Qualified Plans

Qualified retirement plans set up by self-employed individuals are sometimes called Keogh or H.R. 10 plans. A sole proprietor or a partnership can set up a qualified plan. A common-law employee or a partner cannot set up a qualified plan. The plans described here can also be set up and maintained by employers that are corporations. All the rules discussed here apply to corporations except where specifically limited to the self-employed.

The plan must be for the exclusive benefit of employees or their beneficiaries. A qualified plan can include coverage for a self-employed individual. A self-employed individual is treated as both an employer and an employee.

As an employer, you can usually deduct, subject to limits, contributions you make to a qualified plan, including those made for your own retirement. The contributions (and earnings and gains on them) are generally tax free until distributed by the plan.

Kinds of Plans

There are two basic kinds of qualified plans --defined contribution plans and defined benefit plans--and different rules apply to each. You can have more than one qualified plan, but your contributions to all the plans must not total more than the overall limits discussed under Contributions and Employer Deduction, later.

Defined Contribution Plan

A defined contribution plan provides an individual account for each participant in the plan. It provides benefits to a participant largely based on the amount contributed to that participant's account. Benefits are also affected by any income, expenses, gains, losses, and forfeitures of other accounts that may be allocated to an account. A defined contribution plan can be either a profit-sharing plan or a money purchase pension plan.

Profit-sharing plan. A profit-sharing plan is a plan for sharing your business profits with your employees. However, you do not have to make contributions out of net profits to have a profit-sharing plan.

The plan does not need to provide a definite formula for figuring the profits to be shared. But, if there is no formula, there must be systematic and substantial contributions.

The plan must provide a definite formula for allocating the contribution among the participants and for distributing the accumulated funds to the employees after they reach a certain age, after a fixed number of years, or upon certain other occurrences.

In general, you can be more flexible in making contributions to a profit-sharing plan than to a money purchase pension plan (discussed next) or a defined benefit plan (discussed later). But the maximum deductible contribution may be less under a profit-sharing plan (see Limits on Contributions and Benefits, later).

Forfeitures under a profit-sharing plan can be allocated to the accounts of remaining participants in a nondiscriminatory way or they can be used to reduce your contributions.

Money purchase pension plan. Contributions to a money purchase pension plan are fixed and are not based on your business profits. For example, if the plan requires that contributions be 10% of the participants' compensation without regard to whether you have profits (or the self-employed person has earned income), the plan is a money purchase pension plan. This applies even though the compensation of a self-employed individual as a participant is based on earned income derived from business profits.

Defined Benefit Plan

A defined benefit plan is any plan that is not a defined contribution plan. Contributions to a defined benefit plan are based on what is needed to provide definitely determinable benefits to plan participants. Actuarial assumptions and computations are required to figure these contributions. Generally, you will need continuing professional help to have a defined benefit plan.

Forfeitures under a defined benefit plan cannot be used to increase the benefits any employee would otherwise receive under the plan. Forfeitures must be used instead to reduce employer contributions.

Setting Up a Qualified Plan

There are two basic steps in setting up a qualified plan. First you adopt a written plan. Then you invest the plan assets.

You, the employer, are responsible for setting up and maintaining the plan.

If you are self-employed, it is not necessary to have employees besides yourself to sponsor and set up a qualified plan. If you have employees, see Eligible Employee, later.

Set-up deadline. To take a deduction for contributions for a tax year, your plan must be set up (adopted) by the last day of that year (December 31 for calendar year employers).

Adopting a Written Plan

You must adopt a written plan. The plan can be an IRS-approved master or prototype plan offered by a sponsoring organization. Or it can be an individually designed plan.

Written plan requirement. To qualify, the plan you set up must be in writing and must be communicated to your employees. The plan's provisions must be stated in the plan. It is not sufficient for the plan to merely refer to a requirement of the Internal Revenue Code.

Master or prototype plans. Most qualified plans follow a standard form of plan (a master or prototype plan) approved by the IRS. Master and prototype plans are plans made available by plan providers for adoption by employers (including self-employed individuals). Under a master plan, a single trust or custodial account is established, as part of the plan, for the joint use of all adopting employers. Under a prototype plan, a separate trust or custodial account is established for each employer.

Plan providers. The following organizations generally can provide IRS-approved master or prototype plans.

• Banks (including some savings and loan associations and federally insured credit unions).
• Trade or professional organizations.
• Insurance companies.
• Mutual funds.

Individually designed plan. If you prefer, you can set up an individually designed plan to meet specific needs. Although advance IRS approval is not required, you can apply for approval by paying a fee and requesting a determination letter. You may need professional help for this. Revenue Procedure 2000-6 may help you decide whether to apply for approval of your plan. Revenue Procedure 2000-6 is in Internal Revenue Bulletin No. 2000-1. It is also available at most IRS offices and at certain libraries.

Internal Revenue Bulletins are available on the IRS web site at www.irs.gov. Select Tax Info For You to view Internal Revenue Bulletins published in the last few years.

Investing Plan Assets

In setting up a qualified plan, you arrange how the plan's funds will be used to build its assets.

• You can establish a trust or custodial account to invest the funds.
• You, the trust, or the custodial account can buy an annuity contract from an insurance company. Life insurance can be included only if it is incidental to the retirement benefits.
• You, the trust, or the custodial account can buy face-amount certificates from an insurance company. These certificates are treated like annuity contracts.

You set up a trust by a legal instrument (written document). You may need professional help to do this.

You can set up a custodial account with a bank, savings and loan association, credit union, or other person who can act as the plan trustee.

You do not need a trust or custodial account, although you can have one, to invest the plan's funds in annuity contracts or face-amount certificates. If anyone other than a trustee holds them, however, the contracts or certificates must state they are not transferable.

