What Is A Qualified Retirement Plan?
As you begin researching more about retirement, you may stumble across the words: “qualified”, and “non-qualified”, and wonder if the difference between the two terms is important. The simple answer is – Yes! and it determines if you’ll be taxed on your retirement income by the IRS or not.
So what is the difference between qualified and non-qualified retirement plans?
Qualified Retirement Plans
A qualified plan is an employer-sponsored retirement plan that is given special tax treatment under Section 401(a) of the Internal Revenue Code. Qualified plans come in two main types: defined benefit and defined contribution. There is also a hybrid of those two, called a cash balance plan.
A defined benefit plan assures a specific monthly benefit at retirement. The plan may outline the benefit as an exact dollar amount (such as $100 per month at retirement). Or, it may calculate a benefit amount using a plan formula that considers factors such as your salary and number of years worked – for example, 1 percent of average salary for the last 5 years of employment for every year worked with an employer. An example of a defined benefit plan is a pension.
* Note: any benefits earned/received through a defined benefit plan are covered by federal insurance (up to certain limitations), and in most cases creditors cannot reach your qualified retirement plan funds to satisfy your debts.
In contrast, a defined contribution plan does not promise a specific amount of benefits at retirement. The amount employees receive in retirement through this plan type depends on how well they and/or their employer invested during their working years. The value of the account will fluctuate due to the changes in the value of the investments. Examples of defined contribution plans include 401(k) plans, 403(b) plans, or employee stock ownership plans (ESOP).
A cash balance plan is a combination of a defined benefit plan and a defined contribution plan. When an employee becomes entitled to receive benefits under a cash balance plan, the benefits that are received are defined in terms of an account balance. Through this plan, an employee’s account is credited each year with a “pay credit” and an “interest credit”. Increases and decreases in the value of the plan’s investments do not affect the benefit amounts promised to the employee. Investment risks and rewards on the plan assets are assumed solely by the employer.
List Of Qualified Plans:
- 401(k) plans
- Retirement savings contributions provided by an employer, deducted from the employee’s paycheck before taxation, and limited to a maximum pre-tax annual contribution of $20,500 (as of 2022).
- 403(b) plans
- Retirement plan offered by public schools and certain organizations exempt from tax under Internal Revenue Code (IRC) Section 501(c)(3).
- SARSEP plans
- Salary Reduction Simplified Employee Pension plan. A plan set up before 1997 that permits employees to contribute through employee salary reductions, also called “employee elective deferrals.”
- SEP-IRA plans
- A type of traditional IRA for self-employed individuals or small businesses.
- SIMPLE IRA plans
- A Savings Incentive Match Plan for Employees of Small Employers (SIMPLE) IRA plan is a simplified way for employers and their employees to save for retirement. This is an IRA-based plan that allows employees to contribute part of their salary, and requires employers to contribute for eligible employees.
- Profit-sharing plans
- A profit-sharing plan accepts discretionary employer contributions only. Note: If a “salary deferral feature” is added to a profit-sharing plan – it becomes a “401(k).”
- Money purchase plans
- Money purchase plans require contributions from the employer or employee. A participant’s benefit is based on the amount of contributions to their account and the gains or losses associated with the account at the time of retirement.
- Target benefit plans
- A type of pension plan that requires fixed contributions.
- Employee stock ownership (ESOP) plans
- An employee stock ownership plan (ESOP) is a stock bonus plan or money purchase plan.
- Keogh (HR-10)
- A type of retirement plan for small businesses and self-employed people.
What Makes A Plan Qualified?
The IRS has strict guidelines as to what makes a retirement plan qualified. The plan must meet the standards of the Employee Retirement Income Security Act (ERISA), as well as meet the following conditions:
- Once earned, benefits can’t be forfeited.
- Benefits commence at retirement age.
- The plan must offer life annuities in the form of a Single Life Annuity (SLA) and a Qualified Joint & Survivor Annuity (QJSA).
- The plan must maintain sufficient funding levels.
- It must be administered according to the plan document.
- The plan may not discriminate in favor of highly compensated employees.
- The plan must be insured by the PBGC.
Failure to meet IRS requirements can lead to plan disqualification, which can come with gigantic tax implications.
* To determine whether your plan is a qualified plan, check with your employer or the plan administration.
Non-Qualified Retirement Plans
Non-qualified plans are those that are not eligible for tax-deferral benefits. You pay income tax on the funds before you deposit them into your account, but when you withdraw your money, the funds are tax-free.
Non-qualified plans are supplemental benefits provided in addition to a company’s qualified retirement plan offerings. They are usually an added incentive for executives (or other employees with higher salaries). Non-qualified plans are not required to meet ERISA standards nor do they have a maximum contribution amount. The employer/employee can contribute as much as they want to the plan.
Types of Non-Qualified Plans:
- Bonus Deferral Plan
- Employee defers their bonuses to a future date.
- Excess Benefit Plan
- Employee whose benefits are limited by employer’s qualified plan.
- Salary Reduction Arrangement
- Employees can choose to receive a portion of their earnings on a future date (reducing their current salary).
- Supplemental Executive Retirement Plans (SERPs)
- Plan offered to employee that is typically part of company’s upper-level management and/or its highest paid employee bracket.
Examples of Non-Qualified Plans:
- Public Sector plans
- 457 retirement plans for state and municipal employees
- 403b programs for nonprofit organizations
- Roth IRA
What Are Other Differences Between Qualified and Non-Qualified?
- Employer contributions to a qualified plan can be deducted immediately. But, contributions to a non-qualified plan are not deductible to the employer until the employee takes a withdrawal and is taxed on the income.
- Qualified plans must benefit all employees equally, and there can’t be differentiation between compensation levels. Non-qualified plans do not have the same restrictions on participation.
- Qualified plans are subject to annual contribution limits set by the IRS each year.
- For 2022, the cap on IRA contributions is $6,000 for individuals under age 50 and $7,000 for those over 50.
- 401(k), 403(b) plan deferrals are limited to $20,500 for the year.
- Contributions in excess of these amounts are not deductible and may subject the employee to excise taxes.
- Contributions to non-qualified plans are unlimited.
- A qualified plan must file Form 5500 with the IRS each year. The employer must also distribute a Summary Annual Report to all employees and beneficiaries no later than two months after the IRS filing deadline.
- For a non-qualified retirement plan, you are only required to file one form with the U.S. Department of Labor.
Are you considering taking an “early” retirement? Check out our article about health insurance options.
Kate writes about retirement benefits for retirementinsurance.org. She has a Masters Degree in Social Work (MSW). She has over a decade of experience in assisting elderly and disabled populations navigate governmental and private programs to obtain the monetary assistance they need to lead better lives. As she watched her parents begin their own retirement journeys and navigate similar systems to obtain Social Security, Medicare and other retirement benefits, she gleaned a further personal knowledge about the topic and is eager to share what she has learned with others.