Key Takeaways
- Qualified plans must meet ERISA requirements to receive tax benefits: deductible contributions, tax-deferred growth, and ERISA protection
- Pension plans promise a pension at retirement with mandatory funding; profit sharing plans promise deferred compensation with discretionary funding
- Defined benefit plans: employer bears investment risk, participants have accrued benefits, PBGC coverage, favor older employees
- Defined contribution plans: employee bears investment risk, participants have individual account balances, no PBGC coverage, favor younger employees
- Pension plans limited to 10% investment in employer securities; profit sharing plans may invest up to 100%
- Employer contributions to qualified plans avoid payroll taxes; employee deferrals remain subject to FICA/Medicare
Qualified Plan Overview
A qualified retirement plan is an employer-sponsored retirement savings arrangement that meets the requirements of the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code. By meeting these requirements, qualified plans receive significant tax advantages for both employers and employees.
ERISA and Qualification Requirements
What Makes a Plan "Qualified"?
To be qualified, a retirement plan must satisfy specific requirements under IRC Section 401(a) and ERISA, including:
- Written plan document - Must be in writing by end of tax year (funding can occur until tax return filing plus extensions)
- Eligibility requirements - Age 21 and one year of service (or two years with 100% immediate vesting, except 401(k) plans)
- Coverage tests - Must cover a sufficient percentage of non-highly compensated employees
- Vesting schedules - Must meet minimum vesting requirements for employer contributions
- Nondiscrimination - Cannot discriminate in favor of highly compensated employees
- Contribution/benefit limits - Must comply with IRC Section 415 limits
Tax Advantages of Qualified Plans
Qualified plans offer three major tax benefits:
| Tax Advantage | Description |
|---|---|
| Deductible Contributions | Employer contributions are tax-deductible as a business expense |
| Tax-Deferred Growth | Investment earnings accumulate tax-free until distributed |
| Payroll Tax Avoidance | Employer contributions avoid FICA/Medicare payroll taxes |
Important Distinction: While employer contributions avoid payroll taxes, employee elective deferrals (such as 401(k) contributions) remain subject to Social Security and Medicare taxes.
ERISA Protections
Qualified plans provide significant legal protections:
- Anti-alienation provision - Plan assets cannot be assigned, garnished, levied, or subject to bankruptcy proceedings
- Fiduciary requirements - Plan fiduciaries must act in participants' best interests
- Reporting and disclosure - Annual Form 5500 filing, Summary Plan Description (SPD) to participants
- Enforcement - DOL and IRS oversight with penalties for violations
CFP Exam Note: When assets are rolled from a qualified plan to an IRA, ERISA protection is lost, though federal bankruptcy law provides protection for rollover IRAs.
Categories of Qualified Plans
Qualified plans are organized into two main categories, each with distinct characteristics:
Pension Plans vs. Profit Sharing Plans
| Characteristic | Pension Plan | Profit Sharing Plan |
|---|---|---|
| Legal Promise | Pay a pension at retirement | Defer compensation |
| Mandatory Funding | Yes | No (but must be substantial and recurring) |
| In-Service Withdrawals | Only after age 59 1/2 (DB plans) | After 2 years of participation |
| Investment in Employer Securities | Limited to 10% | Up to 100% |
| QJSA/QPSA Required | Yes | No (unless plan distributes annuities) |
Types Within Each Category
Pension Plans:
- Defined Benefit Pension Plans
- Cash Balance Pension Plans
- Money Purchase Pension Plans
- Target Benefit Pension Plans
Profit Sharing Plans:
- Profit Sharing Plans
- 401(k) Plans (CODA)
- Stock Bonus Plans
- Employee Stock Ownership Plans (ESOPs)
- Thrift Plans
Defined Benefit vs. Defined Contribution Plans
The most important classification of qualified plans is whether they are defined benefit (DB) or defined contribution (DC):
Key Differences
| Feature | Defined Benefit | Defined Contribution |
|---|---|---|
| What is Defined | The retirement benefit | The contribution amount |
| Investment Risk | Employer | Employee |
| Account Type | Commingled (accrued benefits) | Separate individual accounts |
| PBGC Coverage | Yes (with exceptions) | No |
| 2025 Limit | $280,000 annual benefit | $70,000 annual additions |
| Favors | Older employees | Younger employees |
| Prior Service Credit | Allowed | Not allowed |
| Forfeitures | Reduce plan costs only | Reduce costs OR allocate to participants |
| Actuary Required | Yes (annually for DB, at inception for target benefit) | No (except target benefit) |
Investment Risk Allocation
One of the most critical distinctions for exam purposes:
-
Defined Benefit: The employer bears all investment risk. Poor investment performance increases employer funding requirements, but participant benefits remain unchanged.
