A retirement plan that meets the requirements of Internal Revenue Code Section 401(a) is referred to as a "qualified plan." IRC Section 401(a) sets standards for retirement plans including:
- Who is eligible for plan participation,
- When participants have a nonforfeitable right to their plan benefits,
- How much may be contributed to the plan by both participant and employer, and
- When and how distributions from the plan may be made.
Both employers and participants in qualified plans may take advantage of significant tax benefits that include taking a deduction for contributions to the plan (employer) and sheltering income and plan earnings from income tax until distributed (participant).
In general, a qualified plan can include a 401(k) feature only if the qualified plan is one of the following types of plans:
- A profit-sharing plan
- Stock bonus plan
- A money purchase pension plan in existence on June 27, 1974, that included a salary reduction arrangement on that date
- Rural cooperative plan.
401(k) plan qualification rules
General plan qualification rules can be found in:
- Publication 560, Retirement Plans for Small Business (SEP, SIMPLE, and Qualified Plans)
- Publication 4222, 401(k) Plans for Small Businesses (PDF)
- Guide to Common Qualified Plan Requirements
To qualify for the tax benefits available to qualified plans, a plan must both contain language that meets certain requirements (qualification rules) of the tax law and be operated in accordance with the plan's provisions. The following is a brief overview of important qualification rules. It is not intended to be all-inclusive.
Plan assets must not be diverted.
The plan must make it impossible for its assets to be used for or diverted to, purposes other than the benefit of employees and their beneficiaries. As a general rule, the assets cannot be diverted to the employer.
Contributions or benefits must not discriminate.
Under the plan, contributions or benefits must not discriminate in favor of highly compensated employees. Generally, employees with compensation of $130,000 or more from the employer in the prior year are considered highly compensated for 2020 ($125,000 for 2019;120,000 for 2015, 2016, 2017 and 2018, subject to cost-of-living adjustments). In order to satisfy this requirement with regard to elective deferrals and employer matching contributions, 401(k) plans may provide (safe harbor) minimum employer contributions or meet the Actual Deferral Percentage and Actual Contribution Percentage tests.
Contributions and allocations are limited.
Contributions to a 401(k) plan must not exceed certain limits described in the Internal Revenue Code. The limits apply to the total amount of employer contributions, employee elective deferrals and forfeitures credited to the participant's account during the year. See 401(k) and Profit-Sharing Plan Contribution Limits.
Elective deferrals must be limited.
In general, plans must limit 401(k) elective deferrals to the amount in effect under IRC section 402(g) for that particular year. The elective deferral limit is $19,500 in 2020 and $19,000 in 2019. The limit is subject to cost-of-living adjustments. However, a 401(k) plan might also allow participants age 50 and older to make catch-up contributions in addition to the amounts contributed up to the regular 402(g) dollar limitation, provided those contributions satisfy the requirements of IRC section 414(v). These limits apply to the aggregate of all retirement plans in which the employee participates.
Minimum vesting standard must be met.
A 401(k) plan must satisfy certain requirements regarding when benefits vest. To "vest" means to acquire ownership. The vested percentage is the participant's percentage of ownership in his or her account. All participants must be fully (100%) vested in their 401(k) elective deferrals. A traditional 401(k) plan may require completion of a specific number of years of service for vesting in employer discretionary or matching contributions. For example, a plan may require 2 years of service for a 20% vested interest in employer contributions and additional years of service for increases in the vested percentage. Matching contributions must vest at least as rapidly as a 6-year graded vesting schedule. A safe harbor and SIMPLE 401(k) plan must provide for 100% vesting in employer and employee contributions at all times.
Employee participation standards must be met.
In general, an employee must be allowed to participate in a qualified retirement plan if he or she meets both of the following requirements:
- Has reached age 21
- Has at least 1 year of service
- (A traditional 401(k) plan may require 2 years of service for eligibility to receive an employer contribution if the plan provides that after not more than 2 years of service the participant is 100% vested in all plan account balances. However, the plan must allow the employee to participate by making elective deferral contributions after no more than 1 year of service.)
