Millions of employees save for retirement by deferring a portion of their compensation into an employer-sponsored, tax-deferred savings plan. The majority of these are known as qualified plans and fall under the jurisdiction of ERISA guidelines, which means they are subject to certain limiting requirements.
For example, these requirements can pertain to the type and number of employees who participate, as well as the amount of money that is placed in the plan by rank-and-file employees as compared to executives and owners.
However, there are times when a qualified plan won’t accomplish an employer’s goals. For instance, a company may want to defer a greater amount for retirement than is permitted inside a qualified plan, or reward either themselves or a key employee with additional benefits and compensation that will not be offered to the majority of employees. In cases like these, non-qualified plans are used to achieve specialized objectives.
Characteristics of Non-Qualified Plans
Because of their flexibility, non-qualified plans have very few set criteria they must meet. These plans are usually tailor-made on a case-by-case basis and come in all shapes and sizes.
They can be relatively simple or quite complex depending upon various factors, such as the employer’s objectives and the number of employees that are included. Moreover, the funds that are placed inside them usually grow tax-deferred so long as certain conditions are met.
Cash Value Life Insurance
Non-qualified plans are typically funded with cash value life insurance policies. Also known as “permanent” insurance, cash value policies accumulate cash inside the policy from a portion of the premiums paid. This type of policy becomes “paid up” once a certain amount of premium has been paid into it. At this point, premium payments cease and the policy stays in force until the death of the insured.
Money can also be withdrawn from the cash value of the policy in the form of a tax-free loan that does not have to be repaid. However, the policy will charge interest on the loan, and the death benefit paid by the policy will be reduced by the amount of any outstanding loans.
The policy can also lapse if too much money is taken out. But cash value life insurance is an ideal vehicle for non-qualified plans for a couple key reasons:
- There are no contribution limits for life insurance policies.
- The cash value in them can be withdrawn and used as retirement income with no tax consequences in most cases.
Because non-qualified plans do not fall under ERISA regulation like their qualified cousins, they do not enjoy the same tax advantages. In order for plan assets to grow tax-deferred, the IRS has mandated that the money in these plans must usually meet two conditions:
- Plan assets must be segregated from the rest of the employer’s assets.
- Plan assets must be subject to a substantial risk of forfeiture. This means they may be seized by creditors in the event of bankruptcy.
To accomplish this, the assets in a non-qualified plan are typically placed inside an irrevocable trust, which is a type of legal instrument that is funded by a grantor (in this case, the employer) for the benefit of the employee beneficiary (this can be one person or a group of people).
In most cases, one of two types of irrevocable trusts are used:
- Rabbi Trust. A rabbi trust is one that irrevocably segregates the plan assets for the benefit of the employees, but still allows creditors access to the funds if the employer becomes insolvent. All assets placed inside this type of trust grow tax-deferred until they are paid out to the beneficiary.
- Secular Trust. Similar to a rabbi trust, except that any assets placed inside this trust are unconditionally exempt from attachment by creditors. However, the assets placed inside these trusts are subject to taxation.
The rules pertaining to these plans effectively create a dilemma, as both employers and their employees usually desire that plan assets be safe from creditors while retaining their tax-deferred status. Therefore, many plans have chosen to use a rabbicular trust.
A rabbicular trust is a hybrid that functions as a rabbi trust for the life of the plan unless the employer experiences financial difficulties or becomes bankrupt. Then, this trust will automatically convert to a secular trust, which results in immediate taxation of plan assets, but also protects the assets from creditors. If this happens, plan assets are typically distributed to the participants immediately.
Objectives of Non-Qualified Plans
Non-qualified plans can accomplish several objectives for employers that cannot be achieved with qualified plans, such as:
- Providing additional compensation for a key employee without surrendering control of the business. This is valuable because it allows an employer to financially reward an employee without having to make that person a partner or part owner of the business. For example, a computer company that is owned by a very astute businessman may employ a key programmer or designer who is indispensable to the company, but who is not qualified to make competent business decisions. The owner could therefore create a non-qualified plan for this person that provides him or her with discriminatory compensation.