Eligible Employee

An employee must be allowed to participate in your plan if he or she meets both the following requirements.

• Has reached age 21.
• Has at least 1 year of service (2 years if the plan is not a 401(k) plan and provides that after not more than 2 years of service the employee has a nonforfeitable right to all his or her accrued benefit).

A plan cannot exclude an employee because he or she has reached a specified age.

Other plan requirements. For information on other important plan requirements, see Qualification Rules, later.

Minimum Funding Requirement

In general, if your plan is a money purchase pension plan or a defined benefit plan, you must actually pay enough into the plan to satisfy the minimum funding standard for each year. Determining the amount needed to satisfy the minimum funding standard is complicated. The amount is based on what should be contributed under the plan formula using actuarial assumptions and formulas. For information on this funding requirement, see section 412 and its regulations.

Quarterly installments of required contributions. If your plan is a defined benefit plan subject to the minimum funding requirements, you must make quarterly installment payments of the required contributions. If you do not pay the full installments timely, you may have to pay interest on any underpayment for the period of the underpayment.

Due dates. The due dates for the installments are 15 days after the end of each quarter. For a calendar year plan, the installments are due April 15, July 15, October 15, and January 15 (of the following year).

Installment percentage. Each quarterly installment must be 25% of the required annual payment.

Extended period for making contributions. Additional contributions required to satisfy the minimum funding requirement for a plan year will be considered timely if made by 8 1/2 months after the end of that year.

Contributions

A qualified plan is generally funded by your contributions. However, employees participating in the plan may be permitted to make contributions.

Contributions deadline. You can make deductible contributions for a tax year up to the due date of your return (plus extensions) for that year.

Self-employed individual. You can make contributions on behalf of yourself only if you have net earnings (compensation) from self-employment in the trade or business for which the plan was set up. Your net earnings must be from your personal services, not from your investments. If you have a net loss from self-employment, you cannot make contributions for yourself for the year, even if you can contribute for common-law employees based on their compensation.

When Contributions Are Considered Made

You generally apply your plan contributions to the year in which you make them. But you can apply them to the previous year if all the following requirements are met.

1. You make them by the due date of your tax return for the previous year (plus extensions).
2. The plan was established by the end of the previous year.
3. The plan treats the contributions as though it had received them on the last day of the previous year.
4. You do either of the following.
   1. You specify in writing to the plan administrator or trustee that the contributions apply to the previous year.
   2. You deduct the contributions on your tax return for the previous year. (A partnership shows contributions for partners on Schedule K (Form 1065), Partners' Shares of Income, Credits, Deductions, etc.)

Employer's promissory note. Your promissory note made out to the plan is not a payment that qualifies for the deduction. Also, issuing this note is a prohibited transaction subject to tax. See Prohibited Transactions, later.

Employer Contributions

There are certain limits on the contributions and other annual additions you can make each year for plan participants. There are also limits on the amount you can deduct. See Deduction Limits, later.

Limits on Contributions and Benefits

Your plan must provide that contributions or benefits cannot exceed certain limits. The limits differ depending on whether your plan is a defined contribution plan or a defined benefit plan.

Defined benefit plan. For 2000, the annual benefit for a participant under a defined benefit plan cannot exceed the lesser of the following amounts.

1. 100% of the participant's average compensation for his or her highest 3 consecutive calendar years.
2. $135,000.

Defined contribution plan. For 2000, a defined contribution plan's annual contributions and other additions (excluding earnings) to the account of a participant cannot exceed the lesser of the following amounts.

1. 25% of the compensation actually paid to the participant.
2. $30,000.

The maximum compensation that can be taken into account for this limit is $170,000.

Excess annual additions. Excess annual additions are the amounts contributed that are more than the limits discussed previously. A plan can correct excess annual additions caused by any of the following actions.

• A reasonable error in estimating a participant's compensation.
• A reasonable error in determining the elective deferrals permitted (discussed later).
• Forfeitures allocated to participants' accounts.

Correcting excess annual additions. A plan can provide for the correction of excess annual additions in the following ways.

1. Allocate and reallocate the excess to other participants in the plan to the extent of their unused limits for the year.
2. If these limits are exceeded, do one of the following.
   1. Hold the excess in a separate account and allocate (and reallocate) it to participants' accounts in the following year (or years) before making any contributions for that year (see also Carryover of Excess Contributions, later).
   2. Return employee after-tax contributions or elective deferrals (see Employee Contributions and Elective Deferrals (401(k) Plans), later).

Tax treatment of returned contributions or distributed elective deferrals. The return of employee after-tax contributions or the distribution of elective deferrals to correct excess annual additions is considered a corrective payment rather than a distribution of accrued benefits. The penalties for early distributions and excess distributions do not apply.

These disbursements are not wages reportable on Form W-2. You must report them on a separate Form 1099-R as follows.

• Report the total distribution, including employee contributions, in box 1. If the distribution includes any gain from the contribution, report the gain in box 2a. Report the return of employee contributions in box 5. Enter Code E in box 7.
• Report a distribution of an elective deferral in boxes 1 and 2a. Include any gain from the contribution. Leave box 5 blank and enter Code E in box 7.

Participants must report these amounts on the line for Total pensions and annuities on Form 1040 or Form 1040A, U.S. Individual Income Tax Return.

Employee Contributions

Participants may be permitted to make nondeductible contributions to a plan in addition to your contributions. Even though these employee contributions are not deductible, the earnings on them are tax free until distributed in later years. Also, these contributions must satisfy the nondiscrimination test of section 401(m). See Notice 98-1 for further guidance and transition relief relating to recent statutory amendments to the nondiscrimination rules under sections 401(k) and 401(m). Notice 98-1 is in Cumulative Bulletin 1998-1.

