Retirement Plan Fundamentals

Module 1: Lifecycle of a Plan

Copyright ©2017. All rights reserved. ASPPA is a not-for-profit professional society. The materials
contained herein are intended for instruction only and are not a substitute for professional advice.
Module Overview

Unit 1: Why Do Employers Establish Qualified Plans?

Unit 2: What Is the Process for Setting Up the Plan?
Unit 3: Who Is Covered?
Unit 4: How Does Money Get Into the Plan?
Unit 5: When Can People Take Money Out?
Unit 6: How Does a Plan Maintain Tax Qualification?
Unit 7: Who Helps Manage the Plan?

Introduction
You are probably familiar with retirement plans from the employee perspective; perhaps you’ve had the
opportunity to join a 401(k) plan through your work, or have family members who receive benefits from a
pension plan, or perhaps you even follow the latest trends in retirement planning and attempts to
regulate the industry through legislation.

If you are taking the Retirement Plan Fundamentals course, it is because you have joined the ranks of the
individuals who see retirement plans from a different perspective – you’re about to see the tremendous
amount of skills and knowledge that are required to administer a plan. The retirement plan industry is full
of complexity, codes, and caveats. Professionals in retirement plan administration must stay on top of
frequently changing laws and guidelines, navigate an intricate web of definitions, and develop an
understanding of plans that reaches from the minutia of employee birth dates to the broad goals of plan
design for the employer.

Experts in the industry spend years developing an understanding of the Internal Revenue Code,
Department of Labor regulations, and complex definitions and calculations. They know how to manage
relationships between the many roles that must communicate together to ensure a plan is properly
administered, the employer’s goals are met, and employees’ retirement savings are protected.

The RPF is the first step to developing this understanding and its related skills. There is no quick and easy
way to master the breadth and depth of knowledge this industry requires if it is your goal to make this
your profession. However, this course can give you a quick survey of the industry from behind the scenes,
transforming the way you look at retirement plans from someone on the outside to a true insider.

The Lifecycle of a Plan module introduces the world of retirement plans from the perspective of the
employer and the numerous parties they work with. By the end of this module, you will be aware of the
basic concepts of the industry – from the reason an employer offers a plan, to how employees participate
in plans, to laws and regulations that protect employee rights and the procedures required to abide by
them. You will build a vocabulary for talking about the concepts with colleagues or answering calls from
employees of the plans you administer. Most importantly, you will learn how vital your role is in helping
to make retirement preparedness a reality for millions of Americans.
Unit 1: Why Do Employers Establish Qualified Plans?

Scenario
Fred owns a successful electrical contracting company. The company is growing and becoming very
profitable. Over the last several years a stable core group of employees, both in and out of management,
has become important to the overall success of the firm. Fred wants to provide a competitive retirement
program for his staff, but he is also concerned about saving for his own retirement. The next time Fred
meets with his personal investment advisor, Claire, he mentions his goal. Claire suggests that Fred offer a
401(k) retirement plan which allows Fred and his employees to save for their own retirement. In addition,
Claire suggests that Fred work with an experienced employee benefit consulting firm. She explains that
the firm, called a Third Party Administrator (TPA), can help design a plan that offers a match on employee
contributions to help spur savings for his employees. The match on contributions can enable Fred to save
for his retirement on a tax-efficient basis as a well as allow him to attract and retain highly qualified
workers. Fred is interested, but he has a lot of questions.

Guiding Questions
As you work through the material of this unit, ask the following questions:

1. What benefits does an employer receive by offering a retirement plan?

2. What kinds of laws and limitations must an employer follow when providing a retirement plan?
3. How could participating in a work-sponsored retirement plan help employees save money?
4. Are employer-sponsored retirement plans actually effective in helping people save for
retirement?

Key Terms
Employer-sponsored plan: A retirement plan set up and overseen by an employer for the benefit of its
employees.

ERISA: The Employee Retirement Income Security Act, a law passed in 1974, covering employee benefit
plans. It provides protection to participants of retirement plans.

Plan Sponsor: The employer or group of employers (or in some cases another entity such as an employee
organization, association, committee, or board of trustees) that establishes or maintains the plan.1

Qualified Plan: A retirement plan that meets the requirements of IRC §401(a) and, therefore, provides
special tax advantages to the plan sponsor, the trust, and plan participants.

1
Adapted from the ERISA Outline Book.
Unit Overview
Americans believe that everyone should be able to retire with dignity. Social Security, conceived after the
hardships of the Great Depression, is the US government’s safety net retirement program for millions of
retired workers. Consider the following:

 Retirement can last for 30 years or more.

 A retiree needs 80% or more of their current income to retire comfortably.
 The average monthly amount paid by Social Security is $1,200 dollars.2

Employer-sponsored plans are a vital part of the voluntary retirement plan system in the U.S., second only
to Social Security in providing retirement benefits to Americans. Surveys3 show that many employers are
concerned about their employees’ ability to retire comfortably. They know that an employer-sponsored
retirement plan helps attract and retain employees, and they like the tax advantages that employer-
sponsored retirement plans provide for both employers and employees.

To help achieve Americans’ retirement goals, government policymakers have created numerous benefits
for employees participating in a plan and for employers sponsoring a retirement plan. Sponsoring a
retirement plan is voluntary, not mandatory, and so the rules provide tax incentives for employers who
choose to sponsor a plan.

There are also tax benefits for employees who elect to contribute to a plan. Employee contributions, like
an employer’s decision to be a plan sponsor, are voluntary. Most retirement plans are governed by the
Employee Retirement Income Security Act, or ERISA. ERISA assures that employees’ monies are always
protected, even in the event of an employer’s bankruptcy. Under ERISA, employers must operate their
plan for the exclusive benefit of plan participants and their beneficiaries.

Social Security was designed as a supplemental retirement program, however, it has now become the
primary retirement program for many lower and middle income Americans. As the population ages and
continues to live longer in retirement, Social Security will be under considerable financial pressure.
Fortunately, the voluntary employer-sponsored retirement plan system can provide retirement income
for employees in addition to Social Security.

Why Do Employers Offer Plans?

Fred’s electrical contracting company is an example of why employers offer qualified retirement plans in
their business. Claire, his advisor, explains that a plan will help him retain his current employees as well as
attract new employees to his business. And because his business is profitable, he can take advantage of
tax benefits available by making contributions to a qualified plan. Additionally, he can use the plan to save
for his own retirement.

Employers can benefit from offering a retirement plan in several ways. Employer-sponsored plans are
proven to attract and retain employees. (Many plans increase the benefits employees are entitled to
based on how long they have worked for the employer, thus rewarding employees for longer periods of

2
[Link]
Plan
3
[Link]
service.) Employer contributions are currently tax-deductible to the business. Importantly, owners and
key employees can benefit from the plan along with rank and file employees.

Employees also stand to benefit from participating in the employer-sponsored plan. When employers
make contributions to plans, employees do not currently pay taxes on those contributions. The
contributions are allocated to employees’ accounts and the plan investments are often professionally
managed. In plans that provide benefits at retirement, employees’ benefits are often funded solely by
their company’s contributions.4

In certain types of employer-sponsored plans, employees can save for retirement using a payroll-based
systematic method, in which money is easily and automatically transferred to a retirement account each
pay period. Employee contributions can be made on a pre-tax basis, meaning those contributions are not
included in income for tax purposes. Taxes on earnings from pre-tax monies are deferred. Employees can
have the option of contributing on an after-tax basis and then gain the advantage of tax-free investment
earnings. With pre-tax contributions, employees defer taxes during their high-income working years and
pay tax in retirement when their income tax rate is likely to be lower. Further, employee contributions
can be matched by the employer. As in employer contribution only plans, these employer contributions
are not included in the employee’s income, and are therefore not currently taxed. Employees can also
benefit by having access to professional investment management of their accounts or by choosing their
own investments for their accounts.

Why Are They Called “Qualified” Plans?

Because retirement plans offer considerable tax benefits to employers and employees, they are regulated
by the Internal Revenue Service (IRS) and the Internal Revenue Code (IRC). The IRS considers employer-
sponsored retirement plans that offer these tax benefits to be “qualified” under the IRC.

Section 401(a) of the IRC provides that a qualified plan must be for the employees of the employer and
must be maintained for the exclusive purpose of the plan participants and the plan beneficiaries. Calling a
retirement plan a “qualified plan” means that the plan’s exclusive benefits are “tax-qualified” under the
IRC. Remember that these tax benefits include:

 Employer contributions that are deductible and not includible in employee’s income;
 Employee contributions that can be made on a pre-tax basis;
 Investment earnings not currently taxable to the employee or the employer.

Examples of qualified plans include 401(k) plans, 403(b) plans, defined benefit plans, profit sharing and
other defined contribution plans. To determine if a retirement plan is a qualified plan, read the
description of the plan provided to participants. Plan descriptions will often say in the first few pages:
“This retirement plan is intended to be a qualified plan under Section 401(a) of the Internal Revenue
Code.”

4
Government benefit plans usually require employees to contribute toward their retirement benefits in addition to
government contributions.
There are retirement plans that are not qualified plans. These plans do not have all of the tax benefits of
qualified plans and are subject to different rules. Non-qualified plans are discussed in Unit 2.

Why Does the Government Regulate Qualified Plans?

Qualified plans are regulated by the government both to ensure that plans are maintained exclusively for
participants and beneficiaries and also because of their considerable tax benefits to employees and
employers. Qualified plan tax benefits are designed to help employees save for retirement.

Qualified plan laws are created by Congress and those laws are subject to regulation by the Department
of Labor (DOL) and the IRS. ERISA is an example of a law that impacted all qualified plans and resulted in
considerable regulation of those plans. Prior to ERISA, plans were discretionary in almost every aspect of
their operation. Employers could decide to not pay out benefits or to make employees wait years to enter
plans. ERISA was passed in 1974 to protect participants in qualified plans, and there have been many law
changes since then that changed the way qualified plans are operated and how they benefit employees.5

Once the qualified plan laws are passed by Congress, the IRS and the DOL issue regulations to carry out
those laws. In general, the DOL is responsible for protecting participants and beneficiaries.

The DOL and Title I Requirements

Because these rules are included under Title I of ERISA, they are often called Title I requirements. The DOL
oversees Title I requirements such as:

 Eligibility – minimum waiting periods to get into a plan are set by law and regulation and not only
by the employer;
 Vesting – employees are entitled to their plan accounts based on a specific set of rules, and once
they are entitled to that account, those monies always belong to the employee (and his or her
beneficiaries);
 Reporting and disclosure – qualified plans must report plan information to the government and
disclose plan information to plan participants and beneficiaries;
 Fiduciary standards – plan fiduciaries (employers and others responsible for the qualified plan)
must operate the plan exclusively on behalf of participants and beneficiaries, using a prudent
oversight process of the plan’s operation, investments, service providers and service provider
compensation.

The IRS and Title II Requirements

The IRS is generally responsible for overseeing the tax benefits of qualified plans. Many of these are found
in Title II of ERISA. Because the tax benefits are considerable, the IRC and regulations require that the
plans not be operated primarily for owners and highly paid employees and that benefits for those
employees be limited. Under the IRC, qualified plans must show that they are non-discriminatory and that
they cover a specific percentage of the employees eligible for the plan.

5
For more information, see [Link]
The IRS oversees some of the qualified plan rules under Title I in conjunction with the DOL, including
eligibility, vesting, and reporting and disclosure requirements. The IRS also oversees qualified plan rules
under Title II, including those in the IRC, such as:

 Coverage – plans must cover a certain percentage of eligible employees to be qualified

 Contribution limits – employer and employee contributions are subject to specific limits under IRS
regulations
 Minimum contributions – certain types of plans must contribute monies on behalf of plan
participants
 Non-discrimination – qualified plans are subject to tests to prove that contributions do not
disproportionately benefit owners and highly paid employees

Summary
The employer-sponsored retirement plan system generates an important source of retirement income for
Americans who are living longer in retirement. The tax incentives in the system encourage employers to
adopt retirement plans. Tax incentives are also an important part of plans with employee contributions.
Studies show that employees are 14 times more likely to save when they have a retirement plan at work
than if they are saving for retirement on their own.6

How might an employer-sponsored retirement plan help the employer in our scenario, Fred? Fred’s
desire to establish a plan is focused on two important issues: attracting and retaining employees and
taking advantage of the tax benefits of a qualified plan for his business and his employees. U.S. retirement
plan laws and regulations encourage businesses like Fred’s to adopt and maintain qualified plans so that
workers will have adequate retirement income. When Fred adopts a qualified plan, he can deduct the
contributions he makes to the plan. If he chooses to adopt a plan that allows employee contributions, his
employees may be able to contribute money to the plan on a pre-tax basis. Over time, these
contributions grow on a tax-deferred basis, allowing employees to accumulate a retirement nest egg.

Fred, and other sponsors like him, are regulated by laws that protect employees in plans. ERISA, the
primary law that regulates retirement plans, requires that plans name one or more fiduciaries to be
responsible for the plan, one of whom is likely to be Fred. If Fred is a named fiduciary, he will be
responsible for ensuring that the plan operates on behalf of plan participants and their beneficiaries.

The tax benefits of the plan will also require Fred to comply with IRS rules. His plan will have to ensure
that employees are eligible for the plan and that they earn rights to any contributions that Fred makes to
the plan over a specified period of time. The plan must cover a certain percentage of Fred’s employees
and it must pass tests to show that the contributions do not disproportionately benefit Fred or other
highly paid employees.

