Qualified retirement plans

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

Derek Silva

Derek Silva

Published March 31, 2020

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KEY TAKEAWAYS

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

  • Common examples include 401(k) plans and private pensions

  • Qualified plans are defined by section 401 of the U.S. tax code, so accounts with similar tax benefits, like the traditional IRA, may not be qualified

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

A qualified retirement plan is a tax-deferred plan the IRS allows employers to offer their employees. Contributions are pre-tax and investments grow tax free, with no income tax due until money is withdrawn. Examples of qualified retirement plans include private pensions and 401(k) plans.

You will also see these plans described as tax-advantaged because your contributions and investments grow without you having to pay annual tax on the growth. You only pay tax when you withdraw money — take 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.

Not all employer-sponsored retirement plans are qualified plans. On a more technical level, qualified retirement plans are defined in Internal Revenue Code Section 401(a) and they are managed according to the standards set in the Employee Retirement Income Security Act of 1974 (ERISA). ERISA covers standards for voluntary employer-sponsored retirement plans, but generally doesn’t cover plans set up by government entities, churches, and other nonprofits.

Whether you use a qualified or non-qualified retirement plan, it’s important to save for retirement. A previous Policygenius study found that the average cost of retirement is nearly $1 million. The later you start saving the less likely you are to save enough to enjoy a stress-free and financially secure retirement.

In this article:

Common types of qualified retirement plans

Many of the retirement accounts you can contribute to through a private, for-profit employer are qualified plans. They each have their own eligibility requirements, contribution limits, advantages, and disadvantages. The following are common types of qualified retirement plans:

  • Defined benefit plans, like pensions
  • Defined contribution plans, such as the 401(k), safe harbor 401(k), SIMPLE 401(k), solo 401(k), profit sharing plan, and money purchase plan
  • ESOPs (Employee stock ownership plans)
  • Keogh plans or H.R. 10 plans, which are terms for qualified retirement plans you set up yourself if you’re self-employed

Defined benefit retirement plans

Defined benefit plans, such as pensions, provide employees with guaranteed retirement income. Employers often provide the majority of contributions and employees must work at a company for a certain length of time in order to get full retirement benefits.

Pensions work similarly to Social Security and are not very common nowadays.

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Defined contribution retirement plans

Defined contribution plans, including 401(k) plans, allow employees to contribute a percentage of their income into a retirement account. How much the employee receives in retirement depends on how much they contributed and how it was invested. Employers may also contribute (and receive similar tax benefits) but this isn’t necessary.

A 401(k) plan is the most common retirement plan from for-profit employers. Self-employed workers may qualify for a solo 401(k). Some companies offer their high-level employees, who own more than 5% of their company or earn at least $130,000, a safe harbor 401(k), which have fewer regulations but require the company to make contributions.

Keogh plans

A Keogh plan, or H.R. 10 plan, is just another word for a qualified plan that you set up yourself if you’re self-employed. They generally work like a defined benefit pension plan but may sometimes work as defined contribution plans.

Qualified vs non-qualified retirement plans

A qualified retirement plan is an employer-sponsored plan you can make contributions to using pre-tax income. The money in a qualified account was never subject to income tax before you contributed and you don’t have to pay any tax as your money grows within the account (regardless of whether or not you invest it). Plans are also defined in a specific part of the U.S. tax code.

A non-qualified retirement plan isn’t defined in the same part of the tax code as a qualified plan. Non-qualified retirement accounts generally do not allow you to make contributions directly into them before paying income tax.

The most common examples of non-qualified retirement plans are individual retirement accounts (IRAs), like traditional IRAs and Roth IRAs. These accounts still allow your contributions to grow tax free. In the case of the traditional IRA, it’s even possible to set one up to accept pre-tax contributions, like when it’s set up as part of an employer’s SIMPLE IRA plan. However, these aren’t technically qualified plans.

Common non-qualified retirement plans

Common examples of non-qualified retirement plans include the following:

  • Traditional IRAs, when set up to accept after-tax contributions
  • Roth 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)
  • Self-directed IRAs, when set up to accept after-tax contributions
  • Executive bonus plans
  • Deferred compensation plans
  • 403(b) plans
  • 457(b) plans

Traditional IRAs work similarly to 401(k) plans but you contribute post-tax income and then get a federal tax deduction for the income tax you had paid on your contributions. The money in your traditional IRA grows tax-free and then you pay income tax when you withdraw the money in retirement, just like with a defined contribution plan. The annual contribution limits are much lower than for a 401(k). If you want to invest in assets beyond stocks and bonds, consider a self-directed IRA.

SIMPLE IRAs are retirement plans available to self-employed individuals and businesses with fewer than 100 employees. They basically just create 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 qualified defined contribution plan and a personal IRA. See if a SIMPLE IRA is right for you.

SEP IRAs are available to self-employed individuals and businesses with more than 100 employees. Employee contributions are not possible; only employers can contribute on behalf of their employees. There was another kind of SEP IRA before 1997, known as a SARSEP. Employers making large contributions on behalf of employees may also consider a profit-sharing plan. As with SIMPLE IRAs, SEP IRAs are a sort of hybrid between qualified plans and personal IRAs. They open a traditional IRA for each employee, but the SEP IRA is created by an employer. Learn more about SEP IRAs.

A Roth IRA, takes post-tax contributions and then doesn’t require you to pay income tax again. You can also withdraw your contributions from a Roth IRA at any time after you’ve had the account for at least five years since you have already paid income tax on them. Learn more about who should get a Roth IRA.

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

Non-qualified deferred compensation plans (NQDC plans) are sometimes called deferred compensation programs, DCPs, elective deferral programs, or EDPs. These plans aren’t strictly retirement plans and simply allow you to defer your income until a later date, which could be five years, 10 years, or potentially until you retire.

A 403(b) plan, also called a tax-sheltered annuity or TSA plan, works very similarly to a 401(k) plan except that they’re available to 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. Similarly, other public sector plans, like 401(a) plans or Qualified Excess Benefit Arrangements are not qualified plans.

Qualified retirement plans and your taxes

Tax-deferred retirement contributions lower your taxable income by lowering your adjusted gross income (AGI). For example, let’s say your total income for 2019 was $70,000 and you contributed $10,000 to your employer’s 401(k) plan. Your AGI is now only $60,000. AGI determines your eligibility for most tax deductions. (After considering tax deductions, you will know how much of your actual income is subject to income tax.)

Lowering your AGI by contributing to tax-deferred accounts may allow you to drop into a lower tax bracket, lowering the overall income tax rate you will pay. It can also allow you to qualify for tax credits and deductions that you may not qualify for based on your gross income.

Qualified retirement plans are also tax-advantaged and you don’t have to pay any tax on the growth of investments within the account. Normally, you would have to pay capital gains tax each year on any dividends you receive from your investments. Instead, these accounts only collect tax when you make withdrawals (officially called distributions).

Keep in mind that there are also non-retirement accounts that allow you to make tax-deferred contributions. The most common examples are health savings accounts (HSAs) and flexible spending accounts FSAs.

Learn more about filing your taxes in 2020.

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About the author

Personal Finance Expert

Derek Silva

Personal Finance Expert

Derek is a tax expert at Policygenius in New York City. He has written about multiple personal finance topics in the past, and his work has been covered by Yahoo Finance, MSN, Business Insider and CNBC.

Policygenius’ editorial content is not written by an insurance agent. It’s intended for informational purposes and should not be considered legal or financial advice. Consult a professional to learn what financial products are right for you.

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