Employees can lower their tax liability by deferring compensation, for example. Deferred compensation plans come in two varieties: qualified and nonqualified. Learn how qualified and nonqualified plans differ in order to keep your organization compliant.
Comparing qualified and nonqualified plans
Employee benefits for small businesses include both qualified and nonqualified deferred compensation schemes. However, they are both handled extremely differently. A qualified plan and a nonqualified plan are subject to various rules. You and your staff may experience issues if you don’t comprehend the rules.
When an employee defers payment, they wait to collect their earnings from one year until a subsequent, set year. The employee benefits right away from a tax decrease by doing this.
Qualified retirement plans as opposed to nonqualified ones are more typical for many small enterprises. Nearly 60% of workers in small businesses have access to retirement plans, and choosing between a qualified and nonqualified plan is a crucial business decision.
To eligible and nonqualified plans, both employers and workers may make financial contributions. Additionally, you must provide written notice of both qualified and nonqualified deferred compensation programs to employees so they can review them.
Although they both defer payment, qualified and nonqualified deferred compensation programs are substantially different from one another.
Plans like 401(k)s and some IRAs are examples of qualifying deferred compensation arrangements. Nonqualified deferred compensation (NQDC) schemes include things like supplemental executive retirement plans, salary reduction agreements, bonus deferral programs, and excess benefit plans.
Keep in mind the following distinctions between qualified and nonqualified plans.
Section 409A regulates deferred compensation arrangements, both qualified and nonqualified. The two types of plans are distinguished by Section 409A of the tax code. It also sets forth guidelines that you and your staff must adhere to in order to maintain compliance.
The Employee Retirement Income Security Act (ERISA), which was passed in 1974, also applies to qualified deferred compensation programs. For taking part in qualified plans, ERISA specifies more detailed guidelines. Rules for contribution cap, security, and participation are established by ERISA.
Since ERISA does not apply to nonqualified deferred compensation plans, their regulations are more lax and your employees’ rights are less protected.
2. Limits on contributions
The maximum contributions to qualified and nonqualified retirement plans as well as other comp programs vary.
Plans for qualified deferred compensation have a cap. Employees can only contribute up to $22,500 to their typical 401(k) plan in 2023, for instance.
Plans for nonqualified deferred compensation have no upper limit. The amount of pay that employees would like to defer is up to them.
There is a security risk even if nonqualified deferred compensation plans have no contribution cap. Employees have no assurance that they will receive their money in the future because NQDC plans are not covered by ERISA.
Your general business funds and NQDC plan monies are combined. This implies that you are not required to set away the money. The funds from your employees’ nonqualified plans could be taken by creditors if you had to declare bankruptcy for your small firm.
In contrast, qualified strategies are safe. The money is put into trust accounts, which are kept apart from your business funds.
4. Withholding taxes
Taxes can be postponed by employees in both qualified and nonqualified deferred compensation schemes. FICA tax treatment, though, could differ.
FICA tax is applicable at the time of deferral for qualified plans. Therefore, withhold Social Security and Medicare taxes before to depositing an employee’s contribution into their account (until they reach the Social Security pay base).
At the time they postpone the money, nonqualified plans are also subject to FICA tax. The IRS states that the FICA tax is not due until the employee has completed all the required services, even if the employee is expected to do significant future services before receiving their future payout.
5. Worker involvement
The level of employee engagement in eligible and nonqualified deferred compensation plans is another distinction.
As long as they have been employed by your company for a specific amount of time and are a specific age, you must allow all employees to enroll in eligible plans. Additionally, you must test the strategies for nondiscrimination to ensure that no employees are favored over others.
You are not required to allow all of your employees to enroll in nonqualified plans. In actuality, nonqualified plans are frequently only made available to important personnel or highly compensated employees.
6. Deductions for business taxes
Employee pay and benefit contributions are examples of business expenses that can be written off. However, qualifying and nonqualified plans have different rules about when you can deduct taxes.
Qualified deferred compensation contributions made by both you and your employee are deductible at the time of deferral. For nonqualified plans, you cannot deduct contributions until the employee receives the money, though.
7. Responsibilities for reporting
It is required to declare contributions to qualifying plans. Depending on the kind of qualified plan, a different form must be used.
Nonqualified plans are not subject to any onerous filing or reporting obligations. However, be careful to preserve accurate records of the money you have paid out to employees and the money you still owe them.