5.3 Qualified and non-qualified retirement plans
5 min read•august 15, 2024
Retirement plans are a crucial part of employee compensation, offering tax benefits and financial security. Qualified plans, like s, provide tax advantages but have strict rules. Non-qualified plans offer more but fewer tax perks.
Understanding the differences between these plans is key for both employers and employees. , distribution rules, and tax implications vary widely. Choosing the right plan can significantly impact a company's finances and an individual's retirement savings strategy.
Qualified vs Non-qualified Plans
Plan Requirements and Tax Treatment
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- Qualified retirement plans meet specific requirements set by (IRC) and Employee Retirement Income Security Act () offering tax advantages to employers and employees
- Non-qualified retirement plans do not meet IRC and ERISA requirements providing more flexibility but fewer tax benefits
- Contributions to qualified plans generally tax-deductible for employers and for employees
- Non-qualified plan contributions typically not tax-deductible for employers and may be taxable to employees when vested
- Earnings in qualified plans grow tax-deferred until distribution
- Earnings in non-qualified plans may be subject to immediate taxation depending on plan structure
Plan Types and Distribution Taxation
- Qualified plans include 401(k)s, 403(b)s, and defined benefit pension plans
- Non-qualified plans include deferred compensation arrangements and executive bonus plans
- Distributions from qualified plans generally taxed as ordinary income
- Taxation of non-qualified plan distributions varies based on specific plan design and funding method
- Some non-qualified plans may offer tax-deferred growth (Rabbi Trusts)
- Others may result in immediate taxation of contributions (Secular Trusts)
Examples and Comparisons
- 401(k) plan (qualified)
- Employee contributes 10,000
- Employer matches 50% of contribution ($5,000), which is tax-deductible
- Deferred compensation plan (non-qualified)
- Executive defers $100,000 of salary
- Company records liability but cannot deduct until paid out
- Executive may owe taxes on deferred amount when vested, even if not yet received
Retirement Plan Rules and Limits
Contribution Limits and Adjustments
- Annual contribution limits for qualified plans set by IRS and adjusted periodically for inflation
- Different limits for employee elective deferrals and total contributions
- 2023 employee elective deferral limit for 401(k): $22,500
- 2023 total contribution limit (employee + employer): $66,000
- allow individuals aged 50 and older to make additional contributions above standard limits in certain qualified plans
- 2023 catch-up contribution limit for 401(k): $7,500
Distribution Requirements and Penalties
- from traditional qualified plans must begin by April 1 of year following year individual turns 72 (70½ if born before July 1, 1949)
- Early of 10% generally apply to distributions from qualified plans before age 59½
- Exceptions include disability, financial hardship, first-time home purchase ($10,000 lifetime limit)
- Roth accounts within qualified plans have unique contribution and distribution rules
- Tax-free qualified distributions if account held for 5+ years and age 59½+
- No RMDs for original account owner
Plan Administration and Compliance
- Non-discrimination testing ensures highly compensated employees do not disproportionately benefit from qualified plans compared to non-highly compensated employees
- test for elective deferrals
- test for matching contributions
- Vesting schedules determine when employees gain ownership of
- Cliff vesting (100% after specific period, max 3 years for qualified plans)
- Graded vesting (gradual increase, must be 100% after 6 years for qualified plans)
Tax Benefits and Drawbacks of Retirement Plans
Employer-Sponsored Plans
- 401(k) plans offer tax-deferred growth and potential employer matching
- Higher administrative costs for employers
- Limited investment options for employees
- provide easy administration for small businesses
- Require proportional contributions for all eligible employees
- 2023 contribution limit: lesser of 25% of compensation or $66,000
- Defined benefit pension plans offer guaranteed retirement income for employees
- Create substantial long-term financial obligations for employers
- Complex actuarial calculations required
Specialized Retirement Plans
- provide tax advantages for employers and employees
- Concentrate investment risk in single company's stock
- Potential for significant tax deductions for employers
- combine features of defined benefit and defined contribution plans
- Offer predictable benefits for employees
- Potential tax advantages for employers, especially older, high-income owners
- plans allow self-employed individuals to make large contributions
- Become more complex if business hires employees
- 2023 contribution limit: 73,500 with catch-up)
Collaborative and Alternative Plans
- enable small businesses to pool resources for retirement plans
- Potentially reduce costs and administrative burdens
- May improve investment options and bargaining power
- offer simplified retirement savings for small businesses