Although Fred’s retirement plan will be subject to many rules and regulations, most business owners find
that the benefits of the plan outweigh these costs. The plan can help his business grow by providing a
valuable benefit to his employees.

6
EBRI 2010 Retirement Confidence Survey
Answers to Guiding Questions
Check your answers to the guiding questions by comparing them to the answers below.

1. What benefits does an employer receive by offering a retirement plan?

Retirement plans provide important benefits that help recruit and retain employees. Employers
can deduct contributions they make to the plan from taxes.

2. What kinds of laws and limitations must an employer follow when providing a retirement plan?
Employer-sponsored plans that are qualified are regulated by the DOL and the IRS under ERISA
(the Employee Retirement Income Security Act). ERISA ensures that plans do not discriminate
against lower-paid employees. It also requires certain notifications and disclosures, and sets limits
on how much money can be contributed to the plan.

3. How could participating in a work-sponsored retirement plan help employees save money?
Depending on the plan type and options available in the plan, employees can save more through
the ease of the plan (automatic payroll deductions), tax benefits (tax-free earnings or tax-
deferred contributions and earnings) and employer contributions.

4. Are employer-sponsored retirement plans actually effective in helping people save for retirement?
Employer-sponsored retirement plans make it easy for individuals to save for retirement.
Employees are much more likely to save through an employer-sponsored retirement plan than on
their own.

Additional Resources
For more information on the benefits of employer-sponsored retirement plans, see:

 Lots of Benefits - when you set up an employee retirement plan

[Link]
Employee-Retirement-Plan
Unit 2: What Is the Process for Setting Up the Plan?

Scenario
Claire, Fred’s financial advisor, sets up a meeting with him to discuss his goals for his business and
whether or not a retirement plan is the right solution for his situation. Fred is familiar with 401(k) plans
and pension plans, but he knows nothing about setting one up or administering one. He has a lot of
questions for Claire. How does money get transferred from the business to the plan? What is the plan?
How is the money invested? Who takes care of the day-to-day operations, and who is responsible for
making sure the plan complies with the law? Claire works with companies that provide investment
services and companies that provide plan consulting and administration services. She does her best to
describe the options Fred has. Fred is still uncertain. Offering a retirement plan seems like a big
responsibility. Fred thinks of businesses he’s heard of in the news that have had retirement plans fail and
wipe out the retirement savings of hundreds of employees. Once he starts the plan, is he committed to it
forever?

Guiding Questions
As you work through the material of this unit, ask the following questions:

1. What types of plans are there, and how do employers determine which one is best for them?
2. What decisions must the employer make when starting the plan?
3. Can the employer make changes to the plan later on?
4. What happens to the plan if the employer closes or sells the business?

Key Terms
401(k) Plan: A defined contribution profit sharing plan design that allows for employees to choose to
contribute part of their paycheck to the plan. It always has employee contributions and may have an
employer contribution component.

403(b) Plan: A defined contribution plan very similar to 401(k) plans that is designed for tax-exempt plan
sponsors.

457 Plan: A defined contribution plan for government entities that is similar to a 401(k) plan. Like a 401(k)
plan, the 457 plan always has employee contributions and may have an employer contribution
component.

Adoption Agreement: A document used in conjunction with a base plan document to allow individual
employers to customize provisions of the plan.

Base Plan Document: A plan document issued by a document provider that has been approved by the IRS.
It is customized for individual employers with the use of an adoption agreement.
Defined Benefit Plan: A qualified retirement plan that provides participants with a specifically defined
retirement benefit payable at a stated retirement age. How the benefit is paid and over what period of
time is defined by the plan document.

Defined Contribution Plan: A qualified retirement plan that allocates contributions, earnings, and
forfeitures to individual participant account balances.

Fiduciary: Any person (individual or corporation) who exercises discretionary authority or control over the
management or disposition of plan assets, renders investment advice for a fee or has discretionary
authority or responsibility for the administration of the plan.

Hybrid Plan: A qualified retirement plan that combines DB and DC plan features.

Individually-Designed Plan: A plan document written by an ERISA attorney for use by one (usually large)
company.

Nonqualified Plan: An agreement or promise by an employer to certain employees to pay benefits at

some future date for services performed currently. These plans do not qualify for the special tax
treatment given to qualified plans.

Plan Document: A legal document detailing the specific plan provisions selected by the plan sponsor to
meet retirement plan and business goals.

Summary of Material Modifications (SMM): A detailed summary to notify participants of minor plan
changes to the plan document.

Summary Plan Description (SPD): A detailed, but easily understood, summary describing a qualified plan’s
provisions. It must be provided to participants and beneficiaries.

Termination: The dissolution of a plan, usually due to company merger, acquisition, closing or inability to
pay plan expenses.

Trust: A fund established under local trust law to hold and invest the assets of a plan.

Trustee: The party named in the plan or trust documents that is authorized to hold the assets of the plan
for the benefit of the participants.

Unit Overview
Fred is correct to be concerned about his retirement plan being a big responsibility. However, he can
work with service providers like Claire to help share this responsibility. His first step is to identify the
business and employee goals that should be reached through the plan. Claire and retirement plan
consultants can help Fred review the plan types and plan designs available to him to achieve his
retirement plan goals. There are many plan types both because businesses differ and because retirement
policy has changed over the last 40 years. Fred has a duty under ERISA to seek expert guidance not only
with plan selection but also with the plan’s adoption and operation. There can be several service
providers involved with his retirement plan, which are typically an advisor, a retirement plan-consulting
firm and an investment company. Fred has the fiduciary duty to prudently select and perform ongoing
monitoring of these service providers to the plan.
Once the plan is adopted, the plan is required to follow the rules as laws and regulations change. A plan
must be adopted with the intent that it be permanent, but Fred can make changes to the plan as his
business changes. If Fred’s business is sold or has to close, the plan can be terminated. ERISA requires
that plan changes or plan termination preserve certain employee benefits.

How Does the Employer Select the Right Plan?

One of the first questions Claire should ask Fred is what his goals are with regard to the plan. Different
employers will have different goals and objectives for their qualified plan. Some of those goals will be
based on the size of the company, but other objectives will be based on the plan sponsor’s specific
business.

Fred is likely to want to focus on the tax benefits of a qualified plan, especially maximizing his retirement
contributions. However, his secondary goal is to attract and retain employees. A key consideration is the
business's cash flow, which determines how much his company can afford to contribute to the plan and if
they can afford consistent contribution amounts in future years.

It is helpful to think about plans in terms of their primary goals. “Owner-driven” plans are selected and
designed to provide retirement savings for the company owners (like Fred). Owner-driven plans are often
sponsored by smaller employers who have closely held businesses with a small number of owners – like
Fred’s company.

Generally, owner-driven plans start by establishing a qualified plan to take advantage of the tax-
deductible contributions and the tax deferral of contributions for employees. These plans are often
focused on retirement contributions for the owners and what requirements must be met to allow the
owners to save for retirement while taking advantage of qualified plan tax incentives.

“Participant-driven” plans are selected and designed with the primary goal of attracting and retaining
employees and to allow all employees to save for retirement on a tax-deferred basis. Participant-driven
plans tend to be larger plans where the focus is on a broader cross-section of employees. Benefits to
owners and partners in a participant-driven qualified plan are frequently a secondary consideration, as
these individuals often have other executive benefits outside the qualified plan. These types of sponsors
may also be interested in participant retirement outcomes, providing plan designs that will encourage
long-term employees to retire rather than staying on as their employer-provided healthcare costs
increase. These firms are also likely to want to create different benefit structures for different groups of
employees.

As in Fred’s case when the company is growing, there may be a primary goal of retirement savings for the
owner(s) and a secondary goal of offering a plan to attract and retain employees. Fortunately, there are
different types of qualified retirement plans from which Fred may choose. Because of these various plan
goals related to the business and its owners, firms like Fred’s often work with a retirement plan
consulting firm (commonly referred to as a “Third Party Administrator,” or TPA) in addition to working
with an advisor like Claire. It can be complex to select and design a plan that meets all of the firm’s goals,
and TPA consulting firms can assist with this process.

Fred will make business decisions in selecting and designing his plan. These business decisions not only
include considerations of the types of contributions Fred and his employees may make, but also whom
should be covered by the plan. These choices are often called "settlor functions," which are decisions
made by the business about the plan. Settlor functions are not subject to the fiduciary rules of ERISA,
which means Fred is free to select the plan and the design that is appropriate for himself and his
business. Once the plan is in place, Fred may become a fiduciary responsible for the plan's operation and
investments who must act in the best interest of all participants, not just in consideration for himself and
his business.

Why Are There So Many Plan Types?

There are many plan types for two primary reasons:

1. The retirement plan type and design should fit the needs of the business.
2. As retirement policy changes, legislation changes the retirement plan types that are available to
employers.

After ERISA was passed in 1974, two types of retirement plans emerged for for-profit employers to
provide benefits to their employees: defined benefit plans and defined contribution plans. These plan
types have been modified by legislation since ERISA, but they are still the dominant plans in the
marketplace. Even 401(k) plans, which are the most popular plan type today, are defined contribution
plans with employee contributions as an additional feature.

A defined benefit plan is a qualified retirement plan that provides participants with a pre-determined
retirement benefit at a specific retirement age. ERISA specified a maximum benefit as well as allowable
retirement ages. All contributions and earnings on those contributions are part of a single trust account,
and participants generally do not have individual account balances as they do in defined contribution
plans (with the notable exception of cash balance plans described below). If participants terminate their
employment before retirement age, they are entitled to a portion of their retirement benefit.

A defined contribution plan is a qualified retirement plan that allocates contributions, earnings and
forfeitures to individual participant account balances. Contributions can be either fixed or discretionary,
and depending on the type of defined contribution plan, contributions can be made by the employer or
employee, or both. Retirement benefits are not defined as in a defined benefit plan, but instead are
based on the value of the participant’s account balance when the participant reaches retirement.

Until the advent of 401(k) plans in the early and mid-1980s, employer funded defined benefit and defined
contribution plans dominated the retirement plan landscape. Although some notable large plans in
troubled industries were not able to pay promised defined benefit plan benefits and required
government bailouts (e.g., US Steel), most small and mid-sized employers found the tax benefits of the
larger deductions and higher benefits to both principals and rank-and-file employees to be worth the DB
plan’s complexities. The Tax Reform Act of 1986 (TRA ’86), however, cut maximum benefits of defined
benefit plans almost in half, and simultaneously added more rules to an already complicated list of
requirements.

Employers, overwhelmed by expensive and complicated regulations with decreased allowable benefits,
looked to defined contribution alternatives. The 401(k) plan not only provided simpler plan design and
operation, it also shifted the burden of retirement funding from the employer to the plan participant.
That trend has continued through the present day, with 401(k) plans having virtually replaced the defined
benefit plan as the primary employer sponsored qualified plan.

In the mid-1990s, new 401(k) plan designs were added by legislation to encourage more established small
businesses to adopt plans. Legislation also added 401(k)-style individual retirement account plans to
encourage new businesses to give access to simplified retirement plans for their employees.

Non-profit employers and government entities also wanted to provide retirement benefits and savings
accounts for their employees, but their tax-exempt status made traditional ERISA plans less relevant to
them. Non-profit employers sponsor 403(b) plans, which are very similar to 401(k) plans, but which are
designed for tax-exempt plan sponsors. Government plans are typically defined benefit plans provided by
the government entity and funded with taxpayer dollars. Governments can also elect to offer a
supplemental savings plan with employee contributions called a 457 plan.

Which Are the Main Plan Types?

Defined Contribution Plans
There are several different types of defined contribution (DC) plans including profit sharing plans and
plans with a 401(k) component.

Profit Sharing Plans

Profit sharing plans are qualified DC plans with the following features:
 Discretionary employer contributions up to 25 percent of eligible compensation
 Withdrawals allowed after monies remain in the plan for a specified period of time, not less than
two years

Profit sharing plans have the following advantages:

 Good for employers who want a qualified plan without the complexity of 401(k) rules
 Flexible contributions

Profit sharing plans have the following disadvantages:

 Limited design options for owner-driven plans
 Not as many design options as in 401(k) plans for participant-driven plans

401(k) Plans

A 401(k) plan is a DC profit sharing plan design that allows for employees to choose to contribute part of
their paycheck to the plan in addition to allowing the employer to make contributions. The typical
attributes of 401(k) plans are:
 Employees can contribute money from their paychecks on a pre-tax basis;
 Employee contributions may be matched by the employer;
 Employers can elect to make profit sharing contributions;
 Additional nondiscrimination tests7 to assure that contributions are not discriminating in favor of

7
Nondiscrimination is covered in Unit 6 of this module, “How Does a Plan Maintain Tax Qualification?” and the
Testing Module, Unit 4: “Nondiscrimination Testing.”
 highly compensated employees.
 Employers can elect to make “safe harbor” contribution(s) that can eliminate the need for
nondiscrimination testing

401(k) plans have the following advantages:

 Encourage employees to save for retirement on a pre-tax basis
 May allow employees to select their own investments
 Employers have the option to provide a match on the employees’ contributions
 Employers can elect to make profit sharing contributions

401(k) plans have the following disadvantages:

 More complex operation and recordkeeping due to the multiple contribution types
 May have required employer contributions
 Specific tests unique to 401(k) plans

Individual Retirement Account (IRA) Plans

Employers who want to provide an employee retirement plan but do not want to take on the entire
administrative burden of a traditional qualified 401(k) plan can elect to sponsor one of three types of IRA
plans:
 The simplified employee pension plan (SEP)
 The SIMPLE IRA
 The SIMPLE 401(k)

SIMPLE plans were introduced to offer further simplified retirement savings alternatives for small
businesses. For an employer looking to provide benefits to employees in an inexpensive way, they are a
valid design alternative, especially if small employers are not looking to maximize principal employees’
retirement contributions.

