7.7 Federal Tax Considerations for Retirement Plans
Qualified vs Nonqualified Plans
Qualified retirement plans must comply with the requirements of ERISA (Employee Retirement Income Security Act), a federal law that establishes minimum standards for private-sector pension and retirement plans. ERISA does not require employers to create retirement plans; however, if an employer chooses to establish one, the plan must meet specific regulatory standards.
ERISA-qualified plans must meet the following requirements:
- The plan must benefit employees and their beneficiaries.
- The plan cannot discriminate in favor of highly compensated employees.
- The plan must be approved by the Internal Revenue Service (IRS).
- The plan must include vesting provisions, which grant employees full ownership of employer contributions after a specified period of service.
Qualified retirement plans receive favorable tax treatment under federal tax law. Employer contributions to these plans are immediately tax deductible to the employer at the time they are made. These contributions are not taxed to the employee until they are withdrawn from the plan. In addition, employee contributions are generally made with pre-tax dollars or may be tax deductible, depending on the type of plan.
Distributions taken before age 59½ are typically subject to ordinary income taxation and a 10% early withdrawal penalty. However, the penalty may be waived in certain situations, including death, disability, qualified education expenses, certain medical expenses, first-time home purchases, or substantially equal periodic payments based on life expectancy.
Because most qualified plans provide tax-deferred growth, participants are required to begin taking Required Minimum Distributions (RMDs) by April 1 of the year following the year they reach age 73. Failure to take the required distribution may result in a 25% tax penalty on the amount that should have been withdrawn. When distributions are taken, the entire amount is taxed as ordinary income.
Note: Prior to 2023, individuals were required to begin taking RMDs at age 72, and the penalty for failing to withdraw the required amount was 50%.
Nonqualified retirement plans do not meet the requirements of federal law necessary to receive the favorable tax treatment granted to qualified plans. As a result, contributions to nonqualified plans are not tax deductible.
However, in many cases—such as with a nonqualified annuity—the earnings within the plan may still grow on a tax-deferred basis until funds are withdrawn. When withdrawals occur, only the earnings portion of the distribution is taxable as ordinary income, while the return of the original contributions is not taxed.
Executive Bonus Plans are classified as nonqualified retirement plans. In this arrangement, an employer pays the premiums on a permanent life insurance policy that is owned by the employee.
Under Section 162 of the Internal Revenue Code (IRC), the employer may treat these premium payments as salary or compensation, making them tax deductible to the employer within applicable limits. The premiums paid by the employer are taxable income to the employee when received as compensation.
Executive bonus plans are considered nonqualified because they are designed to benefit select key employees or highly compensated executives, rather than meeting the nondiscrimination requirements of qualified retirement plans. Although the employer typically pays the initial premiums, the employee may also contribute additional funds to the policy if desired.
Quiz
1. Which federal law establishes minimum standards for private-sector retirement plans?
A. Social Security Act
B. ERISA (Employee Retirement Income Security Act)
C. FICA (Federal Insurance Contributions Act)
D. HIPAA (Health Insurance Portability and Accountability Act)
Correct Answer: B
Rationale: The Employee Retirement Income Security Act (ERISA) sets the regulatory framework for qualified retirement plans. It establishes standards related to participation, vesting, funding, fiduciary responsibilities, and plan reporting.
2. Which of the following is a key requirement for a qualified retirement plan?
A. The plan may only benefit company executives
B. The plan must avoid discrimination in favor of highly compensated employees
C. The plan must be funded only by employees
D. The plan must provide immediate vesting of employer contributions
Correct Answer: B
Rationale: One of the core ERISA rules is nondiscrimination, meaning qualified retirement plans cannot favor highly compensated employees over other workers. The plan must benefit employees generally.
3. How are employer contributions to a qualified retirement plan treated for tax purposes?
A. They are not tax deductible
B. They are deductible to the employee
C. They are tax deductible to the employer and tax deferred to the employee
D. They are taxed immediately to the employee
Correct Answer: C
Rationale: Employer contributions to qualified plans are tax deductible for the employer and not taxed to the employee until withdrawn, allowing the funds to grow tax deferred.
4. What penalty generally applies to withdrawals from a qualified retirement plan taken before age 59½?
A. 5% penalty
B. 10% penalty
C. 20% penalty
D. 25% penalty
Correct Answer: B
Rationale: Early distributions from qualified retirement plans are typically subject to ordinary income tax plus a 10% early withdrawal penalty, unless the distribution qualifies for a specific IRS exception.
5. Why are Executive Bonus Plans considered nonqualified plans?
A. They are funded with after-tax dollars
B. They are only offered through insurance companies
C. They are designed to benefit selected key or highly compensated employees
D. They require IRS approval
Correct Answer: C
Rationale: Executive Bonus Plans are considered nonqualified because they are designed to benefit specific executives or key employees, which means they do not meet the nondiscrimination requirements required for qualified retirement plans under ERISA.