11.1 Qualified vs. Nonqualified Plans and ERISA Basics
Key Takeaways
- Qualified plans give pre-tax contributions and tax-deferred growth but tax distributions as ordinary income; nonqualified plans tax only the gain.
- A fully pre-tax qualified plan has zero cost basis, so 100% of distributions are taxable.
- ERISA sets minimum standards for private employer plans: eligibility (age 21/1 year), vesting, funding, reporting, and fiduciary duty.
- Qualified plans must be nondiscriminatory; nonqualified plans may favor select executives.
- Fiduciaries must act solely in participants' interest under the prudent-person standard.
Why the Qualified/Nonqualified Distinction Matters
The single most tested idea in this domain is the tax difference between a qualified plan and a nonqualified plan. A qualified plan meets Internal Revenue Service (IRS) rules and earns favorable tax treatment: the employer gets a current tax deduction for contributions, the employee is not taxed on those contributions today, and the money grows tax-deferred until distribution. A nonqualified plan does not meet those rules, so it loses one or more of those advantages.
The Three Tax Questions
For every retirement arrangement, the exam wants you to answer three questions about the money flow. Are contributions deductible (or pre-tax)? Does growth occur tax-deferred? Are distributions taxable when received? Lining these up reveals the core trade-off.
| Feature | Qualified plan | Nonqualified plan |
|---|---|---|
| Employer contribution deductible now | Yes | Usually deferred until paid |
| Employee taxed on contribution now | No (pre-tax) | Often after-tax |
| Growth taxed annually | No (deferred) | Often deferred |
| Distributions taxable | Yes, as ordinary income | Only the gain portion |
| Must be nondiscriminatory | Yes | No — can favor executives |
| IRS/ERISA approval needed | Yes | No |
Key Takeaway on Cost Basis
In a fully qualified plan funded entirely with pre-tax dollars, the participant has zero cost basis, so 100% of every distribution is taxable as ordinary income. By contrast, a nonqualified annuity bought with after-tax dollars returns the principal tax-free and taxes only the earnings. This is why the test repeats: qualified money is taxed coming out; nonqualified principal already paid its tax going in.
ERISA: The Federal Rulebook
The Employee Retirement Income Security Act (ERISA) of 1974 is the federal law that protects participants in private-sector employer plans. It does not require an employer to offer a plan, but if one is offered, ERISA sets minimum standards. Memorize ERISA's core protective rules — each is a frequent question.
- Eligibility: An employer may require an employee to be age 21 and complete one year of service before participating.
- Vesting: Schedules guarantee that employer contributions become the employee's nonforfeitable property over time (e.g., 3-year cliff or 2-to-6-year graded).
- Funding: Contributions must actually be deposited; the employer cannot merely promise.
- Reporting and disclosure: Participants receive a Summary Plan Description (SPD) explaining their rights.
- Fiduciary duty: Plan managers must act solely in participants' interest (the "prudent person" standard).
Nondiscrimination and Fiduciary Standards
A defining ERISA/IRS requirement is nondiscrimination: a qualified plan cannot favor highly compensated employees, owners, or officers. The plan must cover a broad cross-section of workers. A fiduciary — anyone with discretionary control over plan assets — owes participants loyalty and prudence and can be personally liable for breaches such as self-dealing or imprudent investments. Nonqualified plans escape these rules precisely because they are designed to reward select executives, which is their main business purpose.
Common Nonqualified Arrangements
The most tested nonqualified vehicles are the Section 457 plan (deferred compensation for governmental and tax-exempt employers), the salary reduction (deferred compensation) plan, and executive bonus (Section 162) plans. In a Section 162 executive bonus, the employer pays the premium on a life policy the executive owns; the employer deducts the bonus, and the executive reports it as taxable income. Because the executive owns the policy, the benefit is fully portable — a key contrast with employer-owned nonqualified deferrals that remain exposed to company creditors.
Scenario
Scenario: A company wants to give its three top executives extra retirement compensation without extending the benefit to all 200 employees. A qualified plan would force coverage of the rank-and-file because of nondiscrimination rules. Therefore the company uses a nonqualified deferred compensation arrangement. The trade-off: the employer cannot deduct the contribution until the executive actually receives (and is taxed on) the money, and the funds generally remain subject to the employer's creditors until paid.
Exam Trap: Deduction Timing
A recurring trap pairs the words deduction and taxation. In a qualified plan the employer deducts contributions immediately, and the employee defers tax until distribution — the timing is split. In a nonqualified deferred compensation plan, deduction and taxation happen together later: the employer cannot deduct until the employee is taxed on receipt. Remember the rhyme: qualified = deduct now/tax later; nonqualified = deduct and tax both later. Tying the deduction to the employee's eventual taxable receipt is what makes nonqualified plans "unfunded" in IRS terms.
An employer wants to reward only its top three executives with a supplemental retirement benefit and exclude all other employees. Which arrangement allows this?
In a fully pre-tax qualified retirement plan, how much of each distribution is subject to ordinary income tax?