11.1 Qualified vs. Nonqualified Plans and ERISA Basics
Key Takeaways
- Qualified plans satisfy Internal Revenue Code (IRC) Section 401(a) and earn employer deductions, pre-tax employee deferrals, and tax-deferred growth.
- Nonqualified plans skip those rules, lose the up-front employer deduction, and can favor selected executives without nondiscrimination testing.
- The Employee Retirement Income Security Act (ERISA) of 1974 sets minimum participation, vesting, funding, fiduciary, reporting, and disclosure standards.
- Minimum vesting uses a 3-year cliff or a 6-year graded schedule; an employee's own contributions are always 100% vested.
- Fiduciaries owe duties of loyalty and prudence and must avoid prohibited transactions or face personal liability.
A qualified retirement plan is an employer-sponsored or individually established plan that satisfies the requirements of Internal Revenue Code (IRC) Section 401(a). Meeting those requirements earns the plan favorable federal tax treatment that drives almost every retirement-planning answer on the exam.
The Four Tax Advantages of a Qualified Plan
| Advantage | What It Means |
|---|---|
| Employer deduction | The employer deducts contributions in the year they are made |
| Pre-tax deferral | Employee salary deferrals reduce current taxable income |
| Tax-deferred growth | Earnings compound without annual taxation |
| Deferred taxation | Income tax is due only when funds are distributed |
Because contributions and growth are never taxed until withdrawal, a qualified plan front-loads the benefit and pushes the tax bill into retirement, when the participant is often in a lower bracket.
Qualified vs. Nonqualified Plans
A nonqualified plan deliberately does not meet 401(a) rules. The employer gives up the immediate deduction but gains flexibility: the plan can cover a hand-picked group of executives and ignore the nondiscrimination tests that apply to qualified plans.
| Feature | Qualified Plan | Nonqualified Plan |
|---|---|---|
| Must cover broad employee base | Yes | No (can be selective) |
| Employer deduction timing | When contributed | When employee is taxed |
| Employee taxed on growth | At distribution | Often at vesting/receipt |
| ERISA nondiscrimination testing | Required | Not required |
| Common examples | 401(k), profit-sharing, pension | Deferred compensation, SERP |
Exam trap: With a nonqualified deferred-compensation plan, the employer's deduction is delayed until the executive actually includes the amount in income. The matching-timing rule (employer deduction equals employee inclusion) is heavily tested.
ERISA: The Federal Rulebook
The Employee Retirement Income Security Act (ERISA) of 1974 sets minimum standards that qualified employer plans must follow. ERISA does not require an employer to offer a plan, but if one is offered it must comply.
Participation
A plan generally must allow an employee to participate once the employee is:
- At least age 21, and
- Has completed one year of service (defined as 1,000 hours in a 12-month period).
A plan may be more generous (earlier entry) but never more restrictive than these minimums.
Funding, Reporting, and Disclosure
- Funding: Defined benefit plans must meet minimum funding standards so promised benefits are actually backed by assets.
- Reporting: Plans file Form 5500 annually with the IRS/Department of Labor.
- Disclosure: Participants receive a Summary Plan Description (SPD) explaining their rights.
Vesting Schedules
Vesting is the point at which an employee owns the employer's contributions and cannot forfeit them. An employee's own contributions are always 100% vested immediately.
For defined contribution plans, ERISA permits two minimum schedules:
| Years of Service | 3-Year Cliff | 6-Year Graded |
|---|---|---|
| 1 | 0% | 0% |
| 2 | 0% | 20% |
| 3 | 100% | 40% |
| 4 | 100% | 60% |
| 5 | 100% | 80% |
| 6+ | 100% | 100% |
Worked scenario: Maria leaves after 4 years of service under a 6-year graded schedule. Her employer contributed $20,000. She is 60% vested, so she keeps $20,000 x 0.60 = $12,000; the remaining $8,000 is forfeited back to the plan.
Fiduciary Duties and Prohibited Transactions
A fiduciary is anyone with discretionary control over plan assets or administration. ERISA imposes two core duties:
- Duty of loyalty: Act solely in the interest of participants and beneficiaries.
- Duty of prudence: Use the care a knowledgeable expert would use, including diversifying investments.
Fiduciaries must avoid prohibited transactions, such as lending plan money to the employer or self-dealing. A fiduciary who breaches these duties can be held personally liable to restore losses to the plan.
Exam tip: Remember the order of ERISA's standards with the phrase "Pet Vets Find Reliable Friends" — Participation, Vesting, Funding, Reporting/disclosure, Fiduciary.
Under a 6-year graded vesting schedule, an employee terminates after exactly 3 years of service. The employer had contributed $10,000 to the employee's account. How much of the employer contribution does the employee keep?
Which statement best distinguishes a nonqualified deferred-compensation plan from a qualified plan?
Worked Comparison: Vesting Schedules
ERISA caps how long an employer can require service before employer contributions become non-forfeitable. Two permitted schedules for defined-contribution plans:
| Schedule | Vesting pattern |
|---|---|
| 3-year cliff | 0% until year 3, then 100% at once |
| 2-to-6 graded | 20% after year 2, +20%/year, 100% after year 6 |
Employee elective deferrals are always 100% vested immediately - only employer money is subject to a schedule.
Worked example: an employee leaves after 4 years under a 2-to-6 graded schedule. They are 60% vested in employer contributions (20% + 20% + 20% for years 2, 3, 4) and forfeit the unvested 40%; their own deferrals leave with them in full. A 3-year-cliff employee who leaves at year 2 forfeits all employer contributions. Recognizing 'cliff = all-or-nothing at the cliff' versus 'graded = builds in steps' is the core exam point.