Federal Tax Considerations for Retirement Plans

Question 1

Qualified plans

Answer 1

Qualified plans must meet the requirements of ERISA (Employee Retirement Income Security Act), a federal law that sets minimum standards for pension plans in private industry.

ERISA qualified plans:
Must benefit employees and beneficiaries
May not discriminate in favor of highly-compensated employees
Must be approved by the IRS
Have a vesting requirement that eventually gives the employee full ownership of the employer’s contributions to the plan after a specified number of years

Qualified plans receive favorable tax treatment. Employer contributions are immediately tax deductible to the employer at the time the contribution is made. These contributions are not taxable to the employee until withdrawn.

Because most qualified plans defer taxes, individuals must start receiving distributions by April 1st of the year after they reach age 73 to avoid paying a 25% tax penalty on the amount required to be withdrawn.

Question 2

Nonqualified plans

Answer 2

Nonqualified plans do not meet requirements of federal law to be eligible for favorable tax treatment. Because of this, contributions to a nonqualified plan are not tax deductible. In many cases, such as a nonqualified annuity, the earnings are still tax deferred until withdrawn. Upon withdrawal, only the earnings are taxable.

Question 3

Executive Bonus Plans

Answer 3

Executive Bonus Plans are considered to be nonqualified plans. An executive bonus plan is one in which an employer pays the premiums on a permanent life insurance policy owned by an employee.

These plans are nonqualified because they are designed to discriminate in favor of highly-compensated key employees. While the employer pays the initial premiums, additional funds can be deposited by the employee.