Understanding Nonqualified Deferred Compensation Plans

Nonqualified plans are employer-sponsored plans designed to benefit a select group of management or key employees. In a properly structured plan, the employer can include those employees it chooses without having to abide by any anti-discrimination, participation or vesting rules that all qualified plans must follow.

Nondiscrimination rules require that qualified plans benefit most employees on a generally equal basis. These rules do not apply to nonqualified plans. In fact, the participants must be limited to a select group of management or key employees or the plan may become subject to the rules of a governing qualified plan. As an owner, you can target benefits to yourself and key employees without making similar contributions for the rest of your work force. This in turn makes nonqualified plans more flexible than qualified plans. Depending on your company’s circumstances, nonqualified plans may effectively meet your specific compensation needs.

Nonqualified plans are often used to make up for qualified benefit shortfalls for a select group without having to provide all employees the same supplemental benefits. You may also establish more than one such plan and provide different plan designs and benefit amounts to different employees. The amount of benefits provided is not subject to specific restrictions. Instead, the amounts, as a part of total compensation, must be generally reasonable. Vesting distributions and other plan provisions need not conform to the usual qualified plan standards.

The benefits of a nonqualified plan can include the following:

  • Reversing the “Reverse Discrimination” of qualified benefits

  • Recruiting new executives

  • Rewarding valuable executives

  • Retaining valuable key executives

  • Retirement incentivizing tool

Primary Advantages:

  • More design flexibility than qualified retirement plans

  • Unlimited participant contributions (pre-tax)

  • Corporate contributions can create a retention “hook”

  • Ability to motivate executives through a performance-based company contribution

  • Employee/employer contributions, plus growth, are tax-deductible when paid

Primary Disadvantages:

  • Employee deferrals and corporate contributions are not tax deductible until paid

  • Top Hat rules apply to eligibility in an employer/employee relationship

  • Participants are general creditors and subject to a substantial risk of forfeiture

Common Examples:

  • A Split Dollar Endorsement Plan is a nonqualified plan whereby the owner of the BOLI/COLI policy agrees to allow the insured to designate a beneficiary to receive a portion of the death proceeds.

  • A Supplemental Executive Retirement Plan (SERP) is a nonqualified benefit plan financed by employer dollars that provides key executives with additional retirement income. The payment is often designed to allow the executive to retire with a certain percentage of their final salary. The executive has no option to receive any employer contributions as current compensation. The executive cannot defer any funds toward the retirement obligation.

    A SERP is generally designed to favor the employer since it is financed entirely with employer dollars. The executive’s right to any benefits under the plan is normally restricted through the use of vesting or requiring a set period of service or employment until retirement. These restrictions are often known as “golden handcuffs”.

    SERPs are usually designed as either a Defined Benefit or Defined Contribution Plan.

  • A Pre-tax Compensation Deferral Plan is a nonqualified plan that allows a company to provide a means for its highly compensated employees to postpone current income to a future date. The concept is similar to that of a 401(k) plan in that employees elect an amount of their current income they would like to defer into an account for future use, and an account is created in the employee’s name with interest credited based upon the plan design. However, there are some major differences. With a Pre-tax Compensation Deferral Plan, the company is not subject to requirements for “qualified” plans such as minimum contributions for all employees with two years of service, lower benefits for highly compensated employees and higher tax penalties on distribution to employees.

    A Pre-tax Compensation Deferral Plan allows a company to design a plan for their highly compensated employees that is customized to meet their specific needs.