Nonqualified retirement plans are employer-sponsored retirement plans that are not subject to the rules laid out in the 1974 Employee Retirement Income Security Act (ERISA), which created minimum standards for plan participation, funding, and reporting, among other things. They are distinct from the more common qualified retirement plans, which are subject to ERISA rules.
You usually find nonqualified retirement plans among executives and other highly paid employees who have special needs that can't be met by a qualified plan. Here's a closer look at how nonqualified plans work.
Nonqualified plans don't have age restrictions on when participants can take penalty-free withdrawals
Types of nonqualified retirement plans
You're probably familiar with common retirement accounts, like the 401(k) and IRA, but nonqualified retirement plans aren't as widely known. The most common types are:
|Plan type||Plan overview|
|Deferred compensation plans||Deferred compensation plans, including Supplemental Executive Retirement Plans (SERPs), involve an employer providing an employee with supplemental retirement income that the employee does not have to pay income taxes on until they retire.|
|Executive bonus plans||An employer takes out a life insurance policy in their employee's name and pays the premiums, allowing executives to access the cash value of the policy when they retire.|
|Split-dollar life insurance plans||The employer pays for a permanent life insurance policy on behalf of the employee, and the employee and employer agree upon how to divide the cash value of the policy between them.|
|Group carve-out plans||Group carve-out plans replace group term life insurance coverage in excess of $50,000 with an individual universal life insurance policy providing additional coverage to help the employee avoid taxes on group life insurance over $50,000.|
Advantages of nonqualified retirement plans
Nonqualified retirement plans enable highly compensated employees (HCEs) to save more money for retirement than they could in a qualified plan, which is subject to annual contribution limits. Qualified plans also have discrimination tests in place, designed to ensure that HCEs do not contribute substantially more to their retirement plans than the company's average employee, which may further limit the maximum contribution HCEs can make. Nonqualified plans don't have these limitations, so HCEs can contribute as much as they choose.
Nonqualified retirement plans also enable participants to defer income taxes on part of their earnings until retirement, when they will presumably be in a lower tax bracket and lose a smaller percentage of their income to the government. However, they still must pay Social Security and Medicare taxes in the year they earn the money.
Finally, nonqualified plans don't have age restrictions on when participants can take penalty-free withdrawals, and some don't have required minimum distributions (RMDs), either. Employees and employers can work together to decide upon a distribution schedule that works for both of them.
Disadvantages of nonqualified retirement plans
Nonqualified retirement plan contributions are considered part of the company's assets, so they're not shielded from creditors. If a company goes bankrupt, it may have to draw upon the funds in their employees' nonqualified retirement plans to cover some of its debts.
These plans may also have strict distribution schedules, which determine when you can withdraw funds from the account -- and you usually cannot withdraw funds before the date you and your employer originally agreed upon. You're also not eligible to borrow from the plan, like you can with some 401(k)s, or roll over your nonqualified retirement plan if you decide to leave the company in the future.
Nonqualified retirement plans can make sense for executives and certain high-earning employees, but outside of this group, you're unlikely to find them. For the average person, a qualified retirement plan will be a better fit because it provides better protections and greater flexibility for moving between jobs.