TAX BENEFITS OF QUALIFIED PLANS

The most important tax advantage of a qualified plan is best understood by comparison with the rules applicable to a nonqualified deferred compensation plan. In a nonqualified plan, the timing of the employer's income tax deduction for compensation of employees depends on when the compensation is included in the employee's income. If the employer puts no money aside in advance to fund the plan, there is no deduction to the employer until the retirement income is paid to the employee, at which time the employee also reports the compensation as taxable income. If the employer puts money aside into an irrevocable trust fund, insurance contract, or similar fund for the benefit of the employee, the employer can get an immediate tax deduction, but then the employee is taxed immediately; there is no tax deferral for the employee.

These rules do not apply to a qualified plan. In a qualified plan, the employer obtains a tax deduction for contributions to the plan fund (within specified limits) for the year the contribution is made. Employees pay taxes on benefits when they are received. The combination of an immediate employer tax deduction plus tax deferral for the employee can be obtained only with a qualified plan.

Besides this basic advantage, there are other tax benefits for qualified plans. Four advantages are usually identified:

• The employer gets an immediate deduction, within certain limits, for amounts paid into the plan fund to finance future retirement benefits for employees.

• The employee is not taxed at the time the employer makes contributions for that employee to the plan fund.

• The employee is taxed only when plan benefits are received. If the full benefit is received in a single year, it may be eligible for special favorable "lump sum" income taxation.

• Earnings on money put aside by the employer to fund the plan are not subject to federal income tax while in the plan fund; thus the earnings accumulate tax free.