-
Defined Contribution: The employee bears all investment risk. Investment gains and losses directly affect the participant's account balance and ultimate retirement benefit.
Commingled vs. Separate Accounts
| DB Plans (Commingled) | DC Plans (Separate) |
|---|---|
| Single pooled trust holds all assets | Individual account for each participant |
| Participants have accrued benefits | Participants have account balances |
| Cannot identify "your" assets | Can see specific investments and balance |
| Investment performance affects employer costs | Investment performance affects participant benefits |
PBGC Coverage
The Pension Benefit Guaranty Corporation (PBGC) insures defined benefit pension plans to protect participants if a plan terminates without sufficient assets.
PBGC 2025 Premiums and Guarantees
| Item | 2025 Amount |
|---|---|
| Single-Employer Flat Rate Premium | $106 per participant |
| Variable-Rate Premium | $52 per $1,000 of unfunded vested benefits |
| Maximum Monthly Guarantee (age 65) | $7,432/month ($89,181/year) |
| Multiemployer Plan Maximum | $35.75 per year of service |
Plans NOT Covered by PBGC
- All defined contribution plans (no PBGC coverage)
- Professional service employers (doctors, lawyers, architects, etc.) with fewer than 25 employees
- Plans maintained exclusively for substantial owners
CFP Exam Tip: The "professional firm with fewer than 25 employees" exception is frequently tested. All other DB plans are covered by PBGC.
Forfeitures Treatment
When participants leave before fully vesting in employer contributions, the non-vested portion is forfeited. The treatment of forfeitures differs between plan types:
DB Plans
Forfeitures can only reduce plan costs (employer funding requirements).
DC Plans
Forfeitures can either:
- Reduce employer contributions, OR
- Be reallocated to remaining participants
The plan document specifies which method applies.
Who Benefits Most from Each Plan Type
Defined Benefit Plans Favor Older Employees Because:
- Older employees have less time for compound growth, requiring larger annual contributions
- The actuarial cost to fund a given benefit is higher when there are fewer years to fund it
- Credit can be given for prior service (years worked before plan was established)
- Benefit is based on final average salary (often highest near retirement)
Exception: Cash balance plans (a type of DB plan) favor younger employees because they resemble DC plans with hypothetical accounts.
Defined Contribution Plans Favor Younger Employees Because:
- More years for investments to grow through compound interest
- Same dollar contribution has greater value over 30 years vs. 10 years
- No credit given for prior service
- Early contributions have greatest time for tax-deferred growth
Exception: Target benefit plans (a type of DC plan) favor older employees because contributions are calculated to achieve a target retirement benefit.
| Plan Type | Classification | Favors |
|---|---|---|
| Traditional DB | Defined Benefit | Older employees |
| Cash Balance | Defined Benefit | Younger employees |
| Profit Sharing | Defined Contribution | Younger employees |
| 401(k) | Defined Contribution | Younger employees |
| Money Purchase | Defined Contribution | Younger employees |
| Target Benefit | Defined Contribution | Older employees |
Special Taxation Options
Qualified plans offer special tax treatment not available with IRAs:
Pre-1974 Capital Gain Treatment
Participants with pre-1974 participation may treat a portion of lump-sum distributions as capital gain (rarely tested, but may appear as answer choice).
10-Year Forward Averaging
Participants born before 1936 may use special averaging to reduce tax on lump-sum distributions.
Net Unrealized Appreciation (NUA)
Lump-sum, in-kind distributions of employer stock receive favorable capital gain treatment on the appreciation.
Important: These special taxation options are lost if assets are rolled to an IRA.
Qualified Plan Quick Reference
| Requirement | Standard |
|---|---|
| Written Plan Document | Required by end of tax year |
| Eligibility | Age 21 + 1 year service (or 2 years with 100% vesting) |
| 401(k) Eligibility | Age 21 + 1 year only (cannot use 2-year rule) |
| Coverage | Must pass Safe Harbor, Ratio %, or Average Benefits test |
| DB Vesting | 3-7 year graded or 5-year cliff |
| DC Vesting | 2-6 year graded or 3-year cliff |
| Top-Heavy Vesting | 2-6 year graded or 3-year cliff (both DB and DC) |
| 2025 Covered Compensation | $350,000 |
| 2025 DB Benefit Limit | $280,000 |
| 2025 DC Annual Additions | $70,000 |
| 2025 401(k) Deferral | $23,500 + $7,500 catch-up |
Which of the following is a key tax advantage of qualified retirement plans that is NOT available for employee elective deferrals?
Which statement correctly describes the difference between pension plans and profit sharing plans?
How are forfeitures treated differently in defined benefit plans versus defined contribution plans?