Non-Qualified Plans (W-2)

A lot of employers offer executives and other key employees specific benefits as part of an overall retention plan. Employers would like to know they are valued by having these benefits in place. One example of such benefits is a non-qualified plan. 

What is a non-qualified plan (W-2)? 

A non-qualified plan refers to a type of retirement savings plan that is sponsored by an employer and is tax-deferred. The reason why it is named “non-qualified” is that it does not fall under the guidelines of the Employee Retirement Income Security Act or ERISA.

Non-qualified plans are typically offered by employers to executives and other selected employees of an organization. They offer it as a means to give them additional retirement savings and meet specialized retirement needs. Companies often use non-qualified plan benefits to attract top executives in recruitment and keep them in the organization. 

Before we find out more about non-qualified plans (W-2), keep in mind that 401(k) and 403(b) plans are both qualified plans. Meaning, all the information here does not apply to these popular retirement plans. 

Now that we have that cleared up, let’s learn more. 

Who is eligible for non-qualified plans? 

Non-qualified plans are not offered to all employees. Eligible employees are typically the decision-makers of the organization such as business executives, key employees, and high-earning members of the company. Non-qualified plans are specifically designed to suit their needs. Additionally, non-qualified plans are also implemented as a strategic move by employers to attract top executives to the company. For existing employees, a non-qualified plan is an incentive for them to stay with the business until retirement. 

However, there is one exception to the executive role in non-qualified plan eligibility. This involves teachers who have deferred compensation plans. For teachers, they defer a portion of their income throughout the school year so that they will continue to receive payment even during the summer months when there is no school and they are not working. Aside from teachers, these are also for some seasonal workers. For employers, they can opt to offer non-qualified plans to high-earnings independent contractors where the contractors can defer some of their income into retirement. 

What are the benefits of non-qualified plans to employers? 

There are several ways that non-qualified plans can benefit employers. We’ve already mentioned how offering non-qualified plans can be a useful tool for recruitment and retention. It is a good way to increase company loyalty. 

Non-qualified plans allow more flexibility compared with qualified plans. Employers are free to select specific employees and executives. This will not be seen as a discriminatory move since they do not have non-discrimination rules. They also can be adjusted to meet the needs of the employees. Furthermore, employers can have improved cash flow since some of the compensation is deferred to a future date. 

Are there different types of non-qualified plans? 

Yes, there are a few types of non-qualified plans. 

• Deferred compensation plan – this is a type of non-qualified plan where a portion of an employee’s wages is withheld. These funds accumulate tax deferred until a determined date which is usually upon retirement. Common examples are pensions, retirement plans, and pensions. 
• Salary-continuation plan – a non-qualified plan that is set up between an employer and an employee where funds come from the employer. In simpler terms, the employer will pay the employee in the future if the employee will remain with the business until retirement. 
• Executive bonus plan – in this plan, the employer gives the employee a life insurance policy and pays the annual premiums on behalf of the employee. The payments are considered to be compensation and are reported as deductible to the employer or bonus compensation. 
• Split-dollar life insurance plan – this form of non-qualified plan provides the employee with a permanent life insurance policy. The employer buys a life insurance plan for the employee, but the ownership is shared by both the employer and employee. Both parties share the cash value, tax, and legal responsibilities. A split-dollar insurance plan’s details can vary from one company to another and is not highly regulated. 
• Group carve-out plan – this is another non-qualified plan that is based on a life insurance arrangement. The employer replaces the group life insurance plan beyond $50,000 and replaces it with an individual policy for the employee. 

How are non-qualified plans taxed? 

If you are planning to agree to your employer’s non-qualified plan, it is important to know how and when you will be taxed. First, remember that taxes for these kinds of plans are “separated.” What do we mean by this? There are taxes due when the money is earned and when the money is paid out to you. 

For FICA taxes which are for Social Security and Medicare, these taxes are paid on when you earned the compensation, not on when it is paid out to you. On the other hand, the rest of the federal income tax withholding is computed and collected once the non-qualified plan funds are paid out. Because the amount will depend on future tax rates, there is no way to predict how much the taxes will be. It can take several years or even decades, depending on the executive’s retirement.

 In a way, this is a beneficial arrangement for the employee because, most likely, they will be in a lower tax bracket at the time the money is paid out at retirement compared to when they were in the workforce. 

For employers, there is other key tax information on non-qualified plans. Remember that after-tax dollars are used to fund these plans. Usually, you also cannot claim contributions made as tax deductibles. Distributions are considered supplemental wages for income tax withholding. When It comes to federal tax withholding, employers are required to apply federal tax withholding rules on up to a million dollars worth of supplemental wages, at a rate of 25%. If the supplemental wages go beyond a million dollars, the rate will be 35%. In completing a W-2 form, the non-qualified plan contributions are reported in box 11.