Nonqualified deferred compensation: an important source of retirement income.

Nonqualified deferred compensation plans provide a valuable source of retirement income for many thousands of U.S. employees. These plans benefit not only senior corporate officers, but also many mid-level managers, salespersons, and other professional staff.

Nonqualified plans have been thoroughly scrutinized by Congress and the media in recent months. Although some abuses may have developed in this area that need to be addressed, recent legislative proposals would needlessly curtail many beneficial and nonabusive nonqualified deferred compensation plans.

We provide below some general background on the differences between qualified and nonqualified plans and the key rules that apply to nonqualified plans. We explain how nonqualified plans play a meaningful role in the retirement and compensation programs of U.S. companies and how these plans help fill the gaps in retirement income caused by various Internal Revenue Code (Code) limitations. We explain that unlike "tax shelters," nonqualified plans have substantial economic and legal consequences for employers and employees. Finally, we address some of the nonabusive plan features that Congress and the media have recently scrutinized.

"QUALIFIED" AND "NONQUALIFIED" PLANS

It is difficult to know exactly what types of arrangements are intended to be covered when the term "nonqualified deferred compensation plan" is used. Generally, any employer-sponsored retirement plan or arrangement that does not meet the requirements for a "qualified retirement plan" under section 401(a) of the Code can be described as a "nonqualified deferred compensation plan" or a "nonqualified plan." For purposes of this discussion, only nonqualified plans sponsored by for-profit employers will be considered.

Employers Prefer to Provide Qualified Plan Benefits

Favorable federal income tax rules apply to an employer maintaining a "qualified" retirement plan. The employer may deduct amounts as they are contributed to the plan's trust, and the earnings on the trust assets are not taxed. By contrast, an employer may not deduct amounts set aside to meet its obligations under a nonqualified plan until plan benefits are paid to, and taxable to, employees. Further, the employer must pay tax on the earnings generated by any such amounts set aside. Given these tax advantages, an employer would strongly prefer to provide retirement benefits to its employees through its qualified plan(s), rather than a nonqualified plan.

Employees Prefer to Receive Qualified Plan Benefits

Employees would also strongly prefer to have their retirement benefits provided for in a qualified plan, because (1) an employer is not required to set aside any assets to fund a nonqualified plan, and (2) any amounts it does set aside must remain subject to the claims of its creditors. Thus, if an employer goes bankrupt, employees are very likely to lose a significant portion, or all, of their nonqualified plan benefits. By contrast, employers are required to fund benefits earned under a qualified plan by contributing assets to a trust. If the employer becomes insolvent, its creditors may not reach these assets, as they must be held by the trustee for the "exclusive benefit of plan participants." In addition, benefits under qualified plans (but not nonqualified plans) generally are exempt from the employee's own creditors in bankruptcy.

The federal income tax treatment of an employee is also more favorable under a qualified plan. Generally, benefits earned under both qualified and nonqualified plans are taxed only upon distribution to an employee. However, the taxation of certain distributions from a qualified plan will be deferred if the employee "rolls over" the distribution into an IRA or another qualified plan. Distributions from a nonqualified plan may not be rolled over, and thus, are subject to immediate taxation. In addition, except for 401(k) contributions, there are no Social Security taxes on contributions or benefits under qualified plans.

Thus, there are a host of reasons both employers and employees prefer to have retirement benefits provided under a qualified plan rather than a nonqualified plan. However, as explained below, the Code contains numerous limits on contributions and benefits under qualified plans. These limits are intended to cap …