What Is a Qualified Retirement Plan?
A qualified retirement plan meets the requirements of Internal Revenue Code Section 401(a) of the Internal Revenue Service (IRS) and is therefore eligible to receive certain tax benefits, unlike a non-qualified plan. An employer establishes such a retirement plan on behalf of and for the benefit of the company’s employees. It is one tool that can help employers attract and retain good employees.
What's a Qualified Retirement Plan?
Understanding Qualified Retirement Plans
Qualified plans come in two main types: defined benefit and defined contribution, though there are also some other plans that are hybrids of the two, the most common of which is called a cash balance plan. Defined benefit plans give employees a guaranteed payout and place the risk on the employer to save and invest properly to meet plan liabilities. A traditional annuity-type pension is an example of a defined-benefit plan.
- A qualified retirement plan meets IRS requirements and offers certain tax benefits.
- Examples of qualified retirement plans include 401(k), 403(b), and profit-share plans.
- Stocks, mutual funds, real estate, and money market funds are the types of investments sometimes held in qualified retirement plans.
- Employers offer retirement plans to attract and retain employees.
- Taking contributions out of a retirement plan before retirement age can often result in tax penalties.
Under defined contribution plans, the amount employees receive in retirement depends on how well they save and earn through investment on their own behalf during their working years. The employee bears all the investment and longevity risk and is expected to be a financially savvy saver. A 401(k) is the most popular example of a defined contribution plan. Other examples of qualified plans include the following:
- Profit-sharing plans
- 403(b) plans
- Money purchase plans
- Defined benefit plans
- Employee stock ownership (ESOP) plans
- Salary Reduction Simplified Employee Pension (SARSEP)
- Simplified Employee Pension (SEP)
- Savings Incentive Match Plan for Employees (SIMPLE)
The IRS provides a guide to common qualified plan requirements.
Qualified Retirement Plan and Investing
Qualified plans only allow certain types of investments, which vary by plan but typically include publicly traded securities, real estate, mutual funds, and money market funds. Increasingly, alternative investments like hedge funds and private equity are being considered for defined contribution plans. Some are already available, packaged into target-date funds.
Retirement plans also specify when distributions can be made, typically when the employee reaches the plan’s defined retirement age, when the employee becomes disabled, when the plan is terminated and not replaced by another qualified plan, or when the employee dies (in which case the beneficiary receives the distributions).
Qualified Retirement Plan and Taxes
Qualified retirement plans give employers a tax break for the contributions they make for their employees. Those plans that allow employees to defer a portion of their salaries into the plan can also reduce employees’ present income-tax liability by reducing taxable income. Workers may take distributions from qualified plans before retirement age or before one of the other triggering events occurs, but the distributions will be subject to taxes and penalties that often make it unwise to take an early distribution.
Some plans also allow employees to borrow from the plan under strict rules about how the loan is repaid. For example, plan rules may require that the loan be repaid within a certain number of years, that the worker pays interest (which goes back into the plan) on the loan, and that the loan is repaid immediately if the employee leaves the job to which the qualified retirement plan is tied.