Qualified and nonqualified retirement plans

Two ways to fund retirement through work

A retirement plan is either qualified or nonqualified. The word means one thing: whether the plan meets the requirements of Internal Revenue Code section 401(a). A plan that meets them earns generous tax treatment. A plan that does not can be designed freely, but gives up most of those tax breaks.

Qualified plans

A qualified plan is a written employer plan whose trust satisfies section 401(a), which makes the trust itself tax-exempt. The tax package is the reason employers bother:

• Employer contributions are deductible when they are made.
• Employees are not taxed on pre-tax contributions or on investment growth until money is distributed.
• Earnings accumulate tax-deferred inside the trust.
• Distributions of pre-tax money are generally taxed as ordinary income. Designated Roth contributions are made after tax, and a qualified Roth distribution is tax-free; employer stock paid out in a lump sum can get special net unrealized appreciation treatment. A withdrawal before age 59½ generally adds a 10 percent additional tax unless an exception applies.

In return, the plan must follow rules that protect rank-and-file workers:

• No discrimination. Contributions or benefits may not favor highly compensated employees. Governmental plans are exempt from this requirement.
• Minimum vesting. The plan must meet the vesting standards of section 411, so an employee's right to employer money becomes nonforfeitable on a set schedule.
• Contribution and deferral limits. Elective deferrals cannot exceed the annual section 402(g) limit.
• Spousal protection. Defined benefit plans must pay a vested married participant as a qualified joint and survivor annuity unless the spouse consents in writing to another form.
• Required minimum distributions. Money cannot stay in the plan forever; distributions must begin by the required beginning date, currently tied to age 73.
• IRS determination letter and ERISA. A sponsor may ask the IRS for a determination letter confirming that the plan is qualified, though many sponsors of pre-approved plans rely on the provider's opinion letter instead. Most private-sector qualified plans are also subject to ERISA reporting and fiduciary rules; governmental plans and most church plans are exempt from them.

Common qualified plans include defined benefit pension plans, which promise a stated benefit at retirement, and defined contribution plans, such as profit-sharing, money purchase, stock bonus and 401(k) plans, which promise only what the account grows to. Keogh (HR-10) plans for the self-employed, SEPs and SIMPLE plans follow similar tax-favored rules.

Moving money: rollovers and transfers

Money can leave a qualified plan or IRA without being taxed if it lands in another retirement plan:

• A direct rollover, or trustee-to-trustee transfer, moves the money with no tax and no withholding. Every qualified plan must offer it.
• An indirect rollover pays the money to the owner, who has 60 days to deposit it. A qualified plan withholds 20 percent on an indirect payout. An IRA owner may do only one IRA-to-IRA indirect rollover in any 12-month period.
• Required minimum distributions and inherited IRAs of a non-spouse beneficiary cannot be rolled over.

Nonqualified plans

A nonqualified plan does not meet section 401(a), so it does not need IRS approval and may discriminate. That is the point: it lets an employer reward selected executives or key employees. Examples include deferred compensation plans, salary continuation, executive bonus (section 162) plans and split-dollar life arrangements.

The trade-offs:

• In a deferred compensation plan, the employer cannot deduct the cost until the employee is taxed on the benefit, usually when it is paid. An executive bonus is different: it is taxed to the executive and deducted by the employer when it is paid, so there is no wait.
• The plan is usually unfunded, a promise backed by the employer's general assets, so it is exposed to the employer's creditors.
• The employee pays tax on benefits when received; any money the employee contributed after tax comes back tax-free as cost basis.

Exam shortcut: qualified means it meets section 401(a) (the sponsor may request an IRS determination letter), generally nondiscriminatory, deductible now, pre-tax money taxed later. Nonqualified means no IRS approval needed, flexible and selective, but in deferred compensation the employer's deduction waits.