Qualified Retirement Plans

Qualified retirement plans can be set up by sole proprietors, partnerships — but not partners — and corporations. The plan must be exclusively for the benefit of employees or their beneficiaries. Contributions and earnings grow tax-free until distributed. There are 2 types of qualified plans: defined contribution plans and defined benefit plans, each with different rules. An employer can have more than 1 qualified plan, but the contribution limits apply to contributions to all qualified plans.

The benefits of a defined contribution (DC) plan depend on the total contributions and any net earnings. There are 2 types of defined contribution plans: money purchase pension plan and a profit-sharing plan.

A money purchase pension plan is based on a fixed contribution percentage of the participant's compensation; business profits do not affect the contribution percentage, even for the self-employed.

A profit-sharing plan generally offers greater flexibility than a money purchase pension plan and is best for businesses with young employees who have time to accumulate earnings, thus allowing greater risk for a higher potential return. The business does not actually have to make a profit if it wants to make a contribution for its employees; however, the self-employed would need to make a profit. Employer contributions are discretionary in that the contribution amount is not fixed and can even be skipped in certain years. The plan must provide a formula for allocating the contribution among the participants and for allocating distributions after the employees reach a certain age, after they have worked for a fixed number of years, or some other event trigger.

Defined benefit (DB) plans are not based on contributions, but are based on the benefits that the participant will receive. Consequently, the contributions depend on the benefit level that the participant desires or that the employer allows. Consequently, the required contributions depend on actuarial assumptions, so professional help would be needed to establish a defined benefit plan.

Setting up a Qualified Retirement Plan

Qualified plans must meet certain requirements, which are determined by tax law. Generally, the financial institution that serves as the custodian of the plan will generally help the taxpayer meet the qualifications of the plan and notify the taxpayer of any updates. The following qualification rules also apply to a SIMPLE 401(k) retirement plan except for the top-heavy plan rules and nondiscrimination rules. Plan assets cannot be used by the employer for anything other than providing benefits to its employees.

The minimum coverage requirement is that the defined benefit plan must benefit at least the lesser of the following:

• 50 employees,
• the greater of 40% of all employees or 2 employees, or
• 1 employee, if there is only a single employee.

Neither contributions nor benefits may favor highly compensated employees.

Contributions and benefits cannot exceed certain annual limits, since the government obviously wants to limit the amount of tax deferred.

The plan must have minimum vesting standards, wherein the employee has a nonforfeitable right to the benefit. A benefit is vested when the right to the benefit cannot be forfeited by an event happening or not happening. For defined contribution plans, the allocation of any amounts forfeited must be nondiscriminatory among the remaining participants or they can be used to reduce the contributions of the employer. However, forfeitures under a defined benefit plan can only be used to reduce the contribution by the employer — they cannot be used to increase the benefits for the remaining participants.

There are 2 steps to setting up a qualified plan:

1. adopt a written plan,
2. invest the plan assets.

The self-employed can also adopt a qualified plan. To deduct contributions, the plan must be adopted by the end of the tax year. The written plan can be individually designed or the taxpayer can adopt an IRS approved master or prototype plan offered by sponsoring financial institution.

The written plan must be given to all employees and the provisions of the plan must be explicitly stated. A master plan consists of a single trust or custodial account that is jointly used by adopting employers. Under a prototype plan, a separate trust or custodial account is established for each employer. Many of the following types of organizations can provide IRS approved master or prototype plans: banks, insurance companies, mutual funds, and trade or professional organizations.

A self-designed plan may require professional help and the taxpayer can seek approval from the IRS by requesting a determination letter and paying the appropriate fee. The fee is not charged for employers who have 100 or fewer employees and where at least one of them is a non-highly compensated employee participating in the plan.

For those plans that require a minimum funding requirement, such as a money purchase pension plan or a defined benefit plan, the required funding must be paid every year, in quarterly installments by the 15^th day after the end of each quarter of the tax year. However, the contribution period may be extended if the minimum funding requirement is met by 8½ months after the tax year.