A plan cannot exclude an employee because he or she has reached a specified age.
Leased employee. A leased employee is treated as an employee of the employer for whom the leased employee is providing services for certain plan qualification rules. These rules apply to:
- Nondiscrimination requirements related to plan coverage, contributions, and benefits.
- Minimum age and service requirements.
- Vesting requirements.
- Limits on contributions and benefits.
- Top-heavy plan requirements.
Certain contributions or benefits provided by the leasing organization for services performed for the employer are treated as provided by the employer.
Distribution rules must be followed.
Generally, distributions cannot be made until a "distributable event" occurs. A "distributable event" is an event that allows distribution of a participant's plan benefit and includes the following situations:
- The employee dies, becomes disabled, or otherwise has a severance from employment.
- The plan ends and no other defined contribution plan is established or continued.
- The employee reaches age 59½ or suffers a financial hardship.
Benefit payment must begin when required. Unless the participant chooses otherwise, the payment of benefits to the participant must begin within 60 days after the close of the latest of the following periods:
- The plan year in which the participant reaches the earlier of age 65 or the normal retirement age specified in the plan.
- The plan year which includes the 10th anniversary of the year in which the participant began participating in the plan.
- The plan year in which the participant terminates service with the employer.
Loan secured by benefits. If survivor benefits are required for a spouse under a plan, the spouse must consent to a loan that uses the participant's account balance as security.
Involuntary cash-out of benefits. In certain circumstances, the plan administrator must obtain the participant's consent before making a distribution. Generally, consent is required if the participant's account balance exceeds $5,000. Depending on the type of benefit distribution provided for under the 401(k) plan, the plan may also require the consent of the participant's spouse before making a distribution. The plan may provide that rollovers from other plans are not included in determining whether the participant's account balance exceeds the $5,000 amount.
If a distribution in excess of $1,000 is made, and the participant (or designated beneficiary) does not elect to (i) receive the distribution directly or (ii) make an election to roll over the amount to an eligible retirement plan, the plan administrator must transfer the distribution to an individual retirement plan of a designated trustee or issuer and must notify the participant (or beneficiary) in writing that the distribution may be transferred to another individual retirement plan.
Benefits must not be assigned or alienated.
The plan must provide that its benefits cannot be assigned or alienated. A loan from the plan to a participant or beneficiary is not treated as an assignment or alienation if the loan is secured by the participant's account balance and is exempt from the tax on prohibited transactions under IRC 4975(d)(1) or would be exempt if the participant were a disqualified person. See Publication 560 for additional information on prohibited transactions. A loan is exempt from the tax on prohibited transactions under IRC section 4975(d)(i) if it:
- Is available to all such participants or beneficiaries on a reasonably equivalent basis,
- Is not made available to highly compensated employees (within the meaning of IRC section 414(q)) in an amount greater than the amount made available to other employees,
- Is made in accordance with specific provisions regarding such loans set forth in the plan,
- Bears a reasonable rate of interest, and
- Is adequately secured.
Also, compliance with a qualified domestic relations order qualified domestic relations order (QDRO), does not result in a prohibited assignment or alienation of benefits.
Top-heavy plan requirements must be met.
A plan is top-heavy for any plan year for which the total value of accrued benefits or account balances of key employees is more than 60% of the total value of accrued benefits or account balances of all employees. Additional requirements apply to a top-heavy plan, including the requirement that non-key employees receive a minimum contribution and the requirement to satisfy an accelerated vesting schedule for employer contribution accounts.
Most qualified plans, whether or not top-heavy, must contain language that meets the top-heavy requirements and that will take effect in plan years in which the plans are top-heavy. These qualification requirements for top-heavy plans are explained in section 416 of the Internal Revenue Code.
The top-heavy plan requirements do not apply to SIMPLE 401(k) plans. Additionally, the top-heavy rules do not apply to a plan that consists solely of safe-harbor 401(k) contributions.