- Recruiting top talent and providing incentive for them to stay with the company until retirement. Many non-qualified plans have “golden handcuff” arrangements that stipulate that any plan participants who leave the company or go to work for a competitor forfeit their rights to plan benefits.
- Providing additional compensation for an executive that is terminated in the event of a buyout or takeover. This is usually referred to as a “golden parachute plan or clause.”
Advantages & Disadvantages
Pros of Non-Qualified Plans
Non-qualified plans have several advantages over their qualified counterparts, including:
- No Limits on Contributions. Hundreds of thousands of dollars may be placed in these plans at the discretion of the employer in a single year.
- Tax-Deference. As long as the segregation and forfeiture requirements are satisfied, all money placed inside these plans grows tax-deferred just like it would in an IRA or other qualified plan.
- Insurance Benefits. Non-qualified plans can pay substantial death benefits. Furthermore, modern policies can provide several different types of protection in a single policy with the use of riders that pay out benefits for disability, critical illness, and long-term care, in addition to death. This type of policy effectively provides the employee with a package of benefits that he or she can count on as long as the terms of the plan are met.
- Freedom from ERISA Regulations. These rules prohibit discrimination among employees and require top-heavy testing for qualified retirement plans.
- Substantial Flexibility. Non-qualified plans can be structured many different ways according to the needs of the participants.
- Additional Advantages. These plans require minimal reporting and filing, and are usually cheaper to establish and maintain than qualified plans.
Cons of Non-Qualified Plans
Some of the limitations of non-qualified plans include:
- Substantial Risk of Forfeiture. Unlike the money in qualified plans, funds placed in non-qualified plans are usually subject to attachment from creditors. If this risk does not exist, then the plan may become null and void, and all assets currently inside the plan will become immediately taxable to the employee. The IRS also stipulates that any money in these plans that becomes unconditionally available to employees will be counted as taxable income.
- “Golden Handcuff” Provisions. Employees who do not complete their tenure with the company or do not fulfill other requirements specified within the plan will generally forfeit their rights to the benefits that they would otherwise have been paid.
The 4 Types of Non-Qualified Plans
There are four basic types of non-qualified plans: deferred compensation plans, executive bonus plans, group carve-out plans, and split-dollar life insurance plans.
As mentioned previously, they are usually funded with cash value life insurance policies, but annuity contracts can be used in some instances as well, such as for deferred compensation plans that are designed to make cash payments to participants when they retire.
1. Deferred Compensation Plans
This is probably the most common type of non-qualified plan, and is typically offered to high-ranking corporate executives or key employees of small businesses as an additional form of compensation. One of the main objectives of deferred compensation plans is to lower the amount of tax paid by the employee. This is accomplished by deferring it until retirement when he or she is hopefully in a lower income tax bracket. These plans often also have a “golden handcuff” provision.
Deferred compensation plans come in two forms: deferred savings plans and SERPs (Supplemental Executive Retirement Plans). These two types are similar in many respects, but deferred savings plans are funded from employee contributions, while SERPs are funded entirely by the employer. Deferred savings plans usually mirror their qualified defined-contribution cousins, such as 401k plans, in which the employee can set aside a certain percentage of earnings to grow either in mutual funds or at a fixed rate guaranteed by the employer.
SERPs, on the other hand, are generally structured as a private form of defined benefit plan and are funded with either some sort of sinking fund or corporate-owned life insurance (COLI). Plan benefits may also be paid directly from the company’s coffers, according to an agreement.
2. Executive Bonus Plans
Section 162 of the Internal Revenue Code has deemed bonuses of up to $1 million to executives as reasonable compensation. Many companies pay these bonuses in cash, but some employers choose to pay them in the form of additional benefits instead. These plans are therefore known as executive bonus plans, and they are perhaps the most versatile type of non-qualified plan in use today.