Employee Eligibility

Any employee must be allowed to participate in the retirement plan, if the employee is at least age 21 by year-end, worked for at least 1 year, or 2 years if the plan is not a 401(k) plan and where benefits become vested after no more than 2 years of work, and no employee can be excluded because of age.

Leased employees are treated as common-law employees for certain plan qualification rules, including nondiscrimination, contributions and benefits, employee eligibility, vesting time periods, top-heavy plan requirements, and contribution and benefit limits. However, the employer does not have to provide contributions or benefits if they are provided by the leasing organization.

Retirement Plan Benefits

The retirement plan must provide that benefits will be paid to the participant within 60 days after the latest of the following periods:

• reaches the earlier of age 65 or the retirement age that is specified in the plan;
• the 10^th year after which the participant became a plan member; or
• the plan year when the participant terminates his employment.

The participant can choose a later time in which to receive benefits, but not an earlier time unless allowed by the plan.

A plan can offer an early retirement benefit, but if it does and an employee leaves before the early retirement age, then the participant will be entitled to the benefit if both of the following requirements are satisfied:

• satisfies his service requirement for the benefit;
• the benefit has vested when the employee leaves, in which case, the benefit can be actuarially reduced and becomes payable only when the employee reaches the early retirement age.

As with most tax-deferred retirement accounts, there are required minimum distributions that must begin after the participant reaches age 72. Defined benefit and money purchase pension plans must provide automatic survivor benefits that satisfy both of the following:

• a qualified joint and survivor annuity for a vested participant who survives until the annuity starting date;
• a qualified preretirement survivor annuity for a vested participant who dies before the annuity starting period and who leaves behind a surviving spouse.

A profit sharing plan must also have an automatic survivor benefit unless:

• the participant does not choose a life annuity benefit;
• the fully vested account balance is paid to the participant's surviving spouse or other beneficiary if the participant fails to survive until the benefit period;
• the plan is not a transferee of a plan that must provide automatic survivor benefits.

If the participant's retirement plan has automatic survivor benefits and the participant is married, then the accrued benefits of the plan cannot be used as a security for a loan without the consent of the spouse.

Either or both of the joint and survivor annuity or the preretirement survivor annuity benefit can be waived only with the written consent of the spouse. The consent of the spouse must be witnessed by either a plan representative or a notary public, and the plan must allow the participant to withdraw the waiver.

A 30 day minimum waiting period must be provided after a written explanation of the terms and conditions of the annuities is provided to each participant, but it may be waived by a participant who also has spousal consent. However, the distribution must begin more than 7 days after the written explanation is provided.

A plan may allow for a participant's benefit to be distributed immediately if the present value of the benefit does not exceed $5000 unless the distribution would be made after the annuity starting date, in which case, both the participant and his spouse or the surviving spouse must consent to the distribution in writing if the automatic survivor benefits are required for a spouse under the plan. The same written consent must be provided for any immediate distribution if the present value of the account exceeds $5000. Any benefits that can be attributed to rollovers from other accounts and the associated earnings are not counted when totaling the present value of benefits. Any cash out distribution exceeding $1000 must be rolled over to an individual retirement account or annuity, as the participant so chooses. A §402(f) notice must be sent before any involuntary cash out of an eligible rollover distribution.

The plan must stipulate that benefits cannot be assigned or alienated from anyone other than the plan participants or their beneficiaries. If a merger or consolidation or a transfer of assets or liabilities occurs to any other plan, then each participant must receive at least the benefit that they would have been entitled to before the merger, consolidation, or transfer.

A loan to the participant or a beneficiary from the plan is not considered an assignment or alienation if it is secured by the participant's accrued vested benefit and is exempt from the tax and is not a prohibited transaction under §4975(d)(1) or would be exempt if the participant were a disqualified person.

Benefits cannot be reduced because of post-separation increases in Social Security or the wage base if the participant or his beneficiary is receiving benefits under the plan or who otherwise has nonforfeitable rights to the benefits. Benefits also cannot be reduced because of other benefits provided by other federal or state laws.