- Lower contribution limits than 401(k)s
- Mandatory employer contributions
Retirement Contributions and Tax Impact
Income Tax Effects
- Pre-tax contributions to traditional qualified plans reduce individual's taxable income for year of contribution
- Potentially lower current tax bracket
- Example: 6,000 401(k) contribution reduces taxable income to $54,000
- Employer contributions to qualified plans generally tax-deductible business expenses
- Reduce company's taxable income
- Example: $10,000 deducted from business income
Tax Credits and Future Implications
- provides additional tax credit for low- to moderate-income individuals who contribute to retirement accounts
- 2023 credit up to 2,000 if married filing jointly)
- Credit percentage (10%, 20%, or 50%) based on adjusted gross income
- Roth contributions do not provide immediate but offer and qualified distributions
- Potentially lower future tax liabilities
- Beneficial for those expecting higher tax rates in retirement
Strategic Planning and Compliance
- Timing of contributions and distributions can be strategically planned to optimize tax efficiency
- Contribute more in high-income years to reduce taxable income
- Plan distributions to manage tax brackets in retirement
- Excess contributions to retirement plans may result in penalties and additional tax liabilities if not corrected
- 6% excise tax on excess contributions not withdrawn by tax filing deadline
- Corrective distributions may be subject to early withdrawal penalties
- Contributions to non-qualified plans may not reduce current taxable income for employees
- Can defer taxation to future years when potentially in lower tax bracket
- Example: Executive defers $100,000 bonus to non-qualified plan, pays taxes when distributed in retirement
Key Terms to Review (29)
401(k): A 401(k) is a tax-advantaged retirement savings plan offered by many employers that allows employees to save for retirement through payroll deductions. This plan enables workers to contribute a portion of their salary to individual accounts, where the funds can grow tax-deferred until withdrawal, usually in retirement. Employers often provide matching contributions, making it an attractive option for saving for the future.
Actual Contribution Percentage (ACP): The Actual Contribution Percentage (ACP) is a measure used to evaluate the contributions made by employees in a qualified retirement plan, particularly in relation to non-highly compensated employees versus highly compensated employees. This percentage is crucial for ensuring compliance with the nondiscrimination requirements of retirement plans, helping maintain fairness and equity among plan participants. It serves as a key tool in determining the plan's overall contribution levels and assessing whether they meet regulatory standards.
Actual Deferral Percentage (ADP): The Actual Deferral Percentage (ADP) is a measure used to evaluate the average percentage of salary that employees defer into a qualified retirement plan, such as a 401(k). This metric is crucial in ensuring compliance with non-discrimination rules, which prevent plans from favoring highly compensated employees over others. ADP calculations help maintain the plan's integrity and encourage equitable participation among all eligible employees.
Cash balance plans: Cash balance plans are a type of defined benefit retirement plan that combines features of both traditional defined benefit plans and defined contribution plans. In these plans, employers credit a participant's account with a set percentage of their salary plus interest, providing employees with a clear statement of their retirement benefits. This structure makes cash balance plans appealing for employers and employees alike, as they offer predictable benefits while allowing for easier management and understanding of retirement savings.
Catch-up contributions: Catch-up contributions are additional amounts that individuals aged 50 and older can contribute to their retirement accounts beyond the standard contribution limits. This feature is designed to help older workers save more as they approach retirement, enabling them to 'catch up' on their savings. By allowing increased contributions, catch-up provisions aim to enhance retirement security for those who may not have saved enough earlier in their careers.
Contribution limits: Contribution limits refer to the maximum amounts that individuals can contribute to retirement plans within a given tax year. These limits are set by the Internal Revenue Service (IRS) and vary depending on the type of retirement plan, such as qualified plans like 401(k)s and non-qualified plans like IRAs. Understanding contribution limits is crucial for maximizing tax advantages and ensuring compliance with IRS regulations.
Employee contributions: Employee contributions refer to the amounts that employees voluntarily choose to contribute to their retirement plans, such as qualified and non-qualified plans. These contributions can come from salary deferrals, matching contributions from employers, and other forms of participation, which help employees save for retirement. Understanding how these contributions work is crucial for maximizing retirement savings and ensuring compliance with various regulations governing retirement plans.
