Retirement Plans: Qualified & Non-Qual.

  Qualified Plans

  Non-Qualified Plans

Qualified Plans

What is a qualified retirement plan?

There are two distinct elements embodied in the term “qualified retirement plan.” The main element is the term “retirement plan.” A retirement plan means any plan or program maintained by an employer or an employee organization (or both) that (1) provides retirement income to employees or (2) results in a deferral of income by employees for periods extending generally to the end of employment or beyond, regardless of how plan contributions or benefits are calculated or how benefits are distributed. [ERISA § 3 (2)]

The other element is the term “qualified,” which means that the retirement plan is afforded special tax treatment for meeting a host of requirements of the Internal Revenue Code (the Code). Qualified retirement plans fall into two basic categories: defined contribution plans and defined benefit plans. A defined contribution plan provides benefits based on the amount contributed to an employee’s individual account, plus any earnings and forfeitures of other employees that are allocated to the account. A defined benefit plan provides a definitely determinable annual benefit; that is, the benefits are determined on the basis of a formula contained in the plan.

Defined contribution plan

A defined contribution plan is a retirement plan that “provides an individual account for each participant and for benefits based solely upon the amount contributed to the participant’s account, and any income, expenses, gains and losses, and any forfeitures of accounts of other participants which may be allocated to such participant’s account.” [ERISA § 3(34); IRC § 414(i)]

Profit sharing plan

A profit sharing plan is a defined contribution plan to which the company agrees to make “substantial and recurring”, although generally discretionary, contributions. Amounts contributed to the plan are invested and accumulate (tax-free) for eventual distribution to participants or their beneficiaries either at retirement, after a fixed number of years, or upon the occurrence of some specified event (e.g., disability, death, or termination of employment).
Unlike contributions to a pension plan, contributions to a profit sharing plan are usually keyed to the existence of profits. However, neither current nor accumulated profits are required for a company to contribute to a profit sharing plan. [IRC § 401(a)(27)]
Even if the company has profits, it can generally forgo or limit its contribution for a particular year if the plan contains a discretionary formula.

Money purchase pension plan

A money purchase pension plan is a defined contribution plan in which the company’s contributions are mandatory and are usually based solely on each participant’s compensation.
The obligation to fund the plan makes a money purchase pension plan different from most profit sharing plans. In most profit sharing plans, there are generally no unfavorable consequences for the company if it fails to make a contribution. However, if the company maintains a money purchase pension plan, its failure to make a contribution can result in the imposition of a penalty tax. Contributions must be made to a money purchase pension plan even if the company has no profits. With the increase in the primary limitation on tax-deductible contributions to a profit sharing plan from 15% to 25% of total compensation, there appears to be little reason for an employer to adopt or continue to maintain a money purchase pension plan.
Forfeitures that occur because of employee turnover may reduce future contributions of the company or may be used to increase the benefits of remaining participants.
Retirement benefits are based on the amount in the participant’s account at the time of retirement, that is, whatever pension the money can purchase.

401(k) plan

A 401(k) plan is a qualified profit sharing or stock bonus plan that offers participants an election t receive company contributions in cash or to have these amounts contributed to the plan. A participant in a 401(k) plan does not have to include in income any company contributions to the plan merely because an election could have been made to receive cash instead. [IRC §§ 401(k) (2), 402(a)(8)]

A 401(k) plan may also be in the form of a salary reduction agreement. Under this type of arrangement, each eligible employee may elect to reduce current compensation or elect to forgo a salary increase and have these amounts contributed to the plan. [Treas Reg § 1.401(k)-1(a)(3)(i)]
Benefits attributable to employer contributions to a 401(k) plan generally may not be distributed without penalty until the employee retires, becomes disabled, dies, or reaches age 59 ½. Contributions made by the employer to the plan at the employee’s election are nonforfeitable (i.e., 100% vesting is required at all times).

Defined benefit plan

A defined benefit plan is a retirement plan “other than an individual account plan.” In other words, a plan that is not a defined contribution plan is classified as a defined benefit plan. Under a defined benefit plan, retirement benefits must be definitely determinable. For example, a plan that entitles a participant to a monthly pension for life equal to 30 percent of monthly compensation is a defined benefit plan. [ERISA § 3(35); IRC § 414(j)] The most common types of defined benefit plans are flat benefit plans and unit benefit plans.
If a plan is categorized as a defined benefit plan: (1) plan formulas are geared to retirement benefits and not to contributions (except for cash balance plans); (2) the annual contribution is usually actuarially determined; (3) certain benefits may be insured by PBGC; (4) early termination of the plan is subject to special rules; and (5) forfeitures reduce the company’s cost of providing retirement benefits.

