QUALIFIED PLAN CHARACTERISTICS

The term qualified plan is not amenable to a simple definition; in a sense, it requires all of Part Five of this text to provide an adequate definition. Nevertheless, it is helpful to take a brief overall look at the most significant requirements before getting into the details.

Eligibility and Plan Coverage

The plan can have almost any kind of initial eligibility provision, except for specific restrictions based on age or service. Generally, no minimum age over 21 can be required, nor can more than one year of service be required for eligibility. In addition, the plan in operation must generally cover at least 70 percent of all non-highly compensated employees. These rules have many complex exceptions and limitations.

Nondiscrimination in Benefits and Contributions

Generally speaking, a qualified plan may not discriminate, either in plan benefits or employer contributions to the plan, in favor of highly compensated employees. The law includes a detailed definition of highly compensated for this purpose. However, the plan contribution or benefit can be based on the employee's compensation or years of service, which often will provide a higher benefit for certain highly compensated employees. In addition, the qualified plan can be integrated with Social Security so that a greater contribution or benefit is available for higher-paid employees whose compensation is greater than an amount based on the Social Security taxable wage base. Because of the possibilities for abuse in these areas, the rules for Social Security integration are complex.

Funding Requirements

Generally, a qualified plan must be funded in advance of the employee's retirement. This can be done either through contributions to an irrevocable trust fund for the employee's benefit or under an insurance contract. There are strict limits on the extent to which the employer can exercise control over the plan fund. The fund must be under the control of a fiduciary—the legal designation for a person who holds funds of another—and must be managed solely for the benefit of plan participants and beneficiaries.

Vesting Requirements

Under the vesting rules, an employee must be given a nonforfeitable or vested benefit at the normal retirement date specified in the plan and, in case of termination of employment prior to retirement, after a specified period of service. For example, one common vesting provision grants a fully vested benefit after the employee has attained five years of service, with no vesting until then. If the plan has this vesting provision, an employee who leaves after, say, four years of service with the employer will receive no plan benefit even though the employer has put money into the plan on his behalf over the four-year period. However, an employee who leaves after five or more years of service will receive the entire plan benefit earned up until that time.

These rules are designed to make it more difficult for employers to deny benefits to employees by selectively discharging or turning over employees.

Limitations on Benefits and Contributions

To limit the use of a qualified plan as a tax shelter for highly compensated employees, Section 415 of the Internal Revenue Code contains a limitation on the plan benefit or employer contributions, depending on the type of plan. Under these limitations, a plan cannot generally provide an annual pension of more than $90,000 (as indexed for inflation) or annual employer and employee contributions of more than $30,000. Practically speaking, these limits are high enough so that only highly compensated participants are likely to encounter them.

Benefits for highly compensated employees are further limited by a requirement that only the first $150,000 (as indexed) of a participant's compensation can be taken into account in a plan's contribution or benefit formula.

Payout Restrictions

To ensure that qualified plan benefits are used for their intended purposes, there are various restrictions on benefit payouts. Certain plans (pension plans in particular) do not allow withdrawals of funds before termination of employment. In addition, there is a 10 percent penalty on withdrawal of funds from any qualified plan before early retirement, age 59½, death, or disability, with certain exceptions. Funds cannot be kept in the plan indefinitely; generally, the payout must begin by April 1 of the year after the participant's attainment of age 70½, in specified minimum annual amounts. Loans from the plan to participants are restricted.

Top-Heavy Rules

To reduce the possibility of excessive discrimination in favor of business owners covered under a qualified plan, special rules are provided for top-heavy plans. Basically, a top-heavy plan is one that provides more than 60 percent of its aggregate accumulated benefits or account balances to key employees. A plan that is top-heavy must meet a special rapid vesting requirement and provide minimum benefits for nonkey employees.