The plan that allows elective deferrals must limit the deferrals by the statutory amount for that particular year. A plan cannot be top-heavy, which favors partners, sole proprietors, or other key employees, where more than 60% of the total value of accrued benefits or account balances for all employees goes to the key employees. Qualified retirement plans, regardless of whether they are top-heavy, must meet the qualification requirements in IRC §416 that will apply automatically in those years when the plans are top-heavy. However, the top-heavy rules do not apply to SIMPLE 401(k) plans or safe harbor 401(k) plans.

Deducting Contributions

The employer contributes for the employees and the employees may be permitted to contribute as well. The deadline for deductible contributions is by the due date of the return + extensions for that tax year. The self-employed, of course, will make their own contributions, but their contributions cannot exceed their net profit earned by providing services of the business — the earnings cannot come from investments held by the business or from the sale of business property. A promissory note by the employer in lieu of actually paying the contributions is a prohibited transaction, which is subject to tax.

Contributions and benefits cannot exceed certain limits:

Employees may also make their own contributions, but the employee cannot deduct the contributions. Nonetheless, the benefit of making nondeductible contributions is that the earnings grow tax-free until they are distributed. Employee contributions must satisfy the nondiscrimination test of IRC §401(m).

The employer's deduction for defined contribution plans cannot exceed 25% of the annual compensation paid or accrued to the eligible employees participating in the plan. There is no limit on elective deferrals, but compensation does include them. The maximum compensation for each employee that determines the contribution limit is the Defined Benefit Wage Base, listed in the above table. The deduction for defined benefit plans are based on actuarial assumptions and computations, so the deduction must be calculated by an actuary.

The deduction limit for self-employed individuals is compensation from net earnings minus the self-employment tax deduction and minus any contributions made on behalf of the taxpayer.

Sole proprietors deduct employee contributions on Schedule C, Profit or Loss from Business or Schedule F, Profit or Loss from Farming. Sole proprietors and partners deduct the contributions directly on Form 1040, US individual income tax return.

Any excess of contributions over that allowed cannot be deducted, but can be carried over and deducted in future years, where a portion of the excess carryovers can be used to close the gap between the contributions actually made for that year and the maximum allowable contribution that can be deducted for that year.

Excess contributions to qualified pension and profit sharing plans and SEPs may be subject to a 10% excise tax unless the contribution was made to meet minimum funding requirements for a money purchase pension plan or a defined benefit plan, even if the contribution exceeds earned income from the business. Any tax on nondeductible contributions is reported on Form 5330.

Investments for IRA Types of Accounts Are Restricted

The tax code prohibits retirement funds held in an IRA type of account — traditional and Roth IRAs, SEPs, and SIMPLE IRAs — to be invested in life insurance or collectibles, such as:

• alcoholic beverages
• antiques
• artwork
• coins
• gems
• metals
• rugs
• stamps
• certain other tangible personal property.

Any amount invested in such assets will be considered distributed in the year of the investment, which may incur a 10% additional tax penalty on early distributions. There are specific exceptions for certain types of bullion and coins. Refined bullion can be owned directly if it is physically held by a bank or an IRS-approved non-bank trustee or if it is held indirectly by an IRA-owned limited liability company.

While the tax code does allow an IRA to invest in real estate, trustees are not required to offer that option. Also, investments in closely held companies or real estate will more likely lead to violating rules against self-dealing, thus disqualifying the IRA account as a qualified retirement account under the tax code, subjecting the amount in the account to taxes.

Taxation of Excess Deferrals

An excess deferral occurs when the deferral amount exceeds the limit. In such a case, the employee must notify the plan that an excess amount has been taken and the plan must then pay the employee that amount + any earnings through the tax year by the tax return due date. If the excess deferral is withdrawn by the due date for the tax year, then it is not reported as income and is not subject to the 10% tax on early distributions. Any earnings associated with the excess deferral must also be withdrawn, and the earnings must be reported as income for the tax year in which they were earned. If the employee withdraws only a part of the excess deferrals + the associated earnings, then the amount actually withdrawn will be divided proportionately between the elective deferral and the associated earnings.

