By Ian Berger, JD
Many of you who participate in a company retirement plan may have heard that the plan is “qualified” or “tax-qualified.” That sounds reassuring, but what exactly does it mean? In other words, what qualifies a qualified plan to be qualified? (And, while we’re at it, how much wood can a woodchuck chuck …?)
The carrot and the stick: The concept of a qualified plan resulted from Congress’s desire to incentivize companies to establish retirement plans. So, Congress enacted certain tax breaks for employers who set up those plans, but required the plans to satisfy a number of rules designed to make sure the plans don’t take advantage of rank-and-file workers. Here are the most important of those rules:
- Benefits under a qualified plan can’t discriminate in favor of “highly compensated employees” (HCEs for short), as defined under the tax code. Each type of qualified plan has its own nondiscrimination rules. In a 401(k) plan, employee deferrals for the group of HCEs are limited by the amount made by the group of non-HCEs.
- A qualified plan can’t cover a group of employees that is disproportionately made up of HCEs. As an extreme example, a company can’t set up a plan that covers only management and shuts out the rank-and-file.
- Employees in a qualified plan must be vested in their benefits (i.e., benefits can’t be taken away) after they have worked a certain number of years with the company.
Which plans are qualified? 401(k) plans, profit sharing plans and defined benefit pension plans are the most popular types of qualified plans. They are subject to the rules listed above, which are found in section 401(a) of the tax code.
What about 403(b) and 457(b) plans? 403(b) plans (generally for public schools and tax-exempt employers) and 457(b) plans (for governmental employers) are technically not considered qualified plans since they aren’t subject to the section 401(a) rules. Instead, they operate under their own set of tax rules, similar to (but not the same as) the section 401(a) rules. For this reason, 403(b) and 457(b) plans are often referred to as “tax-favored” instead of “tax-qualified.”
How about IRAs? IRAs are also not considered qualified plans. Individual IRAs are not established by an employer. SIMPLE and SEP IRAs are established by an employer, but like 403(b) and 457(b) plans, they have their own tax rules.
Employee tax rules: Employee tax rules are mostly the same whether we’re dealing with a tax-qualified plan like a 401(k) plan or a tax-favored plan like a 403(b) or a 457(b). For example, employees in any of those plans can make pre-tax deferrals or make Roth contributions (if their plan allows it). In addition, they can roll over most distributions to an IRA or another employer plan. Finally, they are subject to required minimum distribution (RMD) rules.
Now you are qualified to know a lot about qualified plans!