Comparing Non-Qualified and Qualified Plans

At the outset, when comparing nonqualified and qualified plans, it is important to understand that one type of plan is not inherently superior to another.  Both have their place in the business client's employee benefits, and their suitability is determined principally by the client's situation and objectives.  Having said that, let's begin by considering the principal characteristics of qualified plans.

We can begin by identifying the principal qualified retirement plans.  Qualified retirement plans fall into two general categories:

Defined contribution plans, and
Defined benefit plans

A defined contribution qualified plan is a qualified plan characterized by individual accounts.  Under these plans, contributions are typically made to the plan by the employer and may or may not include contributions from the participating employee.  

The benefit that the participant receives depends on the contributions made to the individual's account and any added forfeitures, the investment performance of the account assets and any expenses allocated to it.  Normally, at the employee's retirement he or she may take a lump-sum distribution or receive periodic payments.  Under these plans, the employer does not guarantee a particular benefit.

Plans that fall under the rubric defined contribution plans include all of the following:

Money purchase pension plans
Thrift plans
Target benefit plans
Profit sharing plans
Stock bonus plans
Cash-or-Deferred Arrangements -- more commonly known as 401(k) plans
SEPs (Simplified Employee Pensions)
SIMPLE Plans, and
ESOPs (Employee Stock Ownership Plans).

Defined benefit plans take an approach that can be seen as diametrically opposed to defined contribution plans.  Specifically, while defined contribution plans are couched in terms of the contribution to be made, defined benefit plans are couched in terms of the benefit to be provided.  

Defined benefit plans are characterized by all of the following:

Plan formulas are geared to benefits rather than contributions
The annual contribution from year to year must normally be determined actuarially
Forfeitures reduce the employer's subsequent contributions rather than increase the participants' benefits

For the most part, we can identify a defined benefit qualified plan as any qualified retirement plan that is not a defined contribution plan.

We noted earlier that a qualified plan is simply one that meets certain requirements and, thereby, qualifies for a current income tax deduction for contributions made to it.  It is important that the extent of the requirements not be minimized.  Although there are many other qualified plan requirements, the requirements that a qualified plan must meet -- and which are particularly important in a comparison with a nonqualified plan -- include the following:

The plan must satisfy minimum coverage requirements, and, if it is a defined benefit plan, it must satisfy minimum participation requirements.
Plan contributions or benefits may not discriminate in favor of highly compensated employees, and
The plan must meet certain vesting, i.e. nonforfeitability, requirements.

Minimum Coverage and Participation in Qualified Plans

A qualified plan's minimum coverage and participation requirements, while not requiring that every employee be included, must ensure that a minimum percentage of a company's workforce be included in the plan.  In contrast, a nonqualified plan is generally one specifically designed for a single key executive or -- in some cases -- for a specific group of key executives.

By requiring that a minimum percentage of the workforce be included in the plan, a qualified plan could not operate to provide a benefit to one individual in a workforce of many employees.

Non-discrimination in Qualified Plans

A plan must meet certain non-discrimination requirements in order to be a qualified plan.  One of those important requirements is that neither its benefits nor its contributions may discriminate in favor of highly compensated employees.  

Discrimination -- when that term is used in common parlance -- has been damned largely because of the unequal treatment it causes.  When that discrimination is based on inappropriate criteria, it should be condemned.  However, employers discriminate all the time in terms of salary, position and perquisites.  The difference in permissible discrimination is that it is based on performance.  As a result, the best performers generally receive the largest salaries, the highest positions in the organization and the most sought -- after perks.

In the design of a nonqualified plan for a key executive, the employer legitimately wants to discriminate in favor of that particular executive who would probably be considered a highly compensated employee.  Since a qualified plan may not discriminate in favor of highly compensated employees, it is clearly an inappropriate vehicle for delivering this kind of benefit.

Vesting Requirements in Qualified Plans  

One of the hallmarks of qualified plans is the requirement that, at some point, benefits must be nonforfeitable.  In other words, they must vest in the plan participant.  In general, qualified plan benefits must vest at least as quickly as under one of the following two regimes:

5-year "cliff" vesting, or
7-year graded vesting

Under the 5-year cliff vesting regime, no vesting is required to take place until the participant has 5 years of service with the employer.  Under the 7-year graded vesting regime, benefits must vest at least 20 percent after 3 years of service and vest an additional 20 percent each year thereafter until they are 100 percent vested after 7 years.  The alternative minimum vesting schedules are as shown below:

Minimum Vesting Schedules
Years Of Service
5-Year Cliff Vesting
7-Year Graded Vesting



7 or more

These two minimum qualified plan vesting schedules are accelerated to 3-year cliff vesting and 6-year graded vesting for employer matching contributions and for qualified plans that are considered top heavy.  Of course, an employer may vest benefits faster than shown on either of these minimum schedules.

In a nonqualified plan, the employer may want to retain key executives by making it expensive for them to terminate their employment.  Normally, this is accomplished by making the plan benefits forfeitable in the event of the executive's voluntary termination.  This aspect of salary continuation type deferred compensation plans causes them to be known as the "golden handcuffs."  Obviously, the forfeiture of benefits resulting from an executive's voluntary termination at any time prior to retirement would not be permitted in a qualified plan.

We have discussed the selectivity and lack of qualified plan requirements applicable to nonqualified plans.  There are two other significant differences between qualified plans and nonqualified plans that need explanation:

Income tax treatment, and
Cost recovery.

The most visible difference between qualified plans and nonqualified plans -- and the difference to which business owners are often the most sensitive -- is the income tax treatment of contributions to the plan.  Qualified plans enable business owners to currently deduct contributions made to them; in contrast, nonqualified plan contributions are not deductible.  

 The second difference between qualified plans and nonqualified plans is often not fully appreciated by clients.  That difference is cost recovery.  In many nonqualified plans, an employer may be able to recover its costs for the entire plan and, as a result, have no long-term cost.  Qualified plans have no provision for cost recovery by the employer.