If the excess amount is not withdrawn by the due date of the return, not including extensions, then it will be subject to tax twice — once when the excess deferral was made and again when it is distributed, since the excess deferral will not add to the tax basis of the account. The employer will report any excess deferrals and their earnings on Form 1099-R.

Nondiscrimination Requirements

There are 2 tests to ensure that the employer does not contribute more to highly compensated employees than is allowed under the qualified retirement plan: the actual deferral percentage (ADP) test [IRC §401(k)(3)] and the actual contribution percentage (ACP) test [IRC §401(m)(2)]. Any excess over that allowed by the 2 tests is subject to a 10% excise tax, which is reported on Form 5330, Return of Excise Taxes Related to Employee Benefit Plans. If the retirement plan fails either test and it is not corrected by the next plan year-end, then the plan may become disqualified.

If nondiscrimination rules are violated, then not only will the employer be subject to penalties, but the plan could be disqualified unless any excess contributions + the allocable earned income are distributed back to the highly compensated employees or business owners by a specified time. Complying with the nondiscrimination requirements for 401(k) plans is easier with the safe harbor 401(k) and the SIMPLE 401(k) plans.

Distributions

Distributions can be lump sum payments or periodic, such as annuity payments. Certain loans from the plan may also be treated as distributions. As it is for all tax-deferred retirement accounts, there are required minimum distributions (RMD) that must occur by a certain time, so that the government can start taking its share of the money. The required starting date is generally the later of April 1 after the participant reaches age 72 or when the participant retires while at the employer maintaining the plan. However, the plan can require the participant to receive distributions after reaching 72, even with continued employment. If the participant is at least a 5% owner of the employer maintaining the plan, then the participant must satisfy the 72 rule.

If the participant chooses to receive periodic distributions rather than a lump sum, then the amount of the annual RMD is based on the total account balance divided by the life expectancy of the participant and a designated beneficiary, in which case, after the starting year, a participant must receive annual distributions by year-end. Special rules apply if the participant dies before the required starting date.

Taxation of Distributions

Distributions from retirement accounts funded with pretax contributions are generally taxable. If the taxpayer has any cost basis in the account, such as making non-deductible contributions, then the value of the account minus the cost basis will be subject to tax. The tax treatment of distributions depends on whether they are paid as a lump sum or as periodic distributions.

Distributions from designated Roth accounts or Roth IRAs are made with after-tax contributions, so generally distributions from these accounts are not taxed. A distribution from a designated Roth account to a Roth IRA can be rolled over by any means, but a rollover to another designated Roth account must be a direct transfer.

A distribution may be eligible for a rollover if it is not any of the following:

• a required minimum distribution;
• a series of substantially equal payments made at least annually;
• a hardship distribution;
• a return of a portion of the distribution that consists of nondeductible contributions, which are not taxable;
• loans treated as distributions;
• dividends received from securities of the employer; or
• the cost of any life insurance coverage provided under a qualified retirement plan.

Nontaxable portions of the distribution can be rolled over to another qualified retirement plan or a §403(b) plan or to an IRA, but the transfer must be direct, from trustee to trustee, for which the taxable and nontaxable parts of the rollover are accounted for or the rollover is to an IRA.

If a distribution that is eligible for rollover is paid to the participant, and where the distribution is expected to total at least $200, then the employer must withhold 20% of the taxable portion for federal income tax unless it is a direct transfer to another eligible retirement account. If the distribution is not eligible for a rollover, then, unless the participant chooses otherwise, the distribution must be treated as wages both for periodic distributions and for nonperiodic distributions, in which case, 10% of the taxable part must be withheld.

If insufficient taxes are withheld from a distribution, then the recipient may have to make estimated tax payments.

