Qualified retirement plans meet IRS guidelines and “qualify” for special tax treatment. Special tax treatment means that the contribution to the plan is tax-deferred for the employee and non-taxable for the employer.
Why do employers and employees want their plan to be qualified? The simple answer is taxes!
It said that: “If premiums are not deductible, then benefits are not taxable.” This applies to retirement plans too, but it is opposite. In this case the contributions are tax deductible, so the benefits are taxable.
In other words, because the contributions are not taxed going in, they will be taxed coming out.
Withdrawals from Qualified Retirement Plans
Most qualified plans are 100% taxable in the tax year that the funds are withdrawn.
Withdrawals made before age 59½ are subject to a 10% penalty. The penalty is applied in addition to any regular taxes that are due.
The IRS also requires that withdrawals must be made after age 70½. If insufficient funds are withdrawn from a plan (based on mortality tables) the IRS will penalize the person 50% on any funds they fail to withdraw. Remember: 10% before 59½ and 50% after 70½.
457 Deferred Compensation Plan
The 457 Deferred Compensation Plan is described in the Internal Revenue Code. It allows an employer to set up a deferred compensation plan for employees that reduces the employee’s current income with the promise to pay it later, with interest, during the employee’s retirement. Essentially, the employee receives compensation in the future for work done today.
It is mutually agreed between the employer and employee that compensation is reduced during the working years so that the money, with interest, can be paid to the employee during retirement.
Since the fund is owned and controlled by the employer, the plan is sometimes referred to as “golden handcuffs.” If an employee quits before retirement, the employee has no guarantee of receiving the deferred compensation.
Section 1035 of the Internal Revenue Code governs how qualified funds can be rolled over from one employer to another when an employee changes employers. The general rule is that transfers should be made to the same type of contract.
For example, a variable life insurance account should be transferred to a variable life insurance contract with the new employer.
The rules…
The exchange (rollover) must be completed within 60 days and the owner should not take control of the funds. If the owner takes control of the funds (what the IRS calls constructive receipt), the owner will be penalized and the funds could potentially lose their tax-deferred status.
The IRS regards rollovers as a no gain-no loss transaction, meaning that in the year that the exchange takes place, any gain will not be taxed, and no loss can be deducted.
Non-qualified plans
Simply put, non-qualified plans are just about everything else that is financed with after-tax dollars, but the interest they earn is taxable. An interest-bearing savings account is a non-qualified plan. Savings are paid in with after-tax dollars and taxes are paid on any interest earned.
Most annuities are also non-qualified, but have tax-deferred earnings. For example, with a non-qualified fixed annuity, only the interest income is tax-deferred. As payments are made to the annuitant, taxes are paid only on the interest portion of the payment. The principal portion is not taxed because it was taxed before it was paid in - it was paid in with after-tax dollars.
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2008 Timothy Watson My Tax Guide
