What Is a Qualified Retirement Plan?
Learn about which retirement plans make the cut and what they offer
If you work for a company that offers a retirement plan as an employee benefit, you may have what is known as a qualified retirement plan. These are employer retirement plans that meet certain requirements of the Internal Revenue Code in terms of their setup and ongoing operations. Understanding what qualified retirement plans require and offer allows both employers and employees to leverage the benefits of these unique savings vehicles.
Qualified Retirement Plan Requirements
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.
- 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 ($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 percent of compensation. Similarly, the most that each employee may receive in annual benefits and contributions under a defined-benefit plan is the lesser of $230,000 or 100 percent of the largest average salary that they earned over a consecutive three-year period. The higher limit for defined-benefit plans allows employers to fund a pension that may pay benefits for the remainder of the retired employee's life.
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 individuals 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.
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. The amount you can deduct depends 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 actuarial calculations, so you'll need to enlist an actuary to calculate your deduction limit. Employers generally don't have to pay taxes on contributions until distribution in retirement.
Assets in the plan grow tax-free. Employers generally aren't liable for taxes on earnings on contributions until the time of distribution. 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 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-free 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 them 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-free. 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. One additional benefit that many participants overlook is qualified plan assets are protected under the Employee Retirement Income Security Act of 1974 (ERISA) from creditors.
The Bottom Line
Employer retirement plans must meet certain criteria of the Internal Revenue Code to be classified as a qualified retirement plan, but those that do offer significant benefits to employers and employees.
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. If you have the opportunity to save for retirement through a qualified retirement plan, take advantage of this golden opportunity; it's truly a simple and convenient way to kickstart your retirement.
Internal Revenue Service. "A Guide to Common Qualified Plan Requirements." Accessed Jan. 28, 2020.
Internal Revenue Service. "Retirement Topics - 401(k) and Profit-Sharing Plan Contribution Limits." Accessed Jan. 28, 2020.
Internal Revenue Service. "Choosing a Retirement Plan: Defined Benefit Plan." Accessed Jan. 28, 2020.
Internal Revenue Service. "Publication 560 (2018), Retirement Plans for Small Business (SEP, SIMPLE, and Qualified Plans)." Accessed Jan. 28, 2020.
Internal Revenue Service. "Definitions." Accessed Jan. 28, 2020.
U.S. Securities and Exchange Commission. "Employer-Sponsored Plans." Accessed Jan. 28, 2020.
U.S. Department of Labor. "FAQs about Retirement Plans and ERISA," Page 13. Accessed Jan. 28, 2020.