401(k) and Qualified Plans: Introduction
During the retirement years, income usually comes from three primary sources:
- Social Security benefits
- regular savings (and investment accounts, if any)
- retirement-plan savings, such as IRAs and employer-sponsored retirement plans
One type of employer sponsored plan is a qualified plan (or qualified retirement plan).
A qualified plan is established by an employer to provide retirement benefits for its employees and their beneficiaries.
A qualified plan may be a defined-benefit plan or a defined-contribution plan. Qualified plans allow the employer a tax deduction for contributions it makes to the plan. Employees typically do not pay taxes on plan assets until these assets are distributed. In addition, earnings on qualified-plan assets are tax deferred.
Why Establish a Qualified Plan?
For a business, choosing the right retirement plan is one of its most important financial decisions because the plan must suit not only the employer's immediate needs but also its financial and business profile.
A qualified plan offers benefits to both employer and employees:
Benefits for Employers
- Employers may receive a tax deduction for plan contributions.
- Employers are able to attract and retain high-quality employees. A qualified plan may be the tiebreaker that wins over a skilled person who is offered relatively similar compensation packages from different potential employers.
- Employers may be able to claim a tax credit for part of the "ordinary and necessary costs" of starting up the plan. With a maximum of $500 per year for each of the first three years of the plan, the credit equals 50% of the cost to set up the plan, administer it and educate employees about it.
Benefits for Employees
- Employees are provided with some guarantee that their retirement years will be financially secure.
- For plans that provide salary-deferral features, employees are able to defer paying taxes on a portion of their compensation until their retirement years, when their tax bracket might be lower.
- Some plans allow employees to borrow from the plan. The interest paid on the loan amount is credited to the employee's account, unlike interest on loans obtained from financial institutions, which is paid to the financial institution.
In order for a plan to maintain its qualified status, it must operate in accordance with requirements set by the Internal Revenue Code (IRC), the Department of Labor (DOL) and the Employee Retirement Income Security Act (ERISA) of 1974. Here we take an in-depth look at 401(k) plans, the rules surrounding them and how employees can best use them to their advantage.
401(k) and Qualified Plans: Types of Plans