When you read about retirement planning, the terms "qualified" vs. "non-qualified" appear quite frequently. These terms are so common that you might feel embarrassed to ask what they mean. Unlike other retirement lingo, these descriptions are essential to retirement planning, so let’s dig in and get a clear understanding.
- Qualified retirement plans give employers a tax break for any contributions they make.
- Employees also get to put pre-tax money into a qualified retirement plan.
- All workers must get the same opportunity to benefit.
- A non-qualified plan has its own rules for contributions but offers the employer no tax break.
Have you ever wondered why the IRS is so involved in your retirement planning? It’s because you likely have retirement accounts that come with some very attractive tax benefits. If you were to deposit your retirement funds into a regular investment account, you would pay taxes on contributions and annual taxes on all investment gains. Suppose, for example, you sold 100 shares of stock and made $1,000, you would pay taxes on that $1,000. Same with any dividends you receive or any other “capital gain.”
Retirement accounts are different. Depending on the type of retirement account you hold, you won’t pay any taxes on your gains until you withdrawal the money, potentially decades from now. That’s a lot more in your account for now.
But history has proven that if there’s a loophole, people will find it and take advantage of it. Because of that, the IRS puts rules on these tax-advantaged retirement plans to close the loopholes.
If you have a 401(k), you have a qualified plan. Qualified plans fall under a set of laws that come from the Employee Retirement Income Security Act or ERISA. Employers like qualified plans because they get a tax break for any contributions they make for their employees. Your company may contribute a certain percentage of your income to your 401(k) as part of your benefit package. One of the reasons it makes those contributions is for the tax break it receives.
When you make a contribution to a non-Roth 401(k) or IRA, your employer makes those deposits on your behalf without taking out taxes. This is called a "pre-tax contribution." You also don’t pay taxes on the investment gains from the account until you make the withdrawals later in life.
For the employer, qualified plans must be offered to every employee as long as they meet very minimal requirements—one year of full-time employment, for example. There also can’t be a difference in compensation levels. For example, if the company matches 1% of an employee’s salary, they can’t match upper-level executives at a higher rate. Everybody is treated equally.
Employees fall under the rules that you probably know about. You can only deposit so much into these accounts each year—$19,500 for 401(k)s annually as of 2021, for example. Other retirement accounts have different maximums and offer added benefits for people closer to retirement.
Next, you can’t take withdrawals until you’re at least age 59 1/2 without incurring a hefty 10% penalty. Some plans also require you to start taking withdrawals by the time you reach 70 1/2, and there are certain types of investments you’re not allowed to hold in qualified plans. Of course, there are more rules and many other types of qualified plans than just the 401(k).
Non-qualified plans are still part of your retirement package but don’t come with all of the same rules as qualified plans. The good news is that these plans often still allow employees to defer taxes until retirement but they aren’t deductible to the employer, and the employee has to pay taxes on the contributions right away. Non-qualified plans are often extra perks offered to higher level employees only, so there’s no rule that everybody must have the option to contribute.
Non-qualified plans don’t have a maximum contribution amount. Employees and employers can contribute as much as they would like. In fact, one of the reasons for non-qualified plans is that highly paid employees might have lower maximum contribution limits in their company retirement plan because of IRS rules about “highly compensated employees.” Non-qualified plans allow higher paid employees to save enough to retire and live a similar lifestyle as they currently enjoy.