In 1974, Congress recognized the need for Americans to save for their retirements by passing the Employee Retirement Income Security Act, which gave birth to employer-sponsored retirement savings plans that allow workers to defer a portion of their earnings into tax-deferred accounts. All retirement plans that fall under ERISA guidelines are referred to as “qualified” plans, and each type of plan must meet certain criteria pertaining to who is able to participate in these plans, how much they can contribute and the taxation of the monies that is placed inside them. But qualified plans cannot always meet the needs of every type of employee.
Nature and Purpose of Nonqualified Plans
Corporate executives and small business owners often want to defer amounts of money in excess of what they can contribute to qualified plans, and business owners also at times need to be able to reward key employees financially without surrendering control of their companies. Because they are not restricted by the regulations that govern qualified plans, they can be used to accomplish specialized objectives, such as substantial additional compensation that is not taxed until retirement or creating a financial incentive for an executive or employee to stay with a company for at least a certain period of time. Nonqualified plans are usually funded with cash value life insurance policies or annuity contracts. In most cases, the money that is contributed to these plans must be subject to a substantial risk of forfeiture by the employee, meaning that the funds could be attached by creditors in the event of lawsuit or insolvency.
Types of Nonqualified Plans
There are four main types of nonqualified plans:
Deferred Compensation Plans – These plans allow corporate executives to defer large amounts of additional compensation that they are paid after they retire. The executive isn’t taxed on the income until it is actually paid.
Split Dollar Life Insurance Policies – Under this arrangement, the employer and employee split both the cost and benefits of a cash value life insurance policy. The employer pays for a certain amount of the policy and then lets the employee pay the remainder. The employer then recoups its costs by taking a portion of the death benefit when it is paid out.
Executive Bonus Plans – This type of plan allows employers to purchase cash value policies on employees that they can take with them after they leave the company. These policies often contain riders for critical illness, disability and long-term care, thus providing a package of benefits to the employee as well as retirement income from the cash value in the policy.
Group Carve-Out Plans – These plans are layered on top of the $50,000 of term life insurance that companies can purchase for employees without the premiums being counted as taxable compensation to them. The company will then purchase additional cash value policies on a select group of employees (such as executives) that are counted as additional compensation to them.
Nonqualified plans can be structured in many different ways and funded at different levels. Participants do not necessarily have to wait until age 59 ½ to begin taking distributions from them, and several different variables can govern how they are taxed. For more information on nonqualified plans, visit the IRS website at www.irs.gov or consult your financial adviser.