A recipient of a eligible rollover distribution must receive a IRC §402(f) notice explaining the following:

• that the distribution may be directly transferred to an eligible retirement plan and must also list the distributions that would be eligible for the direct transfer;
• that the tax will be withheld if it is not directly transferred;
• that no tax will be due if the distribution is transferred to an eligible retirement plan within 60 days after receiving the distribution; and
• that the restrictions and tax consequences of the new account may differ from the old account.

The notice must be provided at least 30 days before, but not earlier than 180 days before, the distribution date. The written notice must actually be given to each individual recipient of an eligible rollover distribution, but electronic media may be used if additional requirements are satisfied. There is a $100 tax penalty for each failure to provide a 402(f) notice, up to a maximum limit of $50,000 per calendar year, unless the failure can be shown to be due to reasonable cause — not to willful neglect.

Tax on Early Distributions

A 10% tax penalty will apply on any distribution to a recipient who is younger than 59½. Moreover, the distribution must be included in the employee's income. However, the 10% penalty will not apply if any of the following apply:

• The distribution was made to a beneficiary or to the estate of an employee because of the employee's death.
• The employee had a qualifying disability.
• The taxpayer no longer works for the employer, and the distribution is 1 of substantially equal periodic payments, paid annually, and based on the life expectancy of the participant, or, if applicable, the joint lives of the participant and beneficiary.
• The distribution is paid as an annuity that starts after separation from employment and paid annually for the life of the employee or the joint lives of the employee and a designated beneficiary.
  • Unless disabled, the recipient must continue to receive the annuity payments for the longer of at least 5 years or until the employee reaches 59½.
• The distribution was NOT from an IRA and:
  • the employee left the employer, before receiving a distribution, during or after the calendar year in which the employee reached age 55; or
  • the distribution was paid to an alternate recipient because of a QDRO, qualified domestic relations order.
• The employee paid medical expenses that would otherwise be deductible as an itemized deduction, but is determined without regard to whether the employee actually itemizes.
• The distribution was paid:
  • to reduce excess contributions under a 401(k) plan;
  • to reduce any excess aggregate contributions;
  • to reduce excess elective deferrals;
  • because of an IRS levy on the plan;
  • because it was a permissible withdrawal from an EACA;
  • because it was a qualified reservist distribution;
  • the distribution was from an IRA to pay:
    • qualified higher educational expenses for the taxpayer, spouse, their child or grandchild regardless if the child is the taxpayer's dependent;
    • qualified 1st-time homebuyer expenses ($10,000 lifetime limit);
    • health insurance premiums for the unemployed taxpayer.

Distribution taxes are reported on Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax Favored Accounts. For 5% owners (defined in IRC § 416) of the business maintaining the plan, any benefits exceeding that which was provided by the plan formula is subject to a 10% tax and is also includible in income.

There is a 20% or 50% excise tax on any reversion of plan assets to the employer that is assessed on the fair market value of the property that the employer receives from the qualified plan. The tax is reported on Schedule I of Form 5330.

Notification of Significant Benefit Accrual Reduction

Retirement participants must be notified, in writing, using easily understandable language, of any significant reduction in retirement benefits. If there is a significant reduction in benefits to a defined benefit plan or a money purchase pension plan without notification to the affected employees, then a tax of $100 will be assessed, either on the employer or on a multi-employer plan, for each participant for each day that the notice is late, up to a maximum of $500,000 for the tax year.

Prohibited Transactions

Any person who benefits from a retirement plan but who's not a participant of the plan or who is a participant but benefits in a way not allowed by the plan is considered a disqualified person. A disqualified person includes:

• a fiduciary of the plan; any person providing services to the plan;
• any employer or employee organization offering or benefiting from the plan,
• any owner with a significant ownership percentage of the employer offering the plan,
•  and any family members of any of the above,
• any trust, estate, partnership, or corporation where any of the above owns 50% or more of the entity;
• any officer, director, or shareholder who owns at least 10% of any of the above applicable entities,
• a highly compensated employee who receives at least 10% of the wages paid by the employer;
• a partner or joint venture with at least a 10% interest in capital or profits of any of the above applicable entities.