Employee Stock Ownership Plans (ESOPs): Employee Stock Ownership Plans (ESOPs) are retirement plans that provide employees with an ownership interest in the company through the acquisition of stock. ESOPs serve as a powerful tool for businesses to motivate employees, improve productivity, and provide tax advantages. These plans are classified as qualified retirement plans, meaning they must adhere to specific regulatory requirements set by the Internal Revenue Service (IRS) and the Employee Retirement Income Security Act (ERISA).
Employer contributions: Employer contributions refer to the amounts that employers voluntarily add to their employees' retirement plans, such as 401(k) or pension plans. These contributions can take various forms, including matching contributions or profit-sharing, and are intended to encourage employees to save for retirement while providing additional financial benefits. The nature of these contributions can vary between qualified and non-qualified retirement plans, impacting tax treatment and eligibility.
Employer Match: An employer match is a benefit offered by an employer to match employee contributions to a retirement plan, such as a 401(k), up to a certain percentage or dollar amount. This matching contribution effectively enhances the employee's retirement savings by providing additional funds, often incentivizing employees to save more for their future. The specifics of the match can vary widely among employers and may be subject to certain conditions, like length of service or the employee's contribution level.
ERISA: ERISA, or the Employee Retirement Income Security Act, is a federal law enacted in 1974 to set standards for retirement and health benefit plans in private industry. It was designed to protect the interests of employee benefit plan participants and their beneficiaries by establishing minimum standards for reporting, disclosure, and fiduciary responsibility. ERISA plays a crucial role in distinguishing between qualified and non-qualified retirement plans by imposing specific requirements that qualified plans must meet to enjoy tax benefits.
Executive compensation: Executive compensation refers to the financial pay and benefits provided to top-level management in a company, including salaries, bonuses, stock options, and other perks. This form of compensation is designed to attract and retain talented executives while aligning their interests with those of shareholders. The structure and amount of executive compensation can significantly impact a company's performance, corporate governance, and public perception.
Flexibility: Flexibility refers to the ability to adapt and modify retirement plan structures and rules based on changing circumstances or needs. This concept is crucial in understanding how retirement plans can offer varied options for contributions, withdrawals, and investment choices, ensuring that individuals can tailor their plans to fit their personal financial situations and goals.
Higher contribution limits for non-qualified plans: Higher contribution limits for non-qualified plans refer to the increased amounts individuals can contribute to non-qualified retirement plans, as opposed to qualified plans, which have stricter contribution caps. Non-qualified plans are often used by high-income earners or business executives to save more for retirement than traditional qualified plans allow. These plans provide flexibility in terms of contribution amounts and investment choices, making them an attractive option for those looking to maximize their retirement savings.
Internal Revenue Code: The Internal Revenue Code (IRC) is the comprehensive set of tax laws in the United States, organized under Title 26 of the U.S. Code. It outlines the regulations for federal income tax, estate tax, gift tax, and employment taxes, serving as the backbone for the American tax system and influencing various areas such as business taxation, deductions, credits, and compliance requirements.
IRA: An IRA, or Individual Retirement Account, is a type of savings account designed to help individuals save for retirement while offering tax advantages. There are two primary types of IRAs: Traditional IRAs, which allow contributions to be tax-deductible and grow tax-deferred until withdrawal, and Roth IRAs, which require contributions to be made with after-tax income but offer tax-free withdrawals in retirement. Understanding IRAs is crucial when considering qualified retirement plans, as they play a significant role in helping individuals prepare financially for their retirement years.
Multiple Employer Plans (MEPs): Multiple Employer Plans (MEPs) are retirement plans that are established by multiple employers to provide benefits to their employees, pooling resources for administrative efficiency and cost savings. These plans allow different businesses, often within the same industry or association, to participate in a single retirement plan, making it easier for smaller employers to offer competitive retirement benefits. MEPs can be qualified or non-qualified plans, impacting their tax treatment and regulatory requirements.
Nondiscrimination rules: Nondiscrimination rules are regulations that ensure retirement plans do not favor highly compensated employees over others when providing benefits or contributions. These rules are vital in maintaining fairness in qualified retirement plans, as they prevent discrimination based on salary and promote equitable access to retirement benefits for all employees, regardless of their compensation level. Compliance with these rules is essential for a plan to retain its qualified status and the associated tax advantages.
