11.1 Qualified vs. Nonqualified Plans and ERISA Basics
Key Takeaways
- A qualified plan meets Internal Revenue Code (IRC) Section 401(a) standards, giving the employer a current deduction and the employee tax-deferred growth.
- Qualified plans must be nondiscriminatory; nonqualified plans may favor select executives because they do not get IRC 401(a) tax relief.
- The Employee Retirement Income Security Act (ERISA) of 1974 sets minimum participation, vesting, funding, fiduciary, reporting, and disclosure rules.
- ERISA cliff vesting fully vests employer money at 3 years; graded vesting reaches 100% over 6 years; employee deferrals are always 100% vested.
- Fiduciaries owe duties of loyalty and prudence and must avoid prohibited transactions; nonqualified plan assets remain exposed to the employer's creditors.
What "Qualified" Means
A qualified retirement plan is one that satisfies Internal Revenue Code (IRC) Section 401(a) and the labor rules of the Employee Retirement Income Security Act (ERISA). In exchange for following those rules, the plan receives favorable federal tax treatment that a savings account or ordinary investment never gets.
Three tax mechanics drive every qualified plan, and the exam tests them as a package:
| Tax Feature | Who Benefits | Effect |
|---|---|---|
| Employer deduction | Employer | Contributions are deductible the year they are made |
| Pre-tax deferral | Employee | Salary contributed reduces current taxable income |
| Tax-deferred growth | Employee | Earnings compound untaxed until distribution |
The price of these benefits is that the plan must not discriminate in favor of owners and Highly Compensated Employees (HCEs). Coverage, participation, and contribution rules force rank-and-file employees to share the advantages.
Qualified vs. Nonqualified Plans
A nonqualified plan deliberately fails IRC 401(a) so the employer can pick and choose who participates. These plans reward key executives without the cost of covering every worker, but they forfeit the up-front deduction and creditor protection.
| Feature | Qualified Plan | Nonqualified Plan |
|---|---|---|
| IRC 401(a) approval | Required | None |
| Nondiscrimination | Must cover broad workforce | May favor select executives |
| Employer deduction timing | When contributed | When the employee is taxed (at payout) |
| Employee taxation | At distribution | At constructive receipt / vesting |
| ERISA full coverage | Yes | Largely exempt (top-hat plans) |
| Creditor protection of assets | Protected in trust | Exposed to employer's creditors |
A common exam trap: in a nonqualified deferred compensation plan the employer's deduction is delayed to match the year the executive recognizes income. Funds informally set aside (for example, in a rabbi trust) still belong to the employer and can be reached by the employer's creditors in bankruptcy, which is why these plans suit only executives who can absorb that risk.
ERISA: The Six Pillars
ERISA, enacted in 1974, protects participants in private-sector plans. Government and church plans are generally exempt. The exam expects you to recognize each pillar:
- Participation -- minimum age and service rules for joining the plan.
- Vesting -- the schedule on which employer money becomes non-forfeitable.
- Funding -- minimum funding standards, mainly for defined benefit plans.
- Fiduciary responsibility -- duties of loyalty and prudence for those who manage plan assets.
- Reporting -- annual filing such as Form 5500 to the federal government.
- Disclosure -- giving participants a Summary Plan Description (SPD) and benefit statements.
Participation Minimums
A plan may be more generous but never more restrictive than the ERISA floor:
| Requirement | Standard |
|---|---|
| Minimum age | 21 |
| Minimum service | 1 year (1,000 hours in 12 months) |
| Alternative for 100% immediate vesting | 2 years of service allowed |
Vesting Schedules
Vesting measures how much of the employer's contribution an employee owns if they leave. Employee salary deferrals are always 100% vested immediately. ERISA caps how slow employer vesting can be.
Cliff vesting (3-year): the employee is 0% vested until completing 3 years, then jumps to 100%.
| Years of Service | Vested % |
|---|---|
| 0-2 | 0% |
| 3+ | 100% |
Graded vesting (6-year): ownership rises in steps and reaches 100% at year 6.
| Years of Service | Vested % |
|---|---|
| <2 | 0% |
| 2 | 20% |
| 3 | 40% |
| 4 | 60% |
| 5 | 80% |
| 6+ | 100% |
Worked scenario: An employee with $30,000 of employer matching money leaves after exactly 4 years under a 6-year graded schedule. They are 60% vested, so they keep $18,000 ($30,000 x 0.60); the unvested $12,000 is forfeited back to the plan. Under a 3-year cliff schedule the same employee would already be 100% vested and keep the full $30,000.
Fiduciary Duties and Prohibited Transactions
Anyone with discretionary control over plan assets or administration is a fiduciary and is held to high standards:
- Duty of loyalty -- act solely in the interest of participants and beneficiaries.
- Duty of prudence -- act with the care, skill, and diligence of a prudent expert.
- Duty to diversify -- spread investments to limit large losses.
- Duty to follow the plan document -- operate per the written terms.
Fiduciaries must avoid prohibited transactions such as self-dealing, dealing with parties-in-interest, and receiving kickbacks. A producer who simply sells a product to the plan is generally not a fiduciary, but an adviser with discretionary authority is.
Exam Tip: If a question describes someone who decides how plan money is invested, that person is a fiduciary. A salesperson with no discretion usually is not.
An employer wants to provide extra retirement benefits ONLY to its three top executives without covering rank-and-file staff. Which plan design accomplishes this?
Under a 6-year graded vesting schedule, an employee with $20,000 of employer contributions terminates after completing 3 years of service. How much is non-forfeitable?