Saving for retirement is an important financial goal to have and the sooner you begin, the better. Finding the right asset allocation for your portfolio is important, but it’s also helpful to consider asset location, meaning where you decide to keep your investments for retirement. One important location for your retirement money is in a qualified retirement plan. Here’s what you need to know about such plans. You can also work with a financial advisor to help you create the right mix of assets in your portfolio so that you’re ready to retire when the time is right.
What Is a Qualified Retirement Plan?
Qualified retirement plans are tax-advantaged retirement plans that meet requirements established by Section 401(a) of the Internal Revenue Code. Those requirements apply to the way the plan is set up as well as how it’s operated and the tax benefits it may yield.
A plan is qualified if it also meets Employment Retirement Income Security Act (ERISA) guidelines. ERISA covers voluntary employer-sponsored retirement plans. Plans that don’t adhere to Internal Revenue Code requirements and aren’t managed by ERISA are considered to be nonqualified.
Key Features of Qualified Retirement Plans
One of the primary benefits of a qualified retirement plan is that it allows you to save for retirement on a tax-deferred basis. This means that the money you contribute to the plan is not subject to income tax in the year you make the contribution. Instead, the money grows tax-deferred until you withdraw it from the plan in retirement.
Also, many plans allow for employer contributions, which can help boost your retirement savings even more. These employer contributions are tax-deductible for the employer and not taxable to the employee until they are withdrawn from the plan in retirement.
Thirdly, the IRS-mandated contribution limits are adjusted periodically for inflation.
Types of Qualified Retirement Plans
Broadly speaking, qualified retirement plans can come in two varieties: defined benefit plans and defined contribution plans. Defined benefit plans are offered by employers and they’re designed to provide employees with guaranteed income in retirement. The employee may make contributions to a defined benefit plan but the burden is primarily on the employer to fund the plan.
When an employee retires, they’re eligible to receive benefits from the plan. The amount they receive is calculated using a formula set by the employer, rather than based on what was actually contributed to the plan. Pension plans and annuities are types of defined plans employers can offer.
Defined contribution plans are more common than pensions or annuity plans. With this type of plan, the employee is responsible for funding the plan through elective salary deferrals. The employer can also make matching contributions to the plan, though that’s not a requirement. If you have a 401(k) plan at your job or you’re self-employed and contribute to a solo 401(k), then you have a qualified retirement plan that’s also a defined contribution plan.
Other types of qualified retirement plans include:
The main difference between defined benefit and defined contribution plans lies in how they’re funded and what they pay out.
With defined benefit plans, the employer does the funding; with defined contribution plans, the employee can decide how much to contribute. A defined benefit plan offers predictability since you’ll know what it pays out in retirement. A defined contribution plan is less predictable since the amount you can draw is ultimately based on what you contribute, matching contributions from your employer and how much your investments grow over time.
Qualified Retirement Plans and Taxes
Qualified retirement plans can help you build savings for the future but the chief advantage revolves around your taxes. First, the money you contribute to a defined contribution plan can be deducted from your taxable income for the year. Reducing your taxable income can reduce the amount of taxes you have to pay if you’re able to drop into a lower tax bracket or you become eligible for certain tax credits or deductions.
Aside from that, your money can grow over time on a tax-deferred basis. With a 401(k), for instance, you aren’t taxed on your investment gains year over year. Instead, you pay ordinary income tax on qualified withdrawals once you start taking money out in retirement. Of course, if you take money out of your 401(k) before age 59.5, you’ll owe income tax along with a 10% early withdrawal penalty.
Qualified retirement plans can also make the task of saving easier if your employer matches contributions. Matching contributions are essentially free money you can get just by participating in your company’s plan. Just be sure that you’re contributing at least enough to qualify for the full employer match.
Qualified Retirement Plans vs. Nonqualified Retirement Plans
Nonqualified retirement plans allow you to save and invest for retirement but they aren’t defined or governed by the same tax code rules as qualified plans. They can, however, still offer some tax benefits for retirement savers as most retirement plans offer. The type of tax benefit is going to depend on the plan that you choose.
Examples of nonqualified retirement plans include:
- Traditional IRAs
- Roth IRAs
- Self-directed IRAs
- Executive bonus plans
- Deferred compensation plans
- 457 plans
Traditional IRAs can offer tax benefits in the form of tax-deductible contributions. You’d then pay taxes on the money when you withdraw it in retirement at your ordinary income tax rate. Roth IRAs don’t allow for deductible contributions, since they’re funded with after-tax dollars. But qualified withdrawals in retirement are 100% tax-free.
Self-directed IRAs allow you to invest in alternatives beyond stocks or bonds. These accounts can be used to hold specific types of investments, such as real estate. A self-directed IRA lets you choose how to invest, but there are specific IRS rules you need to follow to maintain any associated tax benefits.
A simple way to gauge whether you have a qualified or nonqualified plan is to consider whether it’s offered by an employer or whether you set it up yourself. Executive bonus plans, deferred compensation plans and 457 plans are the exceptions since those can be offered by your company. If you have questions about whether you have a qualified or nonqualified plan, that’s something you can talk to your plan administrator about.
The Bottom Line
Qualified retirement plans can help you build a nest egg in a tax-favored way. If you have a plan at work, then you likely have a qualified retirement plan. And if you’re self-employed or your job doesn’t offer a retirement plan, you could still save for the future by opening an IRA. If you work for yourself and have no employees, a solo 401(k) could also be an option if you’re interested in a plan that allows you to save more for retirement.
Retirement Planning Tips
- Consider talking to your financial advisor about qualified retirement plans and where they fit into your overall financial planning strategy. If you don’t have a financial advisor yet, finding one doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you have access to a qualified retirement plan at work, such as a 401(k), a free calculator can tell you how much you should be putting away to meet your financial goals. Remember, too that the IRS adjusts for defined benefit and defined contribution plans periodically to account for inflation.
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