Plan fiduciary: A plan fiduciary is an individual or entity that has the authority and responsibility to manage an employee benefit plan, such as a retirement plan, on behalf of the participants and beneficiaries. This role comes with a legal obligation to act in the best interests of the plan participants, ensuring that the plan is operated prudently and that the assets are managed responsibly. Plan fiduciaries must adhere to a high standard of care and loyalty, which is crucial in maintaining the integrity of qualified and non-qualified retirement plans.
Required Minimum Distributions (RMDs): Required Minimum Distributions (RMDs) are the minimum amounts that retirement account holders must withdraw from their qualified retirement plans once they reach a certain age, typically starting at 72 years old. This rule is crucial for ensuring that individuals do not defer taxes indefinitely on their retirement savings and that the funds are eventually distributed and taxed. Understanding RMDs is essential for managing retirement income, tax liabilities, and compliance with IRS regulations.
Salary deferral: Salary deferral refers to the portion of an employee's earnings that is set aside and invested in a retirement plan before taxes are applied. This practice allows employees to reduce their taxable income, as the deferred amounts are not included in their gross income until they are withdrawn in retirement. Salary deferrals can be a key feature of both qualified and non-qualified retirement plans, impacting tax liabilities and overall retirement savings.
Saver's credit: The saver's credit is a tax credit designed to encourage low- to moderate-income individuals to save for retirement by contributing to qualified retirement plans. This credit provides a financial incentive for eligible taxpayers by allowing them to reduce their tax liability based on their contributions to retirement accounts like IRAs and 401(k)s. The saver's credit is an important part of retirement planning, as it helps make saving more accessible for those who may struggle to contribute adequately without additional support.
Simple IRAs: A Simple IRA (Savings Incentive Match Plan for Employees Individual Retirement Account) is a type of retirement plan designed for small businesses and their employees. It allows employees to make tax-deferred contributions and offers employers the option to match employee contributions, making it an attractive option for businesses with limited resources to provide retirement benefits. This plan simplifies the administration process and helps employees save for retirement while encouraging business owners to offer a retirement saving option.
Simplified employee pension (SEP) IRAs: A simplified employee pension (SEP) IRA is a type of retirement savings plan that allows employers to make tax-deductible contributions on behalf of their employees, including themselves. It is designed to be easy to set up and maintain, making it a popular choice for small business owners and self-employed individuals. Contributions made to a SEP IRA are generally tax-deferred until withdrawal, helping individuals save for retirement effectively.
Solo 401(k): A solo 401(k) is a retirement savings plan designed specifically for self-employed individuals and small business owners with no employees, allowing them to save for retirement while enjoying tax advantages. This plan combines features of traditional 401(k) plans with those of a self-employed individual retirement account (IRA), enabling higher contribution limits and flexible investment options. Solo 401(k)s can help maximize retirement savings while minimizing tax liabilities.
Tax deduction: A tax deduction is an expense that you can deduct from your total taxable income, reducing the amount of income that is subject to taxation. Deductions can lower your overall tax bill and are often associated with various expenses, such as those related to qualified retirement plans, which can significantly influence the amount of taxes an individual or business pays.
Tax-deferred: Tax-deferred refers to the treatment of certain investment earnings that are not taxed until a later date, allowing funds to grow without immediate tax liability. This concept is particularly important in retirement plans, where contributions and earnings can accumulate without being taxed until withdrawal, providing a potential tax advantage for savers who can benefit from compounding growth over time.
Tax-free growth: Tax-free growth refers to the increase in value of investments or savings that are not subject to taxes as they appreciate. This is particularly relevant in the context of certain retirement plans, where the contributions and earnings can grow without being taxed until withdrawal, allowing for potentially greater accumulation of wealth over time.
Withdrawal penalties: Withdrawal penalties are fees or charges imposed on individuals who withdraw funds from a retirement account before reaching a specified age or meeting certain conditions. These penalties serve as a deterrent to discourage early withdrawals and encourage individuals to keep their savings invested for the long term. They are a key feature of both qualified and non-qualified retirement plans, affecting how account holders plan their retirement savings strategies.