To encourage Americans to save more money for their retirement, the federal government has created certain types of retirement plans that offer tax benefits. Known as qualified retirement plans, these plans meet the specific requirements detailed in the Internal Revenue Code.
Employers establish qualified retirement plans on behalf of their employees who can choose whether or not to participate in the plan. Qualified retirement plans are managed according to the standards set forth in the Employee Retirement Income Security Act of 1974, more commonly known as ERISA.
Qualified vs. Non-qualified Plans
The main difference between a qualified retirement plan and a non-qualified retirement plan is that qualified plans offer tax benefits. More specifically, contributions are made to qualified plans on a pre-tax basis and assets grow tax-free with no income tax due until withdrawals begin in retirement. This allows retirement assets to grow faster than if they were subject to taxation each year.
In addition, contributions to certain types of qualified retirement plans reduce employees’ current taxable income. Employees generally must wait until they’ve reached retirement age — usually 59½ — to begin making withdrawals; otherwise, early withdrawal penalties may apply and taxes assessed at current ordinary income tax rates. Some plans, however, allow employees to borrow money from their plan balances and thus avoid taxes and penalties.
Meanwhile, examples of non-qualified retirement plans include deferred compensation plans, executive bonus plans, and split-dollar life insurance plans.
Categories of Qualified Retirement Plans
There are two main categories of qualified retirement plans: defined benefit plans and defined contribution plans. With defined benefit plans, employees receive a guaranteed amount of money after they retire regardless of how underlying investments perform. In other words, the investment risk falls on the employer to invest assets properly in order to meet plan liabilities.
A traditional pension plan is the most common type of defined benefit plan. These plans are funded primarily by employers, and employees usually must work at the company for a certain number of years to become fully eligible (or vested) to receive benefits.
Defined contribution plans shift the primary responsibility for retirement saving from employers to employees. In addition, employees also assume all of the investment risk — they must save money consistently and invest assets wisely in order to accumulate a retirement nest egg. However, employers may choose to match employees’ contributions to their retirement accounts.
Only certain types of investments can be made within qualified plans. These vary by type of plan but generally include stocks, bonds, real estate, and mutual funds. Some plans have also begun allowing alternative investments to be included in qualified plans, such as private equity and hedge funds.
Types of Defined Contribution Plans
The most common type of defined contribution plan is a 401k plan. As described above, employees defer a certain percentage of their salary into the plan each pay period, which reduces their current taxable income and thus current tax burden. Employers may choose to match employees’ contributions on a percentage basis — for example, 50 cents for each dollar contributed by employees — up to a percentage of the employee’s salary.
For tax year 2021, employees can defer up to $19,500 unless they are 50 years of age or over. In this case, they can take advantage of an additional catch-up contribution of $6,500, bringing their total allowed salary deferral for the year up to $26,000.
Another common type of defined contribution plan is a 403(b) plan. This is essentially the same as a 401k plan, with the same annual deferral limits, but it’s designed specifically for employees of public schools, certain non-profit organizations, and ministers. And a 457 plan is a 401k-type plan designed for government employees.
A Simplified Employee Pension plan (SEP) is a qualified retirement plan designed for self-employed individuals. The annual contribution limits for SEPS are much higher than the limits for 401k plans: In tax year 2021, self-employed individuals can contribute up to $57,000 or 25% of the business’ net earnings to a SEP.
A Savings Incentive Match Plan for Employees, or SIMPLE plan, is similar to a 401k plan but is designed specifically for small businesses. As the name implies, these plans are simpler than 401k plans and feature lower startup and administrative costs, which makes it easier for small firms to offer retirement benefits to their employees. However, the deferral limits are lower: In 2020, employees can defer up to $13,500 or $16,500 if they’re age 50 or over.
Next Step in Preparing for Retirement
Both qualified and non-qualified retirement plans may have a place in your retirement saving strategy.
For help with retirement planning, you can try out the free Personal Capital Retirement Planner. This interactive, online tool can help you create a customized retirement plan just for you.
This tool is one in a suite of award-winning financial planning tools. Nearly 3 million households rely on this technology to see all of their financial accounts in one place, analyze their investments, and prepare for retirement.
Personal Capital compensates Don Sadler (“Author”) for providing the content contained in this blog post. Compensation not to exceed $500. Author is not a client of Personal Capital Advisors Corporation. The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.