Certified Plan Sponsor Professional (CPSP) Practice Exam

How are distributions from nonqualified plans treated for tax purposes?

1. They are tax-exempt at all times.

2. They are taxable to the employer upon payment.

3. They are deductible by the employer when reported as income to the participant.

4. They incur a penalty if withdrawn early.

The correct answer is: They are deductible by the employer when reported as income to the participant.

Distributions from nonqualified plans are treated as taxable income to the participant when they are received. The employer can deduct the amount of the distribution in the same tax year that the distribution is included in the employee's income. This ensures that the employer is able to match their tax treatment with the tax liability created for the employee when they receive the income. In a nonqualified plan, the timing of when the deduction can be taken by the employer aligns with when the participant recognizes the income. Therefore, the correct answer reflects the tax treatment that allows for the employer to deduct contributions when they are reported as income by the participant. The other choices do not accurately represent the tax implications of nonqualified plan distributions. For example, nonqualified distributions are generally not tax-exempt, they do not incur penalties for early withdrawal in the same way qualified plans do, and they are not taxable to the employer solely upon payment, as taxation primarily occurs when the employee recognizes the income.