By Denise Appleby

Any business, including sole proprietorships, partnerships, corporations and government entities may adopt a qualified plan. An employee may not adopt a qualified plan, but an employee may participate in a qualified plan established by his or her employer.

Establishing a Qualified Plan
A qualified plan document generally consists of an adoption agreement and the basic plan document, which provide the provisions under which the plan must operate. The employer formally adopts the plan by passing a resolution (if applicable) to adopt the plan, completing the adoption agreement and notifying the employees with a summary plan description (SPD), which must be written in non-legalese so that the average employee can understand it.

The information that must be provided in the SPD includes:

  • The 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 in the plan
  • How employees' service and benefits are calculated
  • When employees' benefits becomes vested
  • When employees will receive payment and in what form
  • How employees may request benefits
  • Circumstances under which employees may lose or be denied benefits
  • The employees rights under ERISA
Employees should read the SPD to learn about the particular provisions that apply to them. If the provisions of a plan are changed, employees must be notified in a revised SPD or in a separate document called a summary of material modifications (SMM).

Choosing A Plan Provider
An employer may choose to establish an individually designed plan or use an IRS-approved prototype plan provided by a sponsoring organization.

Individually Designed Plans
Generally, an individually designed plan is drafted to meet the needs of one employer, so no other employer may use this individually designed document. Typically, large companies that want their plans to meet certain specifications that may not be available in a prototype plan adopt individually designed plans.

Advance IRS approval is not required for an individually designed plan. If, however, the employer would like confirmation from the IRS that the qualifications meet prescribed rules and regulations, the employer can apply for approval by paying a fee and requesting a determination letter. Drafting the plan may require assistance from a lawyer or tax professional, and the fees for this service vary among professionals. The IRS may charge a fee for any determination letter that the employer requests.

Master or Prototype Plans
Master and prototype plans, which are already IRS approved, are popular among small business owners. Those who adopt a prototype plan have no need to request a determination letter. Unlike the individually designed plans, master and prototype plans can be used by an unlimited number of employers. Under a master plan, a single trust or custodial account is established as part of the plan for the joint use of all adopting employers. Under a prototype plan, a separate trust or custodial account is established for each employer.

The following are some of the organizations that can sponsor IRS-approved master or prototype plans:

  • Banks (including some savings and loan associations and federally insured credit unions)
  • Trade or professional organizations
  • Insurance companies
  • Mutual fund companies
  • Attorneys
  • Financial planners
  • Accountants
Establishment Deadline
A qualified plan must be established by the last day of the employer's tax year, and the employer contributes to the plan for that year and subsequent years as provided in the plan.

Eligibility Requirements for Employees (Plan Participants)
Employees must meet certain eligibility requirements to participate in the plan their employer adopts. Business owners should therefore take care not to implement eligibility requirements that would exclude themselves from participating in the plan. For instance, a business owner who is 18 years of age should not implement an eligibility requirement of age 21 as he or she would be excluded from participating in the plan.

In general, an employee must be allowed to participate in a qualified plan after meeting the following requirements:

  • He or she has reached age 21 - An employee can be excluded for not having reached a minimum age (which cannot exceed age 21) but cannot be excluded for having reached a maximum age. For instance, an employee cannot be excluded from the plan because he or she is, say, 100 years old.
  • He or she has at least one year of service - This requirement is two years if the plan is not a 401(k) plan and provides that after not more than two years of service the employee has a non-forfeitable right to all his or her accrued benefit (i.e. all contributions are 100% vested). For qualified plan purposes, a year of service is generally 1,000 hours of service performed during the plan year. Employees who do not perform 1,000 hours of service are not considered to have performed one year of service, even if services were performed for a 12-month period.
An employer may implement less restrictive eligibility requirements, such as a minimum age younger than 21 or a service requirement less than one year and 1,000 hours of service. These other eligibility criteria, however, must be within the parameters of the rules and regulations that govern qualified plans. Unless the IRS has approved a plan document that includes these other eligibility requirements, an employer must consult with legal counsel regarding these requirements before they are implemented.

