Common Types Of Qualified Retirement Plans
Most employer-sponsored retirement plans are qualified plans, but each has its own rules, requirements, and contribution limits. Below are the types of qualified retirement plans:
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A 401 plan or similar defined contribution plan
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A pension or other defined benefit plan
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An employee stock ownership plan
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A Keogh plan or H.R. 10 plan
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What Are Qualified Retirement Plans
The Employee Retirement Income Security Act governs qualified plans, commonly referred to as ERISA. There are numerous restrictions and requirements for these plans, such as limited investments, filing requirements, nondiscrimination, and other measures making them somewhat expensive to maintain. These plans include retirement plans such as 401 s, 403 s, IRAs, and pension plans, among other investments.
Employers often favor qualified plans as they provide beneficial tax breaks to the employer as well as the individual employees. For example, contributions to qualified plans are made directly from an employees paycheck and are made pre-tax. In addition, earnings accumulate on a tax-deferred basis, meaning that no taxes are paid until you begin to withdraw funds from the account. However, if distributions are made from the account for a nonqualified expense prior to the employee reaching a specified age , there are taxes and penalties.
Choosing A Retirement Plan
Shopping for retirement plans may leave your head spinning as you consider qualified plans as well as nonqualified plans and the associated eligibility requirements for both options. Without a one-size-fits-all pattern as a guide, your search may begin with a phone call or visit to your tax preparer or tax accountant. You can also visit IRS.gov and search for help with choosing a retirement plan to do a little research of your own before making this important decision.
References
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What Is The Difference Between Qualified And Nonqualified Retirement Plans
Qualified retirement plans must comply with IRS codes and, if sponsored by an employer, must comply with ERISA. This federal law protects participants in employer-sponsored retirement plans by setting standards for nondiscrimination, when employees can join the plan, when contributions vest and are distributed, the information participants receive about the plan, and more. ERISA also requires employers to file reports and holds plan fiduciaries accountable.
There are two types of qualified retirement plans: defined benefit plans and defined contribution plans.
- Defined benefit plans, or traditional pensions, guarantee employees a predetermined amount in retirement. Typically, the employer makes most of the contributions to a defined benefit plan, although some plans let employees contribute as well.
- Defined contribution plans don’t guarantee a specific payout at retirement. Instead, the employee and/or employer contributes to the employee’s retirement account, which is invested at the employee’s discretion. The amount available at retirement depends on how well the investments perform.
Examples of qualified retirement plans include:
Other Important Tax Information About Non
Here are some things employers need to know about the taxes involved, especially when it comes to non-qualified deferred-compensation plans:
The plans are funded using after-tax dollars.
Employers cant claim their contributions as a tax deduction .
For income tax withholding purposes, distributions are considered supplemental wages.
Employers are required to apply federal tax withholding rules on up to $1 million worth of supplemental wages, at a rate of 25%. For supplemental wages exceeding $1 million, the rate is 35%.
On an employees W-2 form, reported distributions from a non-qualified plan are reported in box 11.
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Nonqualified Plan: Executive Bonus Plan
Executive bonus plans are straightforward. A company issues an executive a life insurance policy with employer-paid premiums as a bonus. Premium payments are considered compensation and are deductible by the employer. The bonus payments are taxable to the executive. In some cases, the employer may pay a bonus over the premium amount to cover the executives taxes.
How Nonqualified Plans Work
Like qualified retirement plans, these types of nonqualified plans allow an employee to delay income and its related taxes in exchange for a future benefit . While you may choose to define a nonqualified plan benefit , unlike with a qualified pension, you arent liable for it and you dont have to put anything aside now to pay it in the future . And unlike with a qualified defined contribution plan, the employee has no account balancenonqualified deferred compensation benefits exist only on paper.
A 401 plan allows an employee to defer a portion of their income, invest it, and receive the deferred amount, plus earnings and reduced for taxes, at a later date when the employee is potentially in a lower tax bracket. An NQDC plan provides a similar opportunity for employees, but subject to a much different set of rules. One key difference is that NQDC plans are unfundedthe benefits only exist on paper. Typically, a participant will defer a portion of their income and it will earn a reasonable rate of return until the benefit is distributed however, unlike a qualified plan, the money isnt actually investedits simply a bookkeeping item.
NQDC plans are typically structured to avoid conferring any economic benefit on, or constructive receipt of income to, covered employees.
