11.1 Qualified vs. Nonqualified Plans and ERISA Basics
Key Takeaways
- Qualified plans meet IRC Section 401(a) and ERISA, granting employer deductions, pre-tax deferrals, tax-deferred growth, and deferred employee taxation.
- Nonqualified plans may favor select executives but delay the employer deduction until the employee is taxed.
- ERISA imposes six standards: participation, vesting, funding, fiduciary duty, reporting (Form 5500), and disclosure (SPD).
- Employee deferrals are always 100% vested; employer money must follow at least 3-year cliff or 6-year graded vesting.
- Fiduciaries owe duties of loyalty and prudence and must avoid prohibited transactions such as self-dealing.
Qualified vs. Nonqualified Plans
Retirement plans split into two camps on the exam: qualified and nonqualified. A qualified plan satisfies Internal Revenue Code (IRC) Section 401(a) and the Employee Retirement Income Security Act of 1974 (ERISA), earning a package of tax breaks in exchange for following strict fairness rules.
A nonqualified plan sidesteps those rules to reward select executives, but it gives up most of the tax advantages. Knowing which features attach to which camp is the highest-yield distinction in this chapter.
The Trade-Off at a Glance
The table below contrasts the two structures. Read it as a cause-and-effect chain: qualified plans accept coverage and nondiscrimination rules, and in return everyone gets favorable taxation.
| Feature | Qualified Plan | Nonqualified Plan |
|---|---|---|
| Employer deduction timing | When contributed | When employee is taxed (deferred) |
| Employee taxation | At distribution | Often at vesting/receipt |
| Coverage | Must be broad, nondiscriminatory | Can favor select executives |
| Tax-deferred growth | Yes | Depends on funding vehicle |
| ERISA participation/vesting rules | Apply fully | Generally exempt |
| Creditor protection | Strong (ERISA) | Weaker; assets may be employer's |
Exam trap: In a nonqualified plan the employer's deduction is delayed to match when the employee includes the amount in income. Qualified plans let the employer deduct now while the employee defers.
Tax Advantages of Qualified Plans
Four benefits flow from qualification. Memorize them as a set:
- Employer deduction — contributions are currently deductible business expenses.
- Pre-tax employee deferrals — elective deferrals reduce current taxable income.
- Tax-deferred growth — earnings compound untaxed inside the plan.
- Deferred employee taxation — distributions are taxed as ordinary income, usually in retirement at a lower bracket.
Because contributions and earnings were never taxed, the full distribution is taxable unless the participant made after-tax (basis) contributions, which return tax-free pro-rata.
ERISA's Six Standards
ERISA protects participants by imposing minimum standards. The exam tests these as a checklist.
| Standard | What It Governs |
|---|---|
| Participation | When an employee may join the plan |
| Vesting | When employer money becomes nonforfeitable |
| Funding | Minimum contributions for defined benefit plans |
| Fiduciary | Loyalty, prudence, diversification for those handling assets |
| Reporting | Annual Form 5500 filed with the government |
| Disclosure | Summary Plan Description (SPD) given to participants |
Participation minimums: an employee who is at least age 21 and has one year of service (1,000 hours) must be allowed in. A plan may be more generous but never more restrictive.
Vesting Schedules
Vesting is the participant's nonforfeitable right to employer contributions. Employee deferrals are always 100% vested immediately. Employer money must vest at least as fast as one of two schedules:
| Years of Service | 3-Year Cliff | 6-Year Graded |
|---|---|---|
| 0–1 | 0% | 0% |
| 2 | 0% | 20% |
| 3 | 100% | 40% |
| 4 | 100% | 60% |
| 5 | 100% | 80% |
| 6+ | 100% | 100% |
Worked scenario: An employee with 4 years of service leaves. Under 3-year cliff she is 100% vested in the $12,000 employer match. Under 6-year graded she is 60% vested = $7,200; the remaining $4,800 is forfeited.
Nondiscrimination and Fiduciary Duty
Qualified plans cannot favor Highly Compensated Employees (HCEs) — owners of more than 5% or those earning above the indexed threshold (about $160,000 in the prior year). Coverage and ADP/ACP tests cap HCE deferrals relative to rank-and-file workers.
Fiduciaries owe a duty of loyalty (act solely for participants) and a duty of prudence (care, skill, diligence), must diversify, and must follow plan documents. Self-dealing and other prohibited transactions are barred, with narrow exemptions such as participant loans.
Top-Heavy Plans and Key Employees
A plan is top-heavy when more than 60% of plan assets or accrued benefits belong to key employees — generally officers earning above an indexed amount, 5% owners, and 1% owners with high pay. The 60% test catches small-employer plans dominated by the owner.
When a plan is top-heavy, the employer must make a minimum contribution of 3% of compensation for non-key employees and apply accelerated vesting (the 3-year cliff or 6-year graded schedule). These rules push benefits down to rank-and-file workers so the tax breaks are not concentrated at the top.
Reporting, Disclosure, and Why It Matters on the Exam
Two documents anchor ERISA's reporting and disclosure standards. The Form 5500 is the plan's annual return filed with the federal government, reporting financial condition and operations. The Summary Plan Description (SPD) is the participant-facing booklet that explains eligibility, benefits, vesting, and the claims-and-appeals process in plain language.
A participant must receive the SPD within a set window after joining and an updated version after material changes. On the exam, match Form 5500 = government and SPD = participant; reversing the two is a classic distractor.
An employee with 4 years of service leaves a plan using the 6-year graded vesting schedule. Her employer-contribution balance is $20,000. How much is nonforfeitable?
Which statement correctly distinguishes a nonqualified deferred compensation plan from a qualified plan?