Employer-sponsored IRA plans have the following advantages:

 Individual participant accounts with monies that can be accessed more easily than 401(k)
accounts
 Simplified documentation
 Limited government filing requirements
 Fewer requirements than ERISA qualified plans
 Less expensive to administer than qualified plans

Employer-sponsored IRA plans have the following disadvantages:

 Can limit retirement plan savings due to lower employee contribution limits
 Unfavorable to owners and principal employees
 May have required employer contributions
 Inflexible to changes – the only plan an employer may have in a plan year
 Places the burden of compliance fully on the plan sponsor as there is usually no retirement plan
consultant doing some of the administrative work

Defined Benefit Plans

Traditional defined benefit (DB) plans provide a guaranteed benefit at the plan’s stated normal
retirement age. Employer contributions necessary to fund these benefits must be calculated by an
experienced retirement plan professional known as an “actuary.”

Participants do not have individual accounts. The plan pays benefits when an employee reaches
retirement and those benefits continue until the participant’s death. Many defined benefit plans also
allow a plan to pay out retirement benefits in a lump sum, and many retirees select this option to cash
out and take the money due to them all at once. If the employee is married, his or her spouse may also
receive benefits from the plan after the participant dies. If employees leave the company before
retirement, they are entitled to a smaller portion of their retirement benefit.

Defined benefit plans have the following advantages:

 Higher tax deductible employer contributions than DC plans
 Greater and faster retirement savings for owners and principal employees
 Guaranteed benefits in retirement

Defined benefit plans have the following disadvantages:

 A larger, fixed contribution
 Higher required employer contributions for employees than 401(k) plans
 More complex and expensive administration
 Employee demographic changes can undermine the original goals of the design

ERISA and Non-ERISA Plans

All qualified plans provide tax advantages to employees and employers. This makes all qualified plans
subject to most IRS rules. However, not all qualified plans are subject to certain ERISA requirements.
These are called “non-ERISA” plans and are often sponsored by governments, educational institutions,
and religious organizations. Although these plans are required to have their plan provisions stated in a
plan document, they may not be required to file annual returns, disclose fee information to participants,
or follow ERISA’s fiduciary rules.

ERISA 403(b) and 457 Plans

ERISA 403(b) and 457 plans are unique in that they can only be sponsored by tax-exempt employers.
ERISA 403(b) plans are typically sponsored by non-profit hospitals, private educational institutions, and
non-profit organizations such as museums.

ERISA Section 403(b) and governmental 457(b) plans are similar to 401(k) plans. Both types of plans can
have an employer contribution component, but both plans always have employee contributions. Section
457(b) plans have their own set of requirements that differ from ERISA 403(b) and 401(k) requirements.
Those requirements should be understood by those who work with these plans, but the details of the
specific 457 provisions are beyond the scope of this course.

Non-ERISA 403(b) Plans

Non-ERISA 403(b) plans are tax-favored plans that are offered by public schools, higher education
institutions and specific tax-exempt organizations that qualify under specific IRS rules.

A typical non-ERISA 403(b) arrangement is a public school plan where teachers and staff can elect to
contribute money out of their paychecks to an insurance company individual annuity. Because these are
individual arrangements, non-ERISA 403(b) plans may have to work with many different insurance
companies where employees can pick which insurance company they want to work with. This structure
evolved because public schools have state-provided retirement plans, and 403(b) plans are designed to
supplement the state plan.

Employers who adopt ERISA 403(b) plans will look more like 401(k) plans, where there is one investment
provider and one contract for all participants.

Nonqualified Plans
Participant-driven plans adopted by larger employers are designed primarily to attract and retain
employees and to allow all employees to save for retirement on a tax-deferred basis. Benefits to key
employees in a qualified plan are frequently a secondary consideration, and it is not uncommon for
qualified plans established by large companies to be insufficient at reaching the level of benefits desired
for key management employees. In this situation, nonqualified plans are a common way to provide tax-
deferred benefits to certain executives in excess of the qualified plan limits.

Non-qualified plans have the following advantages:

 Deferred taxation to the employee on employer contributions and earnings on those
contributions
 Minimal regulation of the amounts and timing of the contributions
 Ability to target a small group of management employees (i.e., discrimination is allowed)
 Customize timing of when monies are available to employees
 Tax deduction by the employer when accounts are available to the employee
 Allow for stock options and stock bonuses tied to the employee’s and the employer’s
performance

Non-qualified plans have the following disadvantages:

 Assets of the plan belong to the employer (not to the participant as in ERISA plans) and are
subject to the employer’s creditors
 No current tax deduction for the employer when it makes contributions to the plan
 No tax deferred rollover feature for the employees

What Is a Plan?
A plan is governed by a legal document. The plan document details the specific plan provisions selected
by the plan sponsor to meet retirement plan and business goals. The document also contains ERISA, IRS
and DOL provisions required by law.

An employer can adopt a plan document that integrates the specific provisions selected by the plan
sponsor with the provisions required by law. This is called an “individually designed” document and can
be drafted by an ERISA attorney or an experienced retirement consultant. Employers with specific plan
design needs, such as churches, very large firms and employer stock provisions, may use an individually
designed plan.
Most employers elect to use a qualified plan document with two parts: an adoption agreement and a base
plan document.8 These documents are typically maintained by service providers, and the plan sponsor can
use his document when he chooses to work with the service provider.

The adoption agreement will typically reflect the plan provisions selected by the plan sponsor that best fit
the business goals for the plan. Employers often work with consultants to select options in the adoption
agreement so that the selections match their goals. The language in the base plan document is text
required under either ERISA, the IRC or its regulations.

A retirement plan also has a companion trust. A trust is an arrangement that allows a trustee to hold
assets on behalf of people other than the trustee. Because a trustee is managing assets for other people,
the trustee is considered a fiduciary. In a retirement plan, one of the duties of fiduciaries is to take care of
monies for plan participants. Remember the core rule of ERISA: plans are for the exclusive purpose of
participants and their beneficiaries. A trust must be either part of a retirement plan document, or the
document must reference another trust document to meet the ERISA exclusive purpose rule.

Summary Plan Description (SPD)

ERISA requires that participants and beneficiaries receive a summary of the plan in understandable
language that describes their rights, benefits, and responsibilities under the plan. The SPD must be
provided within 90 days of the employee becoming eligible. The SPD includes information such as the
name and type of plan, the plan’s eligibility requirements, a description of the plan’s benefits and when
participants have a right to those benefits, the sources of contributions that may be made to the plan and
the methods used to calculate the amounts of employer contributions. It also includes provisions
regarding termination of the plan, procedures regarding claims for benefits and remedies disputing
denied claims and statement of rights available to a participant under ERISA.

What Is Involved in Starting the Plan?

The steps for starting a 401(k) plan are:
 Select service providers like an advisor and recordkeeper.
 A service provider will provide plan documents to the employer. This is when the employer
customizes the features of its plan.
 The plan documents are to be signed or “adopted.”
 The employer must communicate the plan to employees and eligible employees may begin
participating in the plan.
 During enrollment, employees must receive certain notices.

More information on the enrollment process is provided in Unit 3.

Retirement plan advisors operate as the “hub” of the qualified plan wheel. Advisors like Claire will work
with Fred to determine his goals for his qualified retirement plan. Claire can then help Fred work with
retirement plan consultants and investment firms to help select and design the plan. Plan design is an
important concept. Many features of retirement plans can be designed or customized to meet the unique

8
IRS language refers to a “basic” plan document when describing the part of the document that contains the non-
optional required provisions of ERISA and the IRC. This course uses the more common industry term “base” plan
document. However, the two terms mean the same thing.
needs and goals of the employer. While plans must operate within a set of rules and guidelines, one plan
can differ vastly from another. The flexibility of retirement plans makes them an attractive benefit, but
also adds to the complexity of their administration. Claire, the consultant and the investment firm can
also assist Fred in operating the plan according to the various rules of ERISA, the IRS, and the DOL.

Claire should educate Fred about his responsibility as the plan sponsor to operate the plan on behalf of
the plan participants. Fred’s responsibility to the plan is that of a fiduciary, assuming he is named as
either the Plan Administrator or one of the trustees. As a fiduciary, he is responsible for his participants’
monies invested in the plan. Fred also has a duty under ERISA to hire service providers if he and his
employees need expert assistance with the plan, which is very likely. Claire can educate Fred about his
fiduciary duty to prudently select the advisor (including herself), the consultant, and the investment firm
for his plan. He also has a duty to evaluate the reasonableness of the service provider’s fees.

It is a best practice to use a written request for proposal (RFP) that is sent out to possible service
providers to assist a plan sponsor like Fred in making a prudent selection of firms that can help him with
the plan’s operation. Claire can assist Fred in creating the RFP, compiling a list of potential service
providers to send the RFP to and managing RFP distribution. Start-up and small plans may not use a
formal RFP process, but they are still responsible for using a prudent process to select service providers
for the plan.

How Does an Employer Make Changes to the Plan?

When a plan is adopted, its plan document provisions are not permanent. The plan sponsor can elect to
amend the plan document provisions. However, the amendment must not violate rules that prohibit
cutting back the benefits that are guaranteed under ERISA, such as vested account balances.

Employers make changes to their plans as their goals change. For example, if the plan initially allows all
employees to participate when they are hired, employee turnover can make the plan costly and
complicated to administer. If the employer experiences a lot of employee turnover, he may want to add
an eligibility requirement of one year of service. This limits employees who will only be employed a short
time from participating in the plan, thus simplifying administration and rewarding longer service
employees.

Amendments that make "material" changes to the plan document must be accompanied by notice to
participants in the form of a summary of material modification (SMM) to the SPD.

Legislative and regulatory changes will require that a plan be amended, or possibly even that the entire
document be rewritten. In recent years, these changes have required that plans be rewritten
approximately every five to seven years, but often long after legislation has passed. For example, the
Pension Protection Act was passed in 2007, and DC plan documents began to be rewritten over seven
years later. One advantage of having to do a complete rewrite of the plan document is that an employer
can make other changes to the plan document that may be needed at the same time as the required
amendments are done.
How Does a Plan Come to an End?
ERISA requires that when plans are established, they should be intended to be permanent. There is no
specific definition of "permanent," but the law recognizes that businesses change and evolve and may
need to terminate their retirement plans as a result. Plan terminations occur when businesses close or
cannot afford the plan contributions and expenses associated with the plan. Plans can also terminate
when businesses merge or are acquired by other firms. Termination by the employer is voluntary (other
than in certain bankruptcy situations for specific types of defined benefit plans), but the law does require
that specific steps be followed:

 Adopt a business or corporate resolution terminating the plan.

 Notify the plan participants and beneficiaries of the termination.
 Vest all participants 100% in their accounts or benefits.
 Amend and update the plan document for all legislative and regulatory changes.
 Distribute all benefits and accounts due to participants and beneficiaries (including providing
distribution election forms)
 File final forms with the IRS and DOL indicating that all assets have been distributed.

Both defined contribution plans (including 401(k) and 403(b) plans) and defined benefit plans must follow
the plan termination steps above.

However, some mid-size and most large defined benefit plans are covered by the Pension Benefit
Guaranty Corporation (PBGC), an entity created by ERISA to insure benefits of defined benefit plans when
a company's plan assets are inadequate to pay benefits. If the defined benefit plan is covered by the
PBGC, the plan termination must be filed with and approved by the PBGC before benefits can be
distributed. The PBGC offers different ways for DB plans that do not have enough assets to pay benefits
to still terminate. A PBGC plan termination is a complex process, and employers and fiduciaries usually
work with actuaries and other service providers to determine the type of termination required, and to file
with the PBGC to terminate the DB plan.

Summary
In making a decision about starting a plan, Claire should work with Fred to determine his goals for the
plan. When he has explained what he is concerned about (e.g., taxes, attracting and retaining employees,
and his personal retirement savings), Claire can assist Fred in working with a retirement plan consultant
to explain the plan types that are available to his business. When creating the plan, Fred, Claire and the
consultant should spend quite a bit of time reviewing the business and plan goals and translating those
goals into choices made in the plan document. When Fred reviews and then signs the plan document, the
plan will be in place for Fred and his employees.

As his business's goals change, he can amend his document. Fred's service providers should explain that
he is likely to be required to amend his document periodically as retirement plan laws change.

If Fred's business has to close, he can terminate the plan. However, participants have the ultimate rights
to their money in the plan, and Fred must ensure that they are properly paid out and notified of the plan
termination.
Answers to Guiding Questions
Check your answers to the guiding questions by comparing them to the answers below.

1. What types of plans are there, and how do employers determine which one is best for them?
Numerous categories of retirement plans exist, including qualified and nonqualified plans, and
defined benefit and defined contribution plans. Employers select plans to meet their business
needs and goals, taking into consideration the cost and complexity of administration for each
plan type, tax benefits and contribution limits and ability to target benefits to certain groups of
employees. An advisor and a plan consultant can help the employer make the best decision.

