What Is It?
A 401(k) wraparound plan is a nonqualified deferred compensation (NQDC) plan that supplements or "wraps around" the already existing tax-qualified 401(k) plan that you offer to your employees. It also allows both you and your employees to make contributions that exceed the limits imposed on contributions made to a qualified 401(k) plan. A wraparound plan usually includes the same features offered through a traditional 401(k) plan, but without any of the restrictions and limitations placed on traditional 401(k) plan contributions.
Tip: A wraparound plan must be unfunded and participation limited to a select group of management and highly compensated employees in order to provide the benefit of tax deferral and avoid most of the burdensome requirements of the Employee Retirement Income Security Act of 1974 (ERISA). This is often referred to as a "top-hat" plan.
Caution: The American Jobs Creation Act of 2004 enacted important provisions, contained in Internal Revenue Code Section 409A, that impacted almost all nonqualified deferred compensation (NQDC) plans. For the first time ever, there were statutory rules that governed NQDC plan deferral elections, distributions, funding, and reporting. The Act imposed serious consequences for noncompliance: the vested benefits of affected participants would be subject to current taxation, and an interest charge and 20% penalty tax would also be imposed. The Act applied to amounts deferred after December 31, 2004. However, amounts deferred before January 1, 2005, were also covered by the new rules if they were not vested by that date. The new rules also applied to amounts deferred before January 1, 2005, under plans that are materially modified after October 3, 2004.
How Does It Work?
Generally, 401(k) wraparound plans work in the following manner:
- Participants elect to defer a percentage of their compensation into the wraparound plan.
- Rather than being paid currently to the participant, compensation is deferred into the wraparound plan where it is credited to a bookkeeping account for the benefit of the participant.
- The participant may decide how the funds in his or her wrap account are invested. The investment alternatives offered will generally mirror those available in the employer's qualified 401(k) plan.
- The earnings in a participant's wrap account depend completely on the performance of the investments selected by the participant. These are often referred to as "hypothetical earnings" to reflect the fact that they are simply credits to the participant's NQDC plan bookkeeping account.
Caution: Usually, the employer (or trustee in a NQDC plan informally funded with a rabbi trust) is not obligated to actually invest any assets in the manner selected by the participant. The participant's investment election merely controls the amount of hypothetical earnings that are credited to the participant's wrap account each year. The IRS has suggested in the past that if the employer (or trustee) is obligated to actually invest assets as directed by the participant, this might be too much "dominion and control," resulting in immediate taxation under the constructive receipt or economic benefit theories.
- Some wraparound plans credit the participant's wrap account with an employer contribution equal to the match the employee would have received if the deferral had been made to the employer's 401(k) plan.
- Upon retirement, separation from service, or some other event, the participant is entitled to the current balance of his or her vested wrap account.
Caution: In the past, some plans provided that distributions from an employee's wrap account would be made at the same time, and in the same form, as the employee's 401(k) plan distribution. This plan design is generally no longer permitted as a result of IRC Section 409A.
- Even though a wraparound plan must be unfunded, employers often set aside assets (for example, in a rabbi trust) or purchase corporate-owned life insurance (COLI) in order to ensure they have enough working capital available when it comes time to pay plan benefits. This is often called "informally funding" the NQDC plan. As with any informally funded supplemental executive retirement plan (SERP), any assets set aside by the employer for the payment of plan benefits remain subject to the claims of the employer's creditors.
How Can A 401(K) Wraparound Plan Complement An Existing Qualified 401(K) Plan?
Individuals can't defer more than $19,500 of annual compensation to a qualified 401(k) plan in 2020 (up from $19,000 in 2019). Highly compensated individuals may wish to defer compensation significantly in excess of this amount each year. A nonqualified 401(k) wraparound plan allows highly compensated individuals to defer as much of their compensation into the plan as they wish, even if the amount deferred exceeds the limit for qualified 401(k) plans.
Tip: Individuals age 50 and older can defer an additional $6,500 to a qualified 401(k) plan in 2020 (up from $6,000 in 2019).
Caution: Remember, there is risk associated with deferring funds into an NQDC plan. The main risk is that the employer may become insolvent and that the employee may end up receiving nothing from the plan.
In addition, the amount that highly compensated individuals can defer into a qualified 401(k) plan often depends upon the average deferrals made by non-highly compensated employees. Highly compensated employees sometimes don't know how much they can defer into a 401(k) plan until after the close of a year, when testing is done on the plan. This is where a nonqualified 401(k) wraparound plan can be very convenient. A 401(k) wraparound plan can be designed as follows:
- All of a participant's deferred compensation goes into the wraparound plan
- At the end of the year, when testing is complete, the maximum amount that an employee can contribute to the qualified 401(k) plan is transferred from the nonqualified 401(k) wraparound plan to the qualified 401(k) plan
- The remaining balance of compensation deferrals, if any, remains in the nonqualified 401(k) wraparound plan
401(K) Wraparound Plan Considerations
Employees Covered By the Plan
You generally cannot include all of your employees who are adversely affected by the traditional 401(k) limits in your 401(k) wraparound plan. You can only include those employees who are members of a select group of management or highly compensated employees (that is, a "top-hat" group).
401(K) Wraparound Plan Features
When setting up a 401(k) wraparound plan, you should be careful not to replicate all of the features of your traditional 401(k) plan because certain provisions (i.e., plan loans, freedom to choose time and manner of distributions, and hardship withdrawals) could cause your employee to be immediately taxed on benefits under either the doctrine of constructive receipt, the economic benefit doctrine, or IRC Section 409A.
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