.” A rabbi trust is an irrevocable trust established by the employer to hold assets to pay nonqualified plan benefits. Crucially, the assets in a rabbi trust are still subject to the claims of the employer’s general creditors in the event of bankruptcy or insolvency. This arrangement helps employees feel more secure that funds are earmarked, but it does not fully protect the assets from the employer’s financial distress.

An alternative, though less common for tax deferral, is a “secular trust.” Unlike a rabbi trust, assets in a secular trust are typically beyond the reach of the employer’s creditors, providing greater security for the employee. However, this increased security usually results in immediate taxation of the contributions to the employee, eliminating the benefit of tax deferral. In most unfunded nonqualified plans, the employee assumes the credit risk of the employer, meaning their ability to receive deferred benefits depends on the company’s continued financial solvency.