Non-Qualified Plans (W-2)
What is a non-qualified retirement plan?
A non-qualified plan—reported on a W-2—is an employer-sponsored, tax-deferred retirement savings plan wherein taxes are typically paid upon withdrawal. These plans are considered non-qualified because they don’t follow Employee Retirement Income Security Act (ERISA) guidelines and are exempt from the testing required with qualified retirement savings plans.
The popular 401(k) and 403(b) plans are both qualified. They aren’t considered non-qualified plans, so the information on this page won’t apply to those plans.
A non-qualified plan is designed to meet the specialized needs of key employees, mainly primary executives and is a tool for their recruitment and retention.
Qualified vs. non-qualified retirement plans
Here’s a quick comparison of qualified vs non-qualified retirement plans to help you understand the key differences in eligibility, tax benefits, and how these plans can work for employees and employers.
What are the types of non-qualified plans?
Non-qualified retirement plans come in several options, each offering unique benefits for employers and high-earning employees. Here are the most common types and how they work:
Deferred-compensation plan
A deferred compensation plan allows an employee to earn wages in one year, but delay receiving the payment until a future date—usually retirement. It may include retirement payouts, pensions, and stock options. Variations of this plan include wraparound 401(k)s, excess benefit plans, bonus arrangements, and severance agreements. These plans are sometimes referred to as 457(b) or 457(f) plans.
Salary-continuation plan
In this setup, the employer commits to paying an executive or senior employee after they retire. Post-retirement income is typically lower than the regular salary, but the employer still provides it as part of a long-term compensation strategy.
Executive bonus plan
Provides supplemental benefits to some executives and employees which are deductible as a business expense for the employer. An employer issues a life insurance policy and pays for the premiums, reporting them as bonus compensation.
Split-dollar life insurance plan
This arrangement allows an employer and employee to share the costs and benefits of a permanent life insurance policy. The structure of the plan varies based on the terms of the agreement, and it’s generally not subject to strict regulation.
Group carve-out plan
Replaces part of an employee’s group life insurance policy with an individual life insurance policy to avoid excess costs.
Which employees are eligible for non-qualified plans?
Employees eligible for non-qualified plans are typically executives and other key personnel. This is because non-qualified plans are designed to meet the specific needs of high earners—and to provide extra incentives to keep them at a particular company.
One exception to the executive rule involves deferred compensation plans, which may also apply to teachers or other specific seasonal workers. But instead of deferring part of their income into retirement as in a standard plan, teachers may defer a portion of their income throughout the school year so that they continue to get paid at the same rate in the summer months when they’re not working.
Employers may also find it valuable to offer non-qualified plans to high-earning independent contractors. By deferring some of their pay into retirement, the employer doesn’t have to pay the entire salary immediately.
How are taxes calculated on non-qualified plans?
Taxes for non-qualified plans are split between when the money is earned and the time of payment.
FICA taxes, which include Medicare and Social Security tax payments, are taken out of the employee’s paycheck when they earn it, as most taxes are.
However, the bulk of the federal income tax withholding for non-qualified plans is not calculated or withheld until the money is paid. Since it’s going to be calculated based on future tax rates (sometimes decades in the future, if the employee is far from retirement), there’s no real way to predict what those taxes will look like.
This can potentially benefit the employee, as many individuals will find themselves in a lower tax bracket during retirement than while they’re still working.
Other important tax information about non-qualified plans
Employers need to be aware of the taxes involved, especially when it comes to non-qualified deferred-compensation plans.
- The plans are funded using after-tax dollars.
- Employers can’t claim their contributions as a tax deduction (in most cases).
- For income tax withholding purposes, distributions are considered supplemental wages.
- Employers are required to apply federal tax withholding rules on up to $1 million worth of supplemental wages at a rate of 25%. For supplemental wages exceeding $1 million, the rate is 37%.
- On an employee’s W-2 form, reported distributions from a non-qualified plan are reported in box 11.
How can non-qualified plans benefit employers?
Non-qualified plans benefit employers in several ways.
- They offer a greater amount of flexibility than plans covered under ERISA because employers can choose to offer them only to the executives and employees who will benefit most from them.
- They don’t have any non-discrimination rules, so the plans can be tailored to meet the needs of executives and key employees and don’t have to be proportionately equal for all employees. One reason for this is to prevent excessive weighting that tends to favor employees who are earning more.
- They can be used as an incentive to keep employees loyal. Employees usually forfeit non-qualified plans if they leave the company before retirement.
- They can improve cash flow since a portion of earned compensation is deferred to the future.
- The costs of setup and administration are minimal, there are no special annual costs, and the IRS doesn’t require any filings.