Excludable Employees
An employer may choose to exclude employees who are covered under a collective bargaining agreement (unionized) or certain nonresident aliens.

Vesting - Employees Non-Forfeitable Rights to Employer Contributions
Vesting is the process by which the employee earns a non-forfeitable right to benefits funded by employer contributions. All qualified plans must ensure that employees are vested in employer contributions according to vesting schedules that meet regulatory requirements. Employees are always 100% vested in their own contributions (i.e. elective-deferral contributions).

An employer may chose between two types of vesting schedules: cliff vesting or graded vesting.

  • Cliff Vesting
    Under a cliff-vesting schedule for employer contributions, such as profit-sharing contributions and employer matching contributions, the employee must perform three years of vesting service to become vested in employer contributions. After the three years the employee becomes 100% vested in these contributions.


  • Graded Vesting
    Under a graded-vesting schedule for employer matching contributions, the employee is 20% vested in employer contributions after completing two years of vesting service. For each subsequent year, the vesting is increased by 20% until it reaches 100%, which occurs after six years of service.
The vesting schedules are summarized in the following tables.

Employer Contributions
Three-Year Cliff Vesting Seven-Year Graded Vesting
Years of Vesting Service Vested Percentage Years of Vesting Service Vested Percentage
1 0 1 0
2 0 2 20
3 100 3 40
4 60
5 80
6 100
An employer may choose to have a faster vesting schedule than the ones indicated in the chart above.

How the Vesting Schedule Affects Employee Assets
An employee who separates from service prior to becoming 100% vested will forfeit the unvested portion of his or her account balance. The number of hours of service performed by the employee determines the employee's vesting service for each year. Generally, an employee who performs at least 1,000 hours of service for a year is credited with one year of vesting service for that year. The following example demonstrates this.

Example 1: Vesting Schedule and Employee Assets
The ABC Corporation's profit-sharing contributions are subject to the following graded schedule:

Years of Vesting Service Vested Percentage
1 20
2 40
3 60
4 80
5+ 100
ABC Corporation requires each employee to perform 1,000 hours each year in order to be credited with one year of vesting service. Larry, a part-time employee whose profit-sharing account had a balance of $5,400 in 2013, performed the following hours of service for these years:

Year Hours of Service Credit for Vesting Service Comment
2008 600 No Larry has not earned a year of vesting service because he performed service for less than 1,000 hours.
2009 1,152 Yes Larry has earned a year of vesting service because he performed service for at least 1,000 hours.
2010 1,010 Yes Larry has earned a year of vesting service because he performed service for at least 1,000 hours.
2011 800 No Larry has not earned a year of vesting service because he performed service for less than 1,000 hours.
2012 1,012 Yes Larry has earned a year of vesting service because he performed service for at least 1,000 hours.
2013 40 No Larry has not earned a year of vesting service because he performed service for less than 1,000 hours.

Larry resigned from ABC Corporation in January 2013. Even though he was employed with ABC Corporation for five years, he was not fully vested in the profit-sharing contributions because he did not work for at least 1,000 hours each year. Because Larry is credited with three years of vesting services, he is entitled to receive 60% of his account balance, which is $3,240 ($5,400 x 0.6). Larry must forfeit the balance of $2,160.

Automatic 100% Vesting
Employees are automatically 100% vested in some contributions such as elective-deferral contributions (also referred to as salary-deferral or salary-reduction contributions). Also, some employers may prefer that the plan not have a vesting schedule, which means that employees are immediately 100% vested in all contributions. However, even for plans with a vesting schedule, there are instances in which employees may become 100% vested in employer contributions even if they have not satisfied the service requirements. This can occur:

  • When there is a complete discontinuance of contributions (under a profit-sharing plan or stock-bonus plan)
  • When the plan is terminated or partially terminated (a plan may be deemed partially terminated if it is amended and the amendment results in the exclusion of a substantial number of employees)
  • When the employee attains normal retirement age as defined under the plan.


Next: 401(k) And Qualified Plans: Contributions »


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