What is a Qualified Plan?

Manning & Napier Advisors, LLC What is a Qualified Plan? January 2012 Approved CAG-CM PUB035 (1/12)

Oftentimes, descriptions of what makes a retirement plan a qualified retirement plan are far too general. Such descriptions typically list some of the more basic tenants of the qualification requirements in very general terms without going into detail and without ever describing each of the 34 actual requirements. Every employer that sponsors or is considering the adoption of a qualified plan needs to have a complete understanding of what constitutes a qualified plan as a part of satisfying its fiduciary obligation to the plan participants. Employers adopt retirement plans to help their employees secure their retirement future. A qualified retirement plan, or qualified plan, enjoys certain tax benefits that a non-qualified plan does not. A basic definition is that a qualified plan is a retirement investment account that, if created and maintained correctly, can accept taxadvantaged financial contributions from a sponsoring employer and its employees, and can experience taxdeferred earnings. Qualified plans appear in a two basic forms: defined benefit plans (target a specific benefit) and defined contribution plans (target a specific contribution). Examples of defined benefit plans are final average pay pension plans and cash balance plans. Examples of defined contribution plans are 401(k) profit sharing plans and money purchase plans. The purpose of this White Paper is to discuss exactly what a qualified plan is, to help employers understand the standards a plan must uphold to retain its qualified status. More technically, a qualified plan is a retirement plan that complies with the requirements of Internal Revenue Code (IRC) 401(a). IRC 401(a) currently describes and/or cross-references 34 requirements for a plan to satisfy in order to be considered qualified. These requirements must be satisfied in both form and operation. Compliance in form means a definite written program (Treas. Reg. 1.401-1(a)(2)) exists in the form of a plan document. Compliance in operation means that all aspects of the mechanical administration of the plan are in accordance with the provisions set forth in the plan document. Failure to comply with 401(a) in form is potentially cause for disqualification. Certain egregious operational failures can also be cause for disqualification. Disqualification is an action taken by the Internal Revenue Service (IRS) when it determines that a plan has lost its qualified status, and hence all of its tax-advantaged benefits. What follows is a brief summary of each subsection of IRC 401(a). It is not uncommon for a subsection to specify its particular qualification requirement in a cross-reference to another IRC section. Of course, the reader is encouraged to consult the actual text of IRC 401(a). Note that subsections (18) and (21) have been repealed. Also note that certain qualification standards apply differently, or not at all, to plans sponsored by governmental agencies, churches and church-controlled organizations. IRC 401(a)(1). IRC 401(a)(2). Only the employer, its employees and their beneficiaries can benefit from the plan. The term employee includes self-employed individuals (i.e. partners of a partnerships & owners of sole proprietorships). IRC 401(c)(1)(A) & (B) provides the exemption that allows self-employed individuals to participate in their own plans. The plan and its assets must exist solely for the exclusive benefit of the employees and their beneficiaries. This is often referred to as the Exclusive Benefit Rule, and is also contemplated in ERISA 404(a)(1), where the employer is prohibited from diverting plan assets for its own benefit. 1

IRC 401(a)(3) & (6). For eligibility purposes, a qualified plan must allow age and service requirements at least as liberal as those set forth in IRC 410. IRC 410(a) provides what are known as the Eligibility Rules, and precludes an eligibility waiting period extending beyond the later of 1) attainment of age 21, or 2) completion of 1 year of service. Certain plans may substitute 1 year of service with 2 years of service so long as 100% vesting is provided. IRC 410(b) prescribes the minimum coverage requirements for a qualified plan. To satisfy the minimum coverage requirements, a plan must pass what is known as the Average Benefits Percentage Test (ABPT). Under the ABPT, the plan must satisfy one of the following conditions: 1. The plan must benefit at least 70% of Non-Highly Compensated Employees (NHCE), or 2. The plan must benefit a percentage of NHCEs which is at least 70% of the percentage of Highly Compensated Employees (HCE) benefitting under the plan. Point of Interest: Employees that are under age 21, work less than 1000 hours per year, or are members of a union whose retirement benefits are the subject of a collective bargaining agreement may always be excluded from participation in a qualified plan. These are known as statutory exclusions. Other statutory exclusions are allowed for independent contractors and non-resident aliens. However, non-statutory exclusions at the discretion of the sponsor can be written into a plan too so long as the minimum coverage requirements of 410(b) are satisfied. Many plan sponsors assume that the plan must allow every employee to participate. Suppose an employer has 4 HCEs and 8 NHCEs; and that 2 of the HCEs are owners while the other 2 are highly-paid salespeople. Of the 8 NHCEs, 4 tend to customer service and 4 tend to clerical duties. The employer could write a plan with a non-statutory exclusion of sales and clerical staff; and the plan would be compliant. The reason for this is that the plan must benefit at least a number of NHCEs equal to 70% of the number of HCEs that will benefit. Since 50% of HCEs or 2 benefit, only 70% of 50% or 35% of NHCEs need to benefit. 35% of 8 is 2.8 (rounded up to 3). Thus, a plan covering only the owners and the 4 customer service staff will pass the coverage test. Care must be taken with this sort of carve-out planning, as changes in the census may require non-statutory exclusions to be brought in to pass testing. IRC 401(a)(4) & (5). Contributions or benefits provided by a qualified plan cannot discriminate in favor of Highly Compensated Employees (HCEs). This means that benefits or contributions for HCEs cannot exceed those of NHCEs by more than statutory amounts. The definition of HCE is provided in IRC 414(q). An employee is an HCE for a plan year if only one of the following two tests is met: 1. 5% Ownership Test. The employee owns more than 5% of the employer (or a related employer) at any time during the current or prior plan year. If the employee s highest ownership percentage during this period is more than 5%, the test is satisfied. Family attribution rules apply (IRC 318). 2. Compensation Test. The employee s compensation for the prior plan year is more than a prescribed dollar amount subject to annual cost-of-living increases. Specifically, for a calendar year 2012 plan looking back to 2011, the applicable dollar amount is $115,000. 2

