A qualified retirement plan is one that meets the Internal Revenue Code requirements for tax benefits. They are usually offered through your employer and allow for pre-tax contributions and tax-deferred growth.
Qualified plans are a great option for building retirement savings. Understanding what these retirement plans require and offer allows both employers and employees to leverage the benefits of these unique savings vehicles.
What Is a Qualified Retirement Plan?
Qualified retirement plans meet all the stipulations laid out in the Internal Revenue Code to allow for tax-deferred contributions. For the most part, these plans include employer-sponsored plans such as 401(k)s, 403(b)s, and Keogh (HR-10) plans.
Voluntary, employer-based retirement plans are governed by the Employee Retirement Income Security Act of 1974. These regulations establish a number of minimum standards in order to provide protection for employees investing in the plans. This includes regulations for tax-deferred contributions.
How Qualified Retirement Plans Work
In order to be considered a qualified plan, retirement plans have to meet numerous provisions in the Internal Revenue Code pertaining to participation, contribution limits, and other operational characteristics. Key plan requirements include:
- Participation: Qualified plans generally must be made available to employees no later than the date on which the employee reaches age 21 or finishes one year of service with the employer.
- Operation in accordance with the plan document: The employer has to prepare a plan document detailing who participates in the plan and what types of contributions and benefits are available to participants. The plan then has to work how it says it works in the document.
- Compensation limits: The maximum compensation for each employee that can be taken into account when calculating employee benefits is $285,000 in 2020 and $290,000 in 2021.
- Elective deferral limits: For 401(k) and other qualified retirement plans that allow them, elective deferrals, including pre-tax and designated Roth contributions, must not exceed $19,500 in 2020 and 2021 ($26,000 if age 50 or older).
- Total contribution limits: For 2020, the maximum allowable contribution to a defined-contribution plan is the lesser of $57,000 ($63,500 if age 50 or over) or 100% of compensation. For 2021, the maximum is the lesser of $58,000 ($64,500 if age 50 or older) or 100% of compensation. Similarly, the most that each employee may receive in annual benefits and contributions in 2020 and 2021 under a defined-benefit plan cannot exceed $230,000.
Contribution limits are subject to cost-of-living adjustments, so they may increase in the future.
Types of Qualified Retirement Plans
A qualified plan can be either a defined-benefit or a defined-contribution plan. Defined-contribution plans grant employers and employees the ability to contribute to individual accounts that the employer establishes under the plan. The value of the account changes over time; you don't receive a fixed benefit upon retirement. Common examples include 401(k), 403(b), profit-sharing, employer stock ownership, or money-purchase plans.
Defined-benefit plans pay a fixed monthly benefit in retirement that is typically based on a formula that takes into account years of service and salary history. Traditional pension plans have declined in popularity recently but remain a good example of a defined-benefit plan.
Nonqualified Retirement Plan vs. Qualified
There are other employer-sponsored retirement plans that do not qualify under the ERISA. These are called nonqualified retirement plans, and they come in various forms. In general, they are based on deferred income in some way and are typically aimed at executives. Qualified plans cannot be based on deferred compensation.
Employer Benefits of Qualified Plans
These employer-sponsored plans provide significant financial and recruitment perks for businesses large and small.
- Employer contributions made to a qualified retirement plan on behalf of their employees are tax-deductible. If you're a sole proprietor, you can deduct the amount you contribute for yourself, depending on the type of qualified plan. Employers can deduct up to 25% of the compensation paid to eligible employees for a defined-contribution plan. However, the deduction for contributions to a defined-benefit plan requires an actuary to calculate your deduction limit.
- Assets in the plan grow tax-free. Employers generally aren't liable for taxes on contributions. For small business owners, this means that qualified retirement plans allow you to make substantial investments and reap the gains in your own retirement without paying taxes on these gains during your career.
- Businesses may receive special tax credits and other incentives for starting a qualified plan. In general, qualifying employers with 100 or fewer employees and who had at least $5,000 in earnings can claim a tax credit of up to half the cost of setting up, running, and educating employees about a qualified plan, up to a maximum of $500 per year.
- The plans make employers more attractive to employees. Qualified retirement plans represent an investment in an employee's future, so these plans play an influential role in helping employers recruit and retain valuable employees.
Employer and employee contributions and earnings generally grow tax-deferred in qualified retirement plans.
Benefits of Qualified Plans for Employees
A 401(k), 403(b), or similar employer retirement plan may be the single most effective way to fund your nest egg, for several reasons.
- It offers convenience. You don't have to manually schedule contributions; you can make them automatically through deductions from your paycheck.
- Employees get an immediate tax break. Taxes on employee contributions can generally be deferred until distribution in retirement. By making contributions with pre-tax dollars, you could cut your final tax bill for the year by hundreds or thousands of dollars.
- Assets grow tax-deferred. Employee contributions made to a qualified retirement plan and the subsequent earnings will continue to grow sheltered from taxes until you withdraw funds. Distributions will generally be taxed at your income tax rate at the time of withdrawal.
- You can potentially receive matching contributions. If your employer matches employee contributions, the decision to participate should be an easy one. Treat those matching contributions as free money that you will receive every pay period. Aim to contribute at least as much to your qualified plan as needed to get the maximum employer match.
- You get diverse investments. You'll have several investment options to choose from, and many qualified retirement plans provide low-cost investments with access to professional investment advice and guidance.
- You get protection from creditors. Qualified plan assets are generally safe from creditor or collection actions under the ERISA.
- Qualified retirement plans are employer-sponsored plans that meet the requirements of the Internal Revenue Code for tax-free contributions and tax-deferred growth.
- Qualified plans can take the form of defined-contribution or defined-benefit plans and can run the gamut from 401(k) plans to pension plans.
- These plans offer one of the best ways to build retirement savings thanks to tax benefits and the fact that employers often make matching contributions.