2. What decisions must the employer make when starting the plan?
The employer selects a plan type, and may make choices (within the confines of the law) such as
who may participate in the plan, requirements for an individual to become eligible to participate
in the plan, contribution types allowed in the plan (e.g., employee contributions and employer
contributions), investment options and what service providers to use.

3. Can the employer make changes to the plan later on?

Plans can be updated to adapt to changing business goals. Plan documents can be amended to
reflect these changes and must be amended to reflect changes in the law.

4. What happens to the plan if the employer closes or sells the business?
A plan may be terminated due to business acquisition, mergers, closure, inability to pay plan
expenses, or any other valid business reason. The plan must follow all the required steps, some of
which include notifying participants and providing full vesting of their accounts, distributing
benefits and accounts to participants and beneficiaries, and filing with the DOL and IRS. Some DB
plans must also take action with the PBGC.

Additional Resources
For more information on setting up a plan and plan documentation, see:

 “Types of Retirement Plans”

[Link]

 “Types of Pre-Approved Retirement Plans”

[Link]

 “Tips For Selecting And Monitoring Service Providers For Your Employee Benefit Plan”
[Link]/ebsa/newsroom/[Link]

 “Amend or Update a Plan”

[Link]

 “Retirement Topics – Termination of Plan”

[Link]
Plan
Unit 3: Who Is Covered?

Scenario
Now that Fred has a plan, the next step is for his employees to join the plan.

Fred has many different types of workers. Some of them are high school students who only work for the
summer. He has a few employees who are from other countries, working temporarily in the United
States. Fred has also hired a part-time contractor to do marketing work for him this year. He has dozens
of employees who work for him full time, some for a few months, and some for many years. Fred
wonders if he must allow all of his workers to join the plan, and if he must offer the same benefits
equally. Claire explains that he has some freedom to specify who may join the plan, but that the law
places restrictions on how he goes about doing so.

Fred, Claire, and the retirement consultant meet with Ingrid, Fred’s human resources manager. They
discuss what information needs to be sent out to Fred’s employees. They schedule a meeting to explain
the plan to the employees and to allow interested employees to join the plan. Claire also reminds Ingrid
that it will be one of her duties to make sure that new employees coming into the company are aware of
the plan and have the option to join.

Guiding Questions
As you work through the material of this unit, ask the following questions:

1. What choices does the employer have in choosing who may or may not join the plan?
2. How do qualified employees join the plan?
3. What documentation does the employer provide to employees as part of the enrollment
process?

Key Terms
Beneficiary: The individual designated by the participant to receive any benefits due to the participant in
the event of the participant’s death.

Elective Deferral: Another term for “salary deferral.”

Eligibility: Requirements set by the retirement plan for employees to be able to participate; may include a
minimum age requirement and a required length of service.

Employee: An individual who provides services for compensation to an employer and whose duties are
under the control of the employer; compare to “participant.”

Enrollment Process: The act of informing employees in plans with employee contributions of their entry
into the plan and collecting required information from them. Information may be transmitted through a
formal meeting, a packet of information, or an online platform.

Entry: The date upon which an eligible employee becomes a plan participant. Entry dates are defined by
the plan document and may occur semiannually, quarterly, monthly, or immediately after eligibility.
Participant: An individual who has met plan eligibility requirements and entered into the plan. An
employee becomes a participant upon plan entry.

Salary Deferral: A portion of an individual’s salary contributed to a retirement plan (e.g. 401(k) plan) that
is “deferred” and will be received at a later date.

Unit Overview
Fred has many different types of employees, some of whom are required to be included when
determining if they are eligible for the plan, and others whom the rules may allow Fred to exclude from
the plan. Claire and the retirement consultant have taken the correct first step: to identify all Fred’s
employees and contractors working for him. The next step is to ask Fred who he would like to be eligible
for the plan and to explain the qualified plan eligibility rules. If Fred selects a 401(k) plan, the rules for
how and when employees choose to contribute a part of their compensation should be discussed. Fred
may also choose to automatically enroll employees in the 401(k) plan.

Once eligibility for the plan is selected, it is recorded in the plan document, along with when employees
will enter the plan, which can be a different date than the day they become eligible. HR and payroll
personnel will be involved in the eligibility and plan entry process throughout the plan year as employees
are hired and as employees leave the firm. Claire and the retirement plan consultant can help Ingrid work
with retirement plan service providers to make this process run smoothly. The service providers can help
payroll staff ensure that eligible employees are promptly enrolled in the plan based on the plan
document.

Who Is Eligible?
Eligibility is one of many features that an employer can customize as part of plan design in order to
achieve employer goals. Determining who is eligible for the plan is a critical administrative function for a
qualified plan. In designing eligibility requirements for a plan, the consultant should work with the
employer in balancing the desire to reward longer service employees with the need to encourage
participation, particularly in 401(k) plans.
Employers are not required to include all their employees in a qualified plan. The law specifies certain
classes of employees that can be excluded, primarily because they are likely to have other benefits
outside the employer’s plan. These classes include union employees and nonresident aliens. Independent
contractors are also legally allowed to be excluded because ERISA plans must be for employees of the
employer sponsoring the plan.
Employers may choose to exclude other groups of employees from their plan, but optional exclusions like
these are subject to IRS rules on eligibility and coverage. The most common optional exclusions are
imposing an age and/or a service requirement for employees to enter the plan. An employee class, such
as salespeople, could also be excluded but the plan would have to pass a nondiscrimination coverage test
to make this exclusion allowable.9

9
Unit 6 explains the details of nondiscrimination tests, including the coverage test.
Allowable Excluded Employees
Independent Contractors
One of the fundamental rules of qualified plans is that the plan must be set up by an employer for its
employees. The first section of the IRC dealing with qualified plans10 says that a qualified plan must be
sponsored by an employer for the employer’s employees. This means that independent contractors are
not eligible to participate in almost all qualified plans.11 A primary exception is government 457(b) plans,
which have a specific rule that allow independent contractors to be eligible for their plans.
Independent contractors are not treated as employees of the employer for whom they are performing
services. Generally, independent contractors are paid according to their contract terms, and their income
is reported on Form 1099. Employers must be careful, however, in determining if a worker is an employee
or an independent contractor. The definition of who is an employee or who is an independent contractor
is not determined solely based on how the person is paid. The IRS imposes a “facts and circumstances”
test to determine if an employee is an independent contractor. This determination is beyond the scope of
this course and is almost always done by the employer in conjunction with his tax advisors.12
Fred’s part-time marketing contractor could be considered an independent contractor, and therefore not
be eligible for his plan. However, the facts and circumstances of his employment should be carefully
reviewed and explained to Fred, especially if Fred intends to hire more contractors in the future.
Union Employees
The law allows plans to exclude union employees who have retirement benefits outside the plan that
were subject to good-faith collective bargaining. Most plan documents refer to these employees as
collectively bargained employees.
Nonresident Aliens
Plans can also legally exclude nonresident aliens (an employee who is not a citizen of the United States
and who receives no income on which they pay U.S. taxes).
Fred’s non-U.S. employees may or may not be excluded under the nonresident alien rule. If they receive
U.S. income, they may have to be included in the plan. An experienced consultant and/or an ERISA
attorney should review Fred’s specific situation before assuming that the non-U.S. workers can be
excluded from the plan.

Age and Service

The IRC provides the maximum age and length of service an employee must meet to be eligible to
participate in a plan. An employee must be eligible to enter a qualified plan after reaching age 21 and
completing one year of service.13

10
IRC §401(a)(1)
11
A multiple employer plan (MEP) may allow independent contractors to participate in their plan in certain
instances. However, MEP requirements are beyond the scope of this course.
12
[Link]
Employee
13
Or two years of service for employer contributions, if the employee is immediately entitled to 100 percent of his
or her employer contributions upon entry into the plan.
These statutory eligibility rules are legal maximums, but plans can provide for more liberal eligibility
parameters. Plan sponsors may add additional eligibility provisions to reflect IRS rules as well as the plan
goals for their employees. As a result, the eligibility and participation requirements will generally narrow
the definition of eligible or participating employees by listing provisions for who will be included in or
excluded from the plan.
It is important for plan sponsors to be aware that service requirements are defined by IRS rules. In
general, one year of service is not just a twelve-month period, but a year in which an employee works at
least 1,000 hours. The 1,000-hour requirement is usually met by a full-time employee in six months.
Because of this requirement, sponsors cannot exclude part-time employees unless they work fewer than
1,000 hours in a year. Employees who work at least 1,000 hours and meet the service requirement are
eligible for the plan even if they are classified as “part-time.”
All qualified plan documents must include language describing when employees are eligible to participate
in the plan. These requirements can range from immediate entry into the plan upon date of hire to
requiring two years of service with the employer (for employer contributions) before entry into the plan.
When employees satisfy the plan’s eligibility requirements, they will not participate in the plan until their
plan entry date, which is also specified in the plan document. Plan entry dates can range from the day
when an employee meets the eligibility requirements to only once or twice each year. Other entry dates
in between are also allowed as long as they meet legal maximums (e.g., every payroll, monthly, quarterly,
etc.).
Example 1
A plan requires an employee to be age 21 and have one year of service before becoming eligible for the
plan. The plan allows employees to enter the plan on January 1st or July 1st, whichever comes first.
Assuming the employee is hired full time on May 1, 2015:

May 1, 2015 May 1, 2016 July 1, 2016

The following plan has more lenient eligibility requirements. It allows for immediate eligibility and entry
into the plan.

May 1, 2015
Eligibility provisions should be selected to meet the sponsor’s goals and objectives. For example, in Fred’s
firm, he has employees who only work for a few months in the year. Eligibility requirements can be set up
to reward those employees who stay with the firm for a year or longer.

The Enrollment Process

In qualified plans without employee contributions, the enrollment process is not necessary. Plans with
employee contributions, most commonly 401(k) plans, will have an enrollment process where employees
choose the amounts that they will contribute to the plan (at this time the employee is also asked to
designate an individual or beneficiary who will receive the benefits (i.e., payment) due to the participant,
in the event of the participant’s death). In general, employees are enrolled in the plan after becoming
eligible for the plan but before they enter the plan.

However, because the enrollment process is important as well as time-sensitive, employees who are
approaching an entry date are typically provided with required and optional information about the plan.
Service providers will often provide this information 30 days prior to employees entering the plan.

Enrollment can take place through enrollment meetings where employees complete enrollment forms, or
employees can decide on their contribution amounts and investments using an online process. If eligible
employees who have reached an entry date – and are now considered plan participants – do not enroll in
the plan, they are still eligible for employer contributions because they are participating in the plan.

401(k) Enrollment
401(k) plans allow plan participants to contribute amounts out of their compensation to a qualified plan
on a pre-tax basis. Because these contributions are actually deferred compensation, they are known as
salary deferrals. Employees are choosing to not take specific salary amounts every pay period, and instead
are electing to contribute those amounts to the plan. Because these monies still belong to the employee,
they are considered “deferred” until a later date.

Employee contributions are optional, with employees enrolling in the plan choosing to have a certain
dollar amount or percentage of compensation deducted from their paycheck and contributed to the plan.
Because these amounts are chosen (“elected”) to be contributed to the plan and deferred to a later date,
they are often known as elective deferrals. The terms “elective deferrals” and “salary deferrals” mean
essentially the same thing.

Because salary deferrals are actually employees’ money, they are subject to rules that safeguard them.
Some of these rules are:
 Employees must make a written election (can be electronic) to defer (unless the plan provides for
automatic enrollment).
 Employees must have the option to stop or change contributions at their election (although the
frequency of those changes can be limited).
 Employee contributions are always 100 percent vested.
 Employers cannot require more than one of year of service to be eligible for 401(k) elective
deferrals.
401(k) participant education, typically provided by the plan advisor, recordkeeper, or retirement plan
consultant in annual or periodic meetings throughout the year, has been the traditional method for
providing information about the plan and its investments. Education is also used to get eligible employees
enrolled into 401(k) plans. In recent years, education has also been available through online tools, videos,
and mobile apps. Education can convey the reasons that the plan sponsor has adopted a plan and how
the plan is designed to reach employees’ retirement goals. These meetings can also educate employees
on how the plan works and help them to appreciate the value of the plan benefits. Some employers offer
one-on-one meetings for participants with the plan’s service providers, but this option becomes more
difficult and increasingly costly in larger companies.

Automatic Enrollment
Education does not consistently overcome employee inertia. Frequently employees will delay enrolling in
their 401k plan by taking an “I’ll do it tomorrow” approach, but there is always another tomorrow and
they never get enrolled. Recent research indicates that enrolling employees automatically in 401(k) plans
can combat this problem of never getting enrolled in the traditional “opt in” approach. In auto-
enrollment 401(k) designs, participants are automatically enrolled in the plan when they are hired at a
deferral percentage specified by the plan document. Participants are given an option to opt out through
an auto-enrollment opt-out notice. However, because opting out requires participant action, inertia takes
over, and participants stay in the plan at their auto-enrolled deferral amounts.

Research by Benartzi and Thaler explain the dramatic benefits of automatic enrollment:

“In one plan studied, participation rates under the opt-in approach were barely 20 percent after
three months of employment, gradually increasing to 65 percent after 36 months of employment.
When automatic enrollment was adopted, enrollment of new employees jumped to 90 percent
immediately and increased to more than 98 percent within 36 months. Automatic enrollment thus
has two effects: participants join sooner, and more participants join eventually.”14

Administering Eligibility and Enrollment

Plan sponsor staff should understand how to coordinate with either an outside payroll vendor or an
internal payroll department to set up a system for notifying employees that they are eligible for the plan
and how to enroll in the plan. For auto-enrollment plans, the HR staff should be clear on how employees
are auto-enrolled through payroll, and how auto-enrollment opt-out notices are distributed.