Hybrid plan

Plans that use features of a Defined Benefit and Defined Contribution to achieve a specific result.
Advantages to employers for Qualified Retirement Plans:

• All contributions are tax deductible to the employer for the year the contribution is made.
• In certain plans, annual contributions do not have to be made to the plan by the employer. (Although for profit sharing plans, contributions must be "substantial and recurring" or the IRS may deem the plan as terminated.)
• Earnings on any investment within the plan are tax-exempt to the employer, and tax-deferred to the employee.
• Contribution limits are considerably higher in a QRP than in an IRA.
Drawbacks to employers for Qualified Retirement Plans
• At least 70% of non-highly compensated employees must be covered by the plan, and government-set vesting schedules must be followed
• Any time a contribution is made to a plan, contributions must be made on all participants' behalf including the non-highly compensated employee participants
• In certain plans, annual contributions are required to be made whether or not the employer is profitable.
• Administration costs can be considerably higher in a QRP than in other retirement plans, such as a SEP
• Subject to very strict government regulations
• Independent contractors or directors are not eligible for coverage under a QRP.
Miscellaneous Information
Cost of Living Increases (10/18/2006)

Here are some of the plan limits as adjusted for cost-of-living increases.

Retirement Administration Fees

The above fees cover the following:

• Standardized Prototype Documents (Adoption Agreement, Plan Document and Summary Plan Description)
• Annual Reports and Related Schedules
• Quarterly Reports
• Testing
• Vesting Calculations
• Assistance with Eligibility and Contribution Calculations
• Distribution Calculations
• Toll Free Customer Assistance 

 Please Note

* The above fees are current but subject to change

The financial services are intended to serve as a basis for further discussion with your other professional advisors. The actual application of some of these concepts may be the practice of law, and is the proper responsibility of your attorney.

NON-Qualified Plans

A nonqualified deferred compensation (NQDC) plan is an arrangement between an employer and one or more employees to defer the receipt of currently earned compensation. You might want to establish a NQDC plan to provide your employees with benefits in addition to those provided under your qualified retirement plan, or to provide benefits to particular employees without the expense of a qualified plan.

Non-qualified retirement plans receive fewer tax benefits, but are not subject to as many government regulations. Most of the time, non-qualified retirement plans are designed for executives or key employees, and not for a broader group of employees. Benefits provided to employees can go beyond the limits allowed in qualified plans. Any earnings within the plan currently will be taxable to the employer, and taxable to the employee when distributed as benefits. However, the employer will be entitled to an income tax deduction at the time of distribution. Independent contractors and directors are eligible for coverage under a non-qualified retirement NQDC plans vs. qualified plans. A qualified plan, such as a profit-sharing plan or a 401(k) plan, can be a valuable employee benefit. A qualified plan provides you with an immediate income tax deduction for the amount of money you contribute to the plan for a particular year. Your employees aren't required to pay income tax on your contributions until those amounts are actually distributed from the plan. However, in order to receive this beneficial tax treatment, a qualified plan must comply with strict and complex ERISA (*) and IRS rules, and the plan must generally cover a large percentage of your employees. In addition, qualified plans are subject to a number of limitations on contributions and benefits. These limitations have a particularly harsh effect on your highly paid executives. In contrast, NQDC plans can be structured to provide the benefit of tax deferral while avoiding almost all of ERISA's burdensome requirements. There are no dollar limits that apply to NQDC plan benefits (although compensation must generally be reasonable in order to be deductible). And you can provide benefits to your highly compensated employees without having to provide similar benefits to your rank and file employees.