Employer Deduction

You can usually deduct, subject to limits, contributions you make to a qualified plan, including those made for your own retirement. The contributions (and earnings and gains on them) are generally tax free until distributed by the plan.

Deduction Limits

The deduction limit for your contributions to a qualified plan depends on the kind of plan you have.

Defined contribution plans. The deduction limit for a defined contribution plan depends on whether it is a profit-sharing plan or a money purchase pension plan.

Profit-sharing plan. Your deduction for contributions to a profit-sharing plan cannot be more than 15% of the compensation paid (or accrued) during the year to your eligible employees participating in the plan. You must reduce this 15% limit in figuring the deduction for contributions you make for your own account. See Deduction Limit for Self-Employed Individuals, later.

Money purchase pension plan. Your deduction for contributions to a money purchase pension plan is generally limited to 25% of the compensation paid (or accrued) during the year to your eligible employees. You must reduce this 25% limit in figuring the deduction for contributions you make for yourself, as discussed later.

Defined benefit plans. The deduction for contributions to a defined benefit plan is based on actuarial assumptions and computations. Consequently, an actuary must figure your deduction limit.

In figuring the deduction for contributions, you cannot take into account any contributions or benefits that are more than the limits discussed earlier under Limits on Contributions and Benefits.

Deduction limit for multiple plans. If you contribute to both a defined contribution plan and a defined benefit plan and at least one employee is covered by both plans, your deduction for those contributions is limited. Your deduction cannot be more than the greater of the following amounts.

• 25% of the compensation paid (or accrued) during the year to your eligible employees participating in the plan. You must reduce this 25% limit in figuring the deduction for contributions you make for your own account.
• Your contributions to the defined benefit plans, but not more than the amount needed to meet the year's minimum funding standard for any of these plans.

For this rule, a SEP is treated as a separate profit-sharing (defined contribution) plan.

Deduction Limit for Self-Employed Individuals

If you make contributions for yourself, you need to make a special computation to figure your maximum deduction for these contributions. Compensation is your net earnings from self-employment, defined earlier under Definitions You Need To Know. This definition takes into account both the following items.

• The deduction for one-half of your self-employment tax.
• The deduction for contributions on behalf of yourself to the plan.

The deduction for your own contributions and your net earnings depend on each other. For this reason, you determine the deduction for your own contributions indirectly by reducing the contribution rate called for in your plan. To do this, use either the Rate Table for Self-Employed or the Rate Worksheet for Self-Employed in the Appendix. Then figure your maximum deduction by using the Deduction Worksheet for Self-Employed in the Appendix.

Multiple plans. The deduction limit for multiple plans (discussed earlier) also applies to contributions you make as an employer on your own behalf.

Where To Deduct Contributions

Deduct the contributions you make for your common-law employees on Schedule C (Form 1040), on Schedule F (Form 1040), on Form 1065, Form 1120, on Form 1120-A, or on Form 1120S, whichever applies.

You take the deduction for contributions for yourself on line 29 of Form 1040.

If you are a partner, the partnership passes its deduction to you for the contributions it made for you. The partnership will report these contributions on Schedule K-1 (Form 1065). You deduct them on line 29 of Form 1040.

Carryover of Excess Contributions

If you contribute more to the plans than you can deduct for the year, you can carry over and deduct the excess in later years, combined with your contributions for those years. Your combined deduction in a later year is limited to 25% of the participating employees' compensation for that year. The limit is 15% if you have only profit-sharing plans (including SEPs). However, these percentage limits must be reduced to figure your maximum deduction for contributions you make for yourself. See Deduction Limit for Self-Employed Individuals, earlier. The amount you carry over and deduct may be subject to the excise tax discussed next.

Table 2. Carryover of Excess Contributions Illustrated

Table 2 illustrates the carryover of excess contributions to a profit-sharing plan.

Excise Tax for Nondeductible (Excess) Contributions

If you contribute more than your deduction limit to a retirement plan, you have made nondeductible contributions and you may be liable for an excise tax. In general, a 10% excise tax applies to nondeductible contributions made to qualified pension, profit-sharing, stock bonus, or annuity plans and to SEPs.

Special rule for self-employed individuals. The 10% excise tax does not apply to any contribution made to meet the minimum funding requirements in a money purchase pension plan or a defined benefit plan. Even if that contribution is more than your earned income from the trade or business for which the plan is set up, the difference is not subject to this excise tax. See Minimum Funding Requirement, earlier.

Exception. If contributions to one or more defined contribution plans are not deductible only because they are more than the combined plan deduction limit, the 10% excise tax does not apply to the extent the difference is not more than the greater of the following amounts.

• 6% of the participants' compensation for the year.
• The sum of employer matching contributions and the elective deferrals to a 401(k) plan.

Reporting the tax. You must report the tax on your nondeductible contributions on Form 5330. Form 5330 includes a computation of the tax. See the separate instructions for completing the form.

Elective Deferrals (401(k) Plans)

Your qualified plan can include a cash or deferred arrangement (401(k) plan) under which participants can choose to have you contribute part of their before-tax compensation to the plan rather than receive the compensation in cash. (As a participant in the plan, you can contribute part of your before-tax net earnings from the business.) This contribution is called an "elective deferral" because participants choose (elect) to set aside the money, and they defer the tax on the money until it is distributed to them.

In general, a qualified plan can include a 401(k) plan only if the qualified plan is one of the following plans.

• A profit-sharing plan.
• A money purchase pension plan in existence on June 27, 1974, that included a salary reduction arrangement on that date.

Automatic enrollment in a 401(k) plan. Your 401(k) plan can have an automatic enrollment feature. Under this feature, you can automatically reduce an employee's pay by a fixed percentage and contribute that amount to the 401(k) plan on his or her behalf unless the employee affirmatively chooses not to have his or her pay reduced or chooses to have it reduced by a different percentage. These contributions qualify as elective deferrals. For more information about 401(k) plans with an automatic enrollment feature, see Revenue Ruling 2000-8 in Internal Revenue Bulletin 2000-7.

