Non-Qualified Plan: Definition, How It Works, and 4 Major Types

What Is a Nonqualified Plan?

A nonqualified plan is a type of tax-deferred, employer-sponsored retirement plan that falls outside of Employee Retirement Income Security Act (ERISA) guidelines. Nonqualified plans are designed to meet specialized retirement needs for key executives and other select employees and can act as recruitment or employee retention tools. These plans are also exempt from the discriminatory and top-heavy testing that qualified plans are subject to.

How a Nonqualified Plan Works

There are four major types of nonqualified plans:

• Deferred-compensation plans
• Executive bonus plans
• Split-dollar life insurance plans
• Group carve-out plans

The contributions made to these types of plans are usually nondeductible to the employer and taxable to the employee.

However, they allow employees to defer taxes until retirement (when they presumably will be in a lower tax bracket). Nonqualified plans are often used to provide specialized forms of compensation to key executives or employees instead of making them partners or part owners in a company or corporation.

One of the other major goals of a nonqualified plan is to allow highly compensated employees to contribute to another retirement plan after their qualified retirement plan contributions have been maxed out, which usually happens quickly given their level of compensation.

Deferred Compensation as a Nonqualified Plan

There are two types of deferred compensation plans: true deferred compensation plans and salary-continuation plans. Both plans are designed to provide executives with supplemental retirement income. The primary difference between the two is in the funding source. With a true deferred compensation plan, the executive defers a portion of their income, which is often bonus income.

With a salary-continuation plan, the employer funds the future retirement benefit on the executive's behalf. Both plans allow for the earnings to accumulate tax-deferred until retirement when the Internal Revenue Service (IRS) will tax the income received as if it were ordinary income.

Other Plans

Nonqualified Plan: Executive Bonus Plan 

Executive bonus plans are straightforward. A company issues an executive a life insurance policy with employer-paid premiums as a bonus. Premium payments are considered compensation and are deductible by the employer. The bonus payments are taxable to the executive. In some cases, the employer may pay a bonus over the premium amount to cover the executive’s taxes.

Nonqualified Plan: Split-Dollar Plan

A split-dollar plan is used when an employer wants to provide a key employee with a permanent life insurance policy. Under this arrangement, an employer purchases a policy on the employee's life, and the employer and the employee divide ownership of the policy.

The employee may be responsible for paying the mortality cost, while the employer pays the balance of the premium. At death, the employee’s beneficiaries receive the main portion of the death benefit, while the employer receives a portion equal to its investment in the plan.

Nonqualified Plan: Group Carve-Out 

A group carve-out plan is another life insurance arrangement in which the employer carves out a key employee’s group life insurance over $50,000 and replaces it with an individual policy. This allows the key employee to avoid the imputed income on group life insurance above $50,000. The employer redirects the premium it would have paid on the excess group life insurance to the individual policy owned by the employee.

Example of a Nonqualified Plan

Consider a high-paid executive working in the financial industry who contributes the maximum to their 401(k), and is looking for additional ways to save for retirement. At the same time, their employer offers nonqualified deferred compensation plans to executives. This allows the executive to defer a greater part of their compensation, along with taxes on this money, into this plan. 

Often, employers and executives will agree on a set period that the income will be deferred, which could be anywhere from five years up until retirement. Ultimately, the deferred income has the ability to grow tax-deferred until it is distributed. These deferral amounts may change from year to year, depending on the agreement between the executive and employer.