Saving for retirement is one of the most important financial decisions individuals can make for themselves and their families. As social security remains unreliable as a future payment and people have fewer children, it’s become incumbent upon individuals to find alternative ways to save for retirement.
One traditional way of saving for retirement is a qualified retirement plan. These employer-sponsored plans allow individuals to divert a portion of their income into a retirement account that their employer may match, such as a 401(k).
However, the 401(k) is not the only qualified retirement account, and individuals have several options in this field, such as self-managed or individual 401(k). In addition, it’s important to understand the differences between a qualified and non-qualified retirement plan before selecting one or the other.
For these reasons, we’ve prepared this brief guide about the pros and cons of a qualified retirement account and the different types of qualified retirement plans to help you make the best decision for your future.
What is a Qualified Retirement Plan?
A qualified retirement plan is an employer-based retirement plan that eligible employees can participate in while working for a specific organization. The most common type of qualified retirement plan is the 401(k), but pensions, 403(b)s, and profit-sharing plans fall into the same category.
For a retirement plan to be considered “qualified,” it must meet several – 21, to be exact – requirements set forth by the Internal Revenue Service (IRS). Requirements include
- Plan participants must receive a document outlining plan features, like how the plan is funded and who and when an employee is eligible to participate.
- All plans must adhere to the terms outlined in the plan document provided to participants.
- Plan contributions can not exceed the limitations outlined in section 415, which limits the annual benefits a participant can receive.
- All plans must comply with the minimum vesting requirements that state “each employee [must] vest or own” the portion of their interest per the vesting schedule outlined in the plan document.
- Minimum distributions must comply with section 401(a)(09), which specifies the date by which a participant must take their first distribution and the minimum distribution amount allowed.
- Benefits offered to “highly compensated” employees must be proportional to the benefits offered to “non-highly compensated” employees.
- A defined benefit plan must meet minimum participation requirements [401(a)(26), which state that the plan must benefit the lesser of 50 employees or the great of 40% of all employees or two employees (one if the organization only has a single employee).
- Defined benefit plans and money purchase pension plans must meet the minimum funding requirements outlined in section 412.
- Any funds contributed to the retirement plan trust, either by the employee or employer, must only be distributed to the employee or their beneficiary.
Employers offering qualified requirement plans must also meet the requirements outlined in the Employee Retirement Income Security Act (ERISA) of 1974. Like the Internal Revenue Code used to govern employer-offered retirement plans, ERISA also outlines fiduciary responsibilities, grievance and appeals processing, and employee rights to seek legal action if there is a breach of fiduciary duty.
Pros and Cons of Qualified Retirement Plans
Many employers offer qualified retirement plans, and as of 2020, 67% of private-sector employees had access to this retirement vehicle. If you’re considering participating in one, it’s important to identify the pros and cons and determine if they fit your retirement investment strategy.
- Great option for individuals who are looking for an easy-to-manage retirement account
- Some employers match contributions, which can increase your investment power and total savings
- Higher contribution limits when compared to other retirement accounts, like traditional and Roth IRAs
- Can be used in conjunction with other retirement plans, including non-qualified options like traditional IRAs, Roth IRAs, and self-directed IRAs
- Investment options are limited to specific asset types (e.g., stock, bonds, mutual funds) offered by the managing financial organization
- Eligibility and management are tied to your employer. If you no longer work for the organization, you’ll need to roll your funds into another account, like a traditional or self-directed IRA. You also may see a reduction of funds if your account isn’t fully vested at the time of your departure.
- Little to no control over account management fees
Types of Qualified Retirement Plans
There are two types of qualified retirement plans: defined benefit plans and defined contribution plans. Let’s explore the difference between both plans below.
Defined benefit plans
Under a defined benefit plan, an employee is promised a specific benefit upon retirement. Commonly these plans provide a monthly benefit based on an employer’s salary and the amount of time the participating organization employed them. However, benefits can also take the form of a specific dollar amount (e.g., $500 monthly). Defined benefit features are outlined in the plan document provided to the participating employee.
Some commonly defined benefit plans include:
- Simplified Employee Pension Plans (SEPs)
- Cash balance plans
Defined contribution plans
Under a defined contribution plan, the employee and/or the employer make regular, pre-tax contributions to a retirement account. For instance, an employee may decide to contribute 4% of their earnings to their retirement plan, and their employer may match or make a smaller contribution, say 2%, into that same plan.
Defined contributions are typically invested in various assets – stocks, bonds, mutual funds, stocks, etc. As such, the value of the employee’s retirement account depends on the performance of those investment assets.
Commonly defined contribution plans include:
- 401(k) plans
- 403(b) plans
- Profit-sharing plans/stock bonus plans
- Employee stock ownership plans (ESOPs)
Qualified vs. Non-Qualified Retirement Plans
Qualified retirement plans are only one type of investment vehicle that you can use to plan for the future. You can also choose to invest in a non-qualified retirement plan if your employer offers them.
The primary difference between qualified and non-qualified retirement plans is adherence to ERISA. While qualified retirement plans must follow the rules and regulations set forth by ERISA, non-qualified retirement plans are not subject to those rules.
Because ERISA does not govern non-qualified retirement plans (e.g., they aren’t held to the same discriminatory restrictions), employers often use them to attract top talent or fill key executive roles. In addition, these plans aren’t subject to IRS contribution limits, making them an attractive benefit to high-earning employees who will inevitably meet the limits attached to qualified retirement plans.
Another key difference is how the funds are taxed. Under a qualified retirement plan, employer contributions are tax-deductible. That’s not the case for employer contributions under a non-qualified retirement plan.
Non-qualified retirement plans include:
- Executive bonus plans, under which an employer takes out a life insurance policy, typically a permanent policy, on the employee. The employee is the owner of the policy and can take loans against the account or withdraw funds penalty-free per the policy rules (often at retirement age). The policy owner can also choose beneficiaries who will receive the death benefits should they die.
- Non-qualified deferred compensation (NQDC) plans allow employees to “defer” a portion of their salary for use at a later date. NQDC funds are not subject to Internal Revenue Code limits and typically become available after a specific milestone or trigger, such as retirement, death, or termination. Funds may also be made available on a specified date or due to an unexpected emergency.
- Group carve-out (GTCO) plans are another option that provides employer-sponsored life insurance offered to a specific group of key employees. Under a GTCO, key employees, often executives, receive $50,000 in group life insurance as well as a permanent life insurance policy paid for by their employer.
Qualified retirement plans can play an important role in your retirement, and it’s worth taking advantage of these plans if offered by your employer. However, depending on your professional and investment goals, a qualified, employer-based retirement plan may not be enough. If you’re looking to round out your investment strategy, you may also consider adding a stand-alone retirement plan, like a self-directed IRA, to your portfolio. Doing so can help you add a secondary investment source and also provide an alternative account should you leave your current position.
Contact Horizon Trust today to find out what investment options are available today so that you can for tomorrow.