Specialized Returns and Taxpayers · Retirement plans

Qualified and non-qualified plans

The word “qualified” is not a compliment. It is a statutory status that buys three specific tax results, and every condition in IRC § 401(a) is the price of one of them. A non-qualified plan gives up all three and gets one thing in return: freedom from the coverage and non-discrimination rules that force an employer to cover rank-and-file workers on the same terms as executives.

The rule

What qualification means (IRC § 401(a)(1)). a qualified trust is a trust created or organised in the United States forming part of a stock bonus, pension or profit-sharing plan of an employer for the exclusive benefit of employees or their beneficiaries, to which the employer, the employees or both contribute for the purpose of distributing the corpus and income to those employees or beneficiaries in accordance with the plan (IRC § 401(a)(1))^TY2026 under the trust instrument it must be impossible, at any time before all liabilities to employees and their beneficiaries are satisfied, for any part of the corpus or income to be used for or diverted to any purpose other than the exclusive benefit of employees or their beneficiaries (IRC § 401(a)(2))^TY2026 The exclusive benefit requirement is the backbone: the assets must be beyond the employer’s reach until every liability to participants is satisfied.

What it buys. the tax bargain of a qualified plan has three parts: the employer deducts the contribution when made under IRC § 404, the employee is not taxed until distribution under IRC § 402(a), and the trust’s earnings accumulate free of tax under IRC § 501(a)^TY2026 any amount actually distributed to a distributee by an IRC § 401(a) employees’ trust exempt under IRC § 501(a) is taxable to that distributee, in the year distributed, under the annuity rules of IRC § 72 (IRC § 402(a))^TY2026 These three results only travel together. A plan cannot have the deduction without the participant’s deferral, or the tax-free accumulation without the exclusive benefit condition that makes it possible.

Benefits cannot be reached. a trust is not qualified unless the plan provides that benefits may not be assigned or alienated, disregarding a voluntary revocable assignment of up to 10 percent of a benefit payment by a participant already receiving benefits; a participant loan secured by the accrued nonforfeitable benefit and exempt from IRC § 4975 is not an assignment or alienation (IRC § 401(a)(13))^TY2026 That protection is also a constraint: it is why a qualified plan cannot be used as collateral, and why the participant loan exemption in IRC § 4975(d)(1) had to be written explicitly.

The non-qualified alternative, if it is funded. contributions to an employees’ trust that is not exempt under IRC § 501(a) are included in the employee’s gross income under IRC § 83, substituting the value of the employee’s interest in the trust for the fair market value of the property — so a funded non-qualified arrangement is taxed on vesting rather than on payment (IRC § 402(b)(1))^TY2026 amounts actually distributed or made available by such a trust are taxable to the distributee in the year distributed or made available under IRC § 72, except that distributions of trust income before the annuity starting date are included in gross income without regard to IRC § 72(e)(5) (IRC § 402(b)(2))^TY2026 A funded non-qualified arrangement is therefore usually pointless: the employee is taxed on vesting, before receiving anything.

And if it is unfunded. The classic non-qualified deferred compensation arrangement is a bare promise. The employee has no property, so IRC § 83 does not apply and nothing is taxed until payment. The price is that the promise ranks with those of the employer’s general creditors, and must genuinely do so — a trust that shelters the money from creditors is a funded arrangement and brings IRC § 402(b) back.

The employer’s deduction follows the employee. where a plan is not a qualified pension, annuity, stock bonus or profit-sharing plan, the employer’s deduction falls in the taxable year in which the amount attributable to the contribution is includible in the participating employees’ gross income — and where more than one employee participates, only if separate accounts are maintained for each (IRC § 404(a)(5))^TY2026 This is the structural difference that matters most in planning. A qualified plan gives the employer a deduction years before the employee is taxed; a non-qualified plan matches the two, so the deferral costs the employer the time value of its deduction.

IRC § 409A polices the promise. the plan must provide that deferred compensation may not be distributed earlier than separation from service, disability, death, a specified time or fixed schedule stated at the date of deferral, a change in ownership or effective control of the corporation or of a substantial portion of its assets, or an unforeseeable emergency (IRC § 409A(a)(2)(A))^TY2026 the plan must not permit acceleration of the time or schedule of any payment, except as the Secretary provides by regulation (IRC § 409A(a)(3))^TY2026 an election to defer compensation for services performed during a taxable year must be made no later than the close of the preceding taxable year; in the first year of eligibility the election may be made within 30 days of becoming eligible, as to services performed after the election; and for performance-based compensation based on services over at least 12 months it may be made up to 6 months before the end of the period (IRC § 409A(a)(4)(B))^TY2026 a subsequent election to delay a payment or change its form may not take effect until at least 12 months after it is made, and for most payment events the first payment under it must be deferred at least 5 years from when it would otherwise have been made (IRC § 409A(a)(4)(C))^TY2026

And punishes failure severely. if a non-qualified deferred compensation plan fails the distribution, acceleration or election requirements at any time during a taxable year, or is not operated in accordance with them, all compensation deferred under the plan for that year and all preceding years is includible in gross income for that year to the extent not subject to a substantial risk of forfeiture and not previously included — but only for the participants to whom the failure relates (IRC § 409A(a)(1)(A))^TY2026 on such an inclusion the tax for the year is increased by interest at the underpayment rate plus one percentage point, computed as though the deferred compensation had been included when first deferred or when it ceased to be subject to a substantial risk of forfeiture, plus an amount equal to 20 percent of the compensation included (IRC § 409A(a)(1)(B))^TY2026 Note who bears it: the employee, not the employer that drafted the plan.