In order to properly administer the plan, many types of information are gathered from the employee,
usually as part of an enrollment process. Other types of information are distributed to the employee.

Many items are usually included in the detailed enrollment information provided when the plan is
introduced to eligible employees. For example, employees need to know what investments are available
if they choose to make contributions. Investment information is commonly part of enrollment
information. Once they have elected to save money in the plan and chosen how that money will be
invested, they should decide how their account would be paid out in the event of their death. As a result,
enrollment information will commonly include a beneficiary designation form.

When employees become eligible for the plan, ERISA and the IRC require them to receive certain notices.

14
Benartzi, Shlomo and Thaler, Richard H., Heuristics and Biases in Retirement Savings Behavior. Journal of
Economic Perspectives, Forthcoming. Available at SSRN: [Link]
These notices are usually required whether or not the employee elects to enroll and make salary deferrals
to the plan. They are designed to protect employees’ rights under ERISA. For example, employees may be
selecting their own investments and they should know what those investments cost. Fee disclosure
notices explain plan expenses. If an employee elects to contribute to the plan, but does not select
investments, the plan must provide for a default investment alternative. Employees will receive a notice
explaining what the default investment is and how they can change to a different investment selection if
they prefer.

Summary
Fred may want to start his discussion of who will be participating in his plan with the legal allowable
exclusions. He may be able to exclude the employees who are working from other countries under the
nonresident alien rules. If he had any union employees, he could exclude those employees as well.

Fred can also set eligibility requirements for his other workers so that they must complete a certain
amount of service and be a minimum age before they can be eligible for and enter his plan. Fred should
discuss what his goals are for his employees in the plan, and who he wants to participate in the plan.

For example, Fred may not want to include the high school students in his plan. He can have the plan
impose a minimum age requirement of up to 21, which means they would not be currently eligible to
participate in the plan. Part-time workers must be considered for eligibility purposes once they have
worked 1,000 hours in a plan year, regardless of how they are classified by Fred’s firm. However,
independent contractors may not be covered by a stand-alone ERISA qualified plan like Fred’s, because
plans are only for the employees of the employer sponsoring the plan. Defining who is an independent
contractor and who is an employee is a complex and important decision, and Fred should work with his
CPA or attorney in making this determination.

When Fred has determined what his plan’s eligibility requirements should be and who is eligible for the
plan, Claire, the retirement plan consultant and/or the recordkeeper, can work with Fred’s staff to ensure
that eligible employees understand the plan’s benefits. Because 401(k) plans allow for employee
contributions, eligible employees will receive enrollment information including: how to make employee
contributions; who to designate as their beneficiary for their plan accounts; how to invest their monies;
and disclosures of important plan information. Claire and other service providers can explain this
information and work with Fred’s staff to ensure that all eligible employees receive the required
documents.

If Fred agrees that automatic enrollment is an effective way to improve participants’ retirement savings,
he should work with the retirement plan consultant and Claire on how to communicate the automatic
enrollment provisions to his employees, including required opt-out notices. Fred’s staff should be trained
on how to auto-enroll employees in the plan and enter their information in the recordkeeping system.

Lastly, Fred should make sure that his staff understands how to work with payroll systems and the plan’s
service providers to assure that employee contributions are correctly deducted from paychecks and
promptly deposited into the investments that employees elected when they enrolled in the plan.
Answers to Guiding Questions
Check your answers to the guiding questions by comparing them to the answers below.

1. What choices does the employer have in choosing who may or may not join the plan?
The law permits employers to exclude nonresident aliens, union employees and independent
contractors (though independent contractors may be difficult to correctly identify). The employer
can set a minimum age requirement (but not more than 21 years of age) and a minimum service
requirement (but not more than one year of service, except in special conditions). Additional
exclusions may be possible but would be subject to nondiscrimination testing.

2. How do qualified employees join the?

Once an employee has met the eligibility requirements, the employee becomes a plan participant
upon the next plan entry date. The plan document specifies plan entry dates (usually annually,
semiannually, quarterly, monthly, or immediately). In plans with employee contributions, such as
401(k) plans, employees may go through an enrollment process in which they are informed of
their options, asked to make certain elections, and provided with documentation.

3. What documentation does the employer provide to employees as part of the enrollment process?
Employees are asked to select a beneficiary. If the plan allows for salary deferrals, they are given
an election form to choose how much they would like to contribute. If the plan allows for the
participant to select investments, they are provided with information on investment options,
investment fees and plan fees, and default investment options. If the plan provides for automatic
enrollment, they are given an auto-enrollment opt-out notice.

Additional Resources
For more information on eligibility and enrollment see:

 Retirement Topics – Eligibility and Participation

[Link]
Participation

 Retirement Topics - Automatic Enrollment

[Link]
Enrollment

Unit 4: How Does Money Get into the Plan? (Contributions)

Scenario
Fred’s 401(k) plan is set up and employees are participating. Fred’s HR manager, Ingrid, is also in charge
of payroll. Each pay period, Ingrid must make sure that money is deducted from the salary payments of
each employee who is contributing to the plan. That money must then be sent to 401(k) Recordkeepers, a
company Fred selected to help with tracking participant accounts, and who makes sure the money is
invested in the right funds. Fred chose Retirement Plan Investments to provide investment services.
Because Fred offers a matching contribution, Ingrid must make sure Fred provides the correct amount of
money on behalf of his employees. That money is also sent to 401(k) Recordkeepers and invested in
funds available from Retirement Plan Investments. However, the employer money is tracked separately
from the employee money.

Sanjay is one of Fred’s employees. He has enrolled in the plan and contributes 5% of his salary each pay
period. Now when he receives his pay stub, he sees a subtraction of $150. Because Sanjay chose to
contribute pre-tax money, this amount is subtracted from his salary before the taxable amount is
calculated. Sanjay is happy to be saving for retirement and wants to monitor his account. Sanjay logs into
the website of 401(k) Recordkeepers. He’s surprised at how much information he sees. His balance is
broken out into many components, including “employee deferrals,” “employer match,” and “rollover.”
Sanjay also sees a column labeled “vesting.” For some amounts, he is 100% vested, and for some he is 0%
vested. He also sees numerous names of funds and the amount invested in each one. But Sanjay doesn’t
remember picking any funds. He remembers meeting with the advisor, Claire, and agreeing to a target
date fund. Sanjay calls up the customer care number on the webpage to get some explanations.

Guiding Questions
As you work through the material of this unit, look for answers to the following questions:

1. What are the different types of contributions?

2. What is vesting?
3. How is the money in a participant’s account invested?
4. Who is in charge of tracking the money?

Key Terms
After-tax: Amounts that a participant voluntarily contributes to a plan in addition to the contributions
made by the employer. After-tax employee contributions, unlike employer contributions, are not
deductible on either the employee's or the employer's tax return. This concept is alternately referred to
as voluntary contributions, post-tax contributions, or employee after-tax contributions; not to be
confused with “designated Roth contributions.”

Designated Roth Contribution: Compensation deferred to the plan at the participant’s election on an
after-tax basis. At the time of distribution, if the designated Roth contributions meet certain
requirements, earnings on the designated Roth contributions may be withdrawn tax-free.

Elective Contribution: An employer contribution that is made to the plan based on a participant’s elective
deferral.
Forfeiture: The benefits that a participant loses if he or she terminates employment before becoming
eligible for full retirement benefits under the plan.

Matching Contribution: An employer contribution that is made to the plan based on a participant’s
contribution. The employer may match all or part of the employee’s pre-tax, catch-up, designated Roth,
and/or after-tax employee contributions.

Nonelective Contribution: A contribution made by the employer on the participant’s behalf. No “election”
by the participant is required (unlike matching contributions). A profit sharing contribution is a
nonelective contribution.

Participant Direction: Participants may choose from a selection of investments to determine how their
account is invested.

Pre-tax Contribution: Employee money contributed to a plan from a paycheck that is not taxed at the time
it is contributed; it is taxed upon withdrawal.

Recordkeeper: The service provider responsible for tracking contributions, distributions, and investments
for all participants in the plan.

Rollover: A method of transferring assets from one plan to another (either an IRA or another qualified
plan), allowing for continued tax-deferral.

Safe Harbor Contribution: A contribution type required for safe harbor plans. Both matching and profit
sharing contributions can be “safe harbor.” A safe harbor contribution is 100% vested.

Trustee Direction: A trustee controls selection of investments for the plan and how assets are invested.

Vesting: The percentage of a participant's accrued benefits to which they are entitled. Vested amounts
may not be forfeited (see “forfeitures”).

Vesting Schedule: The rate at which a participant gains ownership of employer contributions, expressed
as a percentage based on the number of year of service by the participant.

Unit Overview
Fred’s plan has a lot of moving parts. Ingrid has to ensure that employee contributions and Fred’s
employer match reach the recordkeeper accurately and timely. The recordkeeper is responsible for
setting up separate accounts for each type of contribution being invested in the plan. Once those
contributions are in the plan and being tracked by the recordkeeper, they must be prudently invested by
the fiduciaries on behalf of the participants, or participants must be allowed to select their own
investments from a prudently selected investment line-up.

Sanjay has questions not only about his pre-tax contributions made to the plan from his compensation
but also about how they are invested and why there are so many accounts. He can turn to Ingrid or
401(k) Recordkeepers to explain what the contributions are in his plan and to what contributions he is
immediately entitled. He may also have questions about the plan’s investments, which Claire should be
able to answer for him.
Before answering Sanjay’s questions, Fred’s staff can be educated by the plan’s service providers so that
they are familiar with the types of contributions in qualified plans, how and when employees are entitled
to those contributions, why and how they are tracked in different accounts, and how the contributions
are invested.

What Types of Contributions Are There?

Before the wide adoption of 401(k) plans in the 1980’s, defined contribution and defined benefit plans
were primarily funded by employer contributions. Both plan types could allow for after-tax employee
contributions and rollovers into the plan from other qualified plans or IRAs, but there were rarely more
than three or four sources, or “buckets,” of money that a participant would see on his or her statement.

401(k) plans are still defined contribution plans, and so they still can show an employer contribution
known as a “profit sharing” contribution. When 401(k) plans became more popular, pre-tax contributions
were added to the “buckets” of money, or sources as they are commonly known. Employers had the
option to match these employee contributions, adding another type of employer money in the plan.
Legislation in the 1990s and 2000s added more sources of money, some funded by employer deposits,
such as safe harbor contributions, and some funded by employees, such as after tax designated Roth
contributions.

The reason Sanjay might see several sources of money when he accesses his account is because each
type of contribution must be tracked and accounted for separately due to various characteristics and
taxation differences.

Employee Contributions
Elective Deferrals
When an employee chooses or “elects” to contribute to a plan, they are choosing to “defer” receipt of a
portion of their salary until a later date. Contributions to the plan made at the participant’s election are
therefore called “salary deferrals” or “elective deferrals.” Thus, the terms “employee contributions,”
“salary deferrals,” or “employee elective deferrals” may all mean the same thing.

Employee contributions can be further described as those made on a pre-tax basis and those made on an
after-tax basis. Employees can elect to contribute everything on a pre-tax basis, everything on an after-
tax basis, or a combination of both. Sanjay elected to contribute 5% of compensation on a pre-tax basis,
which is the $150 he sees coming out of his paycheck each pay period.

Contributions Made on a Pre-tax Basis

Pre-tax Contributions
401(k), 403(b) and 457(b) plans allow for employees to contribute amounts out of their compensation to
a qualified plan on a pre-tax basis. A pre-tax salary deferral (or pre-tax contribution) then, is a portion of
the employee’s salary that is deposited to the plan rather than received as salary, and which is not
reported as taxable income at the time it is made. Although exempt from federal and state tax, pre-tax
employee contributions are still subject to Social Security and Medicare taxation.
Contributions Made on an After-tax Basis
Employee contributions made on an after-tax basis fall into two types: designated Roth contributions and
after-tax contributions.

Designated Roth Contributions

Some plans offer a type of contribution made on an after-tax basis, known as designated Roth
contributions. Designated Roth contributions are subject to all income and payroll taxes. If the plan allows
for designated Roth contributions, the earnings on those accounts may also be distributed tax-free as
long as the money remains in the Roth account for a specific period of time.

After-tax Contributions
In this course, the term “after-tax contribution” is used separately from the term “designated Roth
contribution,” although designated Roth contributions are made on an “after-tax basis.” Unlike the
designated Roth contributions, the earnings of after-tax contributions are reported as taxable income
when distributed from the account. For reasons explored in more advanced ASPPA education, after-tax
contributions are not considered “elective” deferrals.

Additional Employee Contribution Types

Catch-up Contributions
Because money contributed to a retirement plan receives tax benefits, the government places limits on
how much may be contributed each year. Employee deferrals (both pre-tax and designated Roth money)
are limited to the lesser of 100 percent of compensation, or a maximum dollar limit specified by IRS rules.
If a participant is age 50 or older, the participant can defer an additional amount in catch-up
contributions. 15 Pre-tax, designated Roth, and after-tax contributions may all be catch-up contributions.

