What is a nonqualified retirement plan?

A way to save for retirement even if you don’t have an employer-sponsored plan

Derek Silva

By

Derek Silva

Derek Silva

Personal Finance Expert

Derek is a personal finance editor at Policygenius in New York City, and an expert in taxes. He has been writing about estate planning, investing, and other personal finance topics since 2017. He especially loves using data to tell a story. His work has been covered by Yahoo Finance, MSN, Business Insider, and CNBC.

Published September 7, 2021|5 min read

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Nonqualified retirement plans allow someone to save for retirement either through their employer or individually. Some types of nonqualified retirement plans are available for self-employed individuals, small companies, and people who want to save for retirement without going through an employer’s plan. For example, a traditional IRA allows most people to save for retirement whether or not they have an employer-sponsored retirement plan.

In practice, most nonqualified and qualified retirement plans — such as 401(k) plans — work very similarly. The exact difference comes down to tax law. Qualified retirement plans are defined in Section 401 of the Internal Revenue Code, but nonqualified plans are not. Qualified plans are also subject to the rules of the Employee Retirement Income Security Act of 1974 (ERISA). ERISA lays out how qualified plans should be managed and the legal requirements that employers must follow with any retirement plans they offer.

Key Takeaways

  • Nonqualified retirement plans generally work like qualified plans, allowing you to set aside some of your income now so that you can access it years later

  • Some types of nonqualified retirement plans are available for self-employed individuals, small companies, and people who can’t save for retirement through their employer

  • Nonqualified plans that are set up as deferred compensation plans don’t allow you to save and invest in the same way as other types of retirement plans

  • Eligibility requirements, contribution limits, and withdrawal rules vary so make sure to check the details of your specific plan

Nonqualified vs. qualified retirement plans

Qualified and nonqualified retirement plans both allow someone to save for retirement and they often work similarly. In general, a qualified retirement plan is offered by an employer and allows an employee to save for retirement using pre-tax money (income tax hasn’t been removed yet). Some nonqualified retirement plans are only available through an employer, but others don’t require you to go through your employer (like a traditional IRA). 

Your money in both a qualified and nonqualified plan grows tax-free, but when you pay tax depends on the type of plan you have. Most plans allow you to defer income taxes until you withdraw money, as with a 401(k) and traditional IRA. Roth accounts, like a Roth 401(K) or Roth IRA, require you to pay income tax before you contribute, but then you don’t have to pay income tax again.

Other differences between qualified and nonqualified retirement plans come down to the tax law. Qualified plans are defined in Section 401 of the Internal Revenue Code and legal requirements for their management are covered in ERISA, a 1974 labor law. Some nonqualified plans also work as deferred compensation plans, which is legally different from the plans laid out in Section 401 of the tax code.

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Types of nonqualified retirement plans

The most common types of nonqualified retirement plans include the following:

  • Traditional IRAs

  • Roth IRAs

  • Self-directed IRAs

  • SIMPLE IRAs (Savings Incentive Match Plan for Employees Individual Retirement Accounts)

  • SEP IRAs (Simplified Employee Pension Individual Retirement Accounts)

  • SARSEPs (Salary Reduction Simplified Employee Pensions)

  • Executive bonus plans

  • Deferred compensation plans

  • 403(b) plans

  • 457(b) plans

Individual retirement accounts (IRAs)

There are many types of IRAs and which you can use depends on how much you earn and whether an open an account yourself or through your employer.

A traditional IRA works much like a 401(k) plan with your money growing tax-free and you only paying income tax when you withdraw the money in retirement. However, instead of contributing pretax money straight from your paycheck, you contribute post-tax income to a traditional IRA and then you get a federal tax deduction for the income tax you paid on your contributions. The annual contribution limit is also much lower for an IRA than for a 401(k).

Roth IRAs take post-tax contributions and then don’t require you to pay income tax again. The idea is that you already paid income tax on the money you contribute, so you don’t need to pay it again when you withdraw in retirement. Because you pay tax up front, you can also withdraw your Roth IRA contributions before retirement as long as you’ve owned the account for at least five years.

A SIMPLE IRA functions similarly to a traditional IRA but it’s only available to self-employed individuals and businesses with fewer than 100 employees. An employer must create a SIMPLE IRA for their employee and accounts do take pre-tax contributions. SIMPLE IRAs are a hybrid of a personal IRA and an employer-sponsored qualified retirement plan.

SEP IRAs are only available to self-employed individuals and businesses with more than 100 employees. Additionally, only employers can create and make contributions to a SEP IRA (on behalf of an employee). Another kind of SEP IRA existed before 1997, known as a SARSEP, but SARSEPs are no longer available.

Executive bonus plans

An executive bonus plan, also called a 162 executive bonus plan or Section 162 plan, allows employers to offer additional benefits to company executives or owners. These plans can provide an indirect form of compensation, while offering tax benefits to the employees. One common use for an executive bonus plan is to provide employees with life insurance (particularly a whole life policy with a cash value).

Nonqualified deferred compensation plan (NQDC)

Nonqualified deferred compensation plans (NQDC plans) aren’t strictly retirement plans, but they allow a worker to defer their income until a later date. You could potentially use an NQDC to defer income for five years, 20 years, or potentially until you retire. NQDC plans are unique because you’re simply deferring income and you aren’t able to invest it or otherwise use it until the day you receive it. Your company may hold it in a trust (specifically a Rabbi trust), but they also may not. Deferred compensation is subject to loss since it’s still a company asset. For example, if the company goes bankrupt, it may be possible for creditors to seize money that would otherwise have been your deferred compensation.

NQDC plans can offer a lot of flexibility to employers. A company can pay salaries, bonuses, equity, and other benefits according to a vesting schedule or based on whether an employee meets performance goals. NQDC plans also allow companies to defer payment differently for regular employees and highly compensated employees, something that qualified retirement plans do not allow.

This type of plan is sometimes called a Section 409A NQDC plan because that section of the tax code regulates deferred compensation plans. You may also see the names deferred compensation program (DCP) or elective deferral program (EDP). 

403(b) plans

A 403(b) plan, also called a tax-sheltered annuity or TSA plan, works very similarly to a 401(k) except it’s offered by nonprofit organizations like churches and nonprofit universities. These plans are technically deferred compensation plans in which money is set aside until employees retire, but they function nearly the same as qualified plans.

457(b) plans

A 457(b) plan is a type of deferred compensation plan for certain state and municipal employees. It works much like a qualified plan, such as a 401(k). Similar public sector plans include 401(a) plans and Qualified Excess Benefit Arrangements.