Qualified and Nonqualified Plans
The determination of whether a plan is qualified or nonqualified is by its tax status under the law.[1] Qualified and nonqualified both have different tax implications for both employees and employers. Both programs can be useful for employers in attracting and retaining employees depending on different situations. Careful consideration should be used in determining which type an employer chooses in establishing a retirement program for their employees. A qualified plan is established by an employer to provide retirement benefits for employees and their beneficiaries.
Qualified Plans are a program established under the established tax laws by which an employer provides retirement income for employees and their beneficiaries. Qualified plans are not IRA based like SIMPLE or SEP IRAs and are therefore subject to different rules concerning distributions and contributions. Qualified plans can either be defined benefit or defined contribution plans, which are discussed later. Any type of business entity may adopt a qualified plan, including sole proprietorships, partnerships, corporations, and government. Employees on the other hand, may not adopt a qualified plan but may be a participant in their employer’s plan. Examples include money purchase plans and profit sharing.
Qualified plans have several advantages such as favorable federal tax treatment for employers. A qualified plan allows the employer’s portion of the contributions to be tax deductible. The benefits to plan participants include current tax deferral of their contributions. In addition, plan participants are not taxed until they start making withdrawals from there accounts. In order to maintain this tax status, plans must operate under the provisions set forth by the IRC, DOL, and ERISA. Some of those provisions include participation, vesting, coverage, and nondiscrimination.
Employers wishing to formally establish a qualified plan must complete an adoption agreement. The adoption agreement contains a general description of the plan in addition to operating provisions. Furthermore, employers must notify employees with a Summary Plan Description. The SPD must be provided to all employees in a non-legal format that is easily understood. The SPD must include information such as:
·
Identification
number and location of the plan.
·
A
description of what the plan provides for employees and how it operates.
·
When
employees may begin to participate.
·
How
employees service and benefits are calculated.
·
When
employees benefits will become vested.
·
When
employees will receive benefits and in what form
·
Circumstances
under which employees may lose or be denied benefits.
·
The
employees’ rights under ERISA.
In the event of any revisions in the provisions of the plan, employees must be notified either in a revised SPD or in different document referred to as a Summary of Material Modification (SMM). [2]
Employers have a choice in the types of plans they can choose. They can either choose an individually designed plan or they may choose one that is a prototype provided by a sponsor and already approved by the IRS. Individual plans are ones which are designed and are unique to meet the needs of an employer. No other entity may use an individually designed document. Typically, this type of plan is used by large companies who want to fulfill certain specifications that may not be met under a prototype-plan.
IRS pre-approved prototype and master plans, are typically used by small businesses. These types of plans can be used by any number of employers, unlike individual designed plans. When a master plan is used, a single trust or custodian is set up to accommodate all adopting employers. The prototype plan uses a separate trust or custodian for each employer. There are numerous organizations that sponsor IRS approved master and prototype plans including:
· Banks, some savings & loans and credit unions
· Trade or professional organizations
· Insurance companies
· Attorneys
· Financial planners
· Accountants
There are some disadvantages to qualified plans as well. In order for an employer to benefit from tax laws they must adhere to the many stringent governmental regulations that guarantee the plan is administered with nondiscriminatory goals. Over time government regulations have become increasingly more cumbersome and complex. This puts additional administrative and cost responsibilities on employers. Another disadvantage to a qualified plan is the annual compensation cap in effect. An employer can contribute up to 25 percent of compensation to each eligible employee’s account as long as it does not exceed $40,000 annually. If an employee’s annual remuneration exceeds $200,000 (indexed for future years) then they may not be considered under the employer’s plan. This could be detrimental to retirements of employees who have high annual compensation packages.
Nonqualified plans can present an alternative to qualified plans by offering supplemental employer benefits and income deferral opportunities along with a great deal of flexibility in their design. These plans are less weighted down with and/or restricted by governmental regulations. For example, a nonqualified plan could be used by an employer to establish “golden handcuffs” for a perspective employees if they promise to stay for their career or for a specified period of time. In addition, nonqualified plans could be used to attract and retain employees who are further down the road in there careers by offering them rapid benefit accumulation. [3]
Nonqualified plans can benefit lower-paid employees. Considering the contribution cap on qualified plans, it may be a better alternative to use nonqualified plans to cover highly compensated employees. This could provide a means to offer less compensated employee’s qualified plans.
There are some disadvantages to nonqualified plans as well. From the perspective of employers, the tax advantage is for contributions and deferred compensation can not be realized until the participant actually receives the benefits. Another disadvantage is that the employer usually limits the employees selected as participants. These are usually management or highly compensated individuals, so there is a burden placed on employers in deciding which employees are appropriate. Furthermore, nonqualified plans cannot be funded in the same manner as qualified plans. Funding of nonqualified plans can precipitate government reporting and disclosure and premature tax event for employees. Unfunded obligations can also have an adverse affect on financial statements.
From the employees perspective there are concerns security of the promised benefit. These concerns include bankruptcy, sale of the company, change of control of the company, or even if management changes their mind.[4]