► Employer contributions to a qualified retirement plan are considered a deductible business expense,
which lowers the business's income taxes

► The earnings of a qualified plan are exempt from income taxation

► Employer contributions to a qualified plan are not currently taxable to the employee in the years they
are contributed, but they are taxable when they are paid-out as a benefit (typically when the employee is
retired and in a lower tax bracket)

► Contributions to an individual qualified plan,  such  as an  individual retirement account or annuity  (IRA), are deductible from income under certain conditions 

►The annual addition to an employee's account in a qualified retirement plan cannot exceed the maximum limits set by the IRS

►A plan is considered to be “top heavy” if more than 60% of plan assets are attributable to key employees as of the last day of the prior plan year

►The exclusive benefit rule states that assets held in a company's qualified retirement plan must be maintained for the exclusive benefit of the employees and their beneficiaries

►The survivor benefits under a qualified retirement plan can be waived only with the written consent of a married worker's spouse

If a plan does not meet the specific requirements set forth by the federal government, it is termed a nonqualified
plan and, thus, is not eligible for favorable tax treatment. For example, Bill, age 42, decides he wants to start a
retirement fund. He opens a new savings account at his local bank, deposits $150 a month in that account, and
vows not to touch that money until he reaches age 65. Although his intentions are good, they will not serve to
"qualify" his plan. The income he deposits and the interest he earns are still taxable every year. Our discussion
in this chapter will focus on qualified retirement plans, both individual and employer sponsored.

 

An employer retirement plan is one that a business makes available to its employees. Typically, the employer makes
all or a portion of the contributions on behalf of its employees and is able to deduct these contributions as ordinary
and necessary business expenses. The employees are not taxed on the contributions made on their behalf, nor are
they taxed on the benefit fund accruing to them until it actually is paid out. By the same token, contributions made
by an individual employee to a qualified employer retirement plan are not included in the individual's ordinary
income and therefore are not taxable.

Basic Concepts

Many of the basic concepts associated with qualified employer plans can be traced to the Employee Retirement Income Security Act of 1974, commonly called ERISA. The purpose of ERISA is to protect the rights of workers covered under an employer-sponsored plan. ERISA also regulates group health insurance in the area of disclosure and reporting. Before the passage of ERISA, workers had few guarantees to assure them that they would receive the pension benefit they thought they had earned. An unfortunate, but common plight was the worker who had devoted many years to one employer only to be terminated within a few years of retirement and not be entitled to a pension benefit.

Participation Standards

All qualified employer plans must comply with ERISA minimum
participation standards designed to determine employee eligibility.
In general, employees who have reached age 21 and have
completed one year of service must be allowed to enroll in a
qualified plan. Or, if the plan provides for 100% vesting upon
participation, they may be required to complete two years of
service before enrolling. New employees must receive a copy
of their plan sponsor’s latest Summary Plan Description within
90 days after becoming covered by the plan. Church, governmental, and collectively bargained plans are specifically exempt from ERISA regulations.

Coverage Requirements

Under the IRS "minimum coverage" rules, a qualified retirement plan must benefit a broad cross-section of employees.
The purpose of coverage requirements is to prevent a plan from discriminating against rank and file employees in
favor of the "elite" employees (officers, and highly compensated employees) whose positions often enable them to
make basic policy decisions regarding the plan. The IRS will subject qualified employer plans to coverage tests to
determine if they are discriminatory. A qualified plan cannot discriminate in favor of highly-paid employees in its
coverage provisions or in its contributions and benefits provisions. Form 5500 is a disclosure document that employee
benefit plans use to satisfy annual reporting requirements under ERISA.

Vesting Schedules

All qualified plans must meet standards that set forth the employee vesting schedule and nonforfeitable rights at any
specified time. Vesting means the right that employees have to their retirement funds. Benefits that are "vested"
belong to each employee even if the employee terminates employment prior to retirement. For all plans, an
employee always has a 100% vested interest in benefits that accrue from the employee's own contributions.
Benefits that accrue from employer contributions must vest according to vesting schedules established by law.

Alienation of Benefits

Alienation of benefits involves the assignment of a pension or retirement plan participant's benefits to another person. It's is permitted only under exceptional circumstances per IRS rules, such as certain participant loans and certain domestic relations orders.

