What is a 401(k) Wraparound Plan?

A 401(k) wraparound plan is a nonqualified deferred compensation (NQDC) plan that supplements or "wraps around" the tax-qualified 401(k) plan that you already provide to your employees. It also permits you and your employees to make contributions over the limits imposed on 401(k) contributions. A wraparound plan typically offers the same benefits as a traditional 401(k) plan but without any restrictions and assistance limits imposed by conventional 401(k) plans.

A wraparound plan must be unfunded to provide tax deferral and avoid the majority of the burdensome requirements of the Employee Retirement Income Security Act of 1974. Participation must be restricted to a select group of management and highly compensated employees (ERISA). This is commonly known as a "top hat" plan.

Caution: The American Jobs Creation Act of 2004 enacted significant provisions in Section 409A of the Internal Revenue Code that impacted virtually all nonqualified deferred compensation (NQDC) plans. NQDC plan deferral elections, distributions, funding, and reporting were governed by statute for the first time ever. The Act imposed severe penalties for noncompliance: the vested benefits of affected participants were subject to current taxation, an interest charge, and a 20% penalty tax. After December 31, 2004, the Act applied to amounts deferred. However, amounts deferred prior to January 1, 2005, if not vested by that date, were also subject to the new rules. The new restrictions also apply to amounts deferred before January 1, 2005, under plans substantially modified after October 3, 2004.

How Does It Function?

In General

In general, 401(k) wraparound plans function as follows:

• Participants can defer a portion of their pay into the wraparound plan.
• Instead of being paid to the participant immediately, compensation is deferred into the wraparound plan and credited to a bookkeeping account for the participant's benefit.
• The participant may choose how to invest the funds in their wrap account. Generally, the investment options provided will mirror those of the employer's qualified 401(k) plan.
• The earnings in a participant's wrap account depend entirely on the performance of the participant's chosen investments. These are frequently called "hypothetical earnings" to reflect that they are merely bookkeeping credits to the participant's NQDC plan account.

Caution: Generally, the employer (or trustee in an NQDC plan funded informally with a rabbi trust) is not required to invest the participant's assets in the manner selected. The participant's investment choice merely determines the number of hypothetical earnings credited to the participant's wrap account annually. In the past, the IRS has suggested that if an employer (or trustee) is required to invest assets as directed by a participant, this may constitute too much "dominion and control" and result 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 matching contribution the employee would have received had the deferral has been made to the employer's 401(k) plan.
• The participant is entitled to the current balance of their vested wrap account upon retirement, separation from service, or some other event.

Previously, specific plans stipulated that distributions from an employee's wrap account would be made simultaneously and in the same manner as the employee's 401(k) plan distribution. As a result of IRC Section 409A, this plan design is no longer generally permitted.

• Even though a wraparound plan must be unfunded, employers frequently set aside assets (such as in a rabbi trust) or purchase corporate-owned life insurance (COLI) to ensure they have sufficient working capital to pay plan benefits when the time comes. This is commonly called "informal funding" of the NQDC plan. As is the case with any informally funded supplemental executive retirement plan (SERP), any assets set aside by the employer to pay plan benefits are subject to the claims of the employer's creditors.

How Can A 401(K) Wraparound Plan Complement A Qualified 401(K) Plan?

Individuals can only defer up to $19,500 annually to a qualified 401(k) plan in 2020 (an increase from 2019's limit of $19,000). Highly compensated individuals may wish to defer compensation in excess of this amount each year. A nonqualified 401(k) wraparound plan permits highly paid individuals to wait for as much payment as desired, even if the amount deferred exceeds the limit for qualified 401(k) plans.

In 2020, individuals aged 50 or older can contribute an additional $6,500 to a qualified 401(k) plan, up from $6,000 in 2019.

Remember that there are risks involved with deferring funds into an NQDC plan. The primary risk is that the employer could become insolvent, resulting in the employee receiving nothing from the plan.

In addition, the amount highly compensated individuals can defer into a qualified 401(k) plan frequently depends on the average amount deferred by non-highly compensated employees. Sometimes, highly compensated employees only know how much they can defer into a 401(k) plan when the plan is tested at the end of the year. Here, a nonqualified 401(k) wraparound plan can greatly assist. One can design a 401(k) wraparound plan as follows:

• The participant's total deferred compensation is contributed to the wraparound plan.
• The maximum amount 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 at the end of the year when testing is complete.
• The balance of any remaining compensation deferrals remains in the nonqualified 401(k) wraparound plan.

401(K) Wraparound Plan Factors to Consider

Individuals Covered By the Plan

Generally speaking, you cannot include all of your employees who are negatively impacted by traditional 401(k) limits in your 401(k) wraparound plan. You may only have employees who belong to a select group of management or highly compensated workers (that is, a "top-hat" group).

Features of 401(k) Wraparound Plans

When establishing a 401(k) wraparound plan, you should be careful not to replicate all of your traditional 401(k) plan's features, as specific provisions (e.g., plan loans, freedom to choose time and manner of distributions, and hardship withdrawals) could cause your employee to be immediately taxed on benefits under the doctrine of constructive receipt, the economic benefit doctrine, or IRC Section 409A.

Please Note: While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we need to be qualified to advise on tax or legal matters. Discussing tax or legal problems with the appropriate professional would be best.

The Lynch Retirement Investment Group has prepared some of the following materials. The material is considered reliable, but Raymond James Financial Services, Inc. does not guarantee that the foregoing is accurate or complete. This information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. This information is not intended as a solicitation or an offer to buy or sell any security referred to herein. The investments mentioned may not be suitable for all investors. The material is general in nature. Past performance may not be indicative of future results. Raymond James Financial Services, Inc. does not provide advice on tax, legal, or mortgage issues. These matters should be discussed with the appropriate professional.

401(k) plans are long-term retirement savings vehicles. Withdrawal of pre-tax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59 1/2, may be subject to a 10% federal tax penalty. Matching contributions from your employer may be subject to a vesting schedule. Please consult with your financial advisor for more information.

Lynch Retirement Investment Group 2016, 2017, 2018, and 2019

John M. Lynch, CIMA®, CPWA®

John M. Lynch, CIMA®, CPWA® Managing Director
LRIG, Financial Advisor– RJFS, of Lynch Retirement Investment Group, LLC.
Was named on the 2021 Forbes Best-In-State Wealth Advisor List.

John M. Lynch, CIMA®, CPWA® Managing Director – LRIG, Financial Advisor – RJFS

Andrew Fentress, CFP® Financial Advisor

Adam Tobin, CFP®, CRPC Customer Relationship Manager

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