Most people know that they need to save for retirement, but many do not fully understand all the savings plan options available. Not all retirement savings plans are created equal. Some can offer more tax benefits while others might allow you to make more contributions. Choosing which one is right for you requires knowledge of the available plans and maybe even the help of a financial planner. So, what exactly is a qualified retirement plan and how does it work? We will tell you everything you need to know about these plans below, so just keep reading.
What Is A Qualified Retirement Plan (QRP)
A qualified retirement plan is one in which your savings can grow tax-deferred until retirement age. You do not owe any taxes on the income generated by your investments until you withdraw the funds. Common plans include a 401(k) or a pension plan. Most retirement plans offered by your employer are qualified retirement plans. More specifically, the plan must meet the rules laid out in Section 401 of the United States tax code. The IRS recognizes these plans and gives them special tax treatment. There are a couple of different types of plans that might be offered by your employer.
The most common types of QRP’s offered by employers are defined contribution plans and defined benefit plans. Defined contribution plans are the most common and include things like your 401(k). These plans allow both the employee and employer to contribute to the account. The employee usually contributes a certain percentage of his or her salary, and the employer might make a matching contribution. Most of these plans allow for early withdrawal before retirement, although you might owe a tax penalty if you fail to meet the early withdrawal requirements.
Defined benefit plans are less common. These are typically things like a pension plan. When it comes to a 401(k) versus a pension, there are a few key differences. A defined benefit plan, like a pension, specifically defines the benefit that will be available to you upon retirement. This is usually in the form of an annuity, and you receive monthly payments based on your salary history and length of service with the company. In some instances, employers might offer a hybrid plan such as a cash balance plan. This operates similarly to a pension, but the amount that you receive depends on the cash balance in the plan.
Qualified VS Non-Qualified Retirement Plans
So, what is the difference between a qualified plan and a non-qualified plan? At a very basic level, qualified plans are protected through ERISA. This is a federal law that was enacted in 1974 to help protect workers’ retirement plan savings. Non-qualified plans do not have any ERISA protection. So, what does that mean in practical terms? It means that qualified plans are subject to much more scrutiny. They must meet certain reporting requirements and regulatory requirements around vesting, eligibility, accrual, and funding. Non-qualified plans are not subject to this same level of scrutiny.
There are also tax treatment differences between the two plans. Qualified plans allow an employee to contribute pre-tax dollars to the account and receive a tax deferral of the income taxes on that money. Employers may also deduct the contributions that they make to employee accounts. Examples of qualified plans are a pension plan, 401(k), profit-sharing plan, 403(b) plan, 401(a) plan, employee stock ownership plan (ESOP), Keogh plan, money purchase plan, Simplified Employee Pension (SEP), and a Savings Incentive Match plan (SIMPLE IRA). On the other hand, non-qualified plans are funded with after-tax dollars. These plans do not usually qualify for a tax deduction by the employer. Often, non-qualified plans are only offered to executives and high level employees within a company. Since a non-qualified plan does not need to meet the discrimination guidelines, these plans are not required to be offered proportionately to all employees. Examples of non-qualified plans include an individual retirement account, deferred compensation plan, 457(b) plan, split dollar life insurance, salary deferral, Roth IRA or executive benefit plan.
When it comes to contribution limits, those will vary by plan type. There is not necessarily a standard rule when it comes to qualified vs non-qualified plan contribution limits. The annual contribution rules are set at the plan level. For instance, the limits for an IRA and a 401(k) are different. There are also different limits for employee contributions vs employer contributions. You should check with your plan sponsor or tax advisor to discuss the limits of your specific plan.
Qualified Retirement Plan Tax Treatment
Taxes are often a big topic when it comes to retirement planning. Whether or not your contributions are tax deductible makes a big difference when deciding which type of plan in which to participate. In addition, some plans allow you to make withdrawals tax-free upon retirement. So, what are the tax differences between qualified and non-qualified plans? Generally, the Internal Revenue Code allows qualified plans tax deductions for both the employee and employer. This can be a big advantage for small business owners or the self-employed. Those individuals often consider establishing a solo 401(k) plan for the tax advantages.
Some qualified plans allow for withdrawals before retirement, but most either require reaching a certain age or a triggering event. If those conditions are not met, then both taxes and an additional penalty will be due. Non-qualified plan withdrawals can often be made tax-free since these accounts are often funded with after-tax dollars. In many cases, no triggering event or age requirement is necessary to make withdrawals. However, any income generated on the investments within the account might be subject to taxes and penalties if withdrawn before retirement age.
Benefits Of Qualified Retirement Plans
Plan participants can see many great benefits from participating in a qualified plan. First, the retirement benefits alone from participating in a plan of any kind is a huge benefit. This can help alleviate financial stress and burdens during your retirement years. Some people rely solely on Social Security at retirement, and that can be difficult in today’s world.
The tax credits associated with a qualified plan are another huge bonus. Your elective deferral contributions help lower your taxable income during the current year. In addition, these plans typically offer a wide range of investment options. While the plan documentation will list the investment options available, you can usually invest in stocks, bonds, mutual funds, and other publicly traded funds. Eligible employees can select their own investments from the available options to help diversify their portfolio.
The Bottom Line
If you are saving for retirement, then you are likely participating in either a qualified or non-qualified retirement plan. You might even be contributing to both! Qualified plans offer some additional benefits and protection that are not available with non-qualified plans. There are some tax advantages as well as protections offered by the Employee Retirement Income Security Act of 1974. You should do everything you can to max out your contributions to your plan so that you have plenty of money stashed away at retirement!
Frequently Asked Questions
Is a 401k considered a qualified retirement plan?
Yes, a 401k does meet the IRS rules to be considered a qualified retirement plan. Your employer is responsible for ensuring that the reporting and regulatory requirements are met to keep the plan in compliance. You can make tax deferred contributions to the plan, and your employer can deduct any matching contributions that they make from their corporate tax bill as well.
Is a Roth IRA a qualified retirement plan?
A Roth IRA is not considered a qualified plan. It does not meet the guidelines laid out by the IRS for qualified plans. These plans are not offered through employers, thus they are not subject to ERISA protections. While both a Roth IRA and traditional IRA might offer the same tax advantages as a qualified plan, they do not meet the other requirements laid out in the Internal Revenue Code.
How do I know if I contributed to a qualified retirement plan in 2021?
So, did you contribute to a qualified retirement plan this year? How can you tell? You should first check your paycheck stub to see if any deductions were made for a 401k contribution or other type of qualified plan. If you are uncertain, then you can check with your company’s Human Resources department to determine whether you are enrolled in a qualified plan. If you have a retirement plan outside of your employer like an IRA, then that plan is not considered a qualified plan. While contributing to these plans is still a good idea, they do not offer all the same protections as a qualified plan.
What is the penalty for not contributing to a qualified retirement plan?
There are no penalties, per se, for not contributing to a qualified retirement plan. You would, however, be missing out on some potential benefits by not contributing. If your employer offers a qualified plan, then you should participate if at all possible. It allows you some great tax advantages and helps you grow your retirement savings so that you will be financially secure when you reach retirement age.