What are qualified retirement plan types?
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, 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.
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 and the accrual of funds depends on how much the employee chooses to contribute. For many plans, however, the employer contributes a set amount or matches the contribution of the employee up to a certain percentage of his 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meaning contributions are made with pre-tax dollars, and the employee pays income taxes on funds in the year they are withdrawn.
Most employers that offer a defined-contribution plan offer a 401(k) or a 403(b) if they are a nonprofit, in which an employee contributes a percentage of his 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. On the other end of the spectrum, profit-sharing plans rely solely on contributions made by the employer, totally at its discretion. This does allow employers to contribute more during years when the business is doing well but 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 can also mean you need to start contributing to an individual plan to make sure you are taken care of in the event the business fails.
The other type of qualified plan is called defined-benefit, and this plan is increasingly less common. Defined-benefit means that the plan stipulates a certain amount 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 his 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.