Partnership. A partnership can have a 401(k) plan.

Restriction on conditions of participation. The plan cannot require, as a condition of participation, that an employee complete more than 1 year of service.

Matching contributions. If your plan permits, you can make matching contributions for an employee who makes an elective deferral to your 401(k) plan. For example, the plan might provide that you will contribute 50 cents for each dollar your participating employees choose to defer under your 401(k) plan.

Nonelective contributions. You can, under a qualified 401(k) plan, also make contributions (other than matching contributions) for your participating employees without giving them the choice to take cash instead.

Employee compensation limit. No more than $170,000 of the employee's compensation can be taken into account when figuring contributions.

SIMPLE 401(k) plan. If you had 100 or fewer employees who earned $5,000 or more in compensation during the preceding year, you may be able to set up a SIMPLE 401(k) plan. A SIMPLE 401(k) plan is not subject to the nondiscrimination and top-heavy plan requirements discussed later under Qualification Rules. For details about SIMPLE 401(k) plans, see SIMPLE 401(k) Plan earlier under SIMPLE Plans.

Limit on Elective Deferrals

There is a limit on the amount an employee can defer each year under these plans. This limit applies without regard to community property laws. Your plan must provide that your employees cannot defer more than the limit that applies for a particular year. For 2000, the basic limit on elective deferrals is $10,500. This limit is subject to annual increases to reflect inflation (as measured by the Consumer Price Index). If, in conjunction with other plans, the deferral limit is exceeded, the difference is included in the employee's gross income.

Self-employed individual's matching contributions. Matching contributions to a 401(k) plan on behalf of a self-employed individual are not subject to the limit on elective deferrals. These matching contributions receive the same treatment as the matching contributions for other employees.

Treatment of contributions. Your contributions to a 401(k) plan are generally deductible by you and tax free to participating employees until distributed from the plan. Participating employees have a nonforfeitable right to the accrued benefit resulting from these contributions. Deferrals are included in wages for social security, Medicare, and federal unemployment (FUTA) tax.

Reporting on Form W-2. You must report the total deferred in boxes 3, 5, and 13 of your employee's Form W-2. See the Form W-2 instructions.

Treatment of Excess Deferrals

If the total of an employee's deferrals is more than the limit for 2000, the employee can have the difference (called an excess deferral) paid out of any of the plans that permit these distributions. He or she must notify the plan by March 1, 2001, of the amount to be paid from each plan. The plan must then pay the employee that amount by April 16, 2001.

Excess withdrawn by April 16. If the employee takes out the excess deferral by April 16, 2001, it is not reported again by including it in the employee's gross income for 2001. However, any income earned on the excess deferral taken out is taxable in the tax year in which it is taken out. The distribution is not subject to the additional 10% tax on early distributions.

If the employee takes out part of the excess deferral and the income on it, the distribution is treated as made proportionately from the excess deferral and the income.

Even if the employee takes out the excess deferral by April 16, the amount is considered contributed for satisfying (or not satisfying) the nondiscrimination requirements of the plan. See Contributions or benefits must not discriminate, later, under Qualification Rules.

Excess not withdrawn by April 16. If the employee does not take out the excess deferral by April 16, 2001, the excess, though taxable in 2000, is not included in the employee's cost basis in figuring the taxable amount of any eventual benefits or distributions under the plan. In effect, an excess deferral left in the plan is taxed twice, once when contributed and again when distributed. Also, if the entire deferral is allowed to stay in the plan, the plan may not be a qualified plan.

Reporting corrective distributions on Form 1099-R. Report corrective distributions of excess deferrals (including any earnings) on Form 1099-R. For specific information about reporting corrective distributions, see the 2000 Instructions for Forms 1099, 1098, 5498, and W-2G.

Tax on excess contributions of highly compensated employees. The law provides tests to detect discrimination in a plan. If tests, such as the actual deferral percentage test (ADP test) (see section 401(k)(3)) and the actual contribution percentage test (ACP test) (see section 401(m)(2)), show that contributions for highly compensated employees are more than the test limits for these contributions, the employer may have to pay a 10% excise tax. Report the tax on Form 5330.

The tax for the year is 10% of the excess contributions for the plan year ending in your tax year. Excess contributions are elective deferrals, employee contributions, or employer matching or nonelective contributions that are more than the amount permitted under the ADP or ACP test.

See Notice 98-1 for further guidance and transition relief relating to recent statutory amendments to the nondiscrimination rules under sections 401(k) and 401(m). Notice 98-1 is in Cumulative Bulletin 1998-1.

Distributions

Amounts paid to plan participants from a qualified plan are called distributions. Distributions may be nonperiodic, such as lump-sum distributions, or periodic, such as annuity payments. Also, certain loans may be treated as distributions. See Loans Treated as Distributions in Publication 575.

Required Distributions

A qualified plan must provide that each participant will either:

• Receive his or her entire interest (benefits) in the plan by the required beginning date (defined later), or
• Begin receiving regular periodic distributions by the required beginning date in annual amounts calculated to distribute the participant's entire interest (benefits) over his or her life expectancy or over the joint life expectancy of the participant and the designated beneficiary (or over a shorter period).

These distribution rules apply individually to each qualified plan. You cannot satisfy the requirement for one plan by taking a distribution from another. These rules may be incorporated in the plan by reference. The plan must provide that these rules override any inconsistent distribution options previously offered.

Minimum distribution. If the account balance of a qualified plan participant is to be distributed (other than as an annuity), the plan administrator must figure the minimum amount required to be distributed each distribution calendar year. This minimum is figured by dividing the account balance by the applicable life expectancy. For details on figuring the minimum distribution, see Tax on Excess Accumulation in Publication 575.

