Qualified and nonqualified retirement plans

Two families, one dividing line

Retirement plans split into two families, and the line between them is federal tax law. A qualified plan meets the requirements of the Internal Revenue Code — chiefly 26 U.S.C. § 401(a) for employer plans — and in exchange receives favorable tax treatment. A nonqualified plan does not meet those requirements, usually on purpose: the employer gives up the tax advantages to gain the freedom to choose who is covered.

What a plan must do to qualify

A qualified plan is a written, permanent plan run for the exclusive benefit of employees and their beneficiaries, with its assets held in trust. The Code attaches many conditions to that trust. The ones an insurance producer should know:

• No discrimination in favor of highly compensated employees, tested on contributions or

benefits (26 U.S.C. § 401(a)(4)–(5)).

• Minimum vesting: the plan must meet the section 411 vesting standards, so an employee's

right to employer money becomes nonforfeitable on a set schedule (26 U.S.C. § 401(a)(7)).

• Contribution and deferral limits: an employee's elective deferrals cannot exceed the

annual limit, which the IRS indexes each year (26 U.S.C. § 401(a)(30)).

• Required distributions: money cannot stay sheltered forever — distributions must begin

by the required beginning date (26 U.S.C. § 401(a)(9)), which under current law is keyed to age 73.

• Spousal protection: a defined benefit plan must pay a vested, married participant as a

qualified joint and survivor annuity, with the survivor receiving at least 50% of the joint amount, unless the spouse consents in writing to another form (26 U.S.C. § 401(a)(11)).

• Timely payment: unless the participant elects otherwise, benefits must start within 60

days after the latest of reaching age 65 or the plan's normal retirement age, the 10th anniversary of joining the plan, or leaving the employer (26 U.S.C. § 401(a)(14)).

The tax reward

• The employer deducts its contributions when made.
• The employee is not taxed on employer contributions or on salary deferred into the plan.
• Earnings grow tax-deferred until withdrawn.

Because nothing was taxed on the way in, the participant has no cost basis: every dollar that comes out of a pretax qualified plan is taxed as ordinary income. A withdrawal before age 59½ generally also triggers a 10% additional tax, with exceptions such as death and disability. A pension plan may, however, allow an in-service distribution to an employee who has reached 59½ and is still working (26 U.S.C. § 401(a)(36)).

The main qualified plan types

• Defined benefit: promises a specific retirement income, usually from a formula of

salary and years of service. The employer bears the investment risk.

• Defined contribution: fixes what goes in, not what comes out. Each participant has an

individual account, and the participant bears the investment risk. Examples: money purchase, profit-sharing, and 401(k) plans, where employees defer part of their salary.

• Keogh (HR-10) plans cover self-employed people and their employees. SEP and

SIMPLE plans are simpler employer plans funded through IRAs. 403(b) tax-sheltered annuities serve public schools and nonprofit organizations. 457 plans are deferred compensation for state and local government workers.

• Individual retirement accounts: a traditional IRA may allow deductible contributions

and taxes withdrawals. A Roth IRA takes after-tax contributions, and qualified withdrawals — including the earnings — come out tax-free.

Rollovers

Money can move between qualified plans and IRAs without being taxed.

• Direct rollover: the plan must let the participant send an eligible distribution

straight to another plan or IRA, trustee to trustee (26 U.S.C. § 401(a)(31)(A)). Nothing is paid to the participant, so nothing is withheld.

• 60-day rollover: an amount paid to the IRA owner is not taxed if it is put into an IRA

or eligible plan within 60 days (26 U.S.C. § 408(d)(3)(A)). An IRA owner may make only one such rollover in any 1-year period (26 U.S.C. § 408(d)(3)(B)). When an employer plan pays the participant directly, it withholds 20%, which the participant must replace from other funds to roll over the full amount.

• Not rollable: required minimum distributions (26 U.S.C. § 408(d)(3)(E)), and an IRA

inherited by anyone other than the surviving spouse (26 U.S.C. § 408(d)(3)(C)).

• Small balances: if a plan cashes out a departing employee's vested balance of more than

$1,000 but no more than $7,000 and the employee gives no instruction, the plan must roll it into an IRA and tell the employee in writing (26 U.S.C. § 401(a)(31)(B)).

Nonqualified plans

Nonqualified plans — deferred compensation, salary continuation, executive bonus and split-dollar arrangements — are used to reward selected executives and key employees.

• They may discriminate: an employer can cover one executive and no one else.
• They need no IRS approval and avoid most qualified-plan limits.
• The employer cannot deduct the cost until the employee is taxed on the benefit.
• A deferred compensation promise is often informally funded with **cash value life

insurance** owned by the employer. The funds remain employer assets, open to the employer's creditors, so the employee is relying on an unsecured promise.

• Contributions made with after-tax money, as in a nonqualified annuity, create a

cost basis: at payout only the earnings are taxed.

Rule of thumb: qualified plans trade flexibility for tax breaks; nonqualified plans trade tax breaks for flexibility.