When we think of retirement plans, most of us think of retirement accounts, like 401(k)s. These are types of qualified retirement plans.
However, to draw in and keep important employees and senior officials, employers may offer nonqualified retirement plans intended for executives that earn more.
Nonqualified plans don’t obey ERISA (Employee Retirement Income Security Act) policies, which means that they provide many more customized possibilities (You might want to check out how retirement ratios work here).
This sounds amazing, but these plans can come with added risks.
You’ll learn more about nonqualified retirement plans in this article, including how they work and what makes them different from qualified plans.
What Are Nonqualified Retirement Plans?
Finance experts recommend putting 15% of your pretax earnings into a retirement plan every year.
However, as the IRS place contribution limits on qualified retirement plans, this can make it harder for higher earners to meet this goal.
With the 15% as a standard, executives earning $500,000 every year need to save around $75,000 per year to retire.
In 2022, the maximum amount you could contribute to 401(k)s and 403(b)s was $20,500, just over 4% of the employee’s income.
Nonqualified retirement plans aren’t restricted by these contribution limits, so higher earners can save more for retirement (Find out the Average Retirement Savings).
Employers can construct a nonqualified retirement plan for all of their executive employees, or adapt individual contracts to every individual’s requirements.
There are many possibilities for nonqualified retirement plans, but each one tends to fall into one of four types.
Deferred Compensation
These arrangements let employees postpone compensation, along with bonuses and salary, until an accepted later date, paying taxes on the money once it arrives.
In most cases, compensation will be delayed until retirement, when most individuals are in a lower tax bracket compared to when you were working.
Despite this, some of these plans let you postpone compensation to a different date, like when an executive’s child is about to go to college.
These distributions can be taken in installments or as a total sum.
Executive Bonus
These plans involve the employer paying the premiums on their employees’ fixed life insurance policies. The employee will select the beneficiary and own the policy.
Once the policy’s cash value increases, the employee can usually withdraw it or borrow against it.
Premium expenses are tax-deductible for the employer, but employees will need to pay taxes on the bonus.
Split-Dollar Life Insurance
This involves dividing the death benefits, premiums, and cash value of fixed life insurance policies amongst the employer and the employee.
While these arrangements can be constructed in several methods, the employer generally pays the amount of the premiums equivalent to the policy’s cash value, while the employee pays for everything else.
Group Carve-Out
Employers tend to provide group term life insurance to their employees as a benefit, paying for a specific amount of coverage.
Group carve-out arrangements give important executives $50,000 in group term life insurance, which is the maximum amount permitted until it needs to be recorded on the employee’s taxes.
These plans also give these individuals permanent life insurance policies, while the employer will pay the premiums on both of these policies.
Group term life insurance once employment finishes, but as long as they keep paying for the premiums, employees can keep their permanent life insurance once they leave.
How Are Qualified And Nonqualified Retirement Plans Different?
Qualified retirement plans need to obey IRS codes, as well as ERISA ones if an employer sponsors them.
This federal law will defend those who have employer-sponsored retirement plans by generating specific standards.
These standards include nondiscrimination, when staff can sign up for the plan, when contributions are distributed, data about the plan that participants receive, and various others.
ERISA also needs employers to record reports and keep any plan trustees liable. Retirement plans are available in two main types, defined contribution, and defined benefit plans.
Defined Contribution Plans will not guarantee a particular payout during retirement. The worker and/or the employer will pay into the individual’s retirement account. This will be invested whenever the employee wishes.
The total accessible at retirement will vary depending on how the investments behave.
Defined Benefit Plans, or standard pensions, ensure employees will have a prearranged amount of money during retirement.
The employer generally contributes to a particular benefit plan, though some of these allow workers to pay in contributions too.
Some qualified retirement plans are:
- 401(k) schemes
- 403(b) schemes
- Cash balance pension schemes
- Money purchase pension schemes
- Stock bonus schemes
- Profit-sharing schemes
- ESOPs (Employee Stock Ownership Plans)
- SIMPLE IRAs (Savings Incentive Match Plans For Employees)
- SEP (Simplified Employee Pension) plans
While these are sponsored by employers, nonqualified retirement schemes don’t have to stick to ERISA standards.
ERISA claims that they prohibit schemes that discriminate against higher earners, but this is debatable, as nonqualified schemes do this anyway.
These plans also have various tax differences. Any contributions employers make to qualified plans tend to be tax-deductible once they are made, but contributions employers make to nonqualified plans use after-tax funds.
The most significant difference between the two schemes is that nonqualified plans don’t have the safety of qualified ones.
For instance, if a trustee violated their obligations which made a qualified plan lose money, the trustee would have to pay this pack.
If an employer becomes bankrupt, money within a qualified retirement plan remains safe, as any capital in qualified funds needs to be held apart from the employer’s assets.
If necessary, you can sue to retrieve any benefits from a qualified plan.
Nonqualified retirement schemes are different, as they are essentially a deal with your employer. If your employer goes out of business and can’t keep up with the deal, your wealth may be at risk.
You may also lose your money if you quit your job, unless you leave for retirement, though this may depend on the plan in question.
The Bottom Line
Nonqualified retirement schemes can be great for higher earners so that they keep their present lifestyle during retirement.
However, before one signs up for a nonqualified retirement plan, make sure that you max out any remaining employer-sponsored retirement plans, as well as tax savings arrangements, like flexible spending accounts.
Always make sure that you fully understand the tax outcomes, potential risks, and terms and conditions of your nonqualified plan.
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