Minimum distribution incidental benefit requirement. Minimum distributions must also meet the minimum distribution incidental benefit requirement. This requirement ensures the plan is used primarily to provide retirement benefits to the employee. After the employee's death, only "incidental" benefits are expected to remain for distribution to the employee's beneficiary (or beneficiaries). For more information about this and other distribution requirements, see Publication 575.

Required beginning date. Generally, each participant must receive his or her entire benefits in the plan or begin to receive periodic distributions of benefits from the plan by the required beginning date.

A participant must begin to receive distributions from his or her qualified retirement plan by April 1 of the first year after the later of the following years.

1. Calendar year in which he or she reaches age 70 1/2.
2. Calendar year in which he or she retires.

However, if the participant is a 5% owner of the employer maintaining the plan or if the distribution is from a traditional IRA, the participant must begin receiving distributions by April 1 of the first year after the calendar year in which the participant reached age 70 1/2. For more information, see Tax on Excess Accumulation in Publication 575.

Distributions after the starting year. The distribution required to be made by April 1 is treated as a distribution for the starting year. (The starting year is the year in which the participant meets (1) or (2) above, whichever applies.) After the starting year, the participant must receive the required distribution for each year by December 31 of that year. If no distribution is made in the starting year, required distributions for 2 years must be made in the next year (one by April 1 and one by December 31).

Distributions after participant's death. See Publication 575 for the special rules covering distributions made after the death of a participant.

Distributions From 401(k) Plans

Generally, distributions may not be made until one of the following occurs.

• The employee retires, dies, becomes disabled, or otherwise separates from service.
• The plan ends and no other defined contribution plan is established or continued.
• In the case of a 401(k) plan that is part of a profit-sharing plan, the employee reaches age 59 1/2 or suffers financial hardship. For the rules on hardship distributions, including the limits on them, see section 1.401(k)-1(d)(2) of the regulations.

Certain distributions listed above may be subject to the tax on early distributions discussed later.

Qualified domestic relations order (QDRO). These distribution restrictions do not apply if the distribution is to an alternate payee under the terms of a QDRO, which is defined in Publication 575.

Tax Treatment of Distributions

Distributions from a qualified plan minus a prorated part of any cost basis are subject to income tax in the year they are distributed. Since most recipients have no cost basis, a distribution is generally fully taxable. An exception is a distribution that is properly rolled over as discussed next under Rollover.

The tax treatment of distributions depends on whether they are made periodically over several years or life (periodic distributions) or are nonperiodic distributions. See Taxation of Periodic Payments and Taxation of Nonperiodic Payments in Publication 575 for a detailed description of how distributions are taxed, including the 10-year tax option or capital gain treatment of a lump-sum distribution.

The 5-year tax option is repealed for tax years beginning after 1999.

Rollover. The recipient of an eligible rollover distribution from a qualified plan can defer the tax on it by rolling it over into a traditional IRA or another eligible retirement plan. However, it may be subject to withholding as discussed under Withholding requirement, later.

Eligible rollover distribution. This is a distribution of all or any part of an employee's balance in a qualified retirement plan that is not any of the following.

1. A required minimum distribution. See Required Distributions, earlier.
2. Any of a series of substantially equal payments made at least once a year over any of the following periods.
   1. The employee's life or life expectancy.
   2. The joint lives or life expectancies of the employee and beneficiary.
   3. A period of 10 years or more.
3. A hardship distribution from a 401(k) plan.
4. The portion of a distribution that represents the return of an employee's nondeductible contributions to the plan. See Employee Contributions, earlier.
5. A corrective distribution of excess contributions or deferrals under a 401(k) plan and any income allocable to the excess, or of excess annual additions and any allocable gains. See Correcting excess annual additions, earlier, under Limits on Contributions and Benefits.
6. Loans treated as distributions.
7. Dividends on employer securities.
8. The cost of life insurance coverage.

More information. For more information about rollovers, see Rollovers in Publications 575 and 590.

Withholding requirement. If, during a year, a qualified plan pays to a participant one or more eligible rollover distributions (defined earlier) that are reasonably expected to total $200 or more, the payor must withhold 20% of each distribution for federal income tax.

Exceptions. If, instead of having the distribution paid to him or her, the participant chooses to have the plan pay it directly to an IRA or another eligible retirement plan (a direct rollover), no withholding is required.

If the distribution is not an eligible rollover distribution, defined earlier, the 20% withholding requirement does not apply. Other withholding rules apply to distributions such as long-term periodic distributions and required distributions (periodic or nonperiodic). However, the participant can still choose not to have tax withheld from these distributions. If the participant does not make this choice, the following withholding rules apply.

• For periodic distributions, withholding is based on their treatment as wages.
• For nonperiodic distributions, 10% of the taxable part is withheld.

Estimated tax payments. If no income tax is withheld or not enough tax is withheld, the recipient of a distribution may have to make estimated tax payments. For more information, see Withholding Tax and Estimated Tax in Publication 575.

Tax on Early Distributions

If a distribution is made to an employee under the plan before he or she reaches age 59 1/2, the employee may have to pay a 10% additional tax on the distribution. This tax applies to the amount received that the employee must include in income.

Exceptions. The 10% tax will not apply if distributions before age 59 1/2 are made in any of the following circumstances.