Point of Interest: It s important to understand that the family attribution rules of IRC 318 apply in determining who is an owner. Suppose X, Y and Z are employees of ABC, Inc. Suppose further that X owns 100% of ABC, Inc.; Y is the spouse of X, and Z is the brother of X. According to the family attribution rules, ownership attributes to spouses, lineal ascendants and descendents. Thus X is an HCE. Y is also an HCE because of the spousal relationship. However, Z is not an HCE because there is no lineal relationship to X. If ABC, Inc. also employed W, and W is the son of X and Y; then W is an HCE by virtue of lineal family attribution. IRC 401(a)(7). IRC 401(a)(8). IRC 401(a)(9). IRC 401(a)(10). This section prescribes the minimum vesting standards that apply to a qualified plan, by way of a cross-reference to IRC 411. In general, 411 provides that the participants right to their normal retirement benefit is nonforfeitable upon attainment of the normal retirement age stated in the plan document. It also provides that participants are always fully vested in their own voluntary plan contributions. It goes on to describe the vesting schedules that are allowed for defined benefit and defined contribution plans. Here, the forfeitures in a defined benefit plan are prohibited from being used to increase benefits payable to participants. This is where the minimum distribution rules are spelled out. A qualified plan must begin the payment of benefits no later than the Required Beginning Date, which in part is determined by the date on which a participant reaches age 70-½. Subsection 10 specifies that when a plan is Top Heavy, it must satisfy the rules of IRC 416. A plan becomes Top Heavy, when more than 60% of the plan assets or accrued benefits attribute to the Key Employees. IRC 416 specifies that when a plan becomes Top Heavy, a Top Heavy Minimum employer contribution or benefit accrual is due. This minimum accrual or contribution must be allocated to at least all non-key participants who are active employees on the last day of the plan year, regardless of the actual number of hours worked. Also, IRC 416 specifies the vesting schedules that are allowed for a Top Heavy Plan. Section 416 goes on to define a Key Employee as an employee that meets at least one of the following 3 tests: 3. 5% Ownership Test. The employee owns more than 5% of the employer (or a related employer) at any time during the determination year, which typically means the prior year. 4. 1% Ownership Test. The employee owns more than 1% of the employer (or a related employer) at any time during the determination year and has a determination year compensation of more than $150,000. 5. Officer Test. The employee is an officer of the employer and earns at least $130,000 ($165,000 in 2012) in the determination year. Point of Interest: A special dual plan Top Heavy Minimum applies when an employer sponsors both a Defined Benefit (DB) Plan and a Defined Contribution (DC) Plan. In such situations, the employer may choose to satisfy the Top Heavy Minimum with a 5% of pay allocation in the DC Plan, or with a 2% benefit accrual in the DB Plan. Oftentimes, the 5% of pay DC Plan allocation is a smaller dollar amount than the actuarial cost attributable to the 2% DB Plan benefit accrual. In most Cash Balance and 401(k) combination arrangements, the 5% DC Plan allocation is used to satisfy the Top Heavy Minimum. 3