A disqualified person may be assessed a tax on any such prohibited transactions, such as:

• transferring income or assets to the benefit of the disqualified person;
• receiving consideration for managing the account to the benefit of 3^rd parties; and
• any transaction between the plan and the disqualified person, such as selling, leasing, or exchanging property, lending or borrowing money, or providing goods or services. There are, however, some exemptions provided by IRC §4975.

A 15% tax will be assessed on any prohibited transaction for each year, or part thereof, in the taxable period, which begins when the prohibited transaction began and ends on the earlier of when the transaction is corrected or when the IRS either mails a deficiency notice or assesses the tax. The 15% tax penalty is reported on Form 5330, Return of Excise Taxes Related to Employee Benefit Plans. Additionally, if the prohibited transaction is not corrected within the tax year, then there will be an additional 100% penalty. Correcting the prohibited transaction means to undo the transaction as much as possible without putting the plan in worse financial shape than it would have been had it not been for the prohibited transaction. The 2 taxes are assessed on the total value of money, property, or services involved in the prohibited transaction.

If the prohibited transaction is not corrected during the taxable period, then the taxpayer will have 90 days after IRS notification of the 100% tax assessment to correct the prohibited transaction, or longer, if the IRS grants more time or if the taxpayer petitions the Tax Court.

Qualified Domestic Relations Orders

Although not subject to the claims of creditors, qualified retirement plans are subject to benefits payable to an alternate payee under a Qualified Domestic Relations Order (QDRO), since it is not treated as a prohibited assignment or alienation under ERISA. A domestic relations order is a judgment or decree providing child support, alimony payments, or marital property rights to a spouse, former spouse, child or other dependent of the participant pursuant to a state domestic relations law. A QDRO can require that benefits be paid to the alternate payee at the participant's earliest retirement age under the plan regardless of whether the participant has separated from service or retired. Payments to an alternate payee are not considered an early distribution even if it occurs before the participant reaches age 59½. The transferred benefits can be rolled over tax-free to the alternate payee's IRA or individual retirement annuity.

Pension Benefit Guaranty Corporation

ERISA as provided retirement plan termination insurance in the form of the Pension Benefit Guaranty Corporation (PBGC), a federal insurance company providing mandatory plan termination insurance to protect the benefits of workers with defined-benefit pension plans, up to specified limits. The PBGC provide some benefits for people who had private-sector defined benefit pension plans from companies who can no longer provide the benefits, because of bankruptcy or other problems. All companies providing defined-benefit pension plans pay premiums to the PBGC for the coverage. The PBGC does not receive any funds from tax revenues.

Retirement Plan Reporting Requirements

Retirement plans have specific reporting requirements. One of the following forms must be filed by the end of the 7^th month after the plan year: Form 5500-EZ, Form 5500-SF, Form 5500. Form 5500-EZ, Annual Return of One-Participant (Owners and Their Spouses) Retirement Plan is filed by one-participant plans, which covers only the taxpayer, any partners, or spouses of either. Form 5500-SF can be used by small single-employer plans with fewer than 100 participants at the start of the year that holds no securities of the employer, that is exempt from being audited by an independent qualified public accountant, and where all its assets are either in cash or investment-grade securities with a readily ascertained value. Most taxpayers who qualify for filing Form 5500-EZ can also file Form 5500-SF.

If the taxpayer does not meet the requirements for filing the above 2 forms, then Form 5500 must be filed. Both Form 5500 and Form 5500-SF must be filed electronically with EFAST2.

When the retirement plan is terminated, the plan administrator must file Form 5310, Application for Determination for Terminating Plan and pay a fee that is calculated on Form 8717, User Fee for Employee Plan Determination Letter Request. Further, Form 8955-SSA, Annual Registration Statement Identifying Separated Participants with Deferred Vested Benefits is filed with the IRS to report participants with a deferred vested benefit but are no longer covered by the plan.