• Made to a beneficiary (or to the estate of the employee) on or after the death of the employee.
• Due to the employee having a qualifying disability.
• Part of a series of substantially equal periodic payments beginning after separation from service and made at least annually for the life or life expectancy of the employee or the joint lives or life expectancies of the employee and his or her designated beneficiary. (The payments under this exception, except in the case of death or disability, must continue for at least 5 years or until the employee reaches age 59 1/2, whichever is the longer period.)
• Made to an employee after separation from service if the separation occurred during or after the calendar year in which the employee reached age 55.
• Made to an alternate payee under a qualified domestic relations order (QDRO).
• Made to an employee for medical care up to the amount allowable as a medical expense deduction (determined without regard to whether the employee itemizes deductions).
• Timely made to reduce excess contributions under a 401(k) plan.
• Timely made to reduce excess employee or matching employer contributions (excess aggregate contributions).
• Timely made to reduce excess elective deferrals.
• Made because of an IRS levy on the plan.

Reporting the tax. To report the tax on early distributions, file Form 5329. See the form instructions for additional information about this tax.

Tax on Excess Benefits

If you are or have been a 5% owner of the business maintaining the plan, amounts you receive at any age that are more than the benefits provided for you under the plan formula are subject to an additional tax. This tax also applies to amounts received by your successor. The tax is 10% of the excess benefit includible in income.

5% owner. You are a 5% owner if you meet either of the following conditions at any time during the 5 plan years immediately before the plan year that ends within the tax year you receive the distribution.

• You own more than 5% of the capital or profits interest in the employer.
• You own or are considered to own more than 5% of the outstanding stock (or more than 5% of the total voting power of all stock) of the employer.

Reporting the tax. Include on Form 1040, line 57, any tax you owe for an excess benefit. On the dotted line next to the total, write "Sec. 72(m)(5)" and write in the amount.

Lump-sum distribution. The amount subject to the additional tax is not eligible for the optional methods of figuring income tax on a lump-sum distribution. The optional methods are discussed under Lump-Sum Distributions in Publication 575.

Excise Tax on Reversion of Plan Assets

A 20% or 50% excise tax is generally imposed on the cash and fair market value of other property an employer receives directly or indirectly from a qualified plan. If you owe this tax, report it in Part XIII of Form 5330. See the form instructions for more information.

Prohibited Transactions

Prohibited transactions are transactions between the plan and a disqualified person that are prohibited by law. (However, see Exemption, later.) If you are a disqualified person who takes part in a prohibited transaction, you must pay a tax (discussed later).

Prohibited transactions generally include the following transactions.

1. A transfer of plan income or assets to, or use of them by or for the benefit of, a disqualified person.
2. Any act of a fiduciary by which he or she deals with plan income or assets in his or her own interest.
3. The receipt of consideration by a fiduciary for his or her own account from any party dealing with the plan in a transaction that involves plan income or assets.
4. Any of the following acts between the plan and a disqualified person.
   1. Selling, exchanging, or leasing property.
   2. Lending money or extending credit.
   3. Furnishing goods, services, or facilities.

Exemption. Certain transactions are exempt from being treated as prohibited transactions. For example, a prohibited transaction does not take place if you are a disqualified person and receive any benefit to which you are entitled as a plan participant or beneficiary. However, the benefit must be figured and paid under the same terms as for all other participants and beneficiaries. For other transactions that are exempt, see section 4975 and its regulations.

Disqualified person. You are a disqualified person if you are any of the following.

1. A fiduciary of the plan.
2. A person providing services to the plan.
3. An employer, any of whose employees are covered by the plan.
4. An employee organization, any of whose members are covered by the plan.
5. Any direct or indirect owner of 50% or more of any of the following.
   1. The combined voting power of all classes of stock entitled to vote, or the total value of shares of all classes of stock of a corporation.
   2. A capital interest or profits interest of a partnership.
   3. The beneficial interest of a trust or unincorporated enterprise that is an employer or an employee organization described in (3) or (4).
6. A member of the family of any individual described in (1), (2), (3), or (5). (A member of a family is the spouse, ancestor, lineal descendant, or any spouse of a lineal descendant.)
7. A corporation, partnership, trust, or estate of which (or in which) any direct or indirect owner holds 50% or more of the interest described in 5(a), (b), or (c). For (c), the beneficial interest of the trust or estate is directly or indirectly owned, or held by persons described in (1) through (5).
8. An officer, director (or an individual having powers or responsibilities similar to those of officers or directors), a 10% or more shareholder, or highly compensated employee (earning 10% or more of the yearly wages of an employer) of a person described in (3), (4), (5), or (7).
9. A 10% or more (in capital or profits) partner or joint venturer of a person described in (3), (4), (5), or (7).
10. Any disqualified person, as described in (1) through (9) above, who is a disqualified person with respect to any plan to which a section 501(c)(22) trust is permitted to make payments under section 4223 of ERISA.

Taxes on Prohibited Transactions

The initial tax on a prohibited transaction is 15% of the amount involved for each year (or part of a year) in the taxable period. If the transaction is not corrected within the taxable period, an additional tax of 100% of the amount involved is imposed. For information on correcting the transaction, see Correcting a prohibited transaction, later.

Both taxes are payable by any disqualified person who participated in the transaction (other than a fiduciary acting only as such). If more than one person takes part in the transaction, each person can be jointly and severally liable for the entire tax.

Amount involved. The amount involved in a prohibited transaction is the greater of the following amounts.

• The money and fair market value of any property given.
• The money and fair market value of any property received.

If services are performed, the amount involved is any excess compensation given or received.

Taxable period. The taxable period starts on the transaction date and ends on the earliest of the following days.

• The day the IRS mails a notice of deficiency for the tax.
• The day the IRS assesses the tax.
• The day the correction of the transaction is completed.

Payment of the 15% tax. Pay the 15% tax with Form 5330.

Correcting a prohibited transaction. If you are a disqualified person who participated in a prohibited transaction, you can avoid the 100% tax by correcting the transaction as soon as possible. Correcting the transaction means undoing it as much as you can without putting the plan in a worse financial position than if you had acted under the highest fiduciary standards.

