Nonqualified benefit plans let a business reward and retain key executives beyond the limits of a 401(k). Common forms include nonqualified deferred compensation, supplemental executive retirement plans, and executive bonus plans, often informally funded with corporate-owned life insurance. Benefits usually vest over time, creating golden handcuffs. These are unsecured promises subject to the employer's creditors and to IRS section 409A rules, so set them up with tax and legal counsel.
Is this a fit for you?
Who This Is For
- You want to reward and retain key executives beyond what qualified plans allow
- You want vesting schedules that encourage top people to stay
- You want to informally fund the promise with corporate-owned life insurance
- You want the business to potentially recover its cost through the policy
- You are a profitable business that can commit to the funding
Who This Is Not For
- You need a broad-based, qualified plan for all employees
- You cannot accept the unsecured-promise structure and its creditor risk
- You will not engage counsel to handle section 409A compliance
- Your key people would not value deferred, vesting benefits
- Your cash flow cannot support the funding
How do the options compare?
| Structure | Who Owns the Asset | Tax to the Executive | Typical Use |
|---|---|---|---|
| Nonqualified deferred compensation (NQDC) | The employer owns any informal funding asset, such as corporate-owned life insurance | Deferred amounts are generally taxed when paid, subject to section 409A rules | Let a key executive defer salary or bonus and reward long service |
| Supplemental executive retirement plan (SERP) | The employer owns and funds the promise, often with corporate-owned life insurance | Benefits are generally taxed as ordinary income when received | Provide an employer-paid supplemental retirement benefit to select executives |
| Executive bonus (section 162) plan | The executive owns the life insurance policy; the employer pays or bonuses the premium | The bonus is generally taxable to the executive when paid | Give a select executive a portable, individually owned benefit funded by the employer |
| Split-dollar arrangement | The employer and executive share a life insurance policy's premiums, cash value, and death benefit under a written agreement | Taxed under the split-dollar rules, based on an economic benefit or a loan, so structure it with tax counsel | Provide and often recover the cost of a key executive's coverage while sharing the policy's value |
What are the risks, costs, and alternatives?
The benefit is an unsecured promise
NQDC and SERP benefits are an unsecured promise to pay, so the executive is a general creditor of the employer. If the company becomes insolvent, the promised benefit can be lost to the company's other creditors. Structure and disclose this risk with counsel.
Section 409A rules are strict
IRS section 409A imposes strict rules on when deferral elections are made and how and when distributions occur. Mistakes can carry accelerated taxation and additional penalties for the executive, so the plan document and its administration must be handled carefully with tax and legal counsel.
Corporate-owned life insurance has its own rules
When corporate-owned life insurance informally funds the plan, it carries its own notice-and-consent and tax requirements. Failing to meet the employer-owned life insurance notice and consent rules before issue can affect the tax treatment of the death benefit.
Accounting and administrative obligations
These plans carry ongoing accounting, reporting, and administrative obligations. They should be designed and maintained with tax and legal counsel so the documentation, funding, and disclosures stay consistent over the life of the plan.
What does this look like in practice?
Golden Handcuffs for Three Key Executives
Illustrative example: not an actual client.
A profitable company wants to reward and retain three key executives whose contributions the business depends on. Because a 401(k) alone cannot deliver the level of benefit it has in mind, the company installs a nonqualified deferred compensation plan for the three executives.
The company informally funds the promise with corporate-owned life insurance, and the benefits vest over five years. The vesting schedule acts as golden handcuffs: it encourages the executives to stay through the vesting period rather than leave for a competitor. The policy is structured so the company can potentially recover its cost over time.
The executives understand the benefit is an unsecured promise, meaning they are general creditors of the employer if it becomes insolvent. The company designs the plan with its tax and legal counsel to address section 409A and the corporate-owned life insurance rules.
Illustrative scenario for educational purposes. Plan design, vesting, funding, and tax treatment vary by situation. This is not tax, ERISA, or legal advice; consult your tax and legal counsel.
Common Questions
How do nonqualified benefit plans differ from a 401(k)?
A 401(k) is a qualified plan with contribution limits that apply to all eligible employees. Nonqualified plans, such as deferred compensation, SERPs, and executive bonus plans, let a business reward select key executives beyond those limits. They offer more design flexibility, but they are unsecured promises subject to the employer's creditors and to IRS section 409A rules.
What are golden handcuffs in an executive benefit plan?
Golden handcuffs are vesting schedules that reward an executive for staying. Because benefits usually vest over a period of years, an executive who leaves early forfeits the unvested portion. This structure is designed to encourage top people to remain with the company rather than move to a competitor during the vesting window.
What risk does an executive take with a nonqualified deferred compensation plan?
Nonqualified deferred compensation and SERP benefits are an unsecured promise to pay, so the executive is treated as a general creditor of the employer. If the company becomes insolvent, the promised benefit can be lost to the company's other creditors. This creditor risk should be structured and disclosed with tax and legal counsel.
Why is corporate-owned life insurance used to fund executive benefit plans?
Businesses often informally fund these promises with corporate-owned life insurance so the company can potentially recover its cost over time. The policy is a company asset, not a guarantee to the executive. Corporate-owned life insurance carries its own notice-and-consent and tax requirements that must be met before the policy is issued.
Related Questions
Want to Reward and Retain Your Key People?
We help business owners design a nonqualified plan and its life insurance funding so it fits the company's goals. We work alongside your tax and legal advisors on the section 409A and documentation details.
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