FAQ: Nonqualified Benefit Plans
A nonqualified plan is a contractual arrangement between an employer and an employee, whereby the employer promises to pay the individual or "service provider" a specified benefit at sometime in the future, usually at retirement.
The primary difference between a qualified and a nonqualified plan is the type of funding used to support the payment of benefits. Unlike qualified benefit plans, which have plan assets and a trust; nonqualified plans have no specific assets set aside for the payment of benefits. Nonqualified benefits are unfunded and unsecured.
To provide added security or comfort to an executive that benefits promised will be paid, most employers will "informally" fund a nonqualified benefit using a rabbi trust and/or employer-owned life insurance (BOLI/COLI), mutual funds, or other employer-held assets.
What is a Nonqualified Benefit Plan?
For individuals to maintain their standard of living in retirement, experts recommend having replacement income of 70-80% of pre-retirement income. However, due to non-discrimination testing and benefit limitations for qualified plans, highly compensated individuals are often unable to save sufficiently to reach these retirement goals.
For example, in 2010 the maximum contribution to a 401(k) is $16,500 ($22,000 if age 50+). An individual earning $50,000/yr may contribute a maximum of $16,500, or 33% of his/her income to his/her 401(k). An individual earning $250,000/yr is subject to the same limitation of $16,600, but in this case the maximum contribution represents 6.6% of his/her income. Nonqualified plans allow high earners to save more on a tax deferred basis.
What is the Purpose of Nonqualified Benefit Plans?
Nonqualified plans or "top hat" plans are technically subject to ERISA; however, they are exempt from ERISA's participation, vesting, funding, and fiduciary provisions, which are the most burdensome and costly requirements.
Employers are subject to ERISA's enforcement and preemption provisions, but these requirements are fairly straight forward and are generally not a burden to the employer. Top-hat plans require reporting and disclosure with the Department of Labor (DOL); however, these requirements can generally be satisfied by filing a short report with the DOL at the inception of the plan.
Are Nonqualified Plans Subject to ERISA Requirements?
ERISA defines a top-hat plan as, "a plan which is unfunded and maintained by an employer primarily for the purposes of providing deferred compensation for a select group of management or highly compensated employees." Generally, all nonqualified plans are designed to qualify as a top-hat plan.
What is a "Top Hat" Plan?
For Call Report purposes, nonqualified deferred compensation should be reported on Schedule RC, Item 20, "Other liabilities," and Schedule RC-G, Item 4, "All other liabilities." The annual compensation expense or "accrual" should be reported on Schedule RI, Item 7a, "Salaries and employee benefits."
For TFR reporting, nonqualified deferred compensation should be reported on SC796, "Other liabilities and deferred income." The annual compensation expense or "accrual" should be reported on SO510, "All personnel compensation and expense."
How is Deferred Compensation Reported for Bank Regulatory Purposes?
What is the Income Tax Treatment for Nonqualified Deferred Compensation?
Nonqualified deferred compensation is tax deductible as compensation expense; unlike qualified plans, the employer's tax deduction is delayed until the year benefits are paid to the individual.
Employee and employer contributions to a nonqualified deferred compensation plan are not taxable to the participant when deferred. Generally, there is no income tax on the deferred compensation until benefits are paid to the participant, usually at retirement.
Technically, directors and employees acting the capacity of a director are not employees of a corporation. Accordingly, nonqualified benefits paid to directors constitute self-employment income that is subject to income tax and self-employment tax when received.