IRC 401(a)(11). IRC 401(a)(12). IRC 401(a)(13). IRC 401(a)(14). IRC 401(a)(15). IRC 401(a)(16). Benefits payable to a participant from either a defined benefit or defined contribution plan subject to a required annual contribution must be available upon election in the form of a Qualified Joint and Survivor Annuity (QJSA). Certain profit sharing, 401(k) and stock bonus plans are exempt from this requirement. When plans merge, or when plan assets and liabilities are transferred, participant benefits and account balances must be protected from cutbacks. This section prevents a participant s plan assets or benefits from attachment by creditors, except in the event of a Qualified Domestic Relations Order (QDRO). A qualified plan cannot delay the commencement of normal retirement benefits beyond the 60 th day after the plan year in which occurs the later of 1) the date on which the participant attains age 65 or the normal retirement age stated in the plan, or 2) the 10 th anniversary of the participant s entry to the plan. Here it is stipulated that a qualified plan may not offset retirement benefits by increases in Social Security benefits. A qualified plan may not exceed the limits prescribed by IRC 415. IRC 415(b) limits the annual retirement benefit provided by a defined benefit plan to the lesser of $160,000 (as indexed $200,000 for 2012) or 100% of the participant s average compensation over the highest 3 consecutive years. IRC 415(c) limits the annual addition for a defined contribution plan participant to the lesser of $40,000 (as indexed $50,000 for 2012), or 100% of the participant s current compensation. The term annual addition includes employer and employee contributions, as well as forfeitures. Section 415 also goes on to define compensation for various purposes. Point of Interest: In a Defined Benefit (DB) Plan, the normal form of benefit is the default form of payment to a participant upon becoming eligible for benefits. Examples are: a Life-Only Annuity or a 50% Joint & Survivor Annuity. A DB Plan will oftentimes offer alternate forms of benefits as well, to include the required QJSA. When a plan participant elects an alternate form of payment, the normal form of payment is actuarially converted to an amount that is equivalent in value to the elected alternate form. One common alternate form is a lump sum payment, equal to the vested present value of the participant s accrued benefit; which is oftentimes rolled over to an IRA. This lump sum payment cannot exceed the present value of the dollar amount annual benefit limit proscribed by IRC 415(b), which is in turn based on a Life-Only Annuity. If a plan does not allow lump sum payments, this lump sum limit under 415(b) no longer applies. Also, a Joint & Survivor Annuity is relatively more valuable than a Life-Only Annuity because the dollar amount needed to pay an income stream over the lives of two people is greater than the dollar amount needed to pay an income stream for the life of one person. Thus, DB Plan sponsors should consider whether eliminating lump sums as an optional form and using a normal form more valuable than a Life-Only Annuity would afford them certain advantages. Some of these advantages could be: increased benefits that can be funded for at Normal Retirement Age, retirement benefits that cannot be outlived and increased minimum required and maximum deductible plan contributions. Added estate planning benefits may also be possible, as annuitized benefits keep the bulk of plan assets out of a participant s estate. 4

IRC 401(a)(17). IRC 401(a)(19). IRC 401(a)(20). IRC 401(a)(22). IRC 401(a)(23). IRC 401(a)(24). IRC 401(a)(25). IRC 401(a)(26). IRC 401(a)(27). IRC 401(a)(28). IRC 401(a)(29). The compensation used to determine a participant s benefit or annual addition cannot exceed $200,000 (as indexed $250,000 for 2012). A qualified plan that mandates participant contributions may not, in general, forfeit a participant s benefits if the mandatory contributions are withdrawn. A participant in a qualified pension plan (i.e. a plan subject to the minimum funding standards of IRC 412) may receive a distribution in the event of the plan s termination. A qualified defined contribution plan (except a profit sharing plan) that invests more than 10% of its assets in employer securities that are not readily tradable, must comply with the voting rights requirements specified in IRC 409(e). A qualified stock bonus plan must comply with IRC 409(h) and (o). Oftentimes qualified plans commingle their assets in a group trust. 401(a)(24) prescribes types of plans whose monies can be included in a group trust, by reference to 818(a)(6). A qualified defined benefit plan must define the actuarial assumptions used to calculate optional forms of benefit in the plan document. This section prescribes the famous minimum participation test applicable to all qualified defined benefit plans. A defined benefit plan is not qualified unless, every day, it benefits at least the lesser of 50 employees of the employer, or the greater of 1) 40% of all employees of the employer or 2) 2 employees (or if there is only 1 employee, such employee). A qualified profit sharing plan need not show a profit for a given year in order to declare a contribution. A qualified profit sharing or money purchase must identify itself as such in its plan document. This section spells out qualification requirements unique to Employee Stock Ownership Plans (ESOPs). These requirements pertain to diversification away from employer stock after a certain age and to independent appraisals of employer stock that is not readily tradable. Recently amended by the Pension Protection Act of 2006 (PPA 06), this section levies benefit restrictions under IRC 436 on a defined benefit plan with an adjusted funding target attainment percentage (AFTAP) that is below 80%. This means that if a defined benefit plan s assets are not sufficient to pay its liabilities, the plan must restrict payouts and benefit increases. Point of Interest: If the AFTAP is over 80% there are no restrictions placed on the plan. But, if the AFTAP is between 60% and 80%, restrictions are imposed. First, no more than one-half of any lump sum benefit may be paid from the plan to a former employee. Also, amendments to increase benefits are 5

