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Slash Your Tax Bill: The Financial Strategy Business Owners Need to Know

Updated: Apr 19

## Introduction to Non-Qualified Retirement Plans

A non-qualified retirement plan is a type of deferred compensation plan intended to supplement qualified retirement plans like 401(k)s and IRAs for certain highly compensated employees. Unlike qualified plans, non-qualified plan contributions and earnings are not put into a separate trust. Instead, general assets of the company are typically used to informally fund the plan, allowing greater flexibility and control for the business owner.

While the terminology may be confusing, non-qualified retirement plans have nothing to do with meeting IRS "qualification" requirements. They are simply plans that do not receive the same upfront tax benefits as qualified plans. However, non-qualified plans can still provide substantial tax deferral advantages. Depending on the specific plan design, funds contributed to a non-qualified plan are not taxed until distributed. At that point, the funds distributed are taxed as ordinary income.

For business owners or executives making over the 401(k) contribution limits, non-qualified plans can be an attractive supplement to maximize tax-deferred savings. The plans provide flexibility in plan design and allow targeting benefits to key employees. However, non-qualified plans also come with administrative complexity, risks, and costs that need to be fully considered.

## Benefits of Non-Qualified Plans

Non-qualified plans can provide business owners with a number of benefits compared to traditional qualified retirement plans. Some key advantages include:

**Flexibility** - Non-qualified plans allow for much more flexibility than qualified plans. There are less restrictions on eligibility, vesting schedules, and distribution rules. Business owners can make contributions as they desire each year.

**Allow Larger Contributions** - Non-qualified plans do not have the same contribution limits as 401(k)s and other qualified plans. Owners can contribute well in excess of $20,500 per year if they want. This allows for much faster accumulation of retirement assets.

**Creditor Protection** - Assets in properly structured non-qualified plans receive creditor protection similar to 401(k)s and IRAs. This allows owners to shield retirement savings from lawsuits or bankruptcy. Specific creditor protection rules vary by state.

In summary, non-qualified plans provide business owners with more flexibility, higher contribution levels, and creditor protection. This can allow for more customized and accelerated retirement savings compared to qualified plans.

## Types of Non-Qualified Plans

Non-qualified plans come in several forms that provide business owners different benefits and options for reducing taxes.

### Deferred Compensation

Deferred compensation plans allow business owners to defer receiving a portion of their compensation until a later date, usually retirement. The business deducts the deferred compensation amount when earned, while the owner doesn't have to pay income tax until received. Deferred comp can be set up as elective deferrals or non-elective.

### Split Dollar

Split dollar plans are arrangements where the business and the owner split the costs and benefits of a permanent life insurance policy. The business pays the premiums, which are tax deductible. The cash value and death benefit are split between the business and the owner, allowing tax-deferred growth.

### Supplemental Executive Retirement Plans (SERPs)

SERPs provide supplemental retirement benefits to select executives in excess of qualified plan limits. The business funds the plan and takes a tax deduction, while the executive defers taxation until retirement. These plans can be designed as defined benefit or defined contribution.

## Contribution Limits

Unlike qualified retirement plans, non-qualified plans do not have federal limits on annual contributions. The company sponsoring the plan sets the contribution limits. This gives business owners the flexibility to contribute as much or as little as they want each year.

With qualified plans like 401(k)s, the total annual pre-tax contributions an employee can make are capped by the IRS. For 2022, the contribution limit is $20,500 plus an additional $6,500 catch-up contribution for those over age 50. The total contribution limit to a 401(k) plan is $61,000 for 2022.

Non-qualified plans allow business owners to contribute well beyond these limits. Common contribution amounts range from $50,000 to $500,000 or more per year. The company designs the plan terms and contribution schedule.

Having no federal contribution limits is a main benefit of non-qualified plans. Business owners can save as much as they want on a pre-tax basis. The main constraints are affordability and the impact contributions have on cash flow. With proper planning, non-qualified plans give owners the ability to sock away substantial retirement savings.

## Tax Benefits

Non-qualified plans offer business owners several key tax benefits that can help reduce their overall tax burden:

- **Deductible When Funded**: Contributions made by the business owner to a non-qualified plan are tax deductible as a business expense. This allows the contributions to reduce the business's taxable income for the year.

- **Tax Deferred Growth**: The assets in a non-qualified plan grow tax deferred. This means no taxes are owed on capital gains, interest, dividends or other investment growth until funds are withdrawn. As a result, money can compound and grow more quickly than in a taxable investment account.

- **Distribution Tax Rates**: When funds are eventually distributed, the business owner pays taxes at ordinary income rates rather than capital gains rates. For some business owners in higher brackets, this may be more favorable than paying capital gains. Withdrawals can also be structured to help manage the owner's overall tax liability.

The key benefit is that non-qualified plans allow business owners to set aside substantial funds in a tax-advantaged way. The deductible contributions and tax deferred growth provide significant tax savings that can enable an owner to accumulate wealth more quickly. Consulting with a financial advisor can help determine if a non-qualified plan aligns with an owner's goals and makes sense as part of their overall financial strategy.

## Investment Options

Non-qualified plans offer business owners and employees a great deal of flexibility when it comes to selecting investments. Unlike qualified retirement accounts like 401(k)s, there are no restrictions on the types of investments that can be held in a non-qualified plan.

