Nonqualified Retirement Plans
Nonqualified plans do NOT meet Internal Revenue Code (IRC) Section 401(a) requirements and do NOT receive favorable tax treatment upfront. They are used primarily for highly compensated employees and executives (no nondiscrimination rules). They are not subject to the Employee Retirement Income Security Act (ERISA) in most cases (no funding, vesting, or reporting requirements).
Think of it this way: Qualified plans follow strict government rules in exchange for tax benefits and legal protections. Nonqualified plans skip those rules, giving employers total flexibility on who gets benefits and how much, but the trade-off is that participants have no safety net if the company fails.
Qualified vs Nonqualified Comparison
| Feature | Qualified Plan | Nonqualified Plan |
|---|---|---|
| IRS approval required | Yes | No |
| Tax deduction for employer | When contributed | When paid to employee |
| Tax on employee | Deferred until distribution | Deferred until received |
| Nondiscrimination rules | Yes (must cover broad group) | No (can be selective) |
| ERISA coverage | Yes | Generally no |
| Creditor protection | Yes (ERISA-protected) | No (general assets of employer) |
| Contribution limits | Yes (IRC limits) | No |
| Portability (rollover) | Yes | No |
Exam Tip: Gotchas
- Nonqualified plans can discriminate. They can provide benefits only to key employees. This is their main advantage and their main purpose.
- The employer gets NO tax deduction until benefits are actually paid. With qualified plans, the deduction is immediate when contributions are made.
- Nonqualified plans are NOT portable. They cannot be rolled over to an IRA or another plan.
Types of Nonqualified Plans
- Deferred compensation plans: Executive agrees to defer a portion of salary to a future date; taxed when received
- Supplemental Executive Retirement Plans (SERPs): Employer-funded plans providing additional retirement benefits to select executives
- Excess benefit plans: Provide benefits that exceed the limits imposed on qualified plans
Creditor Risk and Trusts
Plan assets remain the employer's general assets, subject to claims of the employer's general creditors in bankruptcy. This is the defining risk of ALL nonqualified plans and the most frequently tested concept.
- Rabbi trust: Assets set aside in a trust for deferred compensation, but remain subject to employer's creditors (named after the first IRS ruling involving a rabbi's congregation)
- Secular trust: Assets are protected from employer's creditors, but employee is taxed immediately on contributions
Exam Tip: Gotchas
- The critical distinction is creditor protection. Qualified plan assets are PROTECTED from creditors under ERISA. Nonqualified plan assets are the employer's GENERAL ASSETS and are subject to creditors' claims in bankruptcy.
- A rabbi trust does NOT protect against employer bankruptcy. Despite holding assets in a trust, those assets remain available to the company's general creditors.
- An executive with a $2 million deferred compensation balance could lose it all if the company goes bankrupt. This is the "golden handcuffs" concept: it incentivizes the executive to stay and ensure the company succeeds.
Supplemental Executive Retirement Plans (SERPs)
- Employer-funded plans providing additional retirement benefits to select executives
- Company promises a specific future benefit (often a percentage of final salary)
- No contribution limits
- No ERISA coverage; no Pension Benefit Guaranty Corporation (PBGC) insurance
- Unfunded or informally funded; executive is an unsecured general creditor
- Company deducts when paid; executive recognizes income when received
Exam Tip: Gotchas
- SERP is supplemental; it goes on top of a qualified plan, not instead of one. "Supplemental" is in the name.
- SERPs have no PBGC insurance. Unlike qualified defined benefit plans, if the company fails, the executive has no backstop.