A qualified retirement plan is simply a plan that meets the requirements set out in Section 401(a) of the U.S. tax code. This does not mean that other types of plans are not available to build your nest egg, but the majority of retirement savings programs offered by employers are qualified plans since contributions are tax-deductible. There are several types of qualified plans, though some are more common than others.
- Qualified retirement plans must meet the requirements of Section 401(a) of the U.S. tax code, which means that contributions are tax-deductible.
- A defined-contribution plan, which is the most common type of qualified plan, is based on employer and employee contributions that accrue in value over time.
- A common type of defined-contribution plan is a 401(k)—or a 403(b) if the employer is a non-profit—but there are also profit-sharing plans.
- Today there are fewer defined-benefit plans (typically pensions or annuities), which provide workers with a fixed amount upon retirement, regardless of employer/employee contributions.
The most common type is the defined-contribution plan, which means that the employer and/or employee contribute a set amount to the employee's individual account and the total account balance depends on the amount of those contributions and the rate at which the account accrues interest.
Depending on the plan, the employer may not be required to contribute at all, in which case the accrual of funds depends on how much the employee chooses to contribute and how much that money earns.
For many plans, however, the employer contributes a set amount or matches the contribution of the employee up to a certain percentage of their salary. For the most part, these plans are tax-deferred, meaning contributions are made with pre-tax dollars, and the employee pays income taxes on funds in the year in which they are withdrawn.
Most employers that offer a defined-contribution plan offer a 401(k)—or a 403(b) if they are a nonprofit—to which employees contribute a percentage of their compensation each year and employers have the flexibility to choose the kind of contribution they make. Unlike other kinds of retirement plans, a 401(k) allows the employee the ability to withdraw funds prior to retirement, though early withdrawals are subject to certain requirements.
Even if you participate in a qualified retirement plan at work, such as a 401(k), financial experts also recommend opening a traditional or Roth IRA to boost retirement savings.
On the other end of the spectrum, profit-sharing plans rely solely on contributions made by the employer, totally at its discretion. This type does allow employers to contribute more during years when the business is doing well, but it also allows them to contribute little or nothing in years when it is not.
A subset of this type of plan is a stock-bonus plan in which employer contributions are made in the form of company stock. Again, this can be great if the company is doing well when you are ready to retire, but it can also mean you need to start contributing to an individual plan like an individual retirement account (IRA) to make sure you are taken care of in the event the business fails.
IRAs are tax-advantaged retirement savings plans funded by earnings, but are set up by individuals, not employers and are not classified as qualified retirement plans.
The other type of qualified plan is called a defined-benefit plan. These plans are increasingly uncommon. Defined benefit means that the plan stipulates a certain amount is due to the account holder at the time of retirement, regardless of employer or employee contributions or the welfare of the business. These plans are typically either pensions or annuities.
In a pension plan, the employee receives a certain amount per year after retirement based on their salary, years of service, and a predetermined percentage rate. The burden is on the employer to make plan contributions calculated to accrue to the necessary amount by the time of employee retirement.
With an annuity plan, the account holder receives a fixed amount for every year after retirement, generally until death. Some plans have a shorter benefit period, and some include benefits for the surviving spouse after the account holder's death. Again, it is the employer's responsibility to make plan contributions that provide for the payment of these benefits down the road.