Why Would My Company Establish a Nonqualified Deferred Compensation Plan?

Today’s job market is extremely competitive, especially for key talent. Nonqualified plans offer an indispensable means for employers to attract, motivate, reward, and retain key executive talent.

Unlike a “qualified” plan, such as a 401K, tax laws allow employers to establish “nonqualified plans” for a select group of highly compensated employees. Nonqualified plans allow employers to supplement key employees’ retirement and pre-retirement deferred compensation benefits under qualified plans. They also supplement the voluntary, tax-favored savings opportunities available to these employees. This allows these employees to save a percentage of their income for retirement that is more in line with other employees of the company.

Additionally, “nonqualified” plans can be established for independent contractors or directors. By rule, “qualified” plans cannot cover independent contractors or directors. Therefore, companies can use “nonqualified” plans to boost compensation packages for key independent contractors/directors.

Nonqualified plans can serve non-tax-motivated purposes as well. Based on the terms of the plan, it can incentivize employee/independent contractor retainment, to prevent competition following termination of employment, or to provide supplemental retirement benefits. 

As executive salaries and benefit packages increase, nonqualified plans have increasing importance in executive compensation planning. This is because qualified plans are subject to significant monetary restrictions. These restrictions limit a qualified plan’s ability to provide key employees with all of the deferred compensation they require to adequately prepare for retirement.

IRS Limitations on Qualified Plans

Specifically, dollar limitations on annual contributions to qualified defined contribution retirement plans are limited for 2019, to the lesser of $56,000 or 100 percent of the executive’s compensation. See 26 USC § 415(c); see also IRS technical guidance Notice 2018-83.

Additionally, there are also dollar limitations on the annual benefits payable from qualified defined benefit retirement plans. For 2019, this limitation, measured after 10 years of plan participation against plan benefits payable for a single life beginning at age 62, is the lesser of $225,000 or 100 percent of annual compensation for the participant’s highest paid three consecutive years of employment with the employer. See 26 USC § 415(b); see also IRS technical guidance Notice 2018-83.

There is also a limitation on the amount of annual compensation that may be considered for all qualified plan purposes. For 2019, this limitation is $280,000, indexed for inflation in $5,000 increments. See 26 USC § 401(a)(17); see also IRS technical guidance Notice 2018-83. There is also an annual limit on a participant’s voluntary pretax salary reduction contributions to a qualified 401(k) plan or to a 403(b) plan. This limit is $19,000 in 2019. In addition, participants age 50 and older may make additional “catch-up” contributions of $6,000 in 2019, and these catch-up contributions are not subject to the other contribution limitations or the nondiscrimination rules typically applicable to participant contributions. See 26 USC § 402(g); see also IRS technical guidance Notice 2018-83.

Moreover, there are various coverage and discrimination rules imposed on qualified plans that significantly limit their utility as it relates to compensating executive talent. See generally 26 USC §§ 410(b), 401(a)(4), (26), 26(k), 26(m).

The bottom line is that all of these rules serve to limit your company’s ability to effectively reward key executive talent.

Benefits of a Nonqualified Plan

Instead, a nonqualified plan can provide contributions and benefits and permit deferrals without regard to the limits imposed by the Code on tax-qualified plans.

This allows your company to:

  1. Enable executives to save for their own retirement without regard to the limits of tax-qualified plans.
  2. Make your executives whole for the amount the executive loses and the amount the employer saves as a result of the tax-qualified plan not being able to recognize the executive’s entire amount of earned compensation.
  3. Incentivize executives to remain with the company.
  4. Provide an attractive and competitive aggregate compensation and benefits package to attract desired executives.
  5. Avoid the 10 percent penalty tax under IRC Section 72(t) on early distributions from tax-qualified plans.
  6. Avoid the strict minimum distribution requirements imposed on tax-qualified plans by IRC Section 401(a)(9).

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