Nonqualified Retirement Plans

Qualified plans offer great tax benefits but require employers to treat all employees equally. Nonqualified plans sacrifice some tax advantages in exchange for flexibility, allowing employers to selectively benefit key executives and highly compensated employees.

Qualified vs. Nonqualified: The Core Tradeoff

The creditor risk is the critical distinction: in a nonqualified plan, if the employer goes bankrupt, the employee's promised benefits may be lost.

457(b) Deferred Compensation Plans

The 457(b) plan is a deferred compensation plan available to government and nonprofit employees. It has two key features that set it apart from every other retirement plan.

Who is eligible:

• Governmental 457(b): State and local government employees
• Non-governmental 457(b): Certain highly compensated employees of tax-exempt organizations

Contribution limits:

• Same deferral limit as 401(k): $23,000 ($30,500 if age 50+) for 2024
• Employee deferrals are pre-tax; taxed at distribution

Unique feature 1: No early withdrawal penalty

• 457(b) plans do not impose a 10% early withdrawal penalty, regardless of age
• Once separated from service, distributions can be taken at any age without penalty
• This is a major distinction from 401(k) and 403(b) plans, which penalize withdrawals before age 59 1/2

Unique feature 2: Separate contribution limit (double deferrals)

• 457(b) deferral limits are separate from 401(k)/403(b) limits
• An employee eligible for both a 457(b) and a 403(b) can contribute the maximum to each
• Example: A government employee could defer $23,000 into a 403(b) AND $23,000 into a 457(b), totaling $46,000 in employee deferrals in 2024

Exam Tip: Gotchas

• 457(b) plans have no early withdrawal penalty. If a question describes someone leaving their job before age 59 1/2 and accessing retirement funds without penalty, the answer is a 457(b) plan.
• 457(b) limits are completely independent of 401(k)/403(b) limits. An eligible employee can contribute the maximum to both, effectively doubling their annual tax-deferred savings.

Executive Bonus Plans (Section 162 Plans)

An executive bonus plan (also called a Section 162 plan) is a simple nonqualified arrangement where the employer pays for a life insurance policy on behalf of a key employee.

How it works:

• The employer pays the premium on a life insurance policy owned by the executive
• The premium payment is treated as a bonus to the employee
• The bonus is taxable income to the employee (reported on their W-2)
• The employer deducts the bonus as a business expense under Internal Revenue Code (IRC) Section 162

Key characteristics:

• No IRS approval required
• Simple to implement: No plan documents, trust arrangements, or government filings
• The employer can select which employees participate (discrimination is permitted)
• The executive owns the policy and names their own beneficiaries

Exam Tip: Gotchas

• Executive bonus plans give the employer an immediate tax deduction. This is unlike most nonqualified arrangements, where the employer's deduction is deferred until the employee receives the benefit.
• The bonus is currently taxable to the employee. This is the opposite of standard nonqualified deferred compensation, where neither party recognizes income or a deduction until benefits are paid.

Other Nonqualified Plan Features

Beyond 457(b) and executive bonus plans, nonqualified plans share several important characteristics:

• Unsecured promise to pay: Benefits are backed only by the employer's general assets. If the employer becomes insolvent, plan participants are general creditors with no priority
• Constructive receipt doctrine: The employee is not taxed until benefits are actually received or made available without substantial restrictions
• Economic benefit doctrine: If the employee has a current economic benefit (such as employer-funded insurance), tax may be owed even before distribution
• Employer tax timing: The employer does not get a tax deduction until the employee recognizes income (unlike qualified plans, where the deduction is immediate)

Exam Tip: Gotchas

• Nonqualified plan benefits are unsecured promises. If a question asks what happens to deferred compensation when an employer goes bankrupt, the answer is that participants become general creditors with no priority.
• Constructive receipt determines when tax is owed. Benefits are not taxed until actually received or made available without substantial restrictions.