What Are Non-Qualified Plans (W-2)?

Non-qualified plans on a W-2 are a type of retirement savings plan that is employer-sponsored and tax-deferred. They are non-qualified because they  fall outside the Employee Retirement Income Security Act (ERISA)  guidelines and are exempt from the testing required for qualified retirement savings plans.

To be clear, both the popular  401(k)  and  403(b)  plans are qualified. They are not considered non-qualified plans, so the information on this page will not apply to those plans.

The purpose of a non-qualified plan is to meet the special needs of certain employees, primarily key executives, and to serve as a tool for their recruitment and retention.

What are the types of non qualified plans?

Types of non-qualified plans include:

• Deferred-compensation plan:  This allows an employee to earn a salary during one year, but receive pay in a later year (most often during retirement). Deferred compensation can include retirement, pension, and stock option plans. Deferred-compensation plans also include wraparound 401(k), fringe benefits, bonus, and severance pay plans. Sometimes this type of plan is referred to as a 457(b) plan or a 457(f) plan.
• Salary-continuation plan:  The money for an executive or top-level employee's future retirement benefits comes from the employer. In other words, the employer continues to pay the employee during retirement, although it may be at a reduced rate.
• Executive Bonus Plan:  Provides supplemental benefits to favored executives and employees while counting as a deductible business expense for the employer. Basically, an employer issues a life insurance policy and pays the premiums, reporting them as bonus compensation.
• Split-dollar life insurance plan:  Allows the premium costs, cash value, and tax/legal benefits of a permanent life insurance plan to be shared between the employer and employee. This type of arrangement is not highly regulated, so the details can vary depending on the specific situation and contract.
• Group Deduction Plan:  A portion of the employee's group life insurance policy is replaced with an individual life insurance policy to avoid additional costs.

Which employees are eligible for non-qualified plans?

Employees eligible for non-qualified plans are usually executives and other key employees. That's because non-qualified plans are designed to meet their specific needs as high-income people -- and to provide an additional incentive to keep them at a particular company.

One exception to the executive rule involves deferred-compensation plans, which can also cover teachers or other specialized seasonal workers. But instead of deferring part of their income into retirement as in the standard plan, teachers can defer part of their income throughout the school year so they can keep getting paid at the same rate during the summer months when they aren’t working.

Employers may also find it valuable to offer non-qualified plans to high-income independent contractors. By deferring part of their pay until retirement, the employer does not have to pay the full salary right away.

How are taxes calculated on non-qualified plans?

For non-qualified plans the tax is actually split between the time the money is earned and when it is paid out.

FICA taxes, which   consist of  Medicare  and  Social Security tax payments , are, like most taxes, deducted from an employee's pay when he or she earns it.

 However, the bulk of  the federal income tax deduction for non-qualified plans isn't calculated or withheld until the money is actually paid out. Since it will be calculated based on future tax rates (sometimes decades in the future, if the employee is far away from retirement), there's no real way to predict what those taxes will look like.

This can potentially benefit the employee, as many individuals will find themselves in a lower tax slab during retirement than while they are still employed.

Other important tax information about non-qualified plans

Here are some things employers need to know about taxes, especially when it comes to non-qualified deferred-compensation plans:

1. These schemes are funded by post-tax money.
2. Employers cannot claim their contributions as a tax deduction (in most cases).
3. For income tax withholding purposes, distributions   are considered supplemental wages .
4. Employers are required to apply federal tax withholding rules at a rate of 25% on supplemental pay up to $1 million. For supplemental pay over $1 million, the rate is 35%.
5. On an employee's W-2 form, distributions received from a non-qualified plan are shown in Box 11.

How can non-qualified plans benefit employers?

Non-qualified plans benefit employers in several ways:

• They offer greater flexibility than plans covered under ERISA, since employers can choose to offer them only to those executives and employees who will benefit the most from them.
• They have no nondiscrimination rules, so plans can be tailored to meet the needs of executives and key employees and do not need to be proportionately equal for all employees. One reason for this is to prevent excessive weighting that favors higher-earning employees.
• These can be used as incentives to keep employees loyal. Non-qualified plans generally require employees to lose their benefits if they leave the company before retirement.
• They can improve cash flow because a portion of the compensation earned is deferred for the future.
• Setup and administration costs are minimal, there are no special annual costs, and no filings to the IRS are required.