11.1 Qualified vs. Nonqualified Plans and ERISA Basics
Key Takeaways
- A qualified plan meets IRC and ERISA standards to gain tax-deductible employer contributions, pre-tax employee contributions, and tax-deferred growth.
- In a qualified plan the employer deducts now and the employee is taxed later; in a nonqualified plan the deduction is delayed until the employee is taxed.
- ERISA governs eligibility, vesting, funding, reporting/disclosure, fiduciary duty, and nondiscrimination — not benefit amounts.
- Employee contributions are always 100% vested immediately; vesting schedules (3-year cliff or 2-to-6 graded) apply only to employer money.
- Nonqualified plans (deferred comp, salary continuation, Section 162 bonus) sacrifice tax advantages for the freedom to favor selected executives.
Qualified vs. Nonqualified Retirement Plans
A qualified plan is a retirement arrangement that meets federal Internal Revenue Code (IRC) and Employee Retirement Income Security Act of 1974 (ERISA) standards, so it earns favorable tax treatment. A nonqualified plan intentionally does not meet those standards; the employer trades away tax advantages in exchange for design freedom, usually to reward selected executives.
The exam tests the consequences of qualification, not just the label. Memorize the four tax features that flow from a qualified plan, because nonqualified plans lose most of them.
The Four Tax Advantages of a Qualified Plan
| Feature | Qualified plan | Nonqualified plan |
|---|---|---|
| Employer contribution | Tax-deductible when made | Deductible only when employee is taxed (often years later) |
| Employee contribution | Pre-tax (lowers current taxable wages) | After-tax in most designs |
| Growth inside plan | Tax-deferred | Tax-deferred |
| Eligibility | Must cover a broad, nondiscriminatory group | May favor select executives |
The headline trap: in a qualified plan the employer's deduction and the employee's taxation happen at different times (deduct now, tax the worker at distribution). In a nonqualified plan they are matched — the employer cannot deduct the contribution until the employee actually includes it in income.
What ERISA Regulates
ERISA is federal law that protects participants in private-employer retirement and welfare plans. It does not set benefit amounts; it sets rules of fair administration. Key ERISA pillars tested on the life and health exam:
- Eligibility — a plan generally must let an employee join after reaching age 21 and completing 1 year of service (1,000 hours).
- Vesting — schedules that lock in the employer-funded benefit (see below).
- Funding — the employer must adequately fund promised benefits.
- Reporting and disclosure — participants receive a Summary Plan Description (SPD) describing rights, and the plan files reports with the government.
- Fiduciary duty — those who control plan assets must act solely in participants' interest (the prudent expert rule).
- Nondiscrimination — a qualified plan cannot disproportionately favor highly compensated employees (HCEs).
Vesting Schedules (Employer Money)
The employee's own contributions are always 100% vested immediately. Vesting schedules apply only to employer contributions. Two common ERISA-compliant defined-contribution schedules:
| Schedule | How it works |
|---|---|
| 3-year cliff | 0% vested until 3 years of service, then 100% all at once |
| 2-to-6 graded | 20% after year 2, then +20% each year, fully vested after year 6 |
Scenario: Maria has 4 years of service under a 2-to-6 graded schedule. She is 60% vested (20% at year 2 + 20% + 20%). If she quits, she keeps 100% of her own deferrals plus 60% of the employer match; the unvested 40% is forfeited.
Nonqualified Plans and Common Designs
Because nonqualified plans escape ERISA's broad-coverage rules, employers use them to give extra retirement money to a few key people. Watch for these names:
- Deferred compensation — the employee agrees to receive part of pay later (after retirement); taxed when received.
- Salary continuation — employer funds a future benefit without the employee deferring current salary.
- Section 162 executive bonus plan — the employer pays a bonus the executive uses to buy a personally owned life insurance policy; the bonus is deductible to the employer and taxable to the executive now.
Exam trap: a Section 162 plan is technically nonqualified, but the employer still gets a current deduction because the executive is taxed currently on the bonus — the deduct-when-taxed rule still holds.
Nondiscrimination and Coverage Testing
A qualified plan keeps its tax status only if it does not disproportionately favor highly compensated employees (HCEs) and owners. The IRS applies coverage and nondiscrimination tests each year, comparing benefits and contributions for HCEs against those of rank-and-file workers.
If a 401(k) fails its testing, the plan must either return a portion of the HCEs' deferrals (a corrective distribution) or make additional contributions for lower-paid employees. This is precisely the constraint a nonqualified plan avoids — there is no coverage test, so an employer may carve out a single executive without correcting anything.
Reporting, Disclosure, and Fiduciary Conduct
ERISA's administrative spine is information plus accountability. Participants must receive the Summary Plan Description (SPD) explaining how the plan works, an individual benefit statement, and a Summary Annual Report. Plan administrators file the annual Form 5500 with the federal government.
The fiduciary standard is the most heavily tested conduct rule: anyone with discretionary authority over plan assets must act solely in the participants' interest, diversify investments, follow plan documents, and pay only reasonable expenses. A fiduciary who self-deals or makes imprudent investments can be held personally liable for plan losses — a frequent exam scenario.
Why the Qualified/Nonqualified Choice Matters
Think of the trade-off as tax break today versus design freedom. An employer who wants an immediate deduction and a workforce-wide benefit accepts ERISA's coverage, vesting, and reporting rules and builds a qualified plan. An employer who wants to reward two executives and skip the rank-and-file gives up the immediate deduction and builds a nonqualified plan funded with after-tax dollars or life insurance.
On the exam, classify the fact pattern first: Does the plan favor a select group? If yes, it is almost certainly nonqualified, and the deduction will be delayed until the executive is taxed.
An employer makes a $10,000 contribution to its nonqualified deferred compensation plan for an executive who will not receive the money until retirement in 12 years. When may the employer deduct the contribution?
Under a 2-to-6 year graded vesting schedule, what percentage of the employer's contributions has a participant earned after completing 3 full years of service?