A qualified plan is a retirement plan established by an employer to provide retirement benefits for employees and their beneficiaries. Qualified plans must adhere to requirements set by the Internal Revenue Code, the Employee Retirement Income Security Act of 1974 (ERISA) and the Department of Labor.
The primary characteristics of qualified plans:
- Tax deduction - The employer receives a tax deduction for contributing to the retirement plan.
- Tax deferral - Employees pay no taxes on the contributions made on behalf or on earnings until the plan benefits are distributed to them upon retirement.
- Nondiscrimination -Qualified plans may not discriminate in favor of highly compensated employees over nonhighly compensated employees.
A nonqualified plan is an employer - sponsored retirement plan or other deferred compensation plan that does not meet Internal Revenue Code or ERISA requirements for qualified plans. As a result, they do not enjoy the same tax advantages of a qualified plan, but they are easier to set up since regulatory requirements are less burdensome.
Nonqualified plans are used most frequently to attract and retain highly paid executives. They often are used to supplement qualified plans.
Primary characteristics of nonqualified plans:
- Discrimination - An employer uses a nonqualified plan to provide extra incentives above and beyond what rank-and-file employees receive. Because these plans do not enjoy the same tax benefits as qualified plans, they are allowed to discriminate.
- No tax deduction -An employer receives no tax deduction for contributing to a nonqualified retirement plan.
- Tax deferral - A participant in a nonqualified plan can defer receipt of taxable income to a future date.
- No creditor protection - Deferred compensation under a nonqualified plan cannot be secured, meaning it can be subject to the claims of creditors if a company encounters financial difficulty.
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