What is a Qualified Retirement Plan?
When was the last time you looked at the allocation of your retirement assets? Learning the differences between qualified and nonqualified retirement plans can help you get the most of your retirement savings.
Maybe you’ve been contributing to a 401(k) plan since your 20s or 30s—that’s great. Or maybe you’ve been setting money aside each month for an individual retirement account. For many people, retirement savings are not top of mind—but if your lifestyle and career has evolved since you first set up your retirement plan, it may be time to reassess your retirement portfolio.
The first step is to review your current retirement assets. Then, develop a comprehensive retirement plan that helps you meet your goals while maximizing your tax benefits.
Depending on your circumstances, a combination of qualified and nonqualified retirement plans might prove to be a good fit. Read on to learn more about these two distinct types of plans.
Qualified retirement plans are only offered by employers
What are qualified retirement plans? Simply put, qualified retirement plans are employer-sponsored plans that follow certain tax code requirements. Companies voluntarily offer retirement plans as a way to help their employees secure future retirement income. Benefits for companies offering these types of plans may include tax savings for the company and its participating employees.
What distinguishes a qualified retirement plan?
At its basic level, a qualified plan must strictly adhere to the U.S. Tax Code requirements that are set out in the Employee Retirement Income Security Act (ERISA). These laws were enacted in the 1970s to protect the retirement fund interests of U.S. employees from account mismanagement by plan administrators. The IRS recognizes qualified plans as those in which investment income can accumulate and grow tax-deferred for retirement income purposes.
The majority of company-offered retirement plans are tax-qualified retirement plans as opposed to nonqualified plans.
Benefits of qualified retirement plans
Qualified retirement plans provide some great tax benefits to companies and their employees who opt to participate. Below are some pros associated with qualified retirement plans:
- Most qualified plans allow employee and company contributions.
- Taxes on contributions and earnings are often deferred until the plan recipient withdraws them.
- Contributing a portion of your salary into a qualified retirement account lowers the amount of your taxable income.
Drawbacks of qualified retirement plans
While qualified plans offer some benefits, there can also be disadvantages to these types of plans. Drawbacks of qualified retirement plans include:
- Employees may need to stay involved in the investments in the fund and switch priorities among investments as needed.
- Early withdrawals from qualified plans often carry substantial tax penalties. For this reason, individuals usually choose to delay making withdrawals until they reach retirement age.
How do qualified retirement plans work?
In a qualified retirement plan, employees voluntarily set aside a portion of their pay in a tax-deferred account such as a 401(k). Contributions can be in the form of a set percentage or a set dollar amount each pay period using pre-tax dollars. As plan investments and savings grow, taxes are deferred until funds are withdrawn.
Qualified retirement plans allow certain investment types—including mutual funds, money market funds and real estate, among others.
Employers that contribute matching funds to employee plans maintain a vesting schedule. The schedule states the number of years employees must remain with the company to be fully vested and earn the irrevocable right to the company plan contributions. This can encourage employees to stay with the company until their plans become fully vested.
There are two main qualified retirement plan types
Defined benefit and defined contribution plans are the two primary tax-qualified retirement plan types. Defined contribution plans are more common today.
Defined contribution plan
Defined contribution plans are employer-sponsored, tax-deferred retirement plans in which employees contribute a certain amount of money in each pay period. In many situations, the employer will match employee contributions up to a certain amount.
- Example: 401(k) and 403(b) plans
- How it works: Employee contributions fund plans; the company may also fund plans through matched amounts
- Payout: Plans restrict account withdrawals for certain events and conditions and carry penalties for early withdrawals
- Who bears the risk: Employee bears the risk of managing the account investments
Defined benefit plan
Defined benefit plans offer employees pre-determined retirement payments based on factors such as salary and length of employment. Unlike defined contribution plans, employers are responsible for making contributions into the retirement account and managing investments.
While certain types of defined benefit plans—such as pension plans—used to be prevalent, these are now only common for a few industries, such as government or education.
- Example: Pension plans
- How it works: Company funds the plan and manages the investments for its employees, often using an investment counselor
- Payout: Funds are distributed to the recipient in a single payment or a series of scheduled payments, usually upon retirement
- Who bears the risk: Company bears the risk for all planning and investment management
Qualified retirement plan options
- 401(k) plans (used for private and for-profit companies)
- 403(b) plans (used for nonprofit and government organizations)
- Defined benefit plans (pensions)
- Employee stock ownership plans
- Profit-sharing plans
What is a nonqualified retirement plan?
Unlike qualified plans, nonqualified retirement plans fall outside the strict ERISA guidelines. These plans can have similar tax advantages to some qualified plans and are often geared towards higher-income individuals. Some companies opt to include nonqualified plans among their retirement benefits, but they are not as common as their qualified plan counterparts.
Benefits of nonqualified retirement plans
With a nonqualified retirement plan, you may be able to put more money into your retirement savings than you could otherwise. Below are some benefits of nonqualified plans:
- Nonqualified plans can be a good choice for executives and other select employees, as high-salaried employees sometimes reach the contribution limits set for 401(k) traditional plans.
- Individuals can participate in both qualified plans and nonqualified plans, if their employer offers both.
- Contributions to nonqualified plans are tax-deferred, allowing employees to defer paying taxes on contribution amounts until retirement.
- Some nonqualified plans allow you to save for certain future events like your child’s education.
Drawbacks of nonqualified retirement plans
There are also several cons associated with nonqualified retirement plans. These may include:
- Companies must remain financially secure to enable future payouts to nonqualified plan recipients.
- Salary portions that an employee opts to contribute to a nonqualified plan are part of the company’s assets and can be seized by creditors if the company files for bankruptcy.
- Rollover options are not available if you are terminated by your employer.
Nonqualified retirement plan options
- Supplemental executive retirement plans (SERP)
- Split-dollar life insurance
- Deferred compensation plans
- Bonus plans
Responsible retirement advice matters
With so many types of plans out there, it can be difficult to determine which is best for growing your wealth into retirement. A wealth advisor can help you decide whether or not to open a qualified or nonqualified retirement with your employer.
Questions to ask your wealth advisor
Investment professionals for retirement plans and individual retirement accounts have specific obligations intended to protect your interests under Title 1 of ERISA, according to the U.S. Department of Labor. Here are a few questions the Department of Labor recommends asking a retirement investment advisor you may be considering:
- What fees and expenses will I be charged?
- Do I pay all fees and expenses directly to you or are any taken out of my investments?
- Under what circumstances will you monitor the investments in my retirement account and make recommendations for changes in my investments?
Once you’ve found a wealth advisor that you can trust, ask them how qualified and nonqualified plans may be able to benefit you. By examining the types of plans your employer offers, they can recommend a personalized approach to retirement planning that can help you grow your wealth over time. In many cases, this may include a mix of qualified plans, nonqualified plans, and individual retirement accounts (IRAs).
Learn what sets Cadence Bank’s wealth advisors apart
The relationships we build with you make Cadence Bank’s wealth advisors stand out from the crowd. Our professional wealth advisors take the time to understand your needs, so they can give you expert advice on how to best split your retirement assets between qualified and nonqualified accounts.
This article is provided as a free service to you and is for general informational purposes only. Cadence Bank makes no representations or warranties as to the accuracy, completeness or timeliness of the content in the article. The article is not intended to provide legal, accounting or tax advice and should not be relied upon for such purposes.