Some popular investment options for non-qualified plans include:

- Stocks - Both individual stocks and stock mutual funds can be included. This allows participants to invest for growth.

- Bonds - Individual bonds, bond funds, and other fixed-income investments can provide stable returns and income.

- Mutual funds - Equity mutual funds, bond funds, money market funds and more can be used to create a diversified portfolio.

- ETFs - Low-cost exchange-traded funds tracking stock indexes and other investments are commonly used.

- REITs - Real estate investment trusts can provide exposure to real estate.

- Commodities - Commodity funds offer diversification and may help hedge inflation.

The key advantage of non-qualified plans is that there are no restrictions on investment selections beyond what plan documents dictate. This gives participants the flexibility to build a customized portfolio fitting their individual risk tolerance, goals and investment preferences. With thoughtful selection of investments, non-qualified plans can help drive growth, income, and diversity.

## Distribution Rules

Non-qualified plans have more flexibility than qualified plans in terms of distribution rules. While qualified plans require distributions to begin at age 72 and follow required minimum distribution rules, non-qualified plans allow more control over distributions.

Some key aspects of distribution rules for non-qualified plans:

- **Distributions can be taken at any time: ** Account owners can take distributions from a non-qualified plan at any age and are not forced to begin taking required minimum distributions. This provides more flexibility to determine an optimal distribution strategy.

- **Distributions are taxed as ordinary income:** All distributions from a non-qualified plan are taxed at ordinary income tax rates rather than lower capital gains rates. The distributions also increase taxable income for the year taken.

- **Taxation upon separation:** If an employee separates from the company, the non-qualified account balance is usually distributed and taxed immediately at ordinary income rates. This can result in a significant one-time tax bill if the balance is substantial.

- **Ability to pass to beneficiaries:** Non-qualified plans allow account owners to name beneficiaries who can inherit any remaining balance tax-deferred after death. This provides an estate planning benefit compared to qualified plans.

Business owners should understand these distribution rules and factor the less favorable tax treatment into their overall financial plan when using non-qualified deferred compensation. Consulting with a tax advisor can help project tax impacts over time and determine optimal distribution strategies.

## Potential Downsides of Non-Qualified Plans

Non-qualified plans come with some potential drawbacks that business owners should be aware of before implementing them.

- **Not Protected Like Qualified Plans**

One of the biggest downsides is that non-qualified plans do not receive the same creditor protection as qualified plans like 401(k)s. The assets in a non-qualified plan are not in a separate trust, so they can be accessed by creditors in the case of bankruptcy or lawsuits. Business owners should have appropriate liability insurance if implementing a non-qualified plan.

- **Tax Uncertainty**

The tax treatment of non-qualified plans is not set in stone like qualified plans. While Congress has not changed the tax rules so far, there is always the possibility they could in the future. The tax deferral benefits could be eliminated. Business owners take on some tax uncertainty using these plans.

Overall, non-qualified plans should not replace qualified plans, but can be used in conjunction as an additional tax planning strategy for business owners. The lack of creditor protection and potential tax law changes create some uncertainty that must be considered.

## Who Should Consider Non-Qualified Plans

Non-qualified plans are most beneficial for certain types of business owners and employees. Some key groups who may want to consider implementing a non-qualified plan include:

### Highly Compensated Employees

Employees who earn over the compensation limits for qualified retirement plans can benefit from non-qualified plans. For 2023, the compensation limit is $330,000. So executives and other highly paid employees who exceed the limit can use non-qualified plans to shelter more compensation from taxes.

### Business Owners

Owners of companies like partnerships, sole proprietorships, and S-corps that want to contribute more than the defined contribution limits for qualified plans may find non-qualified plans advantageous. The 2023 limit for 401(k) plans is $66,000 for those over age 50. Non-qualified plans allow owners to make larger tax-deferred contributions.

### Those Who Have Maxed Out Qualified Plans

For those who have already contributed their legal maximum to 401(k)s, 403(b)s, SEP IRAs, and other qualified plans, non-qualified plans offer another tax-advantaged savings opportunity. They can supplement qualified plans to optimize retirement savings and tax minimization.

So in summary, non-qualified plans can provide additional benefits beyond qualified plans for top earners, business owners, and savers who have already maximized other options. With strategic planning, they can significantly reduce taxes.

## Implementation Guidance

Properly implementing a non-qualified plan requires careful planning and adherence to plan documents and reporting requirements. Here are some key steps for business owners:

- Work with an experienced attorney to draft the proper plan documents and agreements. These establish eligibility, contribution limits, vesting schedules, and distribution rules. Proper documents are crucial for gaining tax benefits.

- Understand all [IRS reporting requirements]( for non-qualified plans. For deferred compensation plans, forms W-2 and 1099-MISC must reflect compensation when earned, even if not paid until later.

- Set up accounting procedures to track contributions, earnings, distributions and proper tax treatment. Work closely with your finance team and advisors to ensure proper reporting.

- Communicate plan details clearly to participants. Make sure they understand tax implications of participation, any limits on distributions, and applicable vesting schedules.

- Review plans annually to ensure they still meet business needs. Update documents if required and confirm IRS reporting compliance.

- Consult experienced ERISA attorneys, accountants and financial advisor when establishing plans. Their input will help avoid costly mistakes.

Proper setup and administration of non-qualified plans requires dedication. But the tax benefits for business owners make it well worth the effort. Seeking expert help throughout the process is highly recommended.

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