Funding Standards

For a plan to be qualified, it must be funded.  In other words, there must be real contributions on the part of the
employer, the employee, or both.  These funds must be held by a third party and invested. The funding vehicle is
the method for investing the funds as they accumulate.

Federal minimum funding requirements are set to ensure that an employer's annual contributions to a pension
plan are sufficient to cover the costs of benefits payable during the year, plus administrative expenses.

Contributions

Qualification standards regarding the amount and type of contributions that can be made to a plan vary, depending
on whether the plan is a defined contribution plan or a defined benefit plan. Generally, all plans must restrict the
amount of contributions that can be made for, or accrue to, any one plan participant.

With these basics in mind, let's turn to the two major categories of qualified employer retirement plans used
primarily by corporate employers. The first is called a defined contribution plan, which obligates the plan sponsor
to make periodic contributions for each participant per a defined formula. The other category is called a defined
benefit plan, which defines the amount of retirement income each participant will receive.

Defined Contribution Plans

The provisions of a defined contribution plan address the amounts going into the plan currently and identify the
participant's vested (nonforfeitable) account.  These predetermined amounts contributed to  the participant's
account accumulate to a future  point  (i.e.,  retirement). The final amount available to a participant depends on
the total contribution amount, plus interest and dividends.

There are three primary types of defined contribution plans: profit sharing plans, stock bonus plans, and money
purchase plans.

Profit-Sharing Plans

Profit sharing plans are established and maintained by an employer and allow employees to participate in the
profits of the company. They set aside a portion of the firm's net income for distributions to employee's who qualify under the plan. Since contributions are tied to the company's profits, it is not necessary that the employer contribute
every year or that the amount of contribution be the same. However, the IRS states that to qualify for favorable
tax treatment, the plan must be maintained with "recurring and substantial" contributions.
The IRS also states that withdrawals of funds from a profit sharing plan may be subject to a 10% tax
penalty in addition to income taxes if they are made before the age of 59 1/2.

Stock Bonus Plans

A stock bonus plan is similar to a profit sharing plan, except that contributions by the employer do not depend
on profits. Benefits are distributed in the form of company stock.

Money Purchase Plans

Money purchase plans provide for fixed contributions with future benefits to be determined. This most truly
represent a defined contribution plan. A money purchase plan must meet the following three requirements:

► Contributions and earnings must be allocated to participants in accordance with a definite formula
► Distributions can be made only in accordance with amounts credited to participants
► Plan assets must be valued at least once a year, with participants' accounts being adjusted accordingly

Employee Stock Ownership Plans

Employee Stock Ownership Plans, or ESOP’s, are employee-owner programs that provide a company’s workforce with
an ownership interest in the company. Shares are allocated to employees and may be held in an ESOP trust until the employee retires or leaves the company.

Defined Benefit Plans

In contrast to a defined contribution plan that sets up pre-determined contributions, a defined benefit plan
establishes a definite future benefit, pre­ determined by a specific formula. When the term pension is used, the
reference is typically to a defined benefit plan. Usually the benefits are tied to the employee's years of service,
amount of compensation, or both. For example, a defined benefit plan may provide for a retirement benefit equal
to 2% of the employee's highest consecutive five-year earnings, multiplied by the number of years of service. Or
the benefit may be defined as simply as $100 a month for life.

To qualify for federal tax purposes, a defined benefit plan must meet the following basic requirements:

► The plan must provide for definitely determinable benefits, either by a formula specified in the
plan or by actuarial computation.
► The plan must provide for systematic payment of benefits to employees over a period of years
(usually for life) after retirement. Thus, the plan has to detail the conditions under which benefits
are payable and the options under which benefits are paid.
► The plan must provide primarily retirement benefits.  The IRS will allow provisions for death or
disability benefits, but these benefits must be incidental to retirement.
► The maximum annual benefit an employee may receive in any one year is limited to an amount
set by the tax law.
► The appropriate choice of a qualified corporate retirement plan (defined contribution or defined
benefit) requires an understanding of the operation and characteristics of each plan as they relate
to the employer's objectives.