Funded vs. unfunded NQDC plans

NQDC plans fall into two broad categories--funded and unfunded. A NQDC plan is considered funded if you have irrevocably and unconditionally set aside assets with a third party (e.g., in a trust or escrow account) for the payment of NQDC plan benefits, and those assets are beyond the reach of both you and your creditors. In other words, if participants are guaranteed to receive their benefits under the NQDC plan, the plan is considered funded. You might consider establishing a funded plan if your employees are concerned that their plan benefits might not be paid in the future due to a change in your financial condition, a change in control, or your change of heart. Because the assets in a funded plan are beyond your reach, and the reach of your creditors, these plans provide employees with maximum security that their benefits will eventually be paid. Funded plans are rare, though, because they provide only limited opportunity for tax deferral and may be subject to all of ERISA's requirements. Unfunded plans are by far more common because they can provide the benefit of tax deferral while avoiding almost all of ERISA's requirements. With an unfunded plan, you don't formally set aside assets to pay plan benefits. Instead, you either pay plan benefits out of current cash flow ("pay-asyou- go") or you earmark property to pay plan benefits ("informal funding"), with the property remaining part of your general assets and subject to the claims of your general creditors. You can set up a trust ("rabbi trust") to hold plan assets, but those assets must remain subject to any claims of your bankruptcy and insolvency creditors. A rabbi trust can protect your employees against your change of heart or change in control, but not against a change in your financial condition leading to bankruptcy. In order to achieve the dual goals of tax deferral and avoidance of ERISA, your NQDC plan must be both unfunded and maintained solely for a select group of management or highly compensated employees. These unfunded NQDC plans are commonly referred to as "top-hat" plans. While there is no formal legal definition of a "select group of management or highly compensated employees," it generally means a small percentage of the employee population who are key management employees or who earn a salary substantially higher than that of other employees.

Income tax considerations

Generally you can't take a tax deduction for amounts you contribute to a NQDC plan until your participating employees are taxed on those contributions (which can be years after your contributions have been made to the plan). Employees generally don't include your contributions to an unfunded NQDC plan, or plan earnings, in income until benefits payments are actually received from the NQDC plan. The taxation of funded NQDC plans is more complex. In general, your employees must include your contributions in taxable income as soon as they become nonforfeitable (i.e., as soon as they vest). The taxation of plan earnings depends on the structure of the plan; in some cases employees must include earnings in taxable income currently, and in some cases they aren't taxed until they're actually paid from the plan.

Who can adopt a NQDC plan?

NQDC plans are suitable only for regular (C) corporations. In S corporations or unincorporated entities (partnerships or proprietorships), business owners generally can't defer taxes on their shares of business income. However, S corporations and unincorporated businesses can adopt NQDC plans for regular employees who have no ownership in the business. NQDC plans are most suitable for employers that are financially sound and have a reasonable expectation of continuing profitable business operations in the future. In addition, since NQDC plans are more affordable to implement than qualified plans, they can be an attractive form of employee compensation for a growing business that has limited cash resources.

Types of plans

Because a NQDC plan is essentially a contract between you and your employee there are almost unlimited variations. Most common are deferral plans and supplemental executive retirement
plans (also known as SERPs). In a deferral plan your employee defers the payment of current compensation (e.g., salary or bonus) to a future date. A SERP is typically designed to supplement your employee's qualified plan benefits (for example, by providing additional pension benefits).

How to implement a NQDC plan

An ERISA lawyer can guide you through the maze of legal and tax requirements, and draft the plan document. Often the board of directors or compensation committee must approve the plan. Your accountant or consulting actuary can help you decide how to finance the plan. If you choose an unfunded plan, almost all that ERISA requires is that you send a simple statement to the Department of Labor informing them of the existence of the plan, and the number of participants.

Advantages of NQDC plans

• Easier and less expensive to implement and maintain than a qualified benefit plan
• Can be offered on a discriminatory basis
• Can provide unlimited benefits
• Allows you to control timing and receipt of benefits
• Enables you to attract and retain key employees

Disadvantages of NQDC plans

• Employee taxation controls timing of your tax deduction
• Lack of security for employees in an unfunded plan
• Generally, not appropriate for partnerships, sole proprietorships, and S corporations
• Generally, more costly to employer than paying compensation currently

(*)What is ERISA?

ERISA stands for the Employee RetirementIncome Security Act of 1974, landmark legislation that protects workers' retirement benefits. ERISA contains complex rules governing participation, vesting, funding, reporting, disclosure, administration, and fiduciary activities. While ERISA governs most qualified retirement plans, NQDC plans can be structured to avoid
almost all of ERISA's requirements

(*)What is IRC Section 409A?

Section 409A is a new provision of the Internal Revenue Code that provides specific rules
relating to deferral elections, distributions, and funding that apply to most NQDC plans. If
your plan fails to comply with Section 409A's requirements, your employee's NQDC plan
benefits may become immediately taxable and subject to significant penalties and interest charges. It is very important for you to be aware of and follow the rules in IRC Section 409A when establishing or maintaining a NQDC plan.