Determining the difference between qualified and non-qualified retirement plans can be confusing. Here is a guide to assist in retirement planning.
In 1980, over 38% of Americans had access to a pension plan. In 2008, that number had dropped to only 13%. With retirement planning shifting to individuals, it is important to understand the difference between “defined-contribution” and “defined-benefit” as well as “qualified” and “non-qualified” retirement plans.
What is a Defined-Benefit Retirement Plan?
With a defined retirement plan, an employee can access funds held in an account upon reaching a certain retirement age. With a defined-benefit retirement plan, an employer sets aside money for an employee into that account. The amount can depend on the employee’s salary and job tenure. Upon a predetermined retirement age, (usually 65) the employee is guaranteed a set amount of money per month until death. With a defined-benefit plan, the employer assumes the risk for making sure there are enough funds in the account to guarantee the employee payout. An example of a defined-benefit plan would be a pension. Annuities, generally purchased through an insurance company, would be another example of a defined-benefit account. In this case, the insurer, rather than an employer, bears the risk of making sure the policyholder receives a certain amount of money per month, based on the length of time of the policy and age.
What is a Defined-Contribution Plan?
With a defined-contribution plan, the employee sets aside a percentage of their wages into an account (which an employer may or may not match) and selects investments. The money grows, tax-deferred, until retirement. The account total at retirement depends on contributions, time contributing to the account and the performance of the investments. The risk and responsibility for funding the account lies on the employee not the employer. Examples of defined-contribution plans include a 401(k), 403(b) and 457’s.
What is a “Qualified” Retirement Plan?
The IRS recognizes qualified retirement plans as ones created by an employer that meet the guidelines set up under the “Employment Retirement Income Security ACT (ERISA) to protect worker’s retirement income. Examples of qualified retirement plans include defined-contribution plans such as the 401(k), 403(b) and 457 plans mentioned above. While IRA’s may seem like qualified plans, they aren’t created by an employer and are not considered as such by the IRS. Under a qualified plan, an employer takes money out of an employee’s pre-taxed wages and the money grows, tax-deferred. Withdrawals (typically taken at retirement) are taxed as regular income. Employers can take a tax deduction on any contributions they make.
How Does A Retirement Plan Get Qualified?
To become “qualified”, a retirement plan must meet IRS and ERISA guidelines:
- Plan details must be available
- All eligible (based on age and length of time at job) employees must be able to participate, regardless of income and job title.
- All eligible employees are able to contribute the same percentage to the plan, regardless of their compensation amount.
- Vesting – Employees automatically own any funds they contribute to the plan. (Employer matched funds vest over a period.)
What is a “Non-Qualified” Retirement Plan?
Non-qualified retirement plans allow you to put after-tax dollars into an account. Unlike “qualified plans” that have IRS limits on yearly contributions, you can invest as much as you want and can withdraw funds at any time. You do not pay taxes on withdrawals, only on the gains. There are no tax-deferred benefits of a “non-qualified” plan and employers cannot claim matching funds as a tax deduction. Typically, non-qualified plans include things like deferred compensation, executive bonuses and split dollar life insurance policies. Because non-qualified retirement plans are individually negotiated and offered as part of a benefits package for executives and other highly compensated employees, they usually do not meet the ERISA guidelines to be considered “qualified”.
Pros and Cons of Qualified Retirement Plans
The biggest advantage of a qualified retirement plan is the tax savings. Contributions are not taxed during an employee’s earning years when they are in a higher tax bracket. Although withdrawals are taxed, they theory is that employees are typically in a lower tax bracket at retirement and would pay less taxes. The biggest disadvantage of a qualified retirement plan is that there are limits on how much you can contribute to the plan – as of 2020, $19,500 for the year. Individuals over 50 can contribute an additional $6500.
Pros and Cons of Non-Qualified Retirement Plans
Non-qualified plans benefit higher earning individuals as they provide a way to stick part of their compensation into a savings account to avoid paying more in taxes on those earnings. Companies will often use non-qualified plans as a way to attract and retain highly sought after talent, especially if they do not offer a 401K plan. Non-qualified plans provide a way for individuals to add another retirement “bucket” without the contribution limits of qualified plans. On the employer end, non-qualified plans have less reporting requirements and aren’t required for all employees.
While there are advantages to both qualified and non-qualified retirement plans, what makes sense for you depends on your income and tax situation. When making these decisions, it is best to seek advice from a financial advisor.