Cash or Deferred Arrangements (401(k) Plans)

Another form of qualified employer retirement plan is known as the 401(k) plan, whereby employees can elect to
take a reduction in their current salaries by deferring amounts into a retirement plan. These plans are called cash or
a salary deferral option because employees cannot be forced to participate. They may take their income currently
as cash or defer a portion of it until retirement with favorable tax advantages. The amounts deferred are not
included in the employees' gross income and earnings credited to the deferrals grow tax-free until distribution.
Typically, 401(k) plans include matching employer contributions.

Tax-Sheltered Annuities (403(b) Plans)

Another type of employer retirement plan is the tax-sheltered annuity or 403(b) plan. A tax sheltered annuity
is a special tax-favored retirement plan available only to certain groups of employees. Tax-sheltered
annuities may be established for the employees of specified nonprofit charitable, educational, religious,
and other 501(c) (3) organizations, including teachers in public school systems. Such plans generally
are not available to other kinds of employees.

Funds  are  contributed  by  the  employer  or  by  the  employees  (usually through payroll deductions)  to
tax-sheltered annuities and, thus, are excluded from the employees' current taxable income.

IRC Section 457 Deferred Compensation Plans

Deferred compensation plans for employees of state and local governments and nonprofit organizations became
popular in the 1970s. Congress enacted Internal Revenue Code Section 457 to allow participants in such plans to
defer compensation without current taxation as long as certain conditions are met.

If a plan is eligible under Section 457, amounts deferred will not be included in gross income until they are actually
received or made available. Life insurance and annuities are authorized investments for these plans. The annual
amounts an employee may defer under a Section 457 plan are similar to those available for 401(k) plans

Before 1962, many small business owners found that their employees
could participate in and benefit from a qualified retirement plan, but the
owners themselves could not. Self-employed individuals were in the
same predicament. The reason was that qualified plans had to benefit
"employees." Because business owners were considered "employers,"
they were excluded from participating in a qualified plan. The
Self-Employed Individuals Retirement Act, signedinto law in 1962,
rectified this situation by treating small business owners and self-employed individuals as "employees”. This law
enabled them to participate in a qualified plan, if they chose to do so, just like their employees. The result was
the Keogh (or HR-10) retirement plan. 
                                                                                                 
Keogh Plans (HR-10s)

A Keogh plan is a qualified retirement plan designed for unincorporated businesses (self-employed) that allows the business owner (or partner in a business) to participate as an employee, only if the employees of the business are included. These plans may be set up as either defined contribution or defined benefit plans.

In the first years following enactment of the Keogh bill, there was a great deal of disparity between the rules for
Keogh plans and those for corporate plans. However, various laws have eliminated most of the rules unique to
Keogh plans, thereby establishing parity between qualified corporate employer retirement plans and
noncorporate plans. This change means that Keogh plans:

► are subject to the same maximum contribution limits and benefit limits as qualified corporate plans

► must comply with the same participation and coverage requirements as qualified corporate plans

► are subject to the same nondiscrimination rules as qualified corporate plans

Simplified Employee Pensions (SEPs)

Another type of qualified plan suited for the small employer is the simplified employee pension (SEP) plan. Due to
the many administrative burdens and the costs involved with establishing a qualified defined contribution or defined
benefit plan, as well as maintaining compliance with ERISA, many small businesses have been reluctant to set up
retirement plans for their employees. SEPs were introduced in 1978 specifically for small businesses to overcome
these cost, compliance, and administrative hurdles.

Basically, SEP’s are arrangements where an employee (including a self-employed individual) establishes and
maintains an individual retirement account (IRA) to which the employer contributes. Employer contributions are
not included in the employee's gross income. A primary difference between a SEP and an IRA is the much larger
amount that can be contributed each year to an SEP. In accordance with the rules that govern other qualified plans,
SEPs must not discriminate in favor of highly compensated employees with regard to contributions or participation.

Salary Reduction SEP Plans

A variation of the SEP plan is the salary reduction SEP (SARSEP).  SARSEPs incorporate a deferral/salary
reduction approach in that the employee can elect to have employer contributions directed into the SEP or paid
out as taxable cash compensation. The limit on the elective deferral to a SARSEP is the same as a 401(k).
SARSEPs are reserved for small employers (those with 25 or fewer employees) and had to be established
before 1997. As a result of tax legislation, no new SARSEPs can be established. However, plans that were
already in place at the end of 1996 may continue to operate and accept new employee participants.

