Understanding Qualified Retirement Plans

Employers can create two main types of retirement plans for their employees. They are either classed as Qualified or Non-qualified. Qualified plans meet the requirements of the Employee Retirement Income Security Act (ERISA)i, while non-qualified plans do not.

Differences in Plan Types

The main differences between the qualified plan and a non-qualified plan includeii:

  • Non-qualified plans, often used for executive retention and incentives, can be either deferred-compensation plans or split-dollar life insurance plans.
  • Qualified plans include 401(k) plans, 403(b) plans, Keogh Plans, and profit-sharing plans.

Qualifying by meeting the requirements of ERISA results in more tax advantages for both the employer and the employees.

Qualified Plans Highlights

The IRS publishes rules, requirements, and instructions for qualified retirement plans in Publication 560, Retirement Plans for Small Businessiii. There are two basic kinds of qualified retirement plans, defined contribution plans and defined benefit plans, with different rules for each. An employer can set up more than one qualified plan, but the total of contributions to all plans must not exceed overall limits set by the IRS.

From the publication, the IRS explains the basic differences between the two as:

  • Defined Contribution Plan – “A defined contribution plan provides an individual account for each participant in the plan. It provides benefits to a participant largely based on the amount contributed to that participant’s account. Benefits are also affected by any income, expenses, gains, losses, and forfeitures of other accounts that may be allocated to an account. A defined contribution plan can be either a profit-sharing plan or a money purchase pension plan.”
  • Defined Benefit Plan – “A defined benefit plan is any plan that isn’t a defined contribution plan. Contributions to a defined benefit plan are based on what is needed to provide definitely determinable benefits to plan participants. Actuarial assumptions and computations are required to figure these contributions. Generally, you will need continuing professional help to have a defined benefit plan”

The rules for qualification and setting up these types of plans are complex. Though an employer can set up their own custom plan, generally they use one provided by their chosen financial institution. Basic bullet points for requirements include:

  • Plan assets must not be diverted, maintaining all assets only for the management and growth of the plan.
  • There are minimum employee participation requirements.
  • Contributions nor benefits can discriminate between regular and highly compensated employees.
  • Minimum vesting standards are required as to when a participant becomes vested in the plan.
  • There are age and years of employment requirements for participation.
  • There are rules as to when payment of benefits must begin, for early retirement, and for required minimum distributions.

There are many other rules and requirements and choosing a financial institution with experience in setting up these plans and managing them is a good idea.

Setting up a Qualified Plan

There are two basic steps in setting up a qualified retirement plan; you adopt a written plan, and then you invest the plan assets.

  • Adopt a written plan: You must have a written plan, and it must be provided to the employees. The rules and requirements must be set out rather than just referring to IRS regulations or documents. Most employers adopt a plan pre-approved by the IRS to keep things simple and to stay out of trouble.
  • Invest plan assets: In setting up the plan, the employer sets up a plan for how the assets will be invested and the value growth achieved.
    • The employer can establish a trust or a custodial account to invest the funds.
    • An annuity contract can be purchased from an insurance company.

There are around 20 pages in Chapter 4 of IRS Publication 560, but those are the starting out highlights. From there, you can use the publication to learn the other rules and requirements for participation, investment, management, contributions, and more.

i Employee Retirement Income Security Act from U.S. Dept of Labor website.

ii Qualified vs. Nonqualified Retirement Plans: What’s the difference? By Investopedia staff updated Aug 28, 2020

iii IRS Publication 560, Retirement Plans for Small Business. Chapter 4, Qualified Plans

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