- The executive’s share of company profits is very small, and
- The executive is willing to shoulder the employer’s credit risk, and
- Providing the benefits through a qualified plan would be too expensive.
But they’re not so great when any of these conditions are missing. Let’s examine each in turn.
Small share of company profits: Nonqualified deferred compensation isn’t deductible for the company until it becomes taxable for the executive. If the executive is a substantial owner in a profitable enterprise, e.g. a law firm or medical group partner, any deferred income boomerangs right back as taxable profit. In contrast, qualified retirement plan contributions are deductible for the company when they’re made, and not taxable to the employee until they’re received in cash.
Willing to shoulder the employer’s credit risk: Funding vehicles like rabbi trusts can protect the executive from the employer’s unwillingness to pay, but not against its inability to pay. In today’s economic environment where even large companies are struggling, this risk may be unacceptable. Protection from both of these risks – and even from the executive’s personal creditors – is provided by a qualified plan.
Qualified plan too expensive: This is usually the main reason for setting up a deferred compensation plan. Qualified plans have many requirements that don’t apply to most nonqualified plans: coverage, nondiscrimination, government filings etc. But they’re more flexible than most people realize. In a cross-tested profit sharing/401(k) plan, top executives can often reach the annual $49,000 defined contribution limit with a 5% staff contribution. And if that’s not enough, a cash balance or other defined benefit plan can allow much higher deductions: up to an additional $100k-200k per year.
So, are we biased toward qualified plans? Oh, absolutely. Nonqualified plans can be a great choice, but make sure you’ve maximized your qualified plans first.