Correction period. If the prohibited transaction is not corrected during the taxable period, you usually have an additional 90 days after the day the IRS mails a notice of deficiency for the 100% tax to correct the transaction. This correction period (the taxable period plus the 90 days) can be extended if either of the following occurs.

• The IRS grants reasonable time needed to correct the transaction.
• You petition the Tax Court.

If you correct the transaction within this period, the IRS will abate, credit, or refund the 100% tax.

Reporting Requirements

You may have to file an annual return/report form by the last day of the 7th month after the plan year ends. See the following list of forms to choose the right form for your plan.

Form 5500-EZ. You can use Form 5500-EZ if the plan meets all the following conditions.

• The plan is a one-participant plan, defined below.
• The plan meets the minimum coverage requirements of section 410(b) without being combined with any other plan you may have that covers other employees of your business.
• The plan does not provide benefits for anyone except you, you and your spouse, or one or more partners and their spouses.
• The plan does not cover a business that is a member of an affiliated service group, a controlled group of corporations, or a group of businesses under common control.
• The plan does not cover a business that leases employees.

One-participant plan. Your plan is a one-participant plan if, as of the first day of the plan year for which the form is filed, either of the following is true.

• The plan covers only you (or you and your spouse) and you (or you and your spouse) own the entire business (whether incorporated or unincorporated).
• The plan covers only one or more partners (or partner(s) and spouse(s)) in a business partnership.

Form 5500-EZ not required. You do not have to file Form 5500-EZ (or Form 5500) if you meet the conditions mentioned above and either of the following conditions.

• You have a one-participant plan that had total plan assets of $100,000 or less at the end of every plan year beginning after December 31, 1993.
• You have two or more one-participant plans that together had total plan assets of $100,000 or less at the end of every plan year beginning after December 31, 1993.

Example. You are a sole proprietor and your plan meets all the conditions for filing Form 5500-EZ. The total plan assets are more than $100,000. You should file Form 5500-EZ.

All one-participant plans must file Form 5500-EZ for their final plan year, even if the total plan assets have always been less than $100,000. The final plan year is the year in which distribution of all plan assets is completed.

Form 5500. If you do not meet the requirements for filing Form 5500-EZ, you must file Form 5500.

Schedule A (Form 5500). If any plan benefits are provided by an insurance company, insurance service, or similar organization, complete and attach Schedule A (Form 5500), Insurance Information, to Form 5500. Schedule A is not needed for a plan that covers only one of the following.

1. An individual or an individual and spouse who wholly own the trade or business, whether incorporated or unincorporated.
2. Partners in a partnership or the partners and their spouses.

Do not file a Schedule A (Form 5500) with a Form 5500-EZ.

Schedule B (Form 5500). For most defined benefit plans, complete and attach Schedule B (Form 5500), Actuarial Information, to Form 5500 or Form 5500-EZ.

Schedule P (Form 5500). This schedule is used by a fiduciary (trustee or custodian) of a trust described in section 401(a) or a custodial account described in section 401(f) to protect it under the statute of limitations provided in section 6501(a). The filing of a completed Schedule P (Form 5500), Annual Return of Fiduciary of Employee Benefit Trust, by the fiduciary satisfies the annual filing requirement under section 6033(a) for the trust or custodial account created as part of a qualified plan. This filing starts the running of the 3-year limitation period that applies to the trust or custodial account. For this protection, the trust or custodial account must qualify under section 401(a) and be exempt from tax under section 501(a). The fiduciary should file, under section 6033(a), a Schedule P as an attachment to Form 5500 or Form 5500-EZ for the plan year in which the trust year ends. The fiduciary cannot file Schedule P separately. See the Schedule P instructions for more information.

Form 5310. If you terminate your plan and are the plan sponsor or plan administrator, you can file Form 5310, Application for Determination for Terminating Plan. Your application must be accompanied by the appropriate user fee and Form 8717, User Fee for Employee Plan Determination Letter Request.

More information. For more information about reporting requirements, see the forms and their instructions.

Qualification Rules

To qualify for the tax benefits available to qualified plans, a plan must meet certain requirements (qualification rules) of the tax law. Generally, unless you write your own plan, the financial institution that provided your plan will take the continuing responsibility for meeting qualification rules that are later changed. The following is a brief overview of important qualification rules that generally have not yet been discussed. It is not intended to be all-inclusive. See Setting Up a Qualified Plan, earlier.

Generally, the following qualification rules also apply to a SIMPLE 401(k) retirement plan. A SIMPLE 401(k) plan is, however, not subject to the top-heavy plan rules and nondiscrimination rules if the plan satisfies the provisions discussed earlier under SIMPLE 401(k) Plan.

Plan assets must not be diverted. Your plan must make it impossible for its assets to be used for, or diverted to, purposes other than for the benefit of employees and their beneficiaries. As a general rule, the assets cannot be diverted to the employer.

Minimum coverage requirement must be met. To be a qualified plan, a defined benefit plan must benefit at least the lesser of the following.

1. 50 employees.
2. The greater of:
   1. 40% of all employees, or
   2. Two employees.

If there is only one employee, the plan must benefit that employee.

Contributions or benefits must not discriminate. Under the plan, contributions or benefits to be provided must not discriminate in favor of highly compensated employees.

Contribution and benefit limits must not be more than certain limits. Your plan must not provide for contributions or benefits that are more than certain limits. The limits apply to the annual contributions and other additions to the account of a participant in a defined contribution plan and to the annual benefit payable to a participant in a defined benefit plan. These limits were discussed earlier under Contributions.

Minimum vesting standard must be met. Your plan must satisfy certain requirements regarding when benefits vest. A benefit is vested (you have a fixed right to it) when it becomes nonforfeitable. A benefit is nonforfeitable if it cannot be lost upon the happening, or failure to happen, of any event.