SIMPLE Plans

The same legislation that did away with SARSEPs also created a new form of qualified employer retirement plan
(or SIMPLE).  These arrangements allow eligible employers to set up tax-favored retirement savings plans for
their employees without  having  to address many of the usual (and burdensome) qualification requirements.
SIMPLE plans are available to small businesses (including tax exempt and government entities) that employ no
more than 100 employees who received at least $5,000 in compensation from the employer during the previous
year. To establish a SIMPLE plan, the employer must not have a qualified plan in place. SIMPLE plans may be
structured as an IRA or as a 401(k) cash or deferred arrangement.   All contributions to a SIMPLE IRA or
SIMPLE 401(k) plan are nonforfeitable and the employee is immediately and fully vested. Taxation of
contributions and their earnings is deferred until funds are withdrawn or distributed.

Catch-Up Contributions

Both SARSEP and SIMPLE plans allow participants who are at least 50 years old by the end of the plan year
to make additional "catch-up" contributions.

In much the same way that it encourages businesses to establish retirement plans for their employees, federal tax
law provides incentives for individuals to save for their retirement by allowing certain kinds of plans to receive
favorable tax treatment. Individual retirement accounts (IRAs) are the most notable of these plans. Available
IRAs include the traditional tax-deductible IRA, the traditional non-tax-deductible IRA, as well as the Roth IRA.
The Roth IRA was created by the Taxpayer Relief Act of 1997. Roth IRA’s require nondeductible contributions
but offers tax-free earnings and withdrawals.

Traditional IRA

An individual retirement account, commonly called an IRA, is a means by which individuals can save money for
retirement and receive a current tax break, regardless of any other retirement plan. Basically, the amount contributed
to an IRA accumulates and grows tax deferred. IRA funds are not taxed until they are taken out at retirement. Depending
on the individual's earnings and whether or not the individual is covered by an employer-sponsored retirement plan, the
amount the individual contributes to a traditional IRA may be fully or partially deducted from current income,
resulting in lower current income taxes.

IRA Participation

Anyone under the age of 70 1/2 who has earned income may open a traditional IRA and contribute up to the
contribution limit or 100% of compensation each year, whichever is less. A non-wage­ earning spouse may open
an IRA and contribute up to the limit each year.

Since 2002, persons who are age 50 and older have been allowed to make "catch-up" contributions to their IRAs,
above the scheduled annual limit, enabling them to save even more for retirement.  These catch-up payments can
be either deductible or made to a Roth IRA.

Deduction of IRA Contributions

In many cases, the amount an individual contributes to a traditional IRA can be deducted from that individual’s
income in the year it is contributed. The ability of an IRA participant to take a deduction for her contribution rests
on two factors:

► Whether or not the participant is covered by an employer-sponsored retirement plan
► The amount of income the participant makes

Individuals who are not covered by an employer-sponsored plan may contribute up to the annual limit to a
traditional IRA and deduct from their current income the full amount of the contribution, no matter what their
level of income is. Married couples who both work and have no employer-sponsored plan can each contribute
and deduct up to the maximum each year.

Individuals who are covered by an employer-sponsored plan are subject to different rules regarding deductibility
of traditional IRA contributions. For them, the amount of income they make is the determining factor: the more
they make, the less IRA deduction they can take.  Do not confuse deductibility of contributions with the ability to
make contributions. Anyone under age 70 1/2 who has earned income (as well as a non-wage-earning spouse)
can contribute to a traditional IRA. However, level of income and participation in an employer plan may affect
the traditional IRA owner's ability to deduct the contributions.

Traditional IRA Withdrawals

Because the purpose of an IRA is to provide a way to accumulate retirement funds, there are a number of rules
that discourage traditional IRA owners from withdrawing these funds prior to retirement. By the same token,
traditional IRA owners are discouraged from perpetually sheltering their accounts from taxes by rules that
mandate when the funds must be withdrawn.

► Traditional IRA  owners  must  begin  to  receive  payment  from  their accounts  no later 
than  April 1 following the year in which  they reach age 70 1/2. The law specifies a minimum
amount that must be withdrawn every year. Failure to withdraw the minimum amount can result in a
50% excise tax that will be assessed on the amount that should have been withdrawn.

