Understanding Non-Qualified Retirement Plans & What They Bring

Non-qualified retirement plans offer an additional layer of financial security for select employees, primarily executives and high earners, who need more flexibility than traditional retirement plans provide. But before putting your money into a non-qualified plan, you must understand what it is first.

What is a non-qualified retirement plan?

Non-qualified retirement plans are savings plans offered by employers that don’t follow the same rules as ERISA or IRS guidelines for qualified plans like 401(k)s. These plans are set up to provide additional retirement benefits beyond the usual contribution limits and rules. They’re designed for top-level employees and executives, giving them a chance to save more for retirement without the restrictions of qualified plans.

Non-qualified plans on w-2: Understanding the reporting

When reporting non-qualified retirement plans, the details usually show up on the employee’s W-2 form. Distributions from these plans are listed in Box 11. This is different from qualified plans, which have their own reporting rules. For employees with non-qualified plans, the W-2 clearly shows the income and taxes related to these plans.

Types of non-qualified retirement plans

Several types of non-qualified retirement plans are designed for high-income employees. Here’s a look at some common examples:

1. Deferred Compensation Plans: These plans let employees postpone a part of their income to receive it later, often during retirement. The income isn’t taxed until it’s received. Examples include Supplemental Executive Retirement Plans (SERPs) and 457(b) plans. They help employees manage their taxes by delaying income until they might be in a lower tax bracket.
2. Executive Bonus Plans: In this setup, an employer gives a bonus that is used to buy a life insurance policy for the executive. The executive owns the policy, and the bonus is taxed as income. The policy’s cash value and death benefits are available to the employee, while the employer can deduct the premium costs as a business expense.
3. Split-Dollar Life Insurance Plans: These plans share the costs and benefits of a life insurance policy between the employer and employee. The employer pays the premiums, and when the employee passes away, the employer gets back its share of the policy’s value, while the rest goes to the employee’s beneficiaries.
4. Group Carve-Out Plans: These plans replace part of an employee’s group life insurance with an individual policy to provide extra coverage. This helps employees avoid tax issues on group life insurance coverage over $50,000.

Non-qualified retirement plans tax treatment

The tax treatment of non-qualified retirement plans can be complex and varies based on the specific plan type. Here’s a breakdown of how taxes typically work:

• Deferred Compensation Plans: Taxes on deferred income are not applied until the money is distributed, usually during retirement. This deferral allows employees to potentially lower their overall tax burden if they retire in a lower tax bracket. However, Social Security and Medicare taxes are due in the year the income is earned.
• Executive Bonus Plans: The bonus paid to fund the insurance policy is taxable income to the employee. The employer can deduct the cost of the premiums, but the employee must pay taxes on the bonus amount.
• Split-Dollar Life Insurance Plans: Tax implications depend on the specifics of the plan. Generally, the premiums paid by the employer are considered taxable income to the employee. The employee also needs to consider the tax consequences of receiving the death benefit.
• Group Carve-Out Plans: The replacement of group insurance with individual policies can help manage tax issues related to excess group coverage, often allowing for more flexible tax treatment of the insurance benefits.

How non-qualified plans differ from qualified plans

• Contribution Limits: Qualified retirement plans, like 401(k)s and IRAs, have annual limits on how much you can contribute. For instance, in 2024, you can only put up to $23,000 into a 401(k). Non-qualified plans don’t have these limits, so high earners can save much more for retirement.
• Tax Treatment: With qualified plans, you get immediate tax benefits. Your investments grow tax-deferred, and you may be able to deduct your contributions. Non-qualified plans don’t offer these upfront deductions. Instead, they let you defer taxes on the earnings until you take the money out. This can be beneficial if you expect to be in a lower tax bracket when you retire.
• ERISA Protection: Qualified plans are protected by ERISA, which provides a lot of safeguards for employees, including ensuring that benefits are secure. Non-qualified plans don’t have this protection, so they might be riskier if your employer runs into financial trouble.
• Discrimination Testing: Qualified plans must pass tests to make sure they don’t unfairly favor high earners over lower-paid employees. Non-qualified plans don’t need to pass these tests, which lets employers design them specifically for top executives and key staff without worrying about balance across all employees.
• Portability: When you change jobs, qualified plans often allow you to roll over your retirement savings into a new employer’s plan or an IRA. Non-qualified plans usually can’t be transferred, so you can’t take these benefits with you if you leave the company.

Advantages and drawbacks of non-qualified retirement plans

Advantages

• Higher Contribution Limits: Non-qualified plans offer the benefit of no contribution limits, unlike qualified plans that cap how much you can contribute annually. This flexibility allows high earners to save more towards retirement.
• Customizable Design: These plans can be tailored to fit the specific needs of executives and high-level employees, offering greater flexibility in how retirement benefits are structured and distributed.
• No Mandatory Distributions: Non-qualified plans typically do not require mandatory distributions at a certain age, allowing employees to keep their savings invested for a longer period.

Drawbacks

• Lack of ERISA Protection: Unlike qualified plans, non-qualified plans are not protected under ERISA. This means employees have fewer protections if the employer faces financial difficulties or bankruptcy.
• Tax Consequences: Contributions to non-qualified plans are often made with after-tax dollars and may not offer the same upfront tax benefits as qualified plans. Taxes are deferred until the funds are withdrawn.
• Non-Portability: Non-qualified plans are generally not portable, meaning employees cannot roll over the funds if they leave the company. This can be a significant disadvantage for those who change jobs frequently.

Making the most of non-qualified retirement plans

For employers, non-qualified retirement plans are a great way to attract and keep top talent. A lot of flexibility is offered, allowing customization to meet the needs of high-earning employees. But both employers and employees need to understand the tax impacts and details of these plans before jumping in.

Employees should think about how these plans fit into their overall retirement plans and talk to financial advisors to make sure they’re getting the most out of their non-qualified retirement benefits.

Navigating the future with non-qualified plans

Non-qualified retirement plans are a great choice for high-earning employees who need more flexibility than what qualified plans provide. Understanding the different types of non-qualified plans is important for making smart decisions. Whether you’re an employer aiming to attract top talent or an employee looking for extra ways to save for retirement, non-qualified plans can be a useful part of your financial strategy.