Qualified retirement plans

Make pre-tax contributions that grow tax-deferred until you withdraw the money

A qualified retirement plan is a retirement plan that allows you to make tax-deferred contributions, lowering your taxable income in the present and only requiring you to pay income tax when you withdraw money. Most employer-sponsored retirement plans are qualified plans, including 401(k) plans and pensions.

You will also see a qualified plan described as tax-advantaged because your contributions and investments experience tax-free growth. You only pay tax when you make a withdrawal — officially called a distribution — from the account. Qualified plans are voluntary but employers also receive tax benefits, like the ability to deduct 401(k) contributions on company taxes.

Qualified retirement plans provide multiple tax benefits, but are also a bit restrictive. For instance, you cannot access your money until you reach retirement age (at least not without paying a tax penalty). Also, part-time workers and self-employed workers may have difficulty accessing a qualified plan.

Key Takeaways

  • Qualified retirement plans are voluntary, employer-sponsored plans that take pre-tax contributions

  • A 401(k) is a type of qualified retirement plan, as are pensions, Keogh plans, H.R. 10 plans, and ESOPs

  • Making contributions can lower your taxable income for the year, potentially lowering your overall income tax rate

  • There are many similar plans that are not qualified retirement plans, like IRAs, Roth IRAs, 403(b) plans, and 457(b) plans

What is a qualified retirement plan?

Qualified retirement plans are usually voluntary, and allow you to make pre-tax contributions while offering tax-deferred growth so that you only pay income tax when money is withdrawn. What actually meets the definition of a qualified retirement plan is determined by the Internal Revenue Code and the Employee Retirement Income Security Act of 1974 (ERISA). ERISA generally covers how employer-sponsored retirement plans should be managed, but doesn’t usually cover plans set up by government entities, churches, or other nonprofits, since retirement plans from those entities — such as 457(b) and 403(b) plans — aren’t usually qualified retirement plans.

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Types of qualified retirement plans

Many of the employer-sponsored retirement accounts you can contribute to are qualified plans with their own eligibility requirements, contribution limits, advantages, and disadvantages. Below is a list of common qualified retirement plans:

  • Defined contribution plans, like a 401(k)

  • Defined benefit plans, like a pension plan

  • Employee stock ownership plans (ESOPs)

  • Keogh plans or H.R. 10 plans

Defined contribution retirement plans

Defined contribution plans are very common and allow employees to contribute a percentage of their income into a retirement account. The size of the employee’s eventual retirement benefits depends on how much they contributed and how it was invested. Employers may also contribute (and receive similar tax benefits), but aren’t required to.

Examples of defined contribution plans include the 401(k), safe harbor 401(k), SIMPLE 401(k), solo 401(k), profit sharing plan, and money purchase plan.

Read more on how 401(k) plans work.

Defined benefit retirement plans

Defined benefit plans, such as pensions, aren’t nearly as common as they used to be. Pension plans provide employees with guaranteed retirement income and employers often provide the majority of contributions. However, employees must work at a company for a certain length of time in order to get full retirement benefits (or any benefits). A defined benefit plan works similarly to Social Security. (Learn how to apply for Social Security benefits.)

Keogh plans

A Keogh plan, also called an H.R. 10 plan, is a qualified plan for self-employed workers who may not otherwise have access to a retirement plan through their jobs. Keogh plans generally work like a defined benefit pension plan but may sometimes work as a defined contribution plan.

Qualified vs. nonqualified retirement plan

A qualified retirement plan is an employer-sponsored plan that allows you to contribute pre-tax income. You only pay income tax when you withdraw the money, regardless of how you invest it. On the other hand, nonqualified plans generally don’t take pre-tax income. Contributions you make are with income on which you’ve already paid income tax.

Some nonqualified plans, like Roth IRAs, allow you to pay income tax now and then withdraw money tax fee. Other nonqualified plans, like traditional IRAs, mimic the tax benefits of qualified plans because you can deduct the income tax you paid on your contributions. Your investments then grow tax-free and you pay income tax upon withdrawal just like a qualified plan.

On the technical side, even though a nonqualified plan may work very similarly to qualified plans, qualified plans are defined in Section 401 of the Internal Revenue Code, but nonqualified plans are not.

No matter how you do it, make sure to save for retirement, because the average cost of retirement is nearly $1 million.

Types of nonqualified retirement plans

Common examples of nonqualified retirement plans include the following:

  • Traditional IRAs

  • Roth IRAs

  • Self-directed IRAs

  • SIMPLE IRAs (Savings Incentive Match Plan for Employees Individual Retirement Accounts)

  • SEP IRAs (Simplified Employee Pension Individual Retirement Accounts)

  • SARSEPs (Salary Reduction Simplified Employee Pensions)

  • Executive bonus plans

  • Deferred compensation plans

  • 403(b) plans

  • 457(b) plans

A traditional IRA works similarly to a 401(k) plan, but you contribute post-tax income and then get a federal tax deduction for the income tax you paid on your contributions. (Learn more about the IRA deduction.) The money in your traditional IRA grows tax-free and you only pay income tax when you withdraw the money. The annual contribution limit is much lower for an IRA than for a 401(k). Read more in our guide to traditional IRAs.