Because nonqualified benefits arent secured, there are no federal nonqualified plan rules regarding:
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Types Of Nonqualified Retirement Plans
You’re probably familiar with common retirement accounts, such as the 401 and IRA, but nonqualified retirement plans aren’t as widely known. The most common types are:
| Plan type | Plan overview |
|---|---|
| Deferred compensation plans | A nonqualified deferred compensation plan, such as a Supplemental Executive Retirement Plan , is an employer-provided plan that gives the employee supplemental retirement income. The employee does not have to pay taxes on the income until they retire. |
| Executive bonus plans | An employer takes out a life insurance policy in their employee’s name and pays the premiums, allowing executives to access the cash value of the policy when they retire. |
| Split-dollar life insurance plans | The employer pays for a permanent life insurance policy on behalf of the employee, and the employee and employer agree upon how to divide the cash value of the policy between them. |
| Group carve-out plans | Group carve-out plans replace group term life insurance coverage in excess of $50,000 with an individual universal life insurance policy providing additional coverage to help the employee avoid taxes on group life insurance over $50,000. |
What Is A Non
Most of us are familiar with qualified retirement plans — they are employer-sponsored 401, 403, and profit-sharing plans that meet guidelines set forth in the Employee Retirement Income Security Act of 1974.
Qualified plans enjoy attractive tax benefits that make them appealing for millions of American workers. Companies also prefer them because they receive tax breaks for contributions made on behalf of their employees. Many employers also offer non-qualified retirement plans, though, especially to attract and retain high-ranking corporate executives and top-flight creative talent.
In this article well cover the basics of non-qualified retirement plans, their benefits and drawbacks, and why they are used as an executive retirement tool.
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What Are Nonqualified Plans
Nonqualified plans are retirement plans offered by employers that ERISA does not govern. Since these plans are exempt from the discriminatory and top-heavy testing in qualified plans, they are often designed for executives whose needs are not entirely met by qualified plans. Nonqualified plans include group carve-out plans, deferred compensation plans, and others. Although it is not always the case, some types of nonqualified plans may allow the employee to defer taxation until retirement when they access the funds in their plan. In either case, the amount invested into a nonqualified plan is able to grow tax-deferred until it is accessed in retirement.
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Common Types Of Nonqualified Retirement Plans
While most nonqualified retirement plans are still available through an employer, there are options for self-employed workers and people who want to save for retirement without going through their employer.
Common examples of nonqualified retirement plans include the following:
How Nonqualified Retirement Plans Work
Experts advise putting 15% of your pretax income into a retirement plan each year. But IRS limits on contributions to qualified retirement plans can make it difficult for high-income individuals to meet this goal.
Using the 15% guidelines, an executive making $500,000 annually should be saving $75,000 per year for retirement. However, for 2022, the maximum contribution to 401 and 403 retirement accounts is $20,5004.1% of the executive’s income.
Nonqualified retirement plans, which aren’t subject to these contribution limits, allow highly paid employees to save more for retirement. Employers can set up a nonqualified retirement plan that applies to all their executives or can tailor individual contracts to the needs of each executive. Although the options for nonqualified retirement plans are almost endless, the plans generally fall into four types:
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Advantages Of Nonqualified Retirement Plans
Nonqualified retirement plans enable highly compensated employees to save more money for retirement than they could in a qualified plan, which is subject to annual contribution limits. Qualified plans also have discrimination tests in place designed to make sure that HCEs do not contribute substantially more to their retirement plans than the company’s average employee, which may further limit the maximum contribution HCEs can make. Nonqualified plans don’t have these limitations, so HCEs can contribute as much as they choose.
Nonqualified retirement plans also enable participants to defer income taxes on part of their earnings until retirement when they will presumably be in a lower tax bracket and lose a smaller percentage of their income to the government. However, they still must pay Social Security and Medicare taxes in the year they earn the money.
Finally, nonqualified plans don’t have age restrictions on when participants can take penalty-free withdrawals. Some don’t have required minimum distributions either. Employees and employers can work together to decide upon a distribution schedule that works for both of them.
Qualified Vs Nonqualified Retirement Plans: An Overview
Employers create qualified and nonqualified retirement plans with the intent of benefiting employees. The Employee Retirement Income Security Act , enacted in 1974, was intended to protect workers retirement income and provide a measure of information and transparency.
In simple terms, a qualified retirement plan is one that meets ERISA guidelines, while a nonqualified retirement plan falls outside of ERISA guidelines. Some examples:
- Nonqualified plans include deferred-compensation plans, executive bonus plans, and split-dollar life insurance plans.
The tax implications for the two plan types are also different. With the exception of a simplified employee pension , individual retirement accounts are not created by an employer and thus are not qualified plans.
