4. Qualified Plans

Topics

This chapter discusses:

• Kinds of plans
• Setting up a qualified plan
• Minimum funding requirement
• Contributions
• Employer deduction
• Elective deferrals (401(k) plans)
• Distributions
• Prohibited transactions
• Reporting requirements
• Qualification rules

Useful Items You may want to see:

Publication

• 575   Pension and Annuity Income

Forms (and Instructions)

• Schedule C (Form 1040)   Profit or Loss From Business
• Schedule F (Form 1040)   Profit or Loss From Farming
• Schedule K-1 (Form 1065)   Partner's Share of Income, Credits, Deductions, etc.
• W-2   Wage and Tax Statement
• 1040   U.S. Individual Income Tax Return
• 1099-R   Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.
• 5330   Return of Excise Taxes Related to Employee Benefit Plans
• Form 5500   Annual Return/Report of Employee Benefit Plan
• 5500-EZ   Annual Return of One-Participant (Owners and Their Spouses) Retirement Plan
• Schedule A (Form 5500)   Insurance Information

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 Participation, under Qualification Rules, 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. The following revenue procedure and announcement may help you decide whether to apply for approval.

• Revenue Procedure 2001-6 in Internal Revenue Bulletin 2001-1.
• Announcement 2001-77 in Internal Revenue Bulletin 2001-30.

Internal Revenue Bulletins are available on the IRS web site at www.irs.gov. They are also available at most IRS offices and at certain libraries.

User fee.   The fee mentioned earlier for requesting a determination letter does not apply to certain requests made after December 31, 2001, by employers who have 100 or fewer employees, at least one of whom is a non-highly compensated employee participating in the plan. The fee does not apply to requests made by the later of the following dates.

• The end of the 5th plan year the plan is in effect.
• The end of any remedial amendment period for the plan that begins within the first 5 plan years.

The request cannot be made by the sponsor of a prototype or similar plan the sponsor intends to market to participating employers.

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.

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 8½ 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 2001, 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. $140,000 ($160,000 for 2002).

Defined contribution plan.   For 2001, 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. $35,000.

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

For 2002, the percentage in (1) increases to 100% and the amount in (2) increases to $40,000. Also for 2002, the maximum compensation that can be taken into account for this limit is $200,000.

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.

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