Unlike deferred compensation plans, executive bonus plans are funded in the name of the employee and are often portable. These plans usually consist of payments into a cash value life insurance policy or a combination policy that provides a package of benefits, such as life, critical illness, disability, and long-term care coverage.
In most cases, the employer pays the premiums on behalf of the employee and reports it as additional taxable compensation to the employee on the W-2 tax form. The cost of the policy is then deductible as a business expense for the employer. The employer continues to pay the premiums on the policy until the employee either leaves the company, retires, or the policy is paid up. The employee can then access the cash value in the policy as an additional source of retirement income.
Some employers will also bonus the employee an additional sum of money to pay taxes on the initial bonus via a “double bonus” arrangement. It should be noted that the bonus to employees can actually take the form of automobiles or other perks instead of cash or insurance, although the latter two are the most common.
3. Group Carve-Out Plans
This type of non-qualified plan is always layered on top of a group term life insurance plan. Group term life plans allow employees to receive up to $50,000 of term life insurance without it being counted as additional taxable compensation. This plan then “carves out” the employees who are selected to receive additional cash value insurance coverage on top of the group plan. The employer either pays the premiums for the cash value policies directly to the insurance carrier, or bonuses the money to the employee, who then pays the premiums.
Any type of cash value policy can be used for this, including whole life, universal life, or variable universal life. Group carve-out plans may also qualify for simplified underwriting by insurance carriers, thus helping rated or otherwise uninsurable participants get coverage.
Some types of plans require the employer to pay the death benefit to the beneficiary directly from the company coffer. In this case, the benefit is taxable as income to the beneficiary. There are many factors that must be considered when comparing the costs and benefits of this type of plan to an executive bonus or split dollar arrangement, including the employer’s and employees’ tax brackets, the amount of benefits to be paid, and cost of premiums. However, in many cases, group carve-out plans can be the most economical type of non-qualified plan.
A cousin to the group carve-out plan is the Section 79 Plan, a program that is appropriate for small, closely held businesses that file as C corporations or elect C corp treatment as LLCs. This type of plan allows employers to take a deduction for the payment of life insurance premiums for employees in excess of the standard group plan level, while the employees generally only have to declare about two-thirds of this premium as income. The rules pertaining to who can participate in a Section 79 plan are fairly complex, and employers must take care to follow these rules closely in order to avoid tax penalties.
4. Split-Dollar Life Insurance Plans
As the name implies, a split-dollar plan represents a partnership between two parties (employer and employee) who both own a portion of a single cash value life insurance policy. The employer retains a percentage of ownership in the death benefit equal to the cost of premiums the employer has paid, while the employee receives the remainder. Employees are generally taxed on the amount of the insurance premiums that the IRS deems to be of “economic benefit” to the employee, known as the P.S. 58 cost.
Split-dollar plans can be classified according to one of two forms of ownership: endorsement and collateral assignment. The former method has the employer as the owner, which endorses the appropriate percentage of the cash value and death benefit of the policy to the employee, who will either hold no stock in the company or, at most, a minority of shares.
In the collateral assignment method, a majority stock-holding employee is the policy owner. The employee assigns the appropriate percentage of ownership of the cash value and death benefit to the employer as collateral in return for the employer’s payment of premiums. In most cases, any death benefit received by the employee’s beneficiaries is tax-free.
Non-qualified plans can be structured and used in a variety of ways to accomplish the various specialized objectives of employers and employees. Although their lack of regulation as compared to qualified plans provides a great deal of freedom, non-qualified plans do not have the same tax advantages as their qualified cousins.
Moreover, while general guidelines exist pertaining to how these plans are taxed, the specific rules can vary substantially depending on various factors, and must be analyzed and monitored on an individual and regular basis.
Considering that non-qualified plans typically harbor large sums of money, it’s vital to ensure that tax rules and other regulations governing funding and distributions are followed to avoid immediate taxation of benefits and penalties to employees.
For more information on non-qualified plans, download IRS Publication 575 on pension and annuity income, or consult your financial advisor.