Rollover Contributions
When employees are hired, or when they enroll in the plan, some plan documents will allow them to roll
in monies from a previous employer’s plan or certain IRA accounts.16 As with other sources of money,
rollovers are accounted for in a separate source. Rollover money must meet certain requirements before
it can be rolled into an employer’s qualified plan. HR and payroll staff should check with their retirement
plan service provider to determine how best to handle accounts that an employee wants to roll into the
qualified plan.

Employer Contributions
While the terms “contributions” and “deferrals” are commonly interchanged for employee contributions,
the term “deferral” is never used for employer contributions, as they do not represent deferred salary. In
general, the different types of contributions that may be contributed by the employer to a 401(k) plan are
matching contributions and nonelective contributions.

15
See “Elective Deferrals” and “Catch-up Contributions,” [Link]
Dollar-Limitations-on-Benefits-and-Contributions
16
The types of IRAs and qualified plan accounts that may be rolled INTO a qualified plan are subject to detailed rules
that are outside the scope of this course.
Matching Contributions
In their simplest form, matching contributions are made according to a formula based on employee
contributions. For each dollar an employee elects to contribute to the plan, the employer will usually
match an amount from 10 to 100 percent of the elective deferrals up to a cap of either a dollar amount or
a percentage amount.

Example 1
50% of elective deferrals up to 6 percent of compensation
100% of elective deferrals up to 3 percent of compensation

This incentivizes employees to save more by rewarding those employees who contribute. Matching
contributions may be made based on pre-tax, designated Roth, and after-tax contributions.

Nonelective Contributions
While matching contributions are made based on the amount, the employee has “elected” to contribute,
other types of employer contributions are made based on other factors. These are called nonelective
contributions, because they are not tied to any election by the employee. Profit sharing contributions are
a nonelective contribution. Unlike a matching contribution, a profit sharing contribution rewards a broad
base of employees for the company’s success, rather than only the employees who elected to contribute
to the plan. Although it is commonly called “profit sharing,” the contribution is not directly tied to
employer profits.

Example 2
The following is an example of a formula used to provide a profit sharing allocation to employees.
3% of compensation for all eligible employees.

Safe Harbor Contributions

In the mid-1990s, legislation was passed that introduced a new type of contribution applicable to 401(k)
plans: the safe harbor contribution. Both contributions made to all eligible employees (a profit sharing
type contribution) and contributions made only to those who save (a matching type contribution) may be
made as safe harbor contributions. By including a profit sharing or matching safe harbor contribution in
the plan provisions written in the plan document, an employer is required to make annual contributions
to employees. However, this arrangement generally allows the 401(k) plan to be exempt from the annual
testing used to determine whether a plan discriminates against lower paid employees.17 Therefore, safe
harbor contributions are a good option for sponsors who want to allow owners and partners to maximize
their retirement savings.

17
For more information on nondiscrimination testing, see “Unit 6: How Does the Plan Maintain Tax Qualification?”
of this module, or “Unit 4: Nondiscrimination Testing” of the RPF Testing Module.
 Contribution Types
Employee Contributions Employer Contributions
Elective Salary Deferrals Matching Nonelective
Contributions Contributions
Contributions made on Profit Sharing
a pre-tax basis
Pre-Tax* (Based on employee (Not based on employee
Contributions made on an after-tax basis deferrals) deferrals)
Designated Roth* After-tax*
(earnings not taxed, (earnings are subject to
provided certain criteria taxation)
are met)
*Can also be catch-up contributions for participants age 50 or older.

Vesting
Vesting describes the portion of the participant’s account that the participant is entitled to receive upon
an event that allows for money to be withdrawn, such as termination of employment.

Plan sponsors must decide on a vesting schedule, which is how employees usually become entitled to
receive their employer contribution accounts based on the number of years of service completed with
the employer. Vesting allows plan sponsors to reward employees’ continued service by steadily increasing
the amounts of the employer-provided retirement benefits to which participants are entitled.

There are requirements on how long a vesting schedule can make an employee wait to be entitled to all
of their monies, but plan sponsors can choose different schedules as long as they are more liberal than
the legal required maximums. Most documents provide for either a graded schedule, where a participant
earns a specific percentage of their account or their benefits over a specified period, or a cliff-vesting
schedule where participants are not entitled to any benefits until they have reached a certain number of
years of service, at which point they are entitled to all of their benefits.

Example 3
Two of the legally allowable maximum vesting schedules for profit sharing plans.18

Years of Cliff Graded

Service Vesting Vesting
1 0% 0%
2 0% 20%
3 100% 40%
4 100% 60%
5 100% 80%
6 100% 100%

18
[Link]
One Hundred Percent Vesting
The plan sponsor can decide on a vesting schedule that best fits the plan goals and objectives, but there
are specific contribution types that are always 100 percent vested. Because employee contributions
represent payroll deferrals, they are always 100 percent vested. Rollover contributions are another type
of employee contribution and are always 100 percent vested. Although they are employer contributions,
certain safe harbor contributions must also be 100 percent vested.19

How Is the Money Invested?

Employee and employer money that is contributed to a qualified plan becomes a plan asset, which has a
specific meaning under ERISA. Plan assets are set aside exclusively to provide benefits to participants and
their beneficiaries. Because of the importance of protecting this money, employee contributions must be
invested in the plan as soon as possible after they are withheld from payroll. Payroll staff should work
with recordkeepers to assure that this process is as smooth and as error-free as possible. Although
employer contributions are not required to be tied to payroll, they must be deposited according to the
plan document provisions and IRS deadlines. Once contributions are in the employee’s accounts, they are
part of the plan’s trust and subject to ERISA rules.

As soon as contributions become plan assets, they are eligible to be prudently invested. Fiduciaries, such
as the plan sponsor, have a duty to prudently select and monitor investments available to participants,
including default investments if employees do not select their own investment line-up. Investments can
be selected by the employees in a participant-directed plan. Alternatively, contribution accounts can be
invested by the plan trustee, known as a trustee-directed plan.

Regardless of how they are invested, these contributions and the investments make up the participants’
accounts. The accounts will be separated by where the money came from (employee or employer for
example) so they can be tracked for tax and investment purposes.

Investments Overview
With the growth of 401(k) plans, companies began transferring the responsibility of retirement
contributions to employees. Because the 401(k) consisted of participant monies, many plans became
participant-directed plans, allowing participants to select their own investments in their individual
accounts.

Participant direction of these contribution accounts has had mixed results. Many plans now offer
professionally managed funds called “target date” or “lifecycle” funds (especially as their default
investment option) that take advantage of behavioral finance principles and shift investment direction
back to the plan fiduciaries.

Even outside the target date fund, it may be appropriate to limit investment options, as participants are
prone to invest a disproportionate share of their accounts in the riskiest funds at precisely the time when
those funds are more likely to suffer large losses. Fiduciaries can work with consultants and advisors to
help them choose and oversee a prudent line-up with a reasonable number of investment choices.

19
Additional vesting rules are discussed in more detail in the RPF Distributions module and in more advanced ASPPA
courses.
For ERISA purposes, there is no right or wrong when it comes to investment selection. The rules
specifically decline to identify as either prudent or imprudent any specific investment or investment
approach. The facts and circumstances, including industry best practices, will therefore determine
whether a plan’s investment approach is prudent.

Some plans do not allow for participant direction. In a trustee-directed plan, the plan's trustee has the
responsibility for investing the plan's assets. As a plan fiduciary, the trustee is required to prudently
manage the plan monies under the rules of ERISA. As a result, the trustee may seek out prudent
investment experts and must ensure that fees charged to the plan are reasonable. The trustee is required
to select diversified investments to minimize the risk of large losses to the plan. Unlike participant-
directed plans, the investment gains or losses of the trust are shared by all the participants in the plan
based on their account balances, contributions, and withdrawals. Although trustee-directed plans have
the advantage of being professionally managed, they cannot select specific investments for individual
accounts as participants can in a participant-directed plan.

Qualified Plan Investments

ERISA requires that plan assets be diversified to minimize the risk of large losses. As a result, plan
fiduciaries should offer a diverse range of asset classes within their plans.

An asset class is a group of investments with common characteristics. There are four primary asset
classes, including:

 Equities (i.e., stocks);

 Fixed income (bonds);
 Cash; and
 Alternatives.

Stocks, bonds, and cash are regarded as traditional asset classes.

Alternative investments are non-traditional investments including employer stock, real estate,
commodities, limited partnerships, futures, collectibles, and hedge funds. Although non-traditional
investments are allowed in qualified plans, they are subject to specific rules. Fiduciaries must also always
ensure that the plan’s entire investment portfolio, including possible alternative investments, meets the
prudent guidelines of ERISA to act in the best interest of participants and beneficiaries.

Target Date Funds

“Target date funds” are diversified asset allocation funds that are often designed to be held as a single
investment by a participant. They have the advantage of shifting the investment burden from the
participant to a professional investment manager. They can be tailored to the participant’s retirement
age and/or risk tolerance, which make them a good fit for plans focused on retirement readiness. They
also take advantage of the behavioral finance concept of “make it automatic, make it easy” for
participants. Most of these funds are acceptable for use as a default fund in retirement plans for
participants who fail to make an investment election. Even though these funds may be one-stop shopping
for participants, they, as other investments, require ongoing fiduciary due diligence.
Participant Account Information
Sanjay, along with the other participants, is provided account information by 401(k) Recordkeepers, the
plan’s recordkeeping service provider. The recordkeeper tracks contributions, distributions, and
investments for all participants in the plan. When Sanjay logs into his account, he sees different accounts
for his different contribution types. His pre-tax deferrals will be reported separately from his matching
contribution account, for example. He will see 100% vesting in his employee deferral account, but his
employer contribution accounts will be subject to a vesting schedule. If he has worked for Fred’s firm for
only a year or two, he may not be vested in his employer contributions, which could include matching and
profit sharing contributions. If Fred elected to provide a safe harbor plan, however, Sanjay’s employer
safe harbor contributions would show as 100% vested.

If a participant does not see individual investments shown in the account, it could mean that they are
trustee-directed. If the plan allows for participant direction of investments, and the participant still
doesn’t recognize the investments, it may be that the participant didn’t elect to invest contributions in a
specific investment line-up. In this case, contributions would be invested in the plan’s default fund, which
is likely to be a target date fund based on age.

Once Sanjay is logged into his account, however, he can make investment changes to any contributions
that are participant-directed. He can see the investments available to him in the online investment menu
for the plan. He may also be able to change the amount of his future employee contributions online
based on the provisions of Fred’s plan. Most 401(k) plans allow participants to change their contributions
at any time through the online account access.

Sanjay can view his account information online, but he will also receive quarterly account statements
which certain service providers may give him the option to receive as hard copy or electronic format. Fee
disclosure rules require that Sanjay be provided with plan and investment fee information both quarterly
and annually. The annual fee disclosure is likely to be provided on paper unless Sanjay opts to receive it
electronically.

Summary
Fred’s 401(k) plan has many different types of contributions that have to be tracked by Fred’s HR
manager, Ingrid, and the plan’s service provider, 401(k) Recordkeepers. The contributions include pre-tax
employee deferrals, after-tax employee contributions, employer matching contributions, and rollover
contributions from other plans. 401(k) Recordkeepers tracks these contributions separately because they
are not only coming from different sources but they are also subject to different tax rules when they are
distributed. The contributions are also kept separate because some participant monies, such as pre-tax
and after-tax deferrals, are considered 100% vested when they are contributed to the plan. Employer
contribution accounts can be subject to a vesting schedule, where money is earned over time as the
employee works for the employer. 401(k) Recordkeepers will track that vesting and show vested
percentages and amounts on participant plan statements.

Sanjay will see his election to contribute 5% of his salary as a contribution to his 401(k) account tracked
by 401(k) Recordkeepers. If he chooses to make his contribution before taxes, it is considered a “pre-tax
deferral” and Sanjay can defer paying income taxes on that amount and its earnings until it is distributed
to him. He can elect to save money from his paycheck after taxes as a “Roth contribution” and the
account’s investments earnings will be tax-free at the time of distribution. His employer matching
contributions will also not be taxed when they are contributed, and the income tax on the contributions
and earnings is deferred until they are distributed to him.

Ingrid is responsible for distributing enrollment and investment information to employees like Sanjay.
Sanjay can then choose how he wants his monies invested. He can see his investment selections on the
401(k) Recordkeepers’ website and also on his plan statements. 401(k) Recordkeepers is responsible for
investing Sanjay’s money according to his elections, tracking that money, and reporting the investment
performance to Sanjay. Because selecting investments is a complicated process that depends on Sanjay’s
age, his risk tolerance, and his retirement savings goals, he can consult with Claire on how to select the
investments that best meet his personal objectives. Claire can explain investment concepts in general and
educate Sanjay on how investments work in a 401(k) plan.

Answers to Guiding Questions

Check your answers to the guiding questions by comparing them to the answers below.

1. What are the different types of contributions?

Contributions may be made by the employee or employer. Employee contributions may be made
before taxation occurs (pre-tax) or subject to taxation first and then contributed (after-tax).
Employees may also roll over contributions from other qualified plans. Employer contributions
may be matching (based on the amount the employee contributes), profit sharing (provided to
participants regardless of whether or not they contribute), or safe harbor (matching or profit
sharing type contributions used in some plans to exempt them from certain testing
requirements).

2. What is vesting?
Vesting determines what amount of the employer contributions employees are entitled to if they
take a distribution from the plan. It is tied to years of service, and defined by a vesting schedule in
the plan document.

