Certified Plan Sponsor Professional (CPSP) Practice Exam

Why must nonqualified plans remain unfunded?

1. To prevent current taxation of participants

2. To ensure benefits can be protected from creditors

3. If there is no risk of forfeiture of benefits, participants are subject to current taxation

4. To encourage full participation in the plan

The correct answer is: If there is no risk of forfeiture of benefits, participants are subject to current taxation

Nonqualified plans must remain unfunded primarily to avoid current taxation on participants. When a nonqualified deferred compensation plan is unfunded, the benefits are often considered part of the employee's income only when they are actually received. If the plan were funded and the benefits were vested, it could trigger immediate income tax liability for participants, as they would have an enforceable right to the benefits. Retaining an unfunded status allows for the deferral of income tax until the benefits are distributed, which is a key characteristic of these types of plans. In contrast to the other options, which present different aspects or implications of nonqualified plan structures, the critical reason behind keeping these plans unfunded is tied closely to taxation principles. This careful structuring enables employees to benefit from tax deferral until they actually access their funds.