What's the difference between a QUALIFIED and a NON-QUALIFIED retirement plan?

Qualified retirement plans make up most of the plans in the US.  QUALIFIED means that the plan adheres to IRS laws and regulations concerning coverage of employees, reporting to participants and to the government, and benefit limits.  If a plan is filed with IRS for approval, it is said to be a qualified plan.  The qualified status has several advantages:

  • The contributions made by the employer to the plan are tax-deductible to the employer.

  • The investment income generated within the plan is not currently taxed to the employer or to the plan participants.

  • The benefits, when paid out to the participants, are not subject to FICA or other payroll-based taxes.

  • The plan assets are safe from the employer's creditors.

In a NON-QUALIFIED plan, these advantages are not always available.  However, sometimes the disadvantage of not being "qualified" by IRS can be outweighed by other issues.  If the taxation issues are minor or not applicable (such as with non-profit companies), then not having to adhere to IRS standards creates some advantages over qualified plans.  And, for certain types of employers, non-qualified plans are the only types of plans that are legally available.

Non-Qualified Versus Qualified Plan Issues

1.    Do you want the plan to be subject to the coverage, eligibility, vesting, benefit limit and reporting issues under ERISA, IRS, and DOL?  Qualified plans must adhere to all rules, while non-qualified plans usually do not.

2.    Do you want the plan contributions to be absolutely tax-deductible, without question?  In a non-qualified plan, the contributions must be irrevocably made to the plan and be forever unavailable to the employer.  Same for a qualified plan, in which contributions are always deductible.

3.    Do you want the participants NOT to be taxed on the contributions or investment income?  In a qualified plan, this is always true.  In a non-qualified plan, it may be true only if the participant has a "substantial risk of forfeiture" with respect to the benefits.

4.    Do you want the plan assets to be free from creditors?  Usually not true in a non-qualified plan.

5.    Do you want the plan to be "funded" (i.e., cash contributions are actually made in advance) or "non-funded" (ghost accounts are maintained and cash contributed only to pay benefits)?  In a funded arrangement, a non-qualified plan may need a "Rabbi Trust" to achieve these goals.


Types of Non-Qualified Plans

Excess Benefit Plans, Top-Hat Plans, or SERP's

Excess Benefit Plans (EBP), Top-Hat Plans (THP), or Supplemental Executive Retirement Plans (SERP) are non-qualified deferred compensation arrangements designed to supplement qualified retirement plans.  They accomplish this by "making up" for the benefits unavailable to the base qualified plan due to benefit restrictions on the qualified plan.  The non-qualified plan usually covers only the few highest paid employees.  The plan can be funded or non-funded.  If it is funded, a Rabbi Trust is recommended to avoid current tax on the plan assets.  (A Rabbi Trust does NOT shield the plan assets from potential creditors.)  The problem with this type of plan from the employee's standpoint is that nothing is really promised in the event the company goes out of business, or is bought out by another company.


Section 403(b) Plans

Section 403(b) plans were designed to allow certain non-profit organizations access to retirement plans that were similar to qualified plans for profit-seeking entities.  The 403(b) plan is available to a 501(c)(3) company (one organized for religious, charitable, scientific, literary, or educational purposes, or for amateur sports, child safety, or animal cruelty prevention). 

Obviously, the tax-deductibility issues are moot for such a company.  Some years ago, this was the only type of plan available to 501(c)(3) companies.  Today, these companies can adopt conventional qualified 401(k) plans instead of, or in addition to, 403(b) plans.  The popularity of 401(k) plans has made 403(b) plans much less common today.

Issue   

401(k)   

403(b)

Discrimination Testing

ADP Test

None

ERISA Requirements

All

Only if Matched

Government Reporting

Full

Few

Maximum Deferral

$17,500 (2013)

$17,500 (2013)

Can "Catch Up" Deferrals

$5,500 (Age 50 in 2013)

Some

Investment Options

Almost Any

Mutual Funds / Annuities


Section 457 Plans

Section 457 plans are non-qualified deferred compensation plans for state and municipal governments.  This obscure section of the Internal Revenue Code was added in 1978.  It allows contributions set aside in a deferred compensation arrangement, made by a state or municipal government, to be credited to an account for the employee, and not be currently taxable to the employee as long as there is no "constructive receipt" of the income.  The constructive receipt rule is based on whether the employee has ready access to the account.  In a 457 plan, the money is not available until the participant terminates employment with the government body.  The plan may offer several investment options, and may otherwise be made to resemble the 401(k) qualified plan counterpart.  The trust is still subject to the general claims of the government's creditors, but of course the funding of the plan is backed by the taxing authority of the government body.

If you have any more questions about any of these types of non-qualified retirement plans, please contact us at ALI Actuarial & Retirement Plan Services.