Qualified retirement plans earn their name by “qualifying” participants and sponsors for certain tax benefits. But sometimes administrative and other concerns outweigh these benefits. Nonqualified plans offer other options.
Qualified retirement plans are employer-sponsored retirement plans that “qualify” participants for certain tax benefits by meeting requirements under federal law for coverage, participation, funding and vesting.
Employers take a current tax deduction for all plan contributions, while employee accounts grow tax-free until the time of distribution. Employer contributions to qualified plans are held in trust until the employee is entitled to receive them, an arrangement that helps assure employees that the money will actually be there when they retire.
Qualified retirement plans have several drawbacks. Plans must cover at least 70 percent of non-highly compensated employees and employers must generally offer them to all full-time employees on the same terms. Any time an employer makes a contribution, it must make contributions on behalf of all participants. Some plans require employers to make annual contributions whether or not the company is profitable. Benefits are not guaranteed in most plans, and participants face a substantial penalty for early withdrawals.
In addition, complex rules create high administrative costs for plan sponsors, and maximum contribution limits mean employers might not be able to adequately compensate high-wage or valuable workers. In response, some companies have turned to non-qualified plans.
Non-qualified plans allow an employer to offer a benefit to a select group of executive or key employees. If the plan is properly structured, the employer can include only those employees it chooses without having to abide by the anti-discrimination, participation or vesting rules that qualified plans must follow.
Although non-qualified plans are subject to fewer government regulations, they receive fewer tax benefits. Any earnings in the plan are taxable to the employer, and taxable to the employee when distributed as benefits. However, the employer can take a tax deduction at the time of distribution. And since non-qualified plan contributions are not held in a separate trust, employees receive no guarantee that benefits will be there when they retire, and any assets set aside for future payouts are subject to claims by employers’ creditors.
Employers can reduce the potential financial risk to non-qualified benefits by setting up an IRS-approved irrevocable trust into which the employer contributes the plan assets, which are managed and distributed by the trustee. Although these trusts do not protect the assets against creditors’ claims in case of company insolvency, they generally offer protection in the event of a corporate takeover, change in management or other events that could threaten the availability of benefits. Without a requirement that non-qualified plan assets be held in trust, many companies pay non-qualified benefits out of general corporate assets as they become due. This approach assumes that future growth of the company will cover its benefit obligations. Smaller companies might find this arrangement strains their coffers on payout day and leaves executives wondering about the security of their benefits.
An alternative to the pay-as-you-go approach is to create an asset reserve for future plan obligations by using corporate-owned life insurance (COLI). Typically, the company buys a cash value life insurance policy, either whole life or universal life, on the life of the key employee and names itself as beneficiary. The employer owns the policy and pays all premiums. After the employee retires, the company can use the policy’s cash value to pay the benefit. If the employee dies, the policy pays a tax-free death benefit to the company.
The advantage of funding with COLI is that the cash accumulation inside the policy grows tax-free. However, COLI offers no protection against any creditor’s claims, so it won’t provide an employee total peace of mind. A trust can hold the COLI; however, trusts have tax implications for both the employer and the participant.
We can work with your tax professional to help you set up a nonqualified plan that benefits both your company and your highly compensated employees. Call a USI Metro office for more information.