disallowed. These restrictions end when the AFTAP exceeds 80%. When the AFTAP is less than 60%, lump sum payments to former employees are disallowed; and their benefits may be paid in the form of a monthly annuity only. Also, the plan cannot be amended to increase benefits, and current benefit accruals for active participants are frozen. Here again, when the plan s AFTAP exceeds 80%, these restrictions are removed for the next plan year; and frozen benefit accruals may be restored retroactively as long as the AFTAP remains over 80%. The plan s actuary must certify the AFTAP by the first day of the 4 th month of the plan year to avoid benefit restrictions. This means April 1 st for calendar year plans. However, if the AFTAP in the prior year was greater than 90%, the restrictions are avoided until the first day of the 10 th month of the plan year, or October 1 st for calendar year plans. If the current year AFTAP is not done by this time the plan s AFTAP is deemed to be below 60% and all benefit restrictions apply. These restrictions will remain in effect until the following plan year, even if the AFTAP is subsequently certified. IRC 401(a)(30). This subsection limits a participant s elective deferrals into a 401(k) plan to the limits described in IRC 402(g)(1). In 2012, this limit is the lesser of $17,000 or 100% of the participant s compensation. A catch-up of $5,500 applies for any participant that attains age 50 during the year and reaches either any legal or plan imposed addition limit. Point of Interest: It s important to stress that the catch-up is available to participants who are over age 50 and become subject to a plan imposed limitation. This means that if a participant aged 50+, who is an HCE needs to take back a certain amount of salary deferrals to pass the Actual Deferral Percentage (ADP), it s possible to re- characterize some or all of the excess as a catch-up to mitigate the refund or avoid it altogether. IRC 401(a)(31). IRC 401(a)(32). IRC 401(a)(33). IRC 401(a)(34). IRC 401(a)(35). IRC 401(a)(36). A qualified plan must provide a direct rollover option (i.e. arrange for an IRA on the participant s behalf) for an eligible rollover distribution, if the distribution is greater than $1,000 and if the participant does not make an election regarding the payment of the distribution. If a defined benefit plan experiences a liquidity shortfall as defined in IRC 430(j)(4), the resulting suspension of benefit payments will not violate the qualification requirements. An employer experiencing a debtor bankruptcy is prohibited from implementing amendments that increase the plan s liabilities. The qualified status of a defined benefit plan is not lost if the plan remits benefits of missing participants to the Pension Benefit Guaranty Corporation (PBGC). A defined contribution plan that allows participants to invest in publicly traded employer securities must allow the participants the ability to diversify out of such securities, into other investments. A pension plan (i.e. any plan subject to the certain minimum funding and definitely determinable benefit standards) may allow for in-service withdrawals for employees aged at least 62 years without losing its qualified status. 6

Once an employer establishes the plan by adopting the plan document, it can apply to the IRS for a Determination Letter, which asserts the qualified status of the plan. Obtaining a Determination Letter is not a condition for qualification, and is not required. An employer might choose to obtain a Determination Letter to gain assurance that the plan document as adopted by the employer meets all of the qualification standards spelled out in IRC 401(a). The employer makes this application to the IRS using the Form 5300 series and related schedules applicable to the specifics of the request. During the application process, the employer can petition the IRS s determination on not only the form of the plan, but also on specific plan provisions. In addition to a determination by the IRS, the employer may also seek a declaratory judgment for the Tax Court with respect to initial or continuing qualification. This procedure is outlined in IRC 7476. Conclusion Plan sponsors and would-be plan sponsors must have a clear understanding of the standards a qualified plan must comply with to maintain its qualified status. A deep awareness of the qualification standards under IRC 401(a) is a staple in the plan sponsor s overall success at effective plan governance and operation. Simplistically, a qualified plan must in general: Be established & communicated in writing; Exist for the exclusive benefit of the Participants and beneficiaries; Be permanent & ongoing; Be non-discriminatory; Adhere to specific limits; Comply with certain minimum contribution and benefit accrual standards; and Include vesting & funding standards. However, the details of the full complement of qualification standards go far beyond this oft-repeated generalization. Contributions to a qualified plan are generally made before taxes; and earnings on qualified plan assets are taxed-deferred. A plan that is disqualified loses these tax advantages and may suffer other penalties. The IRS has programs for correcting errors in form and operation, as well as programs for confirming the qualified status of a plan. Manning & Napier Advisors, LLC offers other White Papers covering topics relevant to qualified plans. Feel free to ask your representative about these White Papers. Also consider using our Qualified Plans Consulting Service, to help you design and implement the plan that is right for your business. The information in this White Paper is not intended as legal or tax advice. 7