3. How is the money in a participant’s account invested?

Contributions may be invested in the four types of asset classes: equities, fixed income, cash, or
alternatives. In participant directed plans, the participant may choose from the available
investments how much of their contributions are allocated to each investment. Accounts of
participants who do not choose an investment will be invested in default investments. In some
plans, a trustee directs the investments on behalf of the participants.

4. Who is in charge of tracking the money?

A recordkeeper tracks money going into and out of the plan, maintains participant account
balances, tracks sources of contributions, and sees that the money is invested properly.
Additional Resources
For more information on contribution types and recordkeeping see:

 Retirement Topics – Contributions [Link]

Employee/Retirement-Topics-Contributions

 Maintaining Your Retirement Plan Records [Link]

Retirement-Plan-Records
Unit 5: When Can People Take Money Out?

Scenario
After contributing to the plan for two years, Sanjay goes to his HR manager, Ingrid, and says, “I’m buying a
new car. I’d like to take out all my money from my 401(k) account.” Ingrid isn’t certain of all the rules and
regulations that apply to withdrawing money from a retirement plan. She contacts 401(k) Recordkeepers,
the company that tracks the accounts of Fred’s Electrical Contractors 401(k) Plan.

Guiding Questions
As you work through the material of this unit, look for answers to the following questions:

1. Who decides when money can come out of a retirement plan?

2. When are participants allowed to withdraw money?
3. What forms of payments are made from retirement plan accounts?
4. How are payments taxed?

Key Terms
Annuity: A series of periodic payments, usually level in amount or adjusted according to some index (e.g.,
cost-of-living), that continues for the lifetime of the recipient.

Distributable Event: An event or situation that permits a participant to withdraw assets from a plan.

Distribution: The payment of benefits from a plan.

DRO (Domestic Relations Order): A state judgment, decree or order (including approval of a property
settlement agreement) which relates to the provision of child support, alimony payments, or marital
property rights to a spouse, former spouse, child or other dependent of a participant. Upon qualification,
a DRO becomes a QDRO

Hardship Event: A distribution that is on account of an immediate and heavy financial need that must be
necessary to satisfy that financial need.

In-service Withdrawal: A withdrawal of vested money from a qualified plan to an employee who is still
actively employed. Also referred to as an in-service distribution.

Installment: One of a specific number of payments that will be paid whether or not the recipient lives to
receive them.

QDRO (Qualified Domestic Relations Order): A DRO that means certain requirements specified in the IRS
rules that has been “qualified” by the Plan Administrator, the fiduciary responsible for the plan’s day to
day operation. A QDRO creates or recognizes or assigns to someone other than the participant, an
alternate payee, the right to receive plan benefits payable to a participant. The alternate payee may be
the participant's spouse, former spouse, or dependent.
Loan: A withdrawal from a participant’s account that must be paid back, allowing the participant to
“borrow” from the account.

Lump Sum: A one-time payment of all of the participant’s assets, rather than a series of payments.

NRA (Normal Retirement Age): The age of retirement, as defined in the plan document. Reaching NRA
entitles the participant to be 100% vested in a DC plan. In a DB plan, it is the age at which the annuity
payment of the benefits are assumed to commence.

Rollover: A method of transferring assets from one plan to another (either an IRA or another qualified
plan), allowing for continued tax-deferral.

Separation from Service: See “Termination of Employment.”

Unit Overview
Retirement plans were initially established to provide benefits at retirement, so participants and
beneficiaries should only be taking money out of the plan when they reach retirement. Plan fiduciaries,
such as the plan trustee, have a duty to protect plan assets for participants. As a result, the law restricts
when they can distribute plan money to participants.

However, the law allows participants to have access to their retirement accounts for other reasons, such
as termination of employment. When money is paid out from the plan, it is called a distribution.
Retirement, death, and termination of employment are examples of distributable events: events that
allow participants to be eligible for a distribution. Plans can allow distributions even while the participant
is still working for the plan sponsor, although these are optional plan provisions.

This module addresses the types of distributable events, how payments are made, and the tax
consequences of withdrawing the money. It provides only a general overview to help you understand the
distribution process. The rules for processing distributions are complex and important. The complete
rules on distributions are outside the scope of this course.20

When Can You Take Out Your Money?

Other than retirement, there are many distributable events subject to different rules.

Distributions are permissible for the following reasons from any qualified plan:21
 Reaching normal retirement age
 Termination of employment
 Death
 Disability
 Termination of the plan

20
More detailed education on distributions is provided in ASPPA’s DC-2 course, “401(k) Plans and Intermediate
Administration Topics.” Visit [Link]/education for more information.
21
With the exception of specific 401(k) contribution rules.
A plan can also allow optional distributions, most often seen in profit sharing and 401(k) plans, including
the following additional events:
 “In-service” events
 Hardship events

Distributable Events
Retirement: The term “retirement” has a more specific usage and application in the retirement plan
industry than in its common use. As with many terms, plans will define in their documents what
constitutes retirement. The age of retirement as defined by the plan document is called normal
retirement age (NRA). Thus, if a plan defines NRA as 65 and a participant stops working at 55, that
participant would not be considered retired by the plan document’s definitions, and would therefore not
be entitled to take retirement benefits at that time. Conversely, participants may be entitled to take
distributions when they reach normal retirement age even if they don’t leave the company. They can also
delay distributions when they reach retirement age if they are still working for the plan sponsor.
However, owners who are working for the company at age 70-1/2 are likely to be required to take a
legally required minimum distribution amount each year. Lastly, traditional pension plans may offer
withdrawals while participants are still employed when they reach age 62.

Termination of Employment: The most common distributable event is termination of employment.

Sometimes also referred to as separation from service, termination of employment can mean employees
voluntarily leaving the company or employees fired or laid off by the employer.

Death: A participant’s death is a distributable event. The beneficiary designation completed by the
participant prior to death determines who will receive the participant’s benefits or account balance. If
there is no beneficiary designation on file, the plan document dictates to whom the benefits will be paid.

Disability: If a person becomes disabled, the plan document will define what disability is and if and when
they are entitled to plan benefits.

Divorce: ERISA protects spouses as well as participants. If a participant is divorced and the parties agree to
split the participant’s retirement account, the plan will receive a domestic relations order (DRO) indicating
that an ex-spouse may be entitled to benefits. Plan fiduciaries will work with service providers to certify
the DRO, making it a qualified domestic relations order, or QDRO. However, a QDRO is not a distributable
event. It only requires that the spouse’s benefits be segregated and protected.

Termination of the Plan: When a plan terminates, all participants with account balances are entitled to a
distribution. In addition, all participants are entitled to 100% of their plan monies.

Withdrawals while Employed

The plan may allow for withdrawals while a participant is still employed. Hardship withdrawals are a type
of distribution that may be allowed for participants still working for the employer. They are optional, but
may encourage participant deferrals in 401(k) plans. They are subject to detailed and complex rules that
fiduciaries and their service providers should review before electing to add these options to their plans. In
401(k) plans, providing features like hardship withdrawals may result in more employees being willing to
contribute to the plan, since they know they have access to their accounts if they need the money before
retirement.22

Although hardship withdrawals are distributed while an employee is in the service of the employer, the
term “in-service withdrawal” is often used specifically to refer to certain other types of withdrawals. An
in-service withdrawal has specific rules different from those for hardship withdrawals. For example, the
plan may permit distributions:

 For assets that have been in the plan for at least two years;
 For participants with five years of participation;
 For participants who have reached a stated age; or
 For other stated events, such as layoff or illness.

Loans
The plan may allow for participants to borrow from their vested account by taking a loan from the plan.
The advantage of taking a loan is that the participant can receive the funds without paying taxes on them.
The participant then makes loan payments back into their account – usually through payroll deduction.

How Much Is Available for Withdrawal?

As discussed in Unit 4, vesting determines which portion of a participant’s benefit or account balance is
available to him or to her for withdrawal and what they will receive when they have a distributable event.
In 401(k) plans, certain sources are always 100% vested. For example, the participant deferral source is
always 100% vested because it represents deferred income from a paycheck.

In addition to certain sources, certain conditions or situations require 100 percent vesting of employer
contributions:23

 Plans with an eligibility service requirement greater than one year

 Plans that are terminated
 Participants at normal retirement age
The plan sponsor can also choose (but is not required) to add the following additional events or
conditions that would make participants 100 percent vested in employer contributions:

 Participants reach early retirement age

 Participants become disabled
 Participants die prior to normal retirement age
As a practical matter, plans typically vest participants 100 percent at early retirement, on disability and on
death. However, plan sponsors have the option to specify a vesting schedule for these events.

In general, vesting of employer monies is subject to a schedule contained in the plan document and
selected by the employer.

22
Hardships are covered in more detail in the RPF Distributions module, Unit 4: Hardship Withdrawals. Loans are
covered in the RPF Participant Loans module.
23
Additional conditions may apply.
Example 1

Examine the vesting schedule for Fred’s plan and Sanjay’s account information.

Years of Account
Service Vesting Information
1 0% Name: Sanjay
2 20% Age: 30
3 40% Years of Service: 2
4 60% Deferrals: $10,000
5 80% Rollover: $15,000
6 100% Match: $5,000

If Sanjay leaves Fred’s company, he would receive 20% of his employer contribution account ($1,000 of
the match). However, he would be entitled to 100% of his employee deferral account and rollover
money.

Forms of Payment
When benefits are distributed, they may be issued in different ways. The following are forms in which the
plan may distribute benefits:

Lump sum: As the name implies, a lump sum distribution provides the entire amount of the distribution at
one time, and is the most common distribution type. A lump sum is eligible to be rolled over to an IRA or
another qualified plan.

Partial distribution: With this form, a participant takes only a portion of his or her vested account balance
or vested benefit. The distribution may also be eligible for a rollover to another plan or IRA.

Annuity: An annuity is a regular, ongoing payment when a participant reaches retirement or, less
commonly, when a participant terminates service with the employer. An annuity can be paid over the life
of the participant, which is known as a “life only” annuity. Another type of annuity, known as a “joint and
survivor” annuity, is paid over the life of the participant and continues over the designated survivor’s life
(typically a spouse) after the participant’s death.

Installment payments: Participants can elect to receive their vested monies over a specific period of time
if the document allows for it. For example, a participant who reaches age 55 and wants to retire can elect
installment payments from his or her account balance. In this instance, they may be able to avoid
additional excise taxes normally applied to any distributions taken prior to age 59-1/2.

Rollovers: A rollover is the transfer of a qualified plan distribution (or part of the distribution) to another
qualified retirement plan or to an IRA. Most rollovers are completed by direct trustee-to-trustee
transfers. For example, if Sanjay leaves his job with Fred and receives a distribution, he can choose to roll
the distribution into an IRA so that the money is still earning tax-deferred interest and is part of Sanjay’s
retirement monies.
What Is the Effect of Taxation?
Remember the tax benefits of qualified plans: participants can contribute money on a pre-tax basis,
employer contributions are not included in their current income, and all the investment earnings on their
accounts are not currently taxable. However, taxes on qualified plan benefits cannot be deferred
indefinitely. When monies are distributed, they are subject to income tax.

Although the government wants to collect taxes on taxable monies, they also want workers to save for
retirement and not pay taxes until they have retired and are no longer working. As a result, distributions
can be rolled over, or transferred, to an IRA or another qualified plan. As long as the rollover takes place
within a specified period of time, the distribution will not be taxed and will continue to defer taxation of
investment earnings on the account.

Since the primary purpose of retirement plans is to provide income at retirement, a participant who takes
a withdrawal prematurely will have to pay additional tax on the withdrawal. For example, if Sanjay leaves
Fred’s firm and chooses to use his distribution to pay personal expenses, he will pay both income tax and
an additional income tax. The additional income tax on early distributions is 10 percent for distributions
prior to age 59½ (it is often described as a tax penalty, but the official term is additional income tax).
Premature distribution additional taxes only apply to distributions that are not rolled over to another plan
or IRA.

There are exceptions to the 10 percent additional income tax on early distributions penalty. These
exceptions are described in the Distributions module of RPF.

Summary
Sanjay wants to access his 401(k) account balance, and Ingrid knows that there are many rules about
when and how participants can access their money. Her first step should be to work with 401(k)
Recordkeepers and the TPA to review the plan document and see what it says about when distributions
are permissible. If Sanjay qualifies for a distributable event while he is still working, such as an in-service
withdrawal, he may be able to get money out of the plan. If he withdraws the money, he will have to pay
tax on the amount he withdraws and he may also owe additional income tax if he is younger than 59-1/2.

If Sanjay leaves the company, 401(k) Recordkeepers or the TPA will send Sanjay information about rolling
over his distribution to an IRA or another qualified plan. Rollovers are not subject to regular or additional
income tax and help preserve monies in tax-deferred accounts for use in retirement. Not rolling the
money to another account means it will be subject to income tax.

Whether Sanjay leaves or withdraws the money while he is still working, he is only entitled to his vested
portion of his employer account. 100% of his employee deferral money is available to him.

Before Sanjay elects to withdraw money from his plan, he should remember that his retirement savings
are designed to assure he is ready for his eventual retirement. Participants should be encouraged to leave
their money in a qualified plan or IRA rather than use it for personal expenses while they are working.
Answers to Guiding Questions
Check your answers to the guiding questions by comparing them to the answers below.

