What Are Qualified Retirement Plans?
Qualified retirement plans are retirement plans that provide tax benefits and adhere to the guidelines specified in the Employee Retirement Income Security Act (ERISA) of 1974. The requirements for a qualified retirement plan are defined in the Internal Revenue Code Section 401(a). The two types of qualified retirement plans are Defined Contribution plans and Defined Benefit plans.
The advantages of qualified retirement plans are tax benefits and protection against creditors. The disadvantages of qualified retirement plans are that they are subject to several restrictions for design and implementation and withdrawal from such plans is subject to taxes.
Basics of Qualified Retirement Plans
Examples of qualified retirement plans are 401(k) plans and traditional IRA plans. Some of the ERISA guidelines that apply to qualified retirement plans are as follows:
- Plan participants should get documentation and details related to it upon request.
- The plan should not discriminate against in apportioning its benefits for eligible participants.
- The benefits from a plan should accrue to an eligible participant after the vesting period.
- The plan should cover a specified portion but not all employees.
How Do Qualified Retirement Plans Work?
Most qualified retirement plans work in the same manner. The employer or employee makes a periodic contribution to the plan. If the contribution is made by an employee, then they are assigned a menu of investment options to multiply the amount they invested. If the contribution is made by an employer, then they manage the investments themselves.
After a vesting period defined in the plan’s terms, the retirement plan’s funds can be withdrawn by the account holder. Premature withdrawal before the vesting period is complete incurs a penalty and taxation at regular income tax rates. Account holders can also take periodic distributions after retirement.
Qualified Retirement Plans and Taxes
One of the main reasons why qualified retirement plans are named as such is because they offer tax benefits to account holders. Such plans offer two types of tax benefits to account holders:
- Tax advantages: Contributions to qualified retirement plans are made with pre-tax income and, therefore, reduce the overall taxable income.
- Tax deferral: Taxes on investment gains within the account are deferred within a qualified retirement plan account, meaning you are not required to pay capital gains taxes for profits from your investments.
Types of Qualified Investment Accounts
There are two types of qualified retirement accounts.
Defined Contribution Account
Defined contribution accounts are accounts in which the employee makes a periodic contribution to the retirement account. Employer contribution in defined contribution plans is voluntary but they are responsible for furnishing the account with multiple investment options. Employees can withdraw the deposited amount when they retire. Prevailing taxes are applied to the withdrawn amount. A 401(k) plan is an example of a defined contribution plan.
Defined Benefit Account
Defined benefit accounts are employer-sponsored retirement accounts in which a company promises a certain benefit amount to the employee, regardless of whether they make a contribution or not to the account, upon retirement. The onus of making investments and growing the contributed amount lies with the employer and not the employee. Examples of defined benefit plans are pensions and annuities.
Qualified Retirement Plans vs. Non-Qualified Retirement Plans
Non-qualified plans are the opposite of qualified plans. They do not offer the same tax benefits (or, for that matter, any tax benefits) and are not required to adhere to standards defined in ERISA and have considerable latitude in terms of their design and implementation. They also do not offer the same tax benefits as qualified retirement plans. Examples of non-qualified retirement plans are Roth IRAs and Executive Bonus plans.
The main differences between qualified and non-qualified retirement plans are as follows:
- Qualified retirement plan contributions are made with pre-tax income while non-qualified retirement plan contributions are commonly made with pre-tax income.
- Qualified retirement plans reduce the overall taxable income and, therefore, provide tax advantages in the year that the contribution is made while certain non-qualified retirement plans, such as Roth IRAs, offer tax advantages upon withdrawal.
- Qualified retirement plans are subject to several guidelines relating to multiple aspects of their design and implementation while non-qualified retirement plans, such as executive bonus plans, can be crafted to suit employee requirements.
- The assets contained in some non-qualified retirement plans, can be seized by creditors for non-payment of dues but this is not possible for qualified retirement plans. (But qualified retirement plans are subject to tax liens).
- It is not possible to transfer the benefits of certain non-qualified retirement plans, such as executive bonuses, to another retirement plan or instrument.