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Most of us are familiar with 401(k)s, which is a type of qualified retirement plan. But to attract and retain key employees and senior management, employers sometimes offer nonqualified retirement plans designed for high-earning executives. These plans don't follow Employee Retirement Income Security Act (ERISA) guidelines and offer many opportunities for customization as a result, but can also pose some extra risks. Here's what you should know if you're offered a nonqualified retirement plan.
How Nonqualified Retirement Plans Work
Experts advise putting 15% of your pretax income into a retirement plan each year. But IRS limits on contributions to qualified retirement plans can make it difficult for high-income individuals to meet this goal.
Using the 15% guidelines, an executive making $500,000 annually should be saving $75,000 per year for retirement. However, for 2022, the maximum contribution to 401(k) and 403(b) retirement accounts is $20,500—4.1% of the executive's income.
Nonqualified retirement plans, which aren't subject to these contribution limits, allow highly paid employees to save more for retirement. Employers can set up a nonqualified retirement plan that applies to all their executives or can tailor individual contracts to the needs of each executive. Although the options for nonqualified retirement plans are almost endless, the plans generally fall into four types:
- Deferred-compensation plans: These plans allow employees to defer compensation (including salary and bonuses) until an agreed-upon later date and pay taxes on the money then. Typically, compensation is deferred until retirement, when you're generally in a lower tax bracket than during your working years. However, some plans let you defer compensation to another date, such as when you expect a child to start college. Distributions can usually be taken either as a lump sum or in installments.
- Executive bonus plans: The employer pays the premiums on a permanent life insurance policy for the employee. The employee owns the policy and chooses the beneficiary. As the policy's cash value grows, the employee can typically borrow against or withdraw it. The cost of premiums is tax-deductible for the employer; employees pay taxes on the bonus.
- Split-dollar life insurance plans: These split the premiums, death benefits and cash value of a permanent life insurance policy between the employer and the employee. Although these plans can be set up in many ways, traditionally the employer pays the portion of the premiums equal to the policy's cash value, and the employee pays the rest.
- Group carve-out plans: Employers often offer employees group term life insurance as a benefit and pay for a certain amount of coverage. Group carve-out plans give key executives $50,000 in group term life insurance (the maximum allowable before it must be reported on the employee's taxes) plus a permanent life insurance policy. The employer pays the premiums on both policies. Group life insurance terminates with employment, but employees can keep the permanent life insurance after leaving the company, as long as they pay the premiums.
What Is the Difference Between Qualified and Nonqualified Retirement Plans?
Qualified retirement plans must comply with IRS codes and, if sponsored by an employer, must comply with ERISA. This federal law protects participants in employer-sponsored retirement plans by setting standards for nondiscrimination, when employees can join the plan, when contributions vest and are distributed, the information participants receive about the plan, and more. ERISA also requires employers to file reports and holds plan fiduciaries accountable.
There are two types of qualified retirement plans: defined benefit plans and defined contribution plans.
- Defined benefit plans, or traditional pensions, guarantee employees a predetermined amount in retirement. Typically, the employer makes most of the contributions to a defined benefit plan, although some plans let employees contribute as well.
- Defined contribution plans don't guarantee a specific payout at retirement. Instead, the employee and/or employer contributes to the employee's retirement account, which is invested at the employee's discretion. The amount available at retirement depends on how well the investments perform.
Examples of qualified retirement plans include:
- 401(k) plans
- 403(b) plans
- Money purchase pension plans
- Cash balance pension plans
- Simplified Employee Pension (SEP) plans
- Savings Incentive Match Plans for Employees (SIMPLE) IRAs
- Employee Stock Ownership Plans (ESOPs)
- Profit-sharing plans
- Stock bonus plans
Although they are employer-sponsored, nonqualified retirement plans don't have to comply with ERISA guidelines. ERISA forbids plans that discriminate in favor of highly compensated employees, but nonqualified plans are exactly that.
There are tax differences between the plans as well. Employer contributions to qualified plans are usually tax-deductible at the time they are made, but employer contributions to nonqualified plans are made with after-tax money.
The most important difference: Nonqualified plans lack the safeguards of qualified plans. For example, if a fiduciary breached their duties and your qualified plan lost money as a result, the fiduciary has to pay it back. If your employer goes bankrupt, your money in a qualified retirement plan is still safe, because assets in qualified funds must be kept separate from the employer's assets. You can even sue to recover benefits from a qualified plan. Most defined benefit plans are insured by the federal government through the Pension Benefit Guaranty Corporation (PBGC), which guarantees benefits even if your plan is terminated—though payouts may be less than promised.
A nonqualified retirement plan, however, is simply an agreement with your employer. Your money could be at risk if your employer goes out of business or declares bankruptcy and can't keep up their end of the agreement. Depending on the terms of your plan, you could lose the money if you leave your job for any reason other than retirement. (There's a reason these plans are sometimes called "golden handcuffs.")
|Qualified Plans vs. Nonqualified Plans|
|Qualified Plan||Nonqualified Plan|
|IRS sets limits on contributions||No IRS limit on contributions|
|Must follow ERISA guidelines||Not governed by ERISA|
|Employer contributions are tax-deductible||Employer contributions aren't tax-deductible|
|Must be offered to all eligible employees||Offered only to select employees|
Nonqualified retirement plans can help highly compensated executives save enough to maintain their lifestyles in retirement. Before participating in a nonqualified retirement plan, however, max out your other employer-sponsored retirement plans and tax savings vehicles such as flexible spending accounts. Make sure you clearly understand the terms, risks and tax consequences of any nonqualified plan.
A financial planner can help you determine whether a nonqualified retirement plan fits into your overall goals, how to structure a plan to minimize taxes, and how to manage your income in retirement. Free credit monitoring from Experian can help you keep an eye on your credit score and help protect your financial future.