► With few exceptions, any distribution from a traditional IRA before age 59 1/2 will have adverse tax
consequences. In addition to income tax, the taxable amount of the withdrawal will be subject to a 10%
penalty (similar to that imposed on early withdrawals from deferred annuities). Early distributions taken
for any of the following reasons or circumstances will not be assessed the 10% penalty: if the owner dies
or becomes disabled, if the owner is faced with a certain amount of qualifying medical expenses, to pay
for higher  education expenses, to cover first time home purchase expenses (up to $10,000 and must not
have made a principal home purchase in the last 2 years), to pay for health insurance premiums while unemployed,  or to correct or reduce an excess contribution.

► At retirement, or any time after age 59 1/2, the IRA owner can elect to receive either a lump-sum
payment or periodic installment payments from his or her fund. Traditional IRA distributions are taxed in
much the same way as annuity benefit payments are taxed. That is, the portion of an IRA distribution that
is attributed to nondeductible contributions is received tax-free. The portion that is attributed to interest
earnings or deductible contributions is taxed. The result is a tax-free return of the IRA owner's cost basis
and a taxing of the balance (interest).

► If an IRA owner dies before receiving full payment, the remaining funds in the deceased's IRA will be
paid to the named beneficiary.

► If the IRA owner is a military reservist called to active duty (between September 11, 2001 and
December 31, 2007) for more than 179 days or for an indefinite period, the 10-percent early-withdrawal
penalty does not apply. However, regular income taxes will apply.

► If the IRA owner is a firefighter, policeman, or an emergency medical technician (EMT) with a pension or
retirement plan who retires after age 50, he or she is also exempt from the penalty tax.

IRA Funding

An ideal funding vehicle for IRAs is a flexible premium fixed deferred annuity. Other acceptable IRA funding
vehicles include bank time deposit open accounts, bank certificates of deposit, insured credit union accounts,
mutual fund shares, face amount certificates, real estate investment trust units, and certain US gold and silver coins.

Roth IRA

The 1997 Taxpayer Relief Act introduced a new kind of IRA: the Roth IRA.  Roth IRAs are unique in that they
provide for back-end benefits. No income tax deductions can be taken for contributions made to a Roth,
but the earnings on those contributions are entirely tax-free when they are withdrawn. An amount up to the annual
contribution limit can be contributed to a Roth IRA for any eligible individual.  Active participant status is irrelevant.

An individual can open and contribute to a Roth regardless of whether the individual is covered by an employer's
plan or maintains and contributes to other IRA accounts. No more than this amount can be contributed in any
year for any account or combination of accounts.

Unlike traditional IRAs, who are limited to those under age 70 1/2, Roth IRAs, impose no age limits. At any age,
an individual with earned income can establish a Roth IRA and make contributions. However, Roth IRAs subject
participants to earnings limitations that traditional IRAs do not. High income earners may not be able to contribute
to a Roth IRA since the maximum annual contribution that can be made begins to phase out for individuals whose
modified adjusted gross incomes reach certain levels. Above these limits, no Roth contributions are allowed.

Qualified Roth Withdrawals

Withdrawals from Roth IRAs are either qualified or nonqualified. A qualified withdrawal is one that provides for
the full-tax advantage that Roths offer (tax-free distribution of earnings). To be a qualified withdrawal, the
following two requirements must be met:

► The funds must have been held in the account for a minimum of five years

► The withdrawal must occur because the owner has reached age 59 ½, the owner dies, the owner
becomes disabled, or the distribution is used to purchase a first home.

Nonqualified Roth Withdrawal

A nonqualified withdrawal is one that does not meet the previously discussed criteria. The result is that distributed
Roth earnings are subject to tax. This would occur when the withdrawal is taken without meeting the above
requirements and the amount of the withdrawal exceeds the total amount that was contributed.

Since Roth contributions are made with after-tax dollars, they are not subject to taxation again upon withdrawal. The only portion of a Roth withdrawal  that is subject to taxation is earnings, and only when those earnings are removed
from the account without having met the above requirements. If the owner of the Roth IRA is younger than age 59 1/2 when the withdrawal is taken, it will be considered premature and the earnings portion will also be assessed a 10% penalty.

