11.1 Qualified vs. Nonqualified Plans and ERISA Basics
Key Takeaways
- A qualified plan satisfies Internal Revenue Code (IRC) Section 401(a), earning the employer a current deduction while letting employees defer tax until distribution.
- Nonqualified plans skip IRC 401(a) and can discriminate in favor of executives, but the employer generally gets no deduction until the employee is taxed.
- The Employee Retirement Income Security Act of 1974 (ERISA) sets minimum standards for participation, vesting, funding, fiduciary conduct, reporting, and disclosure.
- ERISA permits a maximum eligibility age of 21 with one year of service; vesting follows a 3-year cliff or a 2-to-6-year graded schedule.
- Nondiscrimination testing protects rank-and-file employees against plans that funnel benefits to Highly Compensated Employees (HCEs).
Qualified vs. Nonqualified Plans
Retirement plans split into two camps based on whether they satisfy Internal Revenue Code (IRC) Section 401(a). A qualified plan meets those federal rules and receives favorable tax treatment in exchange for following strict participation, vesting, and nondiscrimination standards.
A nonqualified plan intentionally fails (or ignores) IRC 401(a). Because it is not bound by nondiscrimination rules, an employer can offer it to a hand-picked group of executives. The trade-off: the employer usually loses the up-front deduction.
The Four Tax Outcomes Tested on the Exam
| Question | Qualified Plan | Nonqualified Plan |
|---|---|---|
| Employer deduction timing | When contributed | Deferred until the employee is taxed |
| Employee taxed on contributions | No (pre-tax deferral) | Depends on design; often at vesting |
| Earnings growth | Tax-deferred | Tax-deferred or currently taxed |
| Can it favor executives? | No | Yes |
Key memory hook: with a qualified plan the employer wins early (immediate deduction) but must share broadly. With a nonqualified plan the employer may discriminate freely but waits to deduct.
ERISA: The Rulebook for Qualified Plans
The Employee Retirement Income Security Act of 1974 (ERISA) is the federal law that protects participants in private-sector qualified plans. ERISA does not require an employer to offer a plan, but if one is offered it must meet minimum standards.
The Six ERISA Standards
| Standard | What It Governs |
|---|---|
| Participation | When an employee must be allowed in |
| Vesting | When employer money becomes the worker's to keep |
| Funding | Minimum amounts the employer must set aside |
| Fiduciary | The duty of those who control plan assets |
| Reporting | Annual Form 5500 to the government |
| Disclosure | The Summary Plan Description (SPD) to participants |
A simple mnemonic is "PVF-FRD." Two of these, participation and vesting, generate the most exam questions, so they appear in detail below.
Exam Tip: ERISA governs private plans. Government and most church plans are exempt, which is why 403(b) and 457(b) arrangements have their own quirks.
Participation and Vesting
Eligibility (Participation)
A plan may not set its eligibility bar higher than:
- Age 21, and
- One year of service (defined as 1,000 hours within a 12-month period).
A plan can be more generous (let people in sooner) but never more restrictive. Long-term part-time workers gain access after a reduced service period under recent law.
Vesting Schedules
Vesting is the worker's nonforfeitable right to employer contributions. Employee salary deferrals are always 100% vested immediately. Employer money may follow either schedule below.
| Years of Service | 3-Year Cliff | 2-to-6-Year Graded |
|---|---|---|
| 1 | 0% | 0% |
| 2 | 0% | 20% |
| 3 | 100% | 40% |
| 4 | 100% | 60% |
| 5 | 100% | 80% |
| 6 | 100% | 100% |
Worked example: Maria has four years of service when she resigns. Under cliff vesting she keeps 100% of the employer match. Under graded vesting she keeps 60%, forfeiting the remaining 40% back to the plan.
Nondiscrimination and Fiduciary Duty
Nondiscrimination
A qualified plan cannot tilt benefits toward Highly Compensated Employees (HCEs) — broadly, more-than-5% owners or those earning above an indexed threshold (roughly $160,000). Coverage and the Actual Deferral Percentage / Actual Contribution Percentage (ADP/ACP) tests cap how much more HCEs may defer relative to the rank and file. Failing a test forces corrective refunds to HCEs.
Fiduciary Responsibility
Anyone who exercises discretion over plan assets is a fiduciary and owes:
- A duty of loyalty — act solely in participants' interest.
- A duty of prudence — the care of a knowledgeable expert.
- Diversification of investments.
- Adherence to the written plan documents.
Prohibited transactions — self-dealing, lending plan assets to the employer, or kickbacks — expose the fiduciary to personal liability and excise taxes.
Trap: An insurance producer who merely sells a product to a plan is generally not a fiduciary, but an advisor with discretionary control is.
An employer wants to provide a supplemental retirement benefit only to its three top executives, with no IRS approval required and no obligation to include other staff. Which type of plan fits?
Under ERISA, what is the most restrictive eligibility standard a qualified plan may impose on a rank-and-file employee?
Tax Treatment: Qualified vs. Nonqualified
| Feature | Qualified Plan | Nonqualified Plan |
|---|---|---|
| Employer contributions | Tax-deductible when made | Not deductible until paid out |
| Employee taxation | Deferred until distribution | Varies; may be taxed earlier |
| IRS/ERISA approval | Required, must not discriminate | Not approved; can discriminate |
| Typical use | Broad employee retirement | Select executives (deferred comp) |
A qualified plan earns its tax advantages by following IRS rules and covering employees broadly without discrimination. A nonqualified plan (e.g., a deferred-compensation or executive bonus arrangement) can favor select executives but gives up the immediate employer deduction.
A primary tax advantage of a QUALIFIED retirement plan over a nonqualified plan is that:
ERISA Protections and Fiduciary Standards
ERISA (1974) governs most private qualified plans to protect participants. Core requirements the exam tests:
- Eligibility: generally an employee age 21 with 1 year of service must be allowed to participate.
- Vesting: employer contributions must vest on a schedule (e.g., 3-year cliff or 2-to-6-year graded); employee contributions are always 100% vested.
- Reporting and disclosure: participants receive a Summary Plan Description (SPD).
- Fiduciary duty: those who manage plan assets must act solely in participants' interest (the prudent-expert rule).
Trap: ERISA does not apply to government or church plans; those are exempt. It governs private-sector qualified plans.
Top-Heavy and Coverage Testing
To keep their tax advantages, qualified plans must pass IRS nondiscrimination and coverage tests proving they do not unduly favor highly compensated employees. A plan that is top-heavy (too much value in key employees' accounts) must provide minimum contributions or accelerated vesting for rank-and-file workers.
Contrast this with a nonqualified deferred compensation plan, which is intentionally selective (executives only) and therefore gives up the immediate employer deduction the employer deducts the cost only when the executive is taxed on the payout.
Exam Tip: Qualified = broad, nondiscriminatory, employer deducts now, employee taxed later. Nonqualified = selective, employer deducts later (when employee is taxed). ERISA governs the qualified, private-sector plans, not government or church plans.