Non-qualified retirement plans
401(k) plans are oft-discussed when doing retirement planning for employees at larger-sized companies. However, such savings programs generally limit the contributions of management and or high-income earners.
Why? Because the government doesn’t want high earners to benefit the most from company-sponsored retirement plans. Otherwise, significant conflicts of interest could arise.
For example, I once talked to a CEO who was surprised that his company didn’t offer a specific investment that he wanted through the 401(k) plan. After our consultation ended, he informed me that he would be calling the 401(k) sales representative for his company to have it added.
While such an example might be an isolated case, it is still revealing because, in theory, those who make the most can contribute and benefit the most from 401(k) plans.
Consequently, the government regulates contributions for high-income earners in company 401(k) plans.
But wait, there’s more! High-income earners also have limited access to Roth IRA and tax-deductible traditional IRA contributions due to their incomes.
Now, regardless of the politics surrounding the rich, these individuals still desire to save. So, companies have developed methods to help them save: enter the various non-qualified retirement plans.
What does non-qualified mean?
A non-qualified retirement plan refers to an employer-sponsored savings program that does not conform to ERISA requirements.
ERISA refers to the Employee Retirement Income Security Act, which provides unique benefits to 401(k) plans and participants. And a plan that meets ERISA requirements is known as a qualified plan.
Since non-qualified programs are do not conform to ERISA, they miss out on unique benefits and treatments afforded to 401(k) plans. However, that doesn’t mean they aren’t creative to derive benefits.
Non-qual plan types
Non-qualified retirement plans are unique in that they have minimal government oversight. Each company can create its non-qual retirement plan (or plans), limiting employee access and providing benefits for only those at the top or various management levels, if they so choose.
If you wonder why companies offer these plans, often it is for attracting and or keeping executives through lucrative and delayed payouts.
What are examples of non-qualified plans?
Usually, non-qual plans come in the following three flavors:
•Deferred compensation plans
•Executive bonus plans
•Specialized life insurance plans
Today, I will explain non-qualified deferred compensation plans (NQDC) and possibly address the other two types of programs later if there is reader interest.
Deferred compensation plans (NQDC)
Deferred compensation plans are, as they sound, plans that defer employee compensation until a future date. Employees decide how much of their income to defer each year through them. Then, the money grows tax-deferred within pseudo investments until a future payout date, which the employer stipulates (that date could be five, ten, or even twenty years away).
These pseudo investments track the performance of a given investment vehicle while remaining in cash (in the financial services industry, we call these notional investments).
Often, payouts can be either one-time or over a set duration, such as quarterly for ten years. But, again, the employer determines the payout options, which sometimes allow for employee input and other times do not. Further, once the payout election is selected, it often is irrevocable.
Now, you may wonder how funds can grow tax-deferred when non-qualified plans don’t have ERISA qualifications. The answer lies in the fact that the monies involved never left the company’s balance sheet, and therefore, all growth remains earmarked.
Resultantly, deferred compensation plans are I-Owe-You agreements between employers and employees, where employees must ensure that their employer is in good financial health. Otherwise, non-qualified savings can disappear during employer insolvency since they remain commingled with the company’s other funds.
(With 401(k) plans, employee assets are held in a trust and are untouchable by the company.)
Why would someone use a non-qualified retirement plan?
The most obvious reason to use a non-qualified plan is to defer taxes until later when one is in a lower tax bracket. After all, high-income earners pay greater tax rates than everyone else, so they will want to reduce this.
Further, because these plans are not-qualified, there are no early withdrawal penalties. Examples of reasons one may want access to funds without paying the penalty include funding a child’s college tuition, early retirement, or sabbatical. But, the list could go on.
Lastly, unlike 401(k) plans which limit contributions to $20,500 annually (or $27,000 for those 50+), non-qualified programs have a $1,000,000/year cap on how much income is deferrable; though, the cap could be less for certain employees based on their rolling five-year income. Regardless, the limit is extraordinarily high.
These reasons, coupled with the fact that many larger companies are financially strong, lend to deferred compensation plans being popular.
Additional limitations of NQDC plans
Notwithstanding these benefits, NQDC plans have drawbacks. In addition to company insolvency concerns and the lack of withdrawal flexibility, these plans offer no Roth savings option, loan access, or rollover ability.
So, if you are concerned about your liquidity and need access to funds in the near term, a non-qual plan is likely not suitable. Further, to stress the point, if you have any concerns about a company’s financial health and future, a non-qualified deferred compensation plan is likely worth avoiding.
Non-qualified deferred compensation plans can be a boon for those high enough up the corporate totem pole. However, they present multiple risks that require critical evaluation, such as fund inaccessibility and firm insolvency.
Nevertheless, in my prior role as a workplace financial advisor, I helped many clients out with both their 401(k) and NQDC plans, so I know that they are popular.
While one should always maximize all other eligible retirement plans first, non-qualified deferred compensations can be a tremendous final bucket to utilize when saving.
Do you have access to a non-qualified deferred compensation plan, or have you used one in the past? If so, please let me know how your experience was in the comments below.
As always, have a great day!
Mile High Finance Guy
finance demystified, one mountain at a time