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Company Benefits For Non
Companies are also able to benefit from non-qualified supplemental retirement plans. With non-qualified supplemental retirement plans so common among large firms, a company may have to provide these types of plans to attract and retain talented executives. A generous plan bonus structure can also incentivize the executive with additional compensation based on performance.
These deferred benefit plans also help keep an executive with a company when they might otherwise be drawn away with an increased salary. Many of these plans are structured in a way that the executive has to stay with the company for a certain period or they forfeit their deferred compensation. Supplemental retirement benefits also provide significant compensation to an executive without having to compensate them with an interest in the business, such as stock or partnership status.
Supplemental executive retirement plans have minimal reporting requirements and do not have to meet the strict guidelines applicable to qualified retirement plans. This allows a company to tailor their plan to specific executives to meet their goals. In some cases, a company may be able to recover costs of funding a cash value life insurance policy that is used to fund the deferred retirement benefits.
Nonqualified Deferred Compensation Plans Vs Qualified Deferred Plans
There are a few things youll need to consider when trying to decide between a qualified deferred compensation plan and a nonqualified deferred compensation plan. Qualified deferred compensation plans must abide by rules under the Employee Retirement Income Security Act . While there are rules regarding NQDC plans, the guidelines these plans are subject to arent as strict.
Another key difference between the two kinds of plans is the fact that qualified deferred compensation plans have income caps. For example, a 401 is a qualified deferred compensation plan. Each tax year, theres a limit to how much you can contribute.
NQDC plans dont come with contribution caps. Thats why they can be beneficial to high-income earners who want to contribute more than qualified deferred compensation plans allow them to. At the same time, since NQDC plans are merely agreements theres no guarantee that the benefits will be available to employees .
Plans must me in writing and specify the amount paid, the payment schedule and the event that will trigger payment. This event could be a fixed date, retirement or another event.
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Penalty For Early Withdrawal
While the IRS allows taxpayers to withdraw from a qualified fund at any time, it does impose a hefty fine for any withdrawals before the taxpayer reaches the age of 59.5. Called early distributions by the IRS, any distribution before this age cutoff will incur a 10 percent penalty. In addition to this penalty, the taxpayer will still be required to pay federal income tax on the distribution.
There are, however, several notable exceptions that can allow a taxpayer to dodge the 10 percent penalty . The penalty will not apply if:
The taxpayer is permanently disabled.
The taxpayer is a member of the military serving active duty for at least six months.
The taxpayer has incurred medical expenses that constitute more 10 percent of his or her taxable income that year.
The taxpayer has passed away before 59.5, the beneficiaries of the fund will not be taxed on the early distribution.
Defined Contribution Retirement Plans
Defined contribution plans are very common and allow employees to contribute a percentage of their income into a retirement account. The size of the employees eventual retirement benefits depends on how much they contributed and how it was invested. Employers may also contribute , but arent required to.
Examples of defined contribution plans include the 401, safe harbor 401, SIMPLE 401, solo 401, profit sharing plan, and money purchase plan.
Read more on how 401 plans work.
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Contributions To Qualified Plans Grow Tax
Qualified retirement plans are tax-advantaged and you dont have to pay any tax on the growth of investments within the account, even if those investments pay out regular dividends. Normally, dividends you earn from an investment are subject to capital gains tax each year. You do not have to pay capital gains tax on any investments in qualified retirement plans. You only pay tax when you make a withdrawal .
Looking for tax-free growth outside of a retirement account? Consider a health savings account .
Example Of A Nonqualified Plan
Consider a high-paid executive working in the financial industry who contributes the maximum to their 401, and is looking for additional ways to save for retirement. At the same time, their employer offers nonqualified deferred compensation plans to executives. This allows the executive to defer a greater part of their compensation, along with taxes on this money, into this plan.
Often, employers and executives will agree on a set period that the income will be deferred, which could be anywhere from five years up until retirement. Ultimately, the deferred income has the ability to grow tax-deferred until it is distributed. These deferral amounts may change from year to year, depending on the agreement between the executive and employer.
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How A Nonqualified Plan Works
There are four major types of nonqualified plans:
- Deferred-compensation plans
- Split-dollar life insurance plans
- Group carve-out plans
The contributions made to these types of plans are usually nondeductible to the employer and taxable to the employee.
However, they allow employees to defer taxes until retirement . Nonqualified plans are often used to provide specialized forms of compensation to key executives or employees instead of making them partners or part owners in a company or corporation.
One of the other major goals of a nonqualified plan is to allow highly compensated employees to contribute to another retirement plan after their qualified retirement plan contributions have been maxed out, which usually happens quickly given their level of compensation.
