Deferring compensation is one strategy employees can use to reduce their tax liability. Qualified and nonqualified are the two types of deferred compensation plans. To keep your business legal, learn how qualified vs. nonqualified plans differ.
Qualified vs. nonqualified plans
Qualified and nonqualified deferred compensation plans are both employee benefits for small business. But, both are handled very differently. There is a different set of rules for a qualified plan vs. nonqualified plan. Failing to understand the rules can lead to problems for you and your employees.
Similarities
If an employee defers compensation, they do not receive the money they earned in one year until a later, fixed year. Doing so provides the employee with an immediate reduction in taxes.
For many small businesses, qualified vs. nonqualified retirement plans are the most common. Retirement plans for employees are accessible to nearly 70% of employees, and deciding whether to use a qualified or nonqualified plan is an important business decision.
Both employers and employees can contribute money to qualified and nonqualified plans. And, you must put both qualified and nonqualified deferred compensation plans in writing so employees can review them.
Differences
Although both plans defer compensation, qualified and nonqualified deferred compensation plans are very different.
Examples of qualified deferred compensation plans include 401(k) and some types of IRA plans. Examples of nonqualified deferred compensation (NQDC) plans include supplemental executive retirement plans, salary reduction agreements, bonus deferral plans, and excess benefit plans.
Keep the following differences between qualified vs. nonqualified plans in mind.
1. Governance
Both qualified and nonqualified deferred compensation plans are governed by Section 409A. Section 409A is a tax code that differentiates between the two types of plans. And, it establishes requirements you and your employees must follow to stay compliant.
Qualified deferred compensation plans are also governed by the Employee Retirement Income Security Act (ERISA). ERISA sets more specific rules for participating in qualified plans. ERISA sets contribution limit, security, and participation rules.
Nonqualified deferred compensation plans are not governed by ERISA, so they have more flexible rules and fewer protections for your employees.
2. Contribution limits
Qualified and nonqualified retirement plans and other comp plans have different contribution limits.
Qualified deferred compensation plans have a limit. For example, employees can only defer up to $23,500 to their traditional 401(k) plan in 2025.
Nonqualified deferred compensation plans have no limit. Employees can defer as much of their compensation as they would like.
3. Security
Although there is no contribution limit for nonqualified deferred compensation plans, there is a security risk. Because NQDC plans are not covered by ERISA, employees have no guarantee that they will receive their money in the future.
NQDC plan funds are not separated from your general business funds. This means you do not have to set the money aside. If you were to face small business bankruptcy, creditors could claim your employees’ nonqualified plan money.
Qualified plans, on the other hand, are secure. Funds are placed into trust accounts that are separate from your business money.
4. Tax withholding
Both qualified and nonqualified deferred compensation plans let employees defer income taxes. However, treatment of FICA tax might vary.
Qualified plans are subject to FICA tax at the time of deferral. So before you set aside an employee’s contribution in their account, withhold Social Security (until the employee hits the Social Security wage base) and Medicare taxes.
Nonqualified plans are also subject to FICA tax at the time they defer the money. However, if the employee is required to perform substantial future services to receive their future payment, FICA tax is not owed until the employee has performed all the services, per the IRS.
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5. Employee participation
Another difference between qualified and nonqualified deferred compensation plans is employee participation.
When it comes to qualified plans, you are required to extend enrollment to all employees as long as they have been working at your business for a certain time and are a certain age. And, you must conduct nondiscrimination testing to make sure the plans do not favor certain employees over others.
You do not have to open up enrollment to all your employees for nonqualified plans. In fact, many businesses offer nonqualified plans only to their key or highly compensated employees.
6. Business tax deductions
You can deduct business expenses like employee wages and benefit contributions. However, when you can take tax deductions varies between qualified and nonqualified plans.
You can deduct qualified deferred compensation contributions (from you and your employee) at the time of deferral. However, you cannot deduct contributions for nonqualified plans until the employee actually receives the funds.
7. Reporting responsibilities
Contributions to qualified plans must be reported. The form you use varies depending on the type of qualified plan.
There are no significant reporting or filing requirements for nonqualified plans. However, make sure that you keep clear records of what money you owe employees and what money has been paid.
Offering employee benefits doesn’t have to mess up how you run payroll. Patriot’s online payroll software lets you run payroll in three easy steps so you can withhold deductions and pay employees without breaking a sweat. Try it for free today!
This article has been updated from its original publication date of April 2, 2018.
This is not intended as legal advice; for more information, please click here.