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.

What Is the Core Tradeoff Between Qualified and Nonqualified Plans?

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

How Does a 457(b) Deferred Compensation Plan Work?

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; unlike most nonqualified plans, assets must be held in trust for participants and are not exposed to the employer's general creditors
• Non-governmental 457(b): Certain highly compensated employees of tax-exempt organizations; benefits remain unsecured promises subject to the employer's creditors, like other nonqualified plans

Contribution limits:

• Same base deferral limit as 401(k): $24,500 for 2026
• Age-based catch-up contributions ($32,500 if age 50+, or $35,750 if age 60-63) are available to governmental 457(b) plans, if the plan permits them; non-governmental 457(b) plans generally do not offer this age-based catch-up (though they may allow a separate "final three years" catch-up)
• Traditional 457(b) deferrals are pre-tax, taxed at distribution; governmental 457(b) plans may also offer a designated Roth option (after-tax, tax-free qualified distributions)

Unique feature 1: No early withdrawal penalty

• 457(b) plans do not impose a 10% early withdrawal penalty on regular deferrals, regardless of age
• Once separated from service, distributions can generally 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
• Exception: amounts a 457(b) received as a rollover from a qualified plan, 403(b), or IRA keep the 10% penalty exposure of their source account

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 $24,500 into a 403(b) AND $24,500 into a 457(b), totaling $49,000 in employee deferrals in 2026

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.

How Does an Executive Bonus Plan Work?

An executive bonus plan is a simple nonqualified arrangement where the employer pays for a life insurance policy on behalf of a key employee. The arrangement relies on the ordinary-and-necessary-business-expense deduction available to employers under the Internal Revenue Code.

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 an ordinary-and-necessary business expense under the Internal Revenue Code

Key characteristics:

• No IRS approval required
• Simple to implement: No plan qualification approval or ERISA-style plan documents/trust arrangements are required (the bonus itself is still reported on the employee's W-2, like any other compensation)
• 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.

What Other Rules Apply to Nonqualified Plans?

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.

What Should You Check on Exam Day?

• 457(b) base deferral limit matches 401(k)/403(b) ($24,500 in 2026); the age-based catch-up (up to $35,750 for ages 60-63) generally applies only to governmental 457(b) plans, but the base limit is a separate limit from 401(k)/403(b), enabling double deferrals
• 457(b) plans have no 10% early withdrawal penalty on regular deferrals, at any age (rolled-in amounts from other plan types keep their source penalty exposure)
• Nonqualified plan benefits are unsecured promises exposed to the employer's creditors, unlike qualified-plan trust assets
• Executive bonus plans give the employer an immediate tax deduction and make the bonus currently taxable to the employee
• Constructive receipt and economic benefit doctrines determine when nonqualified deferred compensation is taxed
• Nonqualified plans can discriminate in favor of highly compensated employees; qualified plans cannot