Qualified vs. Nonqualified Retirement Plans: An Overview
Employers create qualified and nonqualified retirement plans with the intent of benefiting employees. The Employee Retirement Income Security Act (ERISA), enacted in 1974, was intended to protect workers’ retirement income and provide a measure of information and transparency.
- Qualified plans include 401(k) plans, 403(b) plans, profit-sharing plans, and Keogh (HR-10) plans.
- Nonqualified plans include deferred-compensation plans, executive bonus plans, and split-dollar life insurance plans.
The tax implications for the two plan types are also different. With the exception of a simplified employee pension (SEP), individual retirement accounts (IRAs) are not created by an employer and thus are not qualified plans.
- A qualified retirement plan meets the guidelines set out by ERISA.
- Qualified plans qualify for certain tax benefits and government protection.
- Nonqualified plans do not meet all ERISA stipulations.
- Nonqualified plans are generally offered to executives and other key personnel whose needs cannot be met by an ERISA-qualified plan.
What Is a Qualified Retirement Plan?
Qualified retirement plans are designed to meet ERISA guidelines and, as such, qualify for tax benefits on top of those received by regular retirement plans, such as IRAs. Employers deduct an allowable portion of pretax dollars from the employee’s wages for investment in the qualified plan. The contributions and earnings then grow tax deferred until withdrawal.
A qualified plan may have either a defined-contribution or defined-benefit structure. In a defined-contribution plan, employees select investments, and the retirement amount will depend on the decisions they made. With a defined-benefit plan, there is a guaranteed payout amount and the risk of investing is borne by the employer.
Plan sponsors must meet a number of guidelines regarding participation, vesting, benefit accrual, funding, and plan information to qualify their plans under ERISA.
What Is a Nonqualified Retirement Plan?
Many employers offer primary employees nonqualified retirement plans as part of a benefits or executive package. Nonqualified plans are those that are not eligible for tax-deferred benefits under ERISA. Consequently, deducted contributions for nonqualified plans are taxed when the income is recognized. In other words, the employee will pay taxes on the funds before they are contributed to the plan.
Qualified vs. Nonqualified: Key Differences
The main difference between the two plans is the tax treatment of deductions by employers, but there are also other differences. Qualified plans have tax-deferred contributions from the employee, and employers may deduct amounts they contribute to the plan. Nonqualified plans use after-tax dollars to fund them, and in most cases employers cannot claim their contributions as a tax deduction.
All employees who meet the eligibility requirements of a qualified retirement plan must be allowed to participate in it, and benefits must be proportionately equal for all plan participants.
A plan must meet several criteria to be considered qualified, including:
- Disclosure—Documents about the plan’s framework and investments must be available to participants upon request.
- Coverage—A specified portion of employees, but not all, must be covered.
- Participation—Employees who meet eligibility requirements must be permitted to participate.
- Vesting—After a specified duration of employment, a participant’s right to a pension is a nonforfeitable benefit.
- Nondiscrimination—Benefits must be proportionately equal in assignment to all participants to prevent excessive weighting in favor of higher-paid employees.
Nonqualified plans are often offered to key executives and other select employees. They can be designed to meet the specific needs of these employees, while qualified plans cannot do so.
Thomas M. Dowling, CFA, CFP®, CIMA®
Aegis Capital Corp, Hilton Head, S.C.
A qualified retirement plan is included in Section 401(a) of the Tax Code and falls under the jurisdiction of ERISA guidelines. Employee and/or employer contributions are distinct from the employer’s balance sheet and are owned by the employee. There are more restrictions to a qualified plan, such as limited deferral amounts and employer contribution amounts. Examples of these are 401(k) and 403(b) plans.
A nonqualified plan does not fall under ERISA guidelines so it does not receive the same tax advantages. They are considered to be assets of the employer and can be seized by creditors of the company. If the employee quits, they will likely lose the benefits of the nonqualified plan. The advantages are no contribution limits and more flexibility. Executive Bonus Plan is an example.