Non-Qualified Plans (W-2)

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

The non-qualified plan on a W-2 is 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 with qualified retirement savings plans.

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

A non-qualified plan is meant to meet specialized needs for certain employees, mainly key executives, and act as a tool for their recruitment and retention. 

What Are the Types of Non-Qualified Plans?

The types of non-qualified plans include:

• Deferred-compensation plan: Allows an employee to earn wages during one year, but receive the wages 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), excess benefit, bonus, and severance pay plans. Sometimes this sort of plan is referred to as a 457(b) plan or a 457(f) plan. 

• Salary-continuation plan: Funds for the future retirement benefit of an executive or top-tier employee come from the employer. In other words, the employer continues to pay the employee even during retirement, although it may be at a reduced rate.

• Executive bonus plan: Provides supplemental benefits to choice executives and employees while being counted as a deductible business expense for the employer. Basically, an employer issues a life insurance policy and pays for the premiums, reporting them as bonus compensation.

• Split-dollar life insurance plan: Permits the premium costs, cash value, and tax/legal benefits of a permanent life insurance plan to be shared between an employer and employee. This sort of arrangement is not highly regulated, so the details can differ based on the specific situation and contract.

• Group carve-out plan: Replaces part of an employee’s group life insurance policy with an individual life insurance policy to avoid excess costs.

Which Employees Are Eligible for Non-Qualified Plans?

The employees who are eligible for non-qualified plans are typically executives and other key employees. This is because non-qualified plans are designed to meet their specific needs as high earners—and to provide extra incentive to keep them at a particular company. 

One exception to the executive rule involves deferred-compensation plans which teachers or other specific seasonal workers may also fall under. But instead of deferring part of their income into retirement as in a standard plan, teachers may defer a portion of their income throughout the school year so that they continue to get paid at the same rate in the summer months when they’re not working.

Employers may also find it valuable to offer non-qualified plans to high-earning independent contractors. By deferring some of their pay into retirement, the employer doesn’t have to play the entire salary immediately. 

How Are Taxes Calculated on Non-Qualified Plans?

Taxes for non-qualified plans are actually split between when the money is earned and when it is paid out.

FICA taxes, which are comprised of Medicare and Social Security tax payments, are taken out of the employee’s paycheck when they earn it, as most taxes are. 

However, the bulk of the federal income tax withholding for non-qualified plans is not calculated or withheld until the money is actually paid out. Since it’s going to be calculated based on future tax rates (sometimes decades in the future, if the employee is far 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 bracket during retirement than while they’re still working.

Other Important Tax Information About Non-Qualified Plans

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

1. The plans are funded using after-tax dollars.

2. Employers can’t 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 on up to $1 million worth of supplemental wages, at a rate of 25%. For supplemental wages exceeding $1 million, the rate is 35%.

5. On an employee’s W-2 form, reported distributions from a non-qualified plan are reported in box 11.

How Can Non-Qualified Plans Benefit Employers?

Non-qualified plans benefit employers in a number of ways:

• They offer a greater amount of flexibility than plans covered under ERISA because employers can choose to offer them only to the executives and employees who will benefit most from them. 

• They don’t have any non-discrimination rules, so the plans can be tailored to meet the needs of executives and key employees and don’t have to be proportionately equal for all employees. One reason for this is to prevent excessive weighting that tends to favor employees who are earning more.

• They can be used as an incentive to keep employees loyal. Employees usually forfeit non-qualified plans if they leave the company before retirement.

• They can improve cash flow since a portion of earned compensation is deferred to the future.

• The costs of setup and administration are minimal, there are no special annual costs, and the IRS doesn’t require any filings.