1. Who decides when money can come out of a retirement plan?

The law places limits on when money may be withdrawn from a plan. The employer further
defines the restrictions or availability (as allowed by law) in the plan document.

2. When are participants allowed to withdraw money?

All plans allow participants to withdraw money at normal retirement age (as defined by the plan),
termination of employment, death, disability, and the termination of the plan. Some plans
(particularly profit sharing and 401(k)) allow for in-service withdrawals, hardship events, and
loans.

3. What forms of payments are made from retirement plan accounts?

Plans may provide payments as lump sum payments, partial payments, installments, or annuities.
Rollovers are lump sums that are transferred appropriately to an IRA or qualified plan.

4. How are payments taxed?

Payments distributed prior to age 59 ½ are generally subject to an additional income tax of 10%
(there are exceptions). If the money was contributed on a pre-tax basis, it will be subject to
income tax when distributed. Rollovers can be used to avoid taxation.

Additional Resources
For more information on distributions see:

 “When Can A Retirement Plan Distribute Benefits?”

[Link]
Distribute-Benefits

 “Retirement Plan and IRA Required Minimum Distributions FAQs”

[Link]
Distributions

 “Retirement Plans FAQs regarding Hardship Distributions”

[Link]

 “Rollovers of Retirement Plan and IRA Distributions”

[Link]
and-IRA-Distributions

 “Retirement Plans FAQs regarding Loans”

[Link]

 “Types of Retirement Plan Benefits”

[Link]
Unit 6: How Does a Plan Maintain Tax Qualification?

Scenario
The Electrical Contractors 401(k) Plan was setup as a tax-qualified plan, but in order for it to stay a tax-
qualified plan, it must meet ongoing requirements. At the end of the first year of Fred’s plan, a third party
administrator (TPA), Plan Administrative Services, performs testing on the plan to make sure it is
complying with the law. Fred reviews the results of the tests and discusses any changes, problems or
opportunities he needs to address with Plan Administrative Services.

Guiding Questions
As you work through the material of this unit, look for answers to the following questions:

What federal agencies oversee retirement plans?

What is the role of the plan document in maintaining tax qualification?

What is annual plan testing, and how does it affect tax qualification?

Key Terms
Benefiting: Generally speaking, participants who receive or make a contribution to the plan, or were
eligible to make or receive a contribution to the plan (whether or not they actually did) are considered
benefiting for that portion of the plan.

Coverage Testing: Testing that compares the number of HCEs who are benefiting under the plan to the
number of NHCEs who are benefiting.

HCE (highly compensated employee): An employee who, (1) during the current or preceding year owned
more than 5 percent of the employer, or (2) received compensation in excess of the specified dollar limit
for the preceding year.

NHCE (nonhighly compensated employee): An employee who is not an HCE is a nonhighly compensated
employee (NHCE).

Nondiscrimination Testing: Testing that compares the benefits or contributions of HCEs and NHCEs to
determine whether the plan discriminates against NHCEs.

Unit Overview
The goal of ERISA is to protect the interests of participants and their beneficiaries in employee benefit
plans. ERISA requires that sponsors of private employee benefit plans provide participants and
beneficiaries with adequate information regarding their plans. To provide this information, ERISA requires
reporting to the government and disclosure to participants. Furthermore, there are civil enforcement
provisions in ERISA to ensure that plan funds are protected and that participants who qualify receive their
benefits. In addition, individuals such as Fred, who manage plans as fiduciaries on behalf of participants
and beneficiaries, must follow specific ERISA rules.

The DOL has primary responsibility in overseeing ERISA Title I rules. They issue regulations (such as recent
participant fee disclosure rules) to protect participants and beneficiaries. They also audit employee
benefit plans to ensure that they are in compliance with ERISA. They oversee ERISA fiduciary standards
and have broad authority to audit and enforce fiduciary rules. These Title I plans include qualified
retirement plans, health plans and other employee benefit arrangements.

The DOL and IRS oversee qualified plans not only through audits, but also by reviewing the qualified plan’s
annual return, known as the Form 5500. 24 The 5500 contains information about the plan, its participants,
and its financial situation and must be filed every year that the plan is in place.

Title II of ERISA contains standards that must be met by employee retirement benefit plans in order to
qualify for favorable tax treatment. The term “qualified plan” comes from these rules. If retirement plans
intend to be qualified and take advantage of the tax benefits of qualified plans, they are subject to Title II
of ERISA. Title II references the IRC sections that lay out the rules for qualified plans, sometimes called the
“400” sections of the Code. In fact, the “401(k) plan” is often called the one Code section that is known by
most Americans. The IRS has primary oversight over Title II and qualified plan compliance with the IRC.

The beginning of the qualified plan rules in the IRC are contained in Section 401(a). All qualified plans
must satisfy IRC §401(a):

In writing, through a plan document; and

In operation, by administering the plan according to the plan document.

The plan document is essentially a road map for the qualified plan. The document contains the rules of
both Title I and Title II of ERISA and the provisions in the regulations and laws since ERISA. A plan is not
considered qualified unless it operates according to a current, signed, and complete plan document.

Plan Document Types

The qualified plan written document provision may be met by adopting a pre-approved document or an
individually designed plan. Although both plan types will contain standard language designed to meet the
plan qualification requirements of ERISA Title I and the IRC, they provide for individual plan sponsor
design choices in different ways.

Pre-approved Plans
Pre-approved plans consist of an adoption agreement and a basic document. They are created by a
service provider, and are adopted by employers who use their services. The advantage to this structure is
that the document provider receives a favorable IRS opinion letter for the plan. Employers who correctly

24
[Link]
complete the adoption agreement do not have to submit the plan to the IRS and may rely on the plan’s
pre-approved IRS status.

Individually Designed Plans

Employers who need specific plan design provisions that are not available in a pre-approved plan may
retain an ERISA lawyer or service provider to prepare an individually designed plan document. Because
the document must follow the same qualification requirements as the other plan types, it will contain
standard language. However, both the standard language and the custom provisions have not been
preapproved by the IRS.

When an IRS favorable determination letter is requested, the entire document is reviewed and the
practitioner works with the IRS to assure that all the provisions satisfy the qualification requirements of
the IRC. This can be an expensive and a time-consuming process for the service provider and the
employer, which is why the vast majority of smaller employers use pre-approved documents. Larger
employers or employers with complex multiple plan designs will more often adopt individually designed
plan documents. Although the plan is not required to obtain a favorable determination letter, the letter is
an advance determination by the IRS saying that it satisfies the qualification rules.

Administering the Plan According to the Plan Document

The qualified plan document answers the “who, what, and when” questions of retirement plans: who is
covered, what are they entitled to and when certain events are required to take place. Some of the main
sections in a plan include:

Eligibility and participation

Compensation definition
Employee and employer contributions, allocations, and limits
Vesting and forfeitures
Distributions, including loans and hardship withdrawals
Required compliance tests
Participant and beneficiary rights and notifications

Defined benefit plans will include provisions about retirement benefit formulas and how participants
accrue, (earn) benefits while they are employed by the plan sponsor. DB plans will also have different
distribution provisions, including annuity options for participants and their spouses.

Eligibility and Participation

In order for the plan to be qualified, the eligibility requirements must be within certain limits. The IRC sets
out the statutory eligibility requirements, which will be in a pre-approved plan’s adoption agreement. The
entry date selected by the employer must also be within limits set by the IRC.

Compensation
Compensation is the income received by employees of the plan sponsor for services rendered. The term
“compensation” has a legal context in a plan document and may include items other than just an
employee’s salary, such as employer fringe benefits. There may be several definitions of compensation in
the adoption agreement: each can be used in the plan for a different purpose. Plan sponsors are allowed
to include or exclude certain components of compensation, as long as the compensation does not
disproportionately favor higher-paid employees.

Contributions and Allocations

In defined contribution plans, the adoption agreement will specify the amounts and types of
contributions that can be contributed by the employee and/or the employer. The adoption agreement
may also describe how those contributions are allocated. The base document will include required IRC
limits as well as other allocation requirements for employee and employer contributions.

Vesting and Forfeitures

Employers can select how employees become entitled to their employer contribution accounts by
choosing a vesting schedule in the adoption agreement.

The portion that the participant is not entitled to, the non-vested portion, cannot be distributed to the
participant and is forfeited. The plan document must specify how those forfeitures will be used by the
plan.

Distributions
In addition to the distributions that are always allowed from qualified plans, documents may also be
drafted to allow for in-service distributions, including loans and hardship withdrawals. Loans are typically
also subject to a loan policy adopted by the plan sponsor, which is usually not part of the plan document.

401(k) plans have specific distribution restrictions on employee monies which will be outlined in a 401(k)
qualified plan document.

Defined benefit plans and defined contribution plans that have received pension plan assets are subject
to required annuity provisions that must be in the plan document. 401(k) and 403(b) plans are not subject
to these annuity rules unless pension monies have been merged into the 401(k) or 403(b) plan.

Participant Rights and Notifications

Plan documents are required to include ERISA Title I provisions and their subsequent regulations that are
designed to protect participants and beneficiaries. These include describing participant rights under ERISA
and required employee notices such as Summary Plan Descriptions, Summary Annual Reports, and
notices of plan changes (including plan termination and required participant disclosures).

Compliance Testing
A qualified retirement plan’s tax favored status means that it must satisfy certain nondiscrimination tests
to assure that the plan’s benefits and contributions do not exclusively or overly favor the plan sponsor’s
higher paid employees. Required tests focus on two areas: covering employees and demonstrating that
contributions and benefits are fair (i.e., nondiscriminatory). Because nondiscrimination involves many
different aspects of the plan, there are several tests and several ways to pass or be exempt from the
tests. Employers can select provisions in their plan document to help with testing.
Coverage
Coverage testing measures the percentage of employees who are considered “benefiting” under the plan.
The concept of benefiting25 is somewhat complicated, but some examples of benefiting employees
include those who accrue benefit during the year in a DB plan, or those who are eligible to make
employee contributions in a DC plan. Plans must prove that they satisfy coverage before performing any
other tests. A qualified plan may impose specified eligibility rules to enter the plan, but it can then
provide separate requirements for benefit and contribution entitlement.

If there were no coverage rules, plan sponsors could exclude a large percentage of the workforce from
the plan. Because qualified plans must be nondiscriminatory to qualify for tax benefits, the coverage rules
ensure that a majority of the workers will be covered under the plan. Although the concept is simple, the
operation of the rules is complex in practice. Coverage can involve multiple employers, multiple
employee groups, and multiple sources of plan contributions. Plan consultants should be aware of the
factors that comprise coverage testing, when helping plan sponsors design plans, to assure that the plans
remain qualified.

Nondiscrimination Tests
There are many nondiscrimination tests that a qualified plan must pass. In general, nondiscrimination
tests compare plan features that impact highly compensated employees (HCEs) and nonhighly
compensated employees (NHCEs). In general, the plan may not discriminate in favor of HCEs over NHCEs.
However, HCEs may be allowed to have higher contributions or benefits, as long as those benefits cannot
be significantly higher than those of NHCEs. In addition to coverage testing, these nondiscrimination
requirements can include:

ADP/ACP (401(k) plans only)

Plan benefits, rights and features
Non-safe harbor compensation definition
Amendments subject to anti-cutback rules

Summary
The Electrical Contractors 401(k) Plan will have a plan document containing both required and optional
provisions. The optional provisions can be chosen by Fred in conjunction with his TPA, Plan Administrative
Services (PAS). PAS uses a pre-approved plan document to ensure that it will be compliant with IRS and
DOL rules. PAS also works with Fred to complete and file the Form 5500 annually for the plan, which
shows the IRS and DOL how the plan is complying with ERISA and IRC requirements. PAS also performs
required annual testing for Fred’s plan to verify that his plan is covering enough eligible employees and
that his plan is nondiscriminatory. If the plan fails the coverage or nondiscrimination tests, PAS can
consult with Fred on possible plan designs to be exempt from testing or on how he can correct failed
tests.

25
For more information on benefiting and coverage, see the RPF Testing module, “Unit 2: Minimum Coverage
Testing,” or more advanced ASPPA courses.
Answers to Guiding Questions
Check your answers to the guiding questions by comparing them to the answers below.

1. What federal agencies oversee retirement plans?

The DOL oversees ERISA Title I rules protecting participants and beneficiaries, including required notices
and disclosures. The IRS oversees the tax qualification provided by ERISA Title II. Both the DOL and IRS
oversee the Form 5500 annual filing requirement.

2. What is the role of the plan document in maintaining tax qualification?

A signed plan document is a requirement for tax qualification. The plan document provides the roadmap
directing how the plan will be operated. It specifies what features and provisions are included in the plan,
and defines eligibility requirements, compensation, vesting schedules, allowable distributions, and
required testing, among others. The plan must be operated according to the plan document in order to
maintain tax qualified status.

3. What is annual plan testing, and how does it affect tax qualification?
In order to maintain tax qualification, plans must demonstrate that they do not discriminate against
nonhighly compensated employees through nondiscrimination testing. They must also demonstrate that
they do not exclude a disproportionate percentage of NHCEs from participating in the plan.

Additional Resources
For more information on tax qualification, notifications and disclosures, and compliance testing, see:

 “A Guide to Common Qualified Plan Requirements”

[Link]

 “Tax Consequences of Plan Disqualification”

[Link]

 “Retirement Plan Reporting and Disclosure”

[Link]

 “Form 5500 Corner”

[Link]

 Nondiscrimination Testing
[Link]
Nondiscrimination-Tests