Rules

Workplace retirement plans can be either qualified or non-qualified. A plan is considered qualified when it meets certain legal requirements and is generally governed by 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 amount of income you report as taxable.

For example, assume you earn $100,000 and it’s subject to income taxes. If you contribute $5,000 to your company’s qualified retirement plan, you’re generally taxed on only $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. 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 learn more about these accounts later in this unit.

Qualified plans are in high demand because of their tax benefits. Organizations offer these plans 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, 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 limits, not required 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 lays 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 job is to make sure the qualified plan operates as the plan document requires. 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.