No Required Distributions

Unlike traditional IRAs, Roth IRAs do not require mandatory distributions. There is no minimum distribution
requirement for the account owner. The funds can remain in the account as long as the owner desires. In fact, the
account can be left intact and passed on to heirs or beneficiaries.

Spousal IRA

Persons eligible to set up IRAs for themselves may create a separate spousal IRA for a nonworking spouse. They
are able to contribute up to the annual maximum to the spousal account. Even in the event that the working
spouse is in an employer-sponsored plan.

Rollover IRA

Normally, benefits withdrawn from any qualified retirement plan are taxable the year in which they are received. However, certain tax-free "rollover" provisions of the tax law provide some degree of portability when an individual wishes to transfer funds from one plan to another, specifically to a rollover IRA.

Essentially, rollover IRAs provide a way for individuals who have received a distribution from a qualified plan to reinvest the funds in a new tax-deferred account and continue to shelter those funds and their earnings from current taxes. Rollover contributions to an IRA are unlimited by dollar amount. Rollover IRAs are used by individuals who, for example, have left one employer for another and have received a complete distribution from their previous employer's plan.

 

Another example would be those who had invested funds in an individual IRA of one kind and want to rollover to another IRA for a higher rate of return.  In addition, a distribution received from an employer-sponsored retirement plan (or from an IRA) is eligible for a tax-free rollover if it is reinvested in an  IRA within 60 days following receipt of the distribution and if the plan participant does not actually  take physical receipt of the distribution.  The entire amount does not need be rolled over. A partial distribution may be rolled over from one IRA or eligible plan to another IRA. However, if a partial rollover is executed, the part retained will be taxed as ordinary income and subject to a 10% early distribution penalty.

Only the person who established an IRA is eligible to benefit from the rollover treatment-with one exception. 
A surviving spouse who inherits IRA benefits or benefits from the deceased spouse's qualified plan is eligible to
establish a rollover IRA in the surviving spouse's own name. Assets passing to a surviving spouse generally are not subject to estate taxes at the time of death due to the Unlimited Marital Deduction. Note that tax law now allows
non-spousal beneficiaries to take IRA proceeds over their lifetimes, plus the lifetimes of their oldest named beneficiary.

Withholding

Any rollover must be made directly from one IRA to another IRA or it will be subject to a 20% withholding.
This is true even if the rollover occurs within the 60-day limit. The key here is the word directly. To escape the
withholding rate, the rollover must take place without the plan’s funds being in the recipient’s control for even
an instant. If such control does occur and the 20% is withheld, the recipient must make up this amount out of other
funds or the amount withheld will be subject to income taxation and possible a penalty for premature distribution.
The amount withheld is, of course, applied toward the tax liability, if any, of money distributed from the fund.
The withholding rule also applies to a trustee-to-trustee transfer of rollover funds.

Conduit IRA

A conduit IRA is a holding tank for funds that originally came from a qualified plan and are on their way to another qualified plan. No withholding tax is necessary unless any of the funds are distributed directly to the individual.

 

Pension Protection Act

The Pension Protection Act of 2006 embodied the most sweeping
reform of America's pension laws in over 30 years. It improves the
pension system and increases opportunities to fund retirement plans.

The act encourages workers to increase their contributions to
employer­ sponsored retirement plans and helps them manage
their investments. For example, automatic enrollment is a means of increasing participation in 401(k) plans,
especially among young workers entering the workforce. The act also provides for automatic deferrals into
investment funds and automatic annual increases in employees' salary deferral rates beginning in 2008.
Since 2007, plan sponsors can offer fund-specific investment advice to participants through their retirement
plan providers or other fiduciary advisers. Counseling in person is also allowed under strict guidelines.

Section 529 Plans

A Section 529 plan is a vehicle for providing for higher education expenses and is named after the tax code that
governs it. There are two types of Section 529 plans:

Prepaid tuition plans:  Allows contributors to prepay college tuition and other fees for a designated beneficiary

College savings plans:  Allows contributors to invest after-tax dollars in professionally managed accounts

Section 529 plans don’t restrict eligibility or limit the amount of contribution based on the income of the contributor.
State residency also is not a restriction. The beneficiary of a Section 529 plan does not need to report income when
withdrawals are used for qualified college costs.