Most people are familiar with having access to a 401(k) at work. Employees defer a portion of their paycheck to the 401(k) plan, choose their investments from a selection of mutual funds offered, and then often forget about it. If they’re fortunate, employees also receive an employer matching contribution, further growing their retirement nest egg. 401(k)s are considered a qualified retirement plan.
Nonqualified retirement plans allow employers to provide additional benefits or incentives to key employees or highly compensated employees to maintain competitive compensation or tie an employee to the company for a certain number of years. Since these plans fall outside the tax codes that govern plans like 401(k)s, nonqualified plans are not required to be offered universally to all employees.
Several types of nonqualified plans exist, including executive deferral plans, supplemental executive retirement plans, executive bonus plans, and selective insurance benefit plans. The most popular options fall under nonqualified deferred compensation, where employees defer compensation into the future, typically upon an executive’s retirement. Nonqualified deferred compensation (NQDC) plans generally fall into two broad categories: funded plans and unfunded plans. Furthermore, NQDC plans do not have contribution caps; therefore, they can be highly advantageous for high-income earners.
Unfunded and informally funded NQDC plans are considered a liability on the company’s books because they are essentially agreements between the employer and employee with no guarantee that the benefits will be available in the future. Executives are incentivized to ensure the company’s success beyond their tenure to secure their payments in retirement. The risk of forfeiture is very real because if the company were to fail, these retirement arrangements would disappear. In contrast, money contributed to a qualified plan, like a 401(k), is placed into a separate account, and employers are responsible for managing and controlling plan assets.
The most common method of informally funding an NQDC plan is through company-owned life insurance on the executive’s life. The company serves as the policy owner and beneficiary, retaining the rights to the cash value and death benefit. The corporation would eventually draw against the accumulated cash value to pay the distributions promised under the nonqualified benefit.
The advantage of using life insurance is that when structured properly, the accumulated cash value is not subject to tax. The IRS treats withdrawals of the accumulated cash value as a nontaxable recovery of investment in the contract. Furthermore, the company can deduct the amounts paid to the executive under the nonqualified plan funded by the company-owned life insurance policy in the year the payments are made. The favorable tax treatment of the life insurance policy can make it financially viable for the company to have this liability on its books.
Given that these plans are not guaranteed, employees with NQDC plans may want to work closely with a financial adviser to help ensure that they achieve their retirement goals.
If you have questions on how a nonqualified retirement plan may affect your retirement planning, the experts at Henssler Financial will be glad to help:
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- Email: experts@henssler.com
- Phone: 770-429-9166
Listen to the August 19, 2023 “Henssler Money Talks” episode.
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