A Roth IRA takes post-tax contributions and then doesn’t require you to pay income tax again. You can also withdraw your Roth IRA contributions at just about any time. Learn more about who should get a Roth IRA.

A SIMPLE IRA is available to self-employed individuals and businesses with fewer than 100 employees. It basically just creates a traditional IRA for each employee, but the SIMPLE IRA is created by an employer, and the employee accounts do take pre-tax contributions. SIMPLE IRAs are a sort of hybrid between a personal IRA and a qualified defined contribution plan. See if a SIMPLE IRA is right for you.

SEP IRAs are available to self-employed individuals and businesses with more than 100 employees, but only employers can make contributions. SEP IRAs are a hybrid plan since they open a traditional IRA for each employee, but the SEP IRA is created by an employer. There was another kind of SEP IRA before 1997, known as a SARSEP, but they are no longer offered by employers. Employers making large contributions on behalf of employees may also consider a profit-sharing plan. Learn more about SEP IRAs.

An executive bonus plan , also called a 162 executive bonus plan or Section 162 plan, allows employers to offer additional benefits, like life insurance, to company executives.

A nonqualified deferred compensation plan (NQDC plan) isn’t strictly a retirement plan and simply allows you to defer your income until a later date, which could be five years, 10 years, or potentially until you retire. This type of plan may also be called a deferred compensation program, DCP, elective deferral program, or EDP.

A 403(b) plan , also called a tax-sheltered annuity or TSA plan, works very similarly to a 401(k) except it’s offered by nonprofit organizations like churches and nonprofit universities. These plans are technically deferred compensation plans in which money is set aside until employees retire, but they function nearly the same as qualified plans.

A 457(b) plan is a type of deferred compensation plan for certain state and municipal employees. It works much like a qualified plan. Similar public sector plans include 401(a) plans and Qualified Excess Benefit Arrangements.

Tax benefits of a qualified retirement plan

A qualified retirement plan offers multiple advantages to employees, particularly through tax benefits. Two of the main tax benefits are lowering your taxable income and allowing your investments to grow tax-free.

Contributions to qualified plans lower your taxable income

Any tax-deferred retirement contributions you make will lower your taxable income because they lower your adjusted gross income (AGI). Lowering your AGI by contributing to tax-deferred accounts may allow you to drop into a lower tax bracket, decreasing the amount of overall income tax you pay. As an example, let’s say your total annual income is $70,000 and you contributed $10,000 to your 401(k) plan. Your AGI is now $60,000. AGI determines your eligibility for most tax deductions, and if you claim $10,000 in tax deductions, you might only end up paying tax on $50,000 of your income.

Related: 53 tax deductions and credits you can claim in 2021

Contributions to qualified plans grow tax-free

Qualified retirement plans are tax-advantaged and you don’t have to pay any tax on the growth of investments within the account, even if those investments pay out regular dividends. Normally, dividends you earn from an investment are subject to capital gains tax each year. You do not have to pay capital gains tax on any investments in qualified retirement plans. You only pay tax when you make a withdrawal (distribution).

Looking for tax-free growth outside of a retirement account? Consider a health savings account (HSA).

Disadvantages of a qualified retirement plan

While they have multiple advantages, qualified plans are also restrictive and inaccessible to many people. Some disadvantages of a qualified plan are that you can only access them through an employer, they may prove a hassle for self-employed individuals, and you can’t access your money until you reach a certain age (or you will pay a tax penalty).

You must get a qualified plan through your employer

You cannot access a qualified retirement plan unless you work for an employer who offers one. Even if your employer does have a plan, you have no control over what type of plan they offer. Your employer’s plan may also have restrictive or unfavorable terms. For example, some 401(k) plans are only available to full-time employees and, even then, only after you’ve worked there for a full year. Some employers also match a portion of employee contributions, while others do not.

Qualified plans are a hassle if you’re self-employed

Self-employed individuals may be able to open qualified plans for themselves, but the whole process is imperfect because it’s still heavily tied to their employment. How much they can contribute depends on their income from self-employment and there may be restrictions on how or when they can contribute. Hiring an employee will also change plan eligibility, so a self-employed person or small business may need to change their plan either after they hire their first employee or after they hire a certain number of employees.

All the work around creating and administering a retirement plan may prove too much of a hassle for many self-employed people and small businesses. Hiring a plan administrator helps, but that also comes with a cost.

Early withdrawal penalties

You generally can’t withdraw money from a qualified retirement plan until you reach age 59½. Taking any early distributions can result in penalties, which you must pay on your next income tax return. You also need to pay income tax on the money you withdraw. For example, an early withdrawal from a 401(k) will result in a 10% penalty. As per usual, the value of your distribution is also added to your annual income. If you think you want access to your money before age 59½, consider opening an IRA or just investing in a brokerage account.

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