What is a Nonqualified Plan?
A nonqualified (NQ) plan is simply a plan that does not qualify under Internal Revenue Code (Code) section 401(a), which includes standards for who can participate in the plan, how benefits are accrued, vesting schedules, distribution options, etc. However, one or more other Code sections will still govern the tax implications of a NQ plan (e.g., 403(b), 457(b), 457(f), 409A, and 451).
Nonqualified Plan Types and Basics
NQ plans come in many different forms and practitioners are continually designing new ways of deferring income, and related investment gain and taxes, to some point in the future. Here are some of the types of NQ plans.
403(b) Plan – Very similar to a 401(k) plan, this plan permits a participant to defer a portion of his/her compensation up to an annual limit, and permits a sponsor to make matching contributions. Only Code section 501(c)(3) tax-exempt entities and governmental educational organizations can sponsor this type of plan. Many school systems and hospitals sponsor 403(b) plans. When a public school system sponsors the plan, the 403 (b) plan is a non-ERISA plan because the sponsoring entity is ERISA-exempt. However, a 403 (b) plan sponsored by a tax-exempt organization may be either an ERISA or a non-ERISA plan depending on the involvement of the plan sponsor. And, yes, this can cause significant confusion when deciding whether an actual QDRO is necessary.
457(b) Plan – Also known as an “eligible deferred compensation plan,” this plan permits a participant to defer a portion of his/her compensation up to an annual limit. Only governmental and tax-exempt entities can sponsor this type of plan. There are a few key differences in these plans depending on whether the sponsor is a governmental or tax-exempt entity. Government sponsored 457(b) plans are not subject to ERISA, while those sponsored by tax-exempt entities are almost always ERISA plans.
457(f) Plan – Similar to a 457(b) plan, this plan is known as an “ineligible deferred compensation plan” because it does not adhere to the 457(b) plan annual deferral limits. As a trade off the tax rules are not as lenient as for a 457(b) plan, especially one sponsored by a tax-exempt entity.
Supplemental Executive Retirement Plan (SERP) – A SERP usually pays to an executive the additional benefits the executive would have received under a qualified plan if the various Code limits on compensation, benefits, and contributions had not applied to the qualified plan. Although this can be an account balance plan (i.e., a defined contribution plan like the 403(b) plan), a SERP usually provides a nonaccount balance benefit (i.e., a defined benefit plan similar to a traditional pension). These are almost always top-hat plans that are partially subject to ERISA.
Deferred Compensation Plan – Although this generic term can apply to just about any plan, we are using it here to describe a top-hat plan that permits a participant to defer a portion of his/her compensation, similar to the 403(b) and 457 plan deferrals, but that is sponsored by a private for-profit employer. These are almost always top-hat plans that are partially subject to ERISA.