Quiz 25: Tax Qualification Requirements


Pension plans are the income plans designed by employer with an intention of providing a continuous income to the employees after retirement. These plans are subject to tax advantages for the funds contributed in it however, a plan is required to achieve a qualified status in order to get benefited for such advantages. To qualify a plan, the sponsor is required to meet the requirements stated by Internal Revenue Code (IRC) so as to achieve the tax qualified status. One of the requirements includes Non-discrimination. It refers to non-discriminatory practice to be followed in favour of highly compensated employees. Highly compensated employees (HCEs) refer to the executives and senior management employees in a company. They are deemed to be highly compensated, if 1. They holds 5% ownership in the company in current or preceding year, or 2. Were compensated $115000 in the preceding year which is included in top 20% of compensated employees. It is necessary to determine such HCEs so as to properly conduct the non-discriminating test as stated in section 415 of IRC. It helps in establishing equity among the employees by not allowing any favourable contribution. Thus, determining of HCEs is necessary in a pension plan in order to fulfil the non-discriminatory requirement stated by IRC and achieie tax qualified status.

Pension plan provided by employer to employees are subject to various tax benefits that can be obtained only when a plan qualifies under its governing body i.e. Internal Revenue Code (IRC). In order to get a qualified status, a plan has to meet the requirement stated by section 401(a) of IRC. Such requirements are as follows- 1. The plan has been obtained for the purpose of employee's and there beneficiaries benefits. 2. Such plan cannot be diverted for any other purpose apart from the employees and beneficiary related to it. 3. Non-discrimination policy should be followed in case of providing contribution to all the employees including executives. 4. In case of defined benefit approach in a pension plan, minimum number of employees should be added as participant. 5. The elective contribution i.e. before tax contribution must be made in a stated maximum amount eligible for deductions. 6. Minimum age and service period of an employee should only be followed and maintained. 7. Benefits should be vested only after a specified period of service. 8. Distribution of such benefits are also required to be made in the stated guidelines without any discrimination. 9. In case of plan merger or transfer of plan assets, accrued benefits must be protected up to amount funded. 10. In case of defined contribution plan, each participant's account should be maintained separately. Apart from these, there are few other requirements that must be met by a pension plan to obtain a tax qualified status.

An employer seeking administrative simplicity as a plan objective has many possible routes to achieve this outcome. Following passage of the Small Business Job Protection Act of 1996, a small employer could utilize a SIMPLE plan and avoid nondiscrimination testing altogether. Alternatively an employer could require mandatory participation and configure a uniform benefit formula whereby the plan would easily pass nondiscrimination coverage testing requirements and also use a design-based safe harbor for nondiscrimination amount testing. Following passage of the PPA of 2006 a safe harbor plan design is available if a plan contains an automatic enrollment feature conforming to certain requirements. However, by choosing a safe harbor design an employer may be foregoing cost saving opportunities that could be achieved by incurring some additional administrative complexity associated with nondiscrimination testing. Also, there may be certain types of employees who will not have a long-term association with the employer and for whom the employer sees no need for providing retirement plan benefits. Balancing administrative complexity with cost-saving opportunities under a more complicated plan is often the reality for most employers.

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