Insights

Qualified retirement plans, such as 401(k), 403(b), pension and profit-sharing plans, adhere to requirements established by the Internal Revenue Code and the Employee Retirement Income Security Act of 1974 (ERISA). These requirements include, among other things, disclosure rules, minimum coverage standards, contribution limits, vesting rules, and participation tests (participation tests are generally designed to ensure that plans do not discriminate in favor of highly compensated employees).

Non-qualified deferred compensation plans are typically offered by companies to attract, reward and retain their most critical employees whose needs cannot be met by qualified plans alone. These tax-deferred plans, which include Deferred Compensation Plans, Benefit Restoration Plans, Supplemental Executive Retirement Plans (SERPs) and IRC 457 Plans, do not meet ERISA guidelines but must follow rules set forth under Section 409A of the Internal Revenue Code. Importantly: non-qualified benefits must be paid from general assets of the plan sponsor (the company) and therefore may be forfeited if the company becomes bankrupt. Because of this “risk of forfeiture,” the IRS does not require nonqualified benefits to be taxed until actually received by the employee.

Today, the most common type of non-qualified deferred compensation plan is a “401k Excess” plan, which allows plan participants to voluntarily defer their compensation in amounts that exceed the contribution limits imposed on 401(k) plans and allows the company to extend the 401(k) match to compensation above the limit.

Most workers can no longer rely on company-paid pension plans to fund their retirement; therefore, it is the responsibility of the individual to contribute a portion of their current compensation to a retirement savings account. 401(k) plans are highly effective for most individuals but IRS limits on contributions ($23,000 in 2024 and $30,500 for individuals 50 years and older) and eligible compensation ($340,000 in 2024) limit their effectiveness for highly compensated employees.

401(k) plans are less effective for highly compensated employees because the aforementioned limits prevent them from deferring and saving the same proportionate amount of their income compared to most other employees. Many financial planners recommend a 70% - 80% income replacement ratio during retirement to maintain one’s pre-retirement standard of living. For example, someone who earns an annual salary of $400,000 would require retirement income of $280,000 - $320,000 to maintain their pre-retirement standard of living – this is may not be possible by only relying on the combination of qualified plans (their 401(k)) and social security benefits. A supplemental retirement plan for highly compensated employees can account for the “retirement savings gap” that might exist.

According to the Department of Labor, to be exempt from certain ERISA requirements, eligibility for a non-qualified deferred compensation plan must be limited to a “select group of management or highly compensated employees.” In practice, this generally means that eligibility should not exceed the highest paid 10% of all company employees and compensation for eligible employees should exceed the highly compensated employee standard ($155,000 for 2024).

Many companies identify a salary grade or title for eligibility so that employees with variable compensation don’t gain or lose eligibility from year-to-year. Furthermore, a “risk of forfeiture” exists if the plan sponsor (employer) becomes bankrupt; this risk is a primary reason for only offering these plans to highly compensated employees because they may be more capable of sustaining a financial loss than others.

Many non-qualified deferred compensation plans include customized deferral elections, company matches, customized vesting schedules and hand-picked investment options.

Plan participants have several potential deferral sources available: base salary, annual bonus, long-term/performance-based compensation and restricted stock units. Unlike 401(k) contributions that can be changed by the employee from one pay period to the next, supplemental retirement plan deferral elections are generally made in the fall of the preceding year from when they will be deferred (i.e., 2024 deferrals were selected in the fall of 2023 and these annual elections became irrevocable on December 31, 2023).

Many companies that offer supplemental retirement plans provide a match to plan participants who are impacted by the IRS limits on their 401(k) plans. Therefore, the company “restores” the match on “excess compensation,” which is the compensation that is greater than the qualified plan limit ($340,000 in 2024). Additionally, some companies choose to establish a vesting schedule for the match that is in-line with their 401(k)-vesting schedule, but others choose to use a delayed vesting schedule to encourage top executives to stay with the company – this is commonly referred to as a “golden handcuff” incentive.

Just as plan sponsors can dictate the supplemental retirement plan vesting schedules, they can also hand-pick the investment options that are included in the plan. Some plan sponsors choose to offer the same funds that are offered under the 401(k) plan, which promotes fund familiarity and ensures due diligence and fiduciary standards already met. However, other companies choose to offer a completely different set of investment options because their plan participants may be a more sophisticated investor than the average 401(k) participant or because there are fund classes available in the supplemental retirement plan that are not available to the 401(k).

Distributions are permitted under the following six circumstances:

1. Separation from service
2. Specified future date
3. Death
4. Disability
5. Financial hardship
6. Change in control of employer

Unlike a 401(k), supplemental retirement plan participants do not need to retire or reach a certain age to begin withdrawing distributions from their supplemental retirement account. However, participants must specify their distribution elections in advance, generally, at the same time they make their deferral elections.

Re-deferral of a previously deferred amount is allowed as long as the election to re-defer is made at least one year prior to the scheduled distribution date and the new distribution date is at least five years later. Short of an approved financial hardship, accelerated distributions are not permitted.

Unlike qualified retirement plans, non-qualified supplemental retirement plans do not provide favorable tax treatment for the sponsoring corporation. Compensation that is deferred is not deductible by the corporation until it is paid out at a later date, so current corporate taxes will be higher than they would be absent the deferred compensation. Similarly, company matching contributions are not deductible until paid out at a later date. If the plan offers mutual funds as investment choices for determining the rate of earnings to be added to the accounts, the capital gains and dividends generated by the funds are taxable on a current basis to the sponsoring corporation, even though the earnings accrue to the employees’ accounts on a tax-deferred basis. For this reason, many companies choose Corporate Owned Life Insurance (COLI) as an informal funding vehicle for their plans, since earnings on the investment funds within the COLI are not taxable to the corporation.