Qualified vs. Non Qualified Plans: What's the Difference?
What You Should Know About These Two Types of Retirement Plans
When you read about retirement planning online 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, qualified vs. non-qualified are essential to retirement planning so let’s dig in and get a clear understanding.
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. Say, for example, you sold 100 shares of stock and made $1,000, you would pay taxes on that $1,000 when you did your taxes for that year. 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 of extra money—all thanks to IRS.
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, better known as ERISA in the industry. 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 they make those contributions is for the tax break they receive.
As an employee, you receive those benefits that we looked at above. 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.
But with the advantages come the rules. For the employer, qualified plans must be offered to every employee as long as they meet very minimal requirements—1 year of full time employment, for example. There also can’t be a different in compensation levels. For example, if the company matches 1 percent of an employee’s salary, they can’t match upper level executives at a higher rate. Everybody is equal.
Employees fall under the rules that you probably know about. You can only deposit so much into these accounts each year––$18,500 for 401(k)s annually as of 2018, 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 59 ½ without incurring a hefty 10 percent penalty charge. Some plans also require you to start taking withdrawals by the time you reach 70 ½, 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) but you get the idea.
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 because highly paid employees might have lower maximum contribution limits in their company retirement plan because of IRS rules surrounding “highly compensated employees.” Non-qualified plans allow higher paid employees to save enough to retire and live a similar lifestyle as they currently enjoy.