Rules

Workplace retirement plans can be either qualified or non-qualified. To be considered qualified, a plan must be governed by the Employee Retirement Income Security Act (ERISA), a federal law that sets standards for many retirement plans. In general, ERISA 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 amount of income you report as taxable.

For example, assume you earn $100,000 and that income is subject to income taxes. If you contribute $5,000 to your company’s qualified retirement plan, you’re taxed on $95,000 of income for the year. Additionally, most qualified retirement plans allow payroll deductions to be deposited directly into a retirement account without being taxed*. The more money you contribute to a qualified retirement plan, the less taxable income you report today. However, retirement plan assets are generally taxable when distributed later in retirement.

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

Qualified plans are in high demand because of their tax benefits. Organizations offer them to stay competitive when attracting 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

• A qualified plan can’t discriminate in favor of highly compensated employees or owners
  • For example, it can’t be offered to executives only
  • The plan doesn’t have to cover every employee - an employer can exclude certain groups of employees (by job classification, location, etc.) as long as the plan still passes the IRS’s minimum coverage tests
• An employer can’t make employees wait longer than certain limits to become eligible to participate. At most, it can require an employee to be:
  • Age 21 or older, and
  • Employed for one year (working at least 1,000 hours in that year)
  • These are maximum conditions, not required minimums - an employer can choose to let employees participate sooner (e.g., immediately, or with no age requirement), but can’t impose stricter conditions than these

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 rules of the plan, 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. You don’t need to know the minor details of a plan document, but seeing an example can 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 job is to make sure the qualified plan operates as intended under the plan document. Their ultimate responsibility is to represent the plan participants (employees with plan access) and put those participants’ interests ahead of the employing organization’s interests. Several entities can serve as the fiduciary, including organization employees (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 in certain situations. Most employer-sponsored retirement plans today are “self-directed” by the employee. That means employees generally decide how much to invest, how their money is invested, and how much risk they take.

Employers and plan fiduciaries can 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 for plan participants to build diversified portfolios. At least three investment alternatives must be provided, each with a unique risk and return profile. Legal analysts generally agree that 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.