What is a Qualified Retirement Plan?
A qualified retirement plan sponsored by an employer is recognized by the IRS, and fulfills the requirements of its code Section 401(a), which allows this plan to get tax benefits. This is in contrast to the unqualified plans that do not fulfil the IRS requirements, making them ineligible for getting tax benefits. The retirement plans are set up by employers as part of employee benefits to attract new employees and retain the existing ones. The qualified retirement plans must also meet the minimum standards specified by the Employment Retirement Income Security Act of 1974 (ERISA).
This article helps you understand qualified vs non qualified retirement plans, guides you on how you can invest in them, and the tax benefits you can receive by subscribing to these plans.
Types of Qualified Retirement Plans
Qualified retirement plans can be divided into two types: defined-contribution plans and defined benefit plans.
1- Defined Contribution Plans:
In defined contribution plans, you and potentially your employer jointly contribute to a retirement account, which can grow by earning a profit on investment. The amount you get on your retirement depends on the performance of your investments, the total amount of contributions, among other factors. In other words, you - the employee - bears the investment risk. The most common type of defined contribution plan is the 403(b) or 401(k) plans.
2- Defined Benefit Plans:
Defined benefit plans are offered mostly by public or state-owned organizations to their employees. In defined benefit plans, a guaranteed fixed amount based on a formula is paid each month after retirement for the rest of the retiree’s life. A typical example of a defined-benefit plan is the traditional annuity type pension that pays a fixed amount at the time of retirement.
Qualified retirement plans include 403(b) plans, defined benefit plans, profit-sharing plans, employee stock ownership plans, money purchase plans, among many others.
Investment Options and Distributions in Qualified Retirement Plans
Qualified plans allow different types of investments, depending on the types of plans. Commonly, the investment options include mutual funds, including both stock and bonds, money market funds, and life cycle funds.
Qualified retirement plans also define the threshold for distributions. Depending on the scenario, distributions can be paid throughout the employee’s retirement, employee’s disability, termination of the plan, or in case of the employee’s death.
Taxes in Qualified Retirement Plans
Employees get tax breaks in the form of reduced taxable income or deferred tax for their contributions to the retirement account. The contributions you make to a qualified plan are tax-deferred and will lower your current taxable income. Also, your contributions to the retirement account grow tax-free until you withdraw them. The distributions, if taken before predetermined ages, can attract penalties and taxes to discourage earlier withdrawals. Borrowing an amount from the plan is allowed in some cases, provided you repay the loan under a defined criterion. You might have to repay the loan within a stipulated period, deposit the interest on the loan into the plan, or repay the loan in full if you leave the job.
Requirements of the Qualified Retirement Plan
Some of the important requirements a qualified retirement plan should meet include the following:
- Employees participating in the plan must satisfy the minimum service and age requirements mentioned in the Internal Revenue Code.
- Documentation of the plan should reflect the actual benefits provided to the participants of the plan.
- The plan sponsors must report distribution statements to the IRS, while periodic statements of the account statements should be sent to the participants.
- An employer must not discriminate amongst employees based on their salaries. If the employer offers matching contributions, it should offer them to all the employees irrespective of the level of their salaries.
- The defined benefit plan should meet the annual benefit limit of $230,000 for 2021.
- The defined contribution plan should fulfill the limit of annual combined contributions (employer & employee) of $58,000 for 2021.
- The annual compensation allowed under a plan for 2021 is capped at $290,000 for each employee.
Qualified Vs. Non-Qualified Retirement Plan
A qualified plan is defined in Section 401 of the Internal Revenue Code and meets the requirements stipulated in it. Non-qualified plans, on the other hand, do not meet those requirements and are not defined by any section of the Internal Revenue Code.
In terms of tax benefits, qualified retirement plans allow you to contribute tax-deferred or pre-tax contributions to the plan. You pay income tax only when you withdraw the distributions after retirement. Contributions to the non-qualified plans are after-tax contributions, which means you have already paid taxes on the contributions, but the withdrawals of original contribution are tax-free. Roth IRAs and traditional IRAs are two common types of qualified retirement plans.
Caveats to the Qualified Retirement Plans
It depends on your employer what type of plan you get as part of your employee benefit. The terms and conditions of the plan are set by employers and may have favorable or unfavorable provisions. This means that you have little authority or freedom to choose your plan.
Self-employed individuals struggle to open qualified plans for themselves as there are bottlenecks to the amount they can contribute to the plan. Hiring an employee changes to plan eligibility, which makes it a hassle to manage qualified plans.
If you withdraw your contributions earlier than your qualified retirement age, you will have to pay penalties and taxes. The distribution or withdrawal will be added to your annual income on which you will be paying taxes and a 10% penalty.
Retirement planning is something most people delay. By understanding different types of retirement plans, you will be able to make an informed decision about your retirement and determine the right retirement plan for yourself. Getting on track to achieve your retirement goal will give you a relaxed state of mind and help you lead a prosperous post-retirement life.