Rules

Workplace retirement plans can be either qualified or non-qualified. A plan is considered qualified when it meets requirements under the Employee Retirement Income Security Act (ERISA), a federal law discussed below. ERISA generally governs qualified plans offered by non-governmental (private) organizations. Qualified plans are eligible for substantial tax benefits for both the employer and the employee.

Most qualified retirement plans allow pre-tax contributions. Normally, every dollar you earn at work is taxable, and higher income generally means higher taxes. Pre-tax contributions reduce the income you report for tax purposes.

For example, assume you earn $100,000 and that income is subject to taxes. If you contribute $5,000 to your employer’s qualified retirement plan, you’re taxed on $95,000 of income for the year. Many qualified plans also allow payroll deductions to be deposited directly into the retirement account before taxes are applied*. The more you contribute pre-tax, the less taxable income you report. However, those retirement plan assets are generally taxable when they’re distributed later in retirement.

*Not all qualified plans offer pre-tax contributions. Roth 401(k)s are a good example. We’ll learn more about these accounts later in this unit.

Qualified plans are popular because of their tax benefits. Employers often offer them to stay competitive when attracting and retaining employees. To offer a qualified plan, an organization must follow specific rules - most importantly, it must comply with ERISA. ERISA is designed to protect employee retirement assets from employer misconduct or mismanagement. Qualified plans must meet ERISA standards, including the following:

Minimum participation/non-discrimination

• The plan can’t discriminate in favor of highly compensated employees or owners
  • For example, it can’t be offered to executives only
  • The employer can still exclude certain groups of employees (by job classification, location, etc.) as long as the plan passes the IRS’s minimum coverage tests
• An employer can’t make employees wait longer than certain limits to become eligible. At most, an employer can require an employee to be:
  • Age 21 or older, and
  • Employed for one year (working at least 1,000 hours in a year)
  • These are maximum limits, not mandatory minimums - employers can allow participation sooner, but can’t impose stricter conditions

Reporting and disclosure

• Details of retirement plan available in writing
• Employees provided annual updates

Funding

• Defined benefit plans (discussed below) must be funded appropriately

Vesting

• Employees must earn employer-provided benefits in a reasonable amount of time
  • Typically five years or less
  • For example, employer-matched contributions*
• Employee contributions are always 100% vested

*Some employers match employee contributions as a workplace benefit. For example, a company offers to match 100% of employee contributions, up to 5% of their salary. If an employee saves 5% of their salary, the employer matches the contribution (allowing the employee to effectively save 10% of their salary). Employers usually apply vesting periods of five years or less, which means an employee quitting their position within the vesting period loses part or all of the employer match.

Every qualified plan is governed by a plan document, which must be created before the plan is offered to employees. The plan document spells out the plan’s rules, including:

• Who can contribute to the plan
• Employer-provided benefits (e.g., matching contributions)
• Vesting schedules
• Investment options
• Beneficiary designation rules
• Distribution guidelines

If you’re interested, here’s a link to a boilerplate plan document. Knowing the minor details of a plan document is unnecessary, but viewing an example may help build real world context.

A fiduciary administers the qualified plan according to the rules in the plan document. The Internal Revenue Service (IRS) defines a fiduciary as:

“A person who owes a duty of care and trust to another and must act primarily for the benefit of the other in a particular activity.”

The fiduciary’s role is to make sure the plan operates as the plan document describes. The fiduciary’s primary responsibility is to the plan participants (employees who have access to the plan), and the fiduciary must put participants’ interests ahead of the employer’s interests. Several entities can serve as the fiduciary, including employees of the organization (often an executive or board member) or unaffiliated third parties.

After the plan document is created and a fiduciary is appointed, the organization must submit the plan documents in writing to the IRS for approval. Once approved, the qualified plan may be offered to employees.

Sidenote

ERISA Section 404(c)

Section 404(c) of ERISA allows employers offering qualified plans and their fiduciaries to avoid liability for poor investment decisions. Most employer-sponsored retirement plans today are “self-driven” by the employee. That means employees generally decide how much to invest, how their money is invested, and how much risk they take on.

Employers and plan fiduciaries can potentially face legal liability if the plan doesn’t provide specific tools or resources. For example, employees could sue their employer if they experienced significant losses in their workplace retirement plan due to a lack of investment choices.

ERISA Section 404(c) lays out several protocols employers and fiduciaries must follow to avoid liability. They include:

• Making proper disclosures
• Offering diversified investment choices
• Allowing frequent investment changes

Making proper disclosures
Many disclosures must be made available to plan participants. These disclosures include:

• The plan document
• Description of the available investments
• Investment disclosures (e.g., a prospectus)
• Fees or costs associated with the plan
• Account statements
• Contact information for the plan fiduciary

Offering diversified investment choices
Section 404(c) requires plans to provide access to enough investments to allow plan participants to create diversified portfolios. At least three investment alternatives must be provided, each with a unique risk and return profile. Legal analysts generally agree offering a broad-based* equity (stock) fund, a broad-based bond fund, and a money market fund meets this standard.

*Broad-based funds are well diversified, covering various industries and geographic regions. The Vanguard Total Stock Market Index Fund (ticker: VTSAX) is a good example. The fund has exposure to nearly 4,000 stocks across 11 major industries in the U.S. Conversely, funds that focus specifically on one industry (e.g., a technology fund) are considered narrow-based.

Allowing frequent investment changes
Plan participants must be allowed to change investments at least quarterly (once every three months). If the plan allows investments into volatile securities, the frequency should be more often than quarterly.

If Section 404(c) protocols are followed, employers and plan fiduciaries are generally shielded from legal liability.