Leased employee. A leased employee, defined earlier under Definitions You Need To Know, who performs services for you (recipient of the services) is treated as your employee for certain plan qualification rules. These rules include those in all the following areas.

• Nondiscrimination in coverage, contributions, and benefits.
• Minimum age and service requirements.
• Vesting.
• Limits on contributions and benefits.
• Top-heavy plan requirements.

Contributions or benefits provided by the leasing organization for services performed for you are treated as provided by you.

Benefit payment must begin when required. Your plan must provide that, unless the participant chooses otherwise, the payment of benefits to the participant must begin within 60 days after the close of the latest of the following periods.

• The plan year in which the participant reaches the earlier of age 65 or the normal retirement age specified in the plan.
• The plan year in which the 10th anniversary of the year in which the participant began participating in the plan occurs.
• The plan year in which the participant separates from service.

Early retirement. Your plan can provide for payment of retirement benefits before the normal retirement age. If your plan offers an early retirement benefit, a participant who separates from service before satisfying the early retirement age requirement is entitled to that benefit if he or she meets both the following requirements.

• Satisfies the service requirement for the early retirement benefit.
• Separates from service with a nonforfeitable right to an accrued benefit. The benefit, which may be actuarially reduced, is payable when the early retirement age requirement is met.

Survivor benefits. Defined benefit and certain money purchase pension plans must provide automatic survivor benefits in both the following forms.

• A qualified joint and survivor annuity for a vested participant who does not die before the annuity starting date.
• A qualified pre-retirement survivor annuity for a vested participant who dies before the annuity starting date and who has a surviving spouse.

The automatic survivor benefit also applies to any participant under a profit-sharing plan unless all the following conditions are met.

• The participant does not choose benefits in the form of a life annuity.
• The plan pays the full vested account balance to the participant's surviving spouse (or other beneficiary if the surviving spouse consents or if there is no surviving spouse) if the participant dies.
• The plan is not a direct or indirect transferee of a plan that must provide automatic survivor benefits.

Loan secured by benefits. If survivor benefits are required for a spouse under a plan, he or she must consent to a loan that uses as security the accrued benefits in the plan.

Waiver of survivor benefits. Each plan participant may be permitted to waive the joint and survivor annuity or the pre-retirement survivor annuity (or both), but only if the participant has the written consent of the spouse. The plan also must allow the participant to withdraw the waiver. The spouse's consent must be witnessed by a plan representative or notary public.

Waiver of 30-day waiting period before annuity starting date. A plan may permit a participant to waive (with spousal consent) the 30-day minimum waiting period after a written explanation of the terms and conditions of a joint and survivor annuity is provided to each participant.

The waiver is allowed only if the distribution begins more than 7 days after the written explanation is provided.

Involuntary cash-out of benefits not more than dollar limit. A plan may provide for the immediate distribution of the participant's benefit under the plan if the present value of the benefit is not greater than $5,000.

However, the distribution cannot be made after the annuity starting date unless the participant and the spouse (or surviving spouse of a participant who died) consent in writing to the distribution. If the present value is greater than $5,000, the plan must have the written consent of the participant and the spouse (or surviving spouse) for any immediate distribution of the benefit.

Consolidation, merger, or transfer of assets or liabilities. Your plan must provide that, in the case of any merger or consolidation with, or transfer of assets or liabilities to, any other plan, each participant would (if the plan then terminated) receive a benefit equal to or more than the benefit he or she would have been entitled to just before the merger, etc. (if the plan had then terminated).

Benefits must not be assigned or alienated. Your plan must provide that its benefits cannot be assigned or alienated.

Exception for certain loans. A loan from the plan (not from a third party) to a participant or beneficiary is not treated as an assignment or alienation if the loan is secured by the participant's accrued nonforfeitable benefit and is exempt from the tax on prohibited transactions under section 4975(d)(1) or would be exempt if the participant were a disqualified person. A disqualified person is defined earlier under Prohibited Transactions.

Exception for qualified domestic relations order (QDRO). Compliance with a QDRO does not result in a prohibited assignment or alienation of benefits. QDRO is defined in Publication 575.

Payments to an alternate payee under a QDRO before the participant attains age 59 1/2 are not subject to the 10% additional tax that would otherwise apply under certain circumstances. The interest of the alternate payee is not taken into account in determining whether a distribution to the participant is a lump-sum distribution. Benefits distributed to an alternate payee under a QDRO can be rolled over tax free to an individual retirement account or to an individual retirement annuity.

No benefit reduction for social security increases. Your plan must not permit a benefit reduction for a post-separation increase in the social security benefit level or wage base for any participant or beneficiary who is receiving benefits under your plan, or who is separated from service and has nonforfeitable rights to benefits. This rule also applies to plans supplementing the benefits provided by other federal or state laws.

Elective deferrals must be limited. If your plan provides for elective deferrals, it must limit those deferrals to the amount in effect for that particular year. See Limit on Elective Deferrals, earlier.

Top-heavy plan requirements. A top-heavy plan is one that mainly favors partners, sole proprietors, and other key employees.

A plan is top heavy for any plan year for which the total value of accrued benefits or account balances of key employees is more than 60% of the total value of accrued benefits or account balances of all employees. Additional requirements apply to a top-heavy plan primarily to provide minimum benefits or contributions for non-key employees covered by the plan.

Most qualified plans, whether or not top heavy, must contain provisions that meet the top-heavy requirements and will take effect in plan years in which the plans are top heavy. These qualification requirements for top-heavy plans are explained in section 416 and its regulations.

SIMPLE 401(k) plan exception. The top-heavy plan requirements do not apply to SIMPLE 401(k) plans.

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