Two funding traps. assets set aside in a trust or similar arrangement to pay non-qualified deferred compensation are treated as property transferred under IRC § 83 — whether or not available to general creditors — if they are located outside the United States when set aside or are later moved there, and a transfer is also deemed to occur when assets are restricted in connection with a change in the employer’s financial health (IRC § 409A(b)(1), (2))^TY2026

Current figures

How it works in practice

When a client asks why they cannot simply defer the executive’s bonus into a plan and deduct it now, the answer is IRC § 404(a)(5). The deduction and the inclusion are welded together outside the qualified plan world. An employer deferring a large bonus for ten years is lending the government the deduction for a decade, and that cost has to be weighed against whatever the arrangement achieves.

Test whether an arrangement is funded before anything else, because that single question decides which regime applies. Money in a rabbi trust — a grantor trust whose assets remain subject to the employer’s general creditors — is unfunded for these purposes and IRC § 402(b) does not apply. Money in a secular trust, or in any arrangement that protects the employee from the employer’s creditors, is funded, and the employee is taxed on vesting under IRC § 83 whether or not anything has been paid.

For IRC § 409A, get the initial election in before the year begins. The general rule allows no deferral election for compensation earned in a year once that year has started. The two exceptions are narrow: thirty days from first eligibility, and six months before the end of a performance period of at least twelve months for performance-based compensation. Neither is a general escape, and an election made in January for that year’s salary is simply invalid.

When an IRC § 409A failure has occurred, quantify it before advising. The inclusion is not the current year’s deferral; it is everything deferred under the plan for that year and every preceding year, to the extent vested and not previously taxed, plus 20 percent of that amount, plus interest computed as though the whole thing had been taxed when first vested. For a long-standing arrangement that number can exceed the account balance.

How this has changed

IRC § 409A was added by the American Jobs Creation Act of 2004, Pub. L. 108-357 § 885, generally for amounts deferred in taxable years beginning after 31 December 2004, in response to the Enron collapse and the acceleration of executive deferrals ahead of it. Before that, non-qualified deferred compensation was governed by constructive receipt and economic benefit doctrine and a body of revenue rulings. The statute did not replace those doctrines; it added a set of hard requirements on top, so an arrangement must now satisfy both.

The final regulations under IRC § 409A were issued in 2007 and the correction programmes in Notice 2008-113 and Notice 2010-6 followed. Those notices remain the practical route out of most operational and document failures, and they matter more in practice than the statute’s own terms, because a failure corrected under them can avoid the additional tax entirely.

The IRC § 402(b) treatment of funded arrangements is much older and has not moved. What has changed is the surrounding practice: rabbi trusts became standard after Rev. Proc. 92-64 published a model trust, and the IRC § 409A(b)(1) offshore rule and IRC § 409A(b)(2) financial-health trigger were added in 2004 to close the two routes by which an arrangement could be made secure without being called funded.

Exam focus

Know the three tax advantages of a qualified plan as a set, and know that IRC § 404(a)(5) removes the first of them outside that world. Expect a question contrasting the timing of the employer’s deduction under the two regimes.

Know that a funded non-qualified arrangement is taxed to the employee on vesting under IRC § 402(b) and IRC § 83, and that “funded” turns on whether the employer’s general creditors can reach the assets.

Know the IRC § 409A election timing rules — prior year in general, thirty days in the first year of eligibility, six months before the end of a performance period of at least twelve months — the six permitted distribution events, the bar on acceleration, and the 20 percent additional tax plus interest on failure.

Check yourself

1. An employer promises a key employee $100,000 payable in five years, records a liability, and deducts it currently. Is the deduction allowable?

Answer: No. IRC § 404(a)(5) defers the employer’s deduction to the taxable year in which the amount is includible in the employee’s gross income, which on an unfunded promise is the year of payment. Accrual accounting does not override it; the section is a specific timing rule that displaces the general rules for this class of payment.

2. A company establishes a trust to pay deferred compensation, funds it, and provides in the trust deed that the assets remain subject to the claims of the company’s general creditors in insolvency. Is the employee taxed on funding?

Answer: No. That is a rabbi trust. Because the assets remain reachable by general creditors the employee has received no property, IRC § 83 is not engaged, and IRC § 402(b) does not apply. The employee is taxed on payment and the employer deducts then. The arrangement gives protection against a change of heart, not against insolvency — which is the only protection the tax law will allow without accelerating the tax.

3. A newly hired executive becomes eligible for a non-qualified plan on 1 September. On 20 September she elects to defer 40 percent of her remaining 2026 salary. Is the election valid?

Answer: Yes, as to services performed after the election. IRC § 409A(a)(4)(B)(ii) allows an election within 30 days of first becoming eligible, and 20 September is inside that window. The election cannot reach compensation for services already performed between 1 and 20 September; only compensation for services performed after the election may be deferred under it.

4. A plan permits a participant to request early payment of deferred amounts on 10 percent forfeiture of the balance. Is that acceptable?

Answer: No. That is the “haircut” provision IRC § 409A(a)(3) was written to stop: the plan permits acceleration of the time of payment, and no regulation allows this one. The plan fails on its terms whether or not anyone uses the provision, and every affected participant faces the cumulative inclusion plus the additional tax.

5. A participant in a non-qualified plan has $600,000 of vested deferrals accumulated since 2018. An operational failure occurs in 2026 affecting her alone. What is included, and what is added?

Answer: The whole $600,000, to the extent vested and not previously included, is income in 2026 under IRC § 409A(a)(1)(A) — not just the 2026 deferral. On top, IRC § 409A(a)(1)(B) adds 20 percent of the included amount, so $120,000, plus interest at the underpayment rate plus one percentage point computed as though each amount had been included when it vested. Only participants to whom the failure relates are affected.