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. Still, 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 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 nonprofit—but there are also profit-sharing plans.
- Today there are fewer defined-benefit plans, such as pensions, which provide workers with a fixed amount upon retirement.
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.
Examples of defined-contribution plans include a 401(k) or a 403(b) if the company is a nonprofit. For the most part, these plans are tax-deferred, meaning contributions are made with pretax dollars, and the employee pays income taxes on funds in the year in which they are withdrawn. Also, the earnings in these plans grow tax-free.
Unlike other kinds of retirement plans, a 401(k) allows the employee the ability to borrow a percentage of their funds in the plan. However, early withdrawals before the age of 59½ will incur a 10% penalty from the Internal Revenue Service (IRS) in addition to income taxes on the distribution.
In a defined-contribution plan, employees contribute a percentage of their compensation each year, and employers have the flexibility to choose the kind of contribution they make.
In other words, 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. However, in many plans, employers contribute a set amount or match the contribution of the employee up to a certain percentage of their salary.
The IRS has established annual contribution limits for 401(k)s. For 2020 and 2021, the maximum contribution limit for a 401(k)—as an employee—is $19,500. If you are 50 or older, you can make an additional catch-up contribution of $6,500 for both 2020 and 2021. In other words, if you're 50 or older, your annual limit for total 401(k) contributions is $26,000.
The IRS also sets limits for total contributions—both employee and employer—to a defined contribution retirement plan. For 2020, the annual contributions to an employee's account cannot exceed $57,000 or $63,500, including $6,500 in allowed catch-up contributions for those employees aged 50 and over.
For 2021, the annual contributions to an employee's plan cannot exceed $58,000 or $64,500, including catch-up contributions. However, most employers do not contribute the maximum amount to an employee's retirement plan.
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.
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.
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.
Other Ways To Save for Retirement
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.
Roth and Traditional IRAs
Still, it can also mean you need to start contributing to an individual plan like an individual retirement account (IRA) or a Roth IRA to make sure you are taken care of in the event the business fails. Both the Roth and the traditional IRA grow your earnings tax-free, but traditional IRAs give you a tax deduction in the years of the contributions, but withdrawals in retirement are taxed. However, Roth gives no tax deduction upfront, but withdrawals in retirement are tax-free.
The annual contribution limit to a Roth and traditional IRA is $6,000 for 2020 and 2021. For individuals aged 50 and over, a catch-up contribution in the amount of $1,000 is allowed as well.