Qualified Retirement Plan

A qualified retirement plan is a retirement account set up by an employer for their employees. This fund offers an accumulated sum to the employees—by the time they retire. Qualified plans are subject to the IRS code.

On qualified plans, the IRS imposes contribution limits and penalties. Employees who withdraw funds before retirement have to pay the penalty.  The 401K and 403(b) structures are typical examples of qualified plans. Retirement accounts must comply with Section 401(a) of the US tax code.

• Qualified retirement plans combine contributions from both the employer and the employee. The IRS governs it.
• Retirement plans must comply with the Employee Retirement Income Security Act of 1974 (ERISA). ERISA offers tax advantages and deferred tax advantages to employers and employees.
• A qualified plan must be equal to all employees. Employees are allowed to take a loan from it. In case of bankruptcy, qualified plans are protected. Lenders cannot seize such retirement funds.

The Internal Revenue Service (IRS) governs a qualified retirement plan. The employer makes contributions on behalf of the employees. These retirement plans allow employers to avail of tax deductions. Also, employee contributions are treated as deferred tax.

Retirement plans must comply with the Employee Retirement Income Security Act of 1974 (ERISA). ERISA offers tax advantages and deferred tax advantages to employers and employees. Retirement funds are put into an investment, and the earnings remain tax-free till the employees withdraw the invested amount.

If an employee withdraws or uses the invested amount before a certain age (primarily 59 ½), they have to pay the penalty. ERISA safeguards US retirement funds and ensures transparency.

A part of the retirement fund investment comes from the employee, and the remainder comes from the employer. The exact break-up varies from company to company. Many employers match 50% of their employees’ contributions; some even go beyond that. 

There are two types of qualified retirement plans.

#1 - Defined Benefit Plan

The company agrees to pay its employees a specific retirement income in the defined structure. The amount is determined from a preestablished formula. This is based on employee compensation, age, and employment duration.

Defined plans are not complex but rigid; they can become expensive for the employer. The employers are obligated to cover the fixed benefit amount.

Also, employees can have other retirement plans along with it. For defined benefit plans, employees file Schedule SB and Form 5500.

#2 - Defined Contribution Plan

In defined contribution plans, both employer and employee contribute to a retirement plan account, but no specific retirement amount is fixed.

Employees receive whatever amount is accumulated over a period. The amount depends on the contributions and the investment performance; 401K and 403B are famous examples of defined contribution plans.

The 401k retirement plan allows workers to safeguard a portion of their remuneration for a financially sound life after retirement. 401k plan has a profit-sharing feature letting workers give away a part of their pay towards retirement savings. Moreover, the Internal Revenue Service (IRS) sets contribution limits on the employee and employer. For example, employees below 50 cannot contribute more than $14,000.

The 403(b)-retirement plan was created in 1958. Usually, 403b plans are offered by academic institutions, although, under IRS Section 501(c)(3), any institution can use it. In addition, 403(b) offers a lifetime catch-up provision. Employees who have served for at least 15 years or contributed less than or equal to an average of $5,000 per annum can invest an extra $3,000 (per annum).

Let us look at qualified retirement plan examples to understand the structure better.

Example #1

Claire works in a US company and earns $90000 annually. She chooses the 401K retirement plan. Therefore, she contributes 9% of her annual salary towards retirement savings. Thus, she saves $8100.  Her firm matches 50% of her contribution and contributes $4050. All in all, every year, $12150 is invested towards the retirement fund.

When Claire joined the company, she was 20 years old, and the fixed retirement age was 59 ½. Claire and the firm, together, chip in $12150 every year. By the time Claire reaches the age of 59, she will save $473,850 in her 401k account.

Retirement funds are invested in an underlying portfolio or different financial instruments. When Claire retires, she can withdraw funds from this account. It acts as her retirement income. It is essential to note Claire is not taxed on the amount saved in the retirement account. But, when she withdraws funds at retirement, she must pay income tax (on the amount withdrawn).

Example #2

Based on inflation, the IRS made a series of amendments for 2023. In addition, the IRS is introducing new limitations for retirement plans.

IRS is increasing the 401k annual limit from $20,500 to $22500—for pre-tax and Roth contributions. Similarly, the IRS hiked catch-up contributions for employees over 50 from $6500 to $7500.

For employers, the advantages of qualified retirement plans are as follows.

• The contributions made by the employer are tax deductible.
• Asset grows and earns a tax-free profit.
• It helps employees retain their employees.

Advantages for employees are -

• Until the distribution occurs, the contributions remain tax deferred.
• Investment earnings are not taxed until they are touched or distributed.
• They offer retirement security to employees.
• It is protected by ERISA and is eligible for an additional tax credit for saving.

Now, let us look at qualified retirement plan vs non-qualified retirement plan comparisons to distinguish between the two.

• A qualified plan must be equal to all employees, but a non-qualified plan can be applied to selective employees.
• A qualified plan allows employees to take loans from their retirement accounts. Non-qualified plans do not have loan provisions.
• Qualified plans have to comply with IRS regulations. In contrast, the IRS does not impose contribution limits on non-qualified plans.
• The firm’s creditors protect qualified plans. However, lenders can seize funds in non-qualified plans if the firm fails to meet its obligations.
• If an employee loses their job, the retirement account gets rolled over to IRA. Transferring funds to an independent retirement account is not possible with non-qualified funds.

This article has been a guide to what is Qualified Retirement Plan. We explain its types, examples, advantages & comparison with the non-qualified retirement plan. You can learn more about it from the following articles -

• Employee Stock Option Plan
• Retirement Planning
• Financial Planner