When you plan for your future retirement expenses, there are a number of things you must focus on. Risk, inflation, future needs, rate of returns, etc., are some factors that can help you select a retirement plan. In addition to this, taxability is another essential aspect that plays a role in retirement planning. How your investment returns are taxed will largely determine your financial standing in retirement. The tax you pay can also impact your present and future standard of living.
Tax is one of the main things that can be used to differentiate between different retirement plans. Qualified retirement plans can help you save tax by claiming tax benefits provided by the Internal Revenue Service (IRS). These plans are governed by the Employee Retirement Income Security Act of 1974 (ERISA) guidelines. On the other hand, non-qualified plans are the opposite of qualified plans. They are not governed by ERISA guidelines and provide no tax benefits to contributors.
The 401(k) is one of the most popular retirement savings vehicles. It can offer tax-advantaged savings and financial security in retirement. If you wish to learn more about 401(k)s, their benefits, and which investments to pick, consult with a professional financial advisor who can advise you on the same.
However, if you are wondering, ‘is a 401(k) a qualified retirement plan’, here are a few things you should know:
Is a 401(k) a retirement plan?
A 401(k) is a tax-advantaged retirement plan. It is a company-sponsored plan that an employer offers to their employees. The employee and the employer can make contributions. In fact, the employer may match a percentage of the employee’s contribution, too. So, the higher your contributions, the more you can benefit from your employer’s contribution. There are two types of 401(k) accounts. The first is a traditional 401(k) account that takes your pre-tax dollars as contributions. This means your withdrawals are taxed in retirement. The second 401(k) is the Roth 401(k), which takes after-tax dollars. So, your contributions are taxed, but your withdrawals can be made tax-free.
As of 2022, the contribution limit for a 401(k) for people below the age of 50 is $20,500 per year. If you are aged 50 or more, you can make a $6,500 catch-up contribution per year. However, the value of your contributions cannot exceed $61,000 per year if you are under 50 and $67,500 if you are 50 or older.
401(k) accounts also have specific withdrawal rules. For instance, you are obligated to take the Required Minimum Distributions (RMD) from the age of 72. Additionally, you can make penalty-free withdrawals after the age of 59.5. But there are some exceptions to this rule as specified by the IRS, such as permanent and total disability. If the withdrawal rules are not met, the IRS can levy a 10% penalty.
You can invest in different instruments in a 401(k), such as stocks, bonds, mutual funds, target-date funds, money market accounts, annuities, etc.
Is a 401(k) a qualified retirement plan for taxes?
In order to understand if a 401(k) is a qualified retirement plan or not, you first need to know the definition of a qualified retirement plan. A qualified retirement plan is a plan that can offer certain tax benefits as per the Internal Revenue Code Section 401(a) of the IRS. Qualified retirement plans are set up by companies for their employees, much like the 401(k), which is also a qualified retirement plan. Most companies offer these plans as a way to lower the attrition rate and retain the workforce for the long run.
To know more about the qualified retirement plan 401(k), you must also know that qualified plans are categorized into two types:
1. Defined benefit plans:
A defined benefit plan is offered by the employer and gives a payout to the employee irrespective of the employer’s business and its performance. It is also known as a traditional investment or pension plan. These plans offer the employee a guaranteed income for life after retirement. The responsibility for the investments and the distribution after retirement lies with the employer with little or no control from the employee. Some of these plans may take contributions from the employee, too. However, in most cases, the employer is the only contributor to the plan.
A defined benefit plan can offer withdrawals in two methods – in a lump sum or as regular annuity payments. The lump-sum payment is given at retirement. In contrast, annuity payments are paid from retirement until the death of the employee. The latter mimics the salary of the employee and ensures financial liquidity throughout retirement.
Since the sole responsibility of generating adequate returns and bearing the risk of investment falls on the employer, these plans are pretty rarely offered these days. Administration and management costs are also high as the employer takes care of all investments. Some employers may hire a board of trustees to decide the asset allocation of the investment, too.
2. Defined contribution plans:
The second type of qualified retirement plan is known as the defined contribution plan. A defined-contribution plan is a shared responsibility of the employer and the employee. While employers match the employee’s contribution, the primary responsibility to fund the investment lies on the employee.
In a defined contribution plan like a 401(k), the employee can contribute a part of their gross income according to the contribution limits set by the IRS for the concerned year. The employee takes the investment decisions. This includes selecting the types of investments, asset allocation, risk appetite, etc. The employer has no interference in this selection. As a result, the administration costs for these accounts are relatively low. The risk involved for the company is also negligible as they have no say in investment decisions. Many companies offer a 401(k) plan where the employer matches 50 cents to every dollar contributed by the employee. There is no fixed rule here, and the company can choose to contribute a percentage of the employee’s contribution or none at all.
Defined contribution plans like 401(k)s are tax-deferred until the funds are withdrawn after retirement. Other examples of defined contribution plans include a 403(b) that is offered by non-profit and government organizations. Individual retirement accounts (IRA), SEP IRAs, SIMPLE IRAs and Simplified Employee Pension Plan (SARSEP) are also examples of defined contribution plans.
What is the difference between a qualified and non-qualified retirement plan?
The primary difference, as mentioned above, is that non-qualified retirement plans do not follow ERISA guidelines, while qualified plans do. However, there are several other differences between the two. A non-qualified plan is not eligible for tax benefits under ERISA. So, you pay tax on your contributions made to these plans. However, non-qualified retirement plans can be customized to the needs of the employee, something that is missing in qualified plans which follow a fixed framework. In fact, non-qualified retirement plans are generally offered to important employees in an organization, such as an Executive Bonus Plan offered to certain high ranking managers of a firm. A critical thing to note here is that a qualified plan is only active until the employee works with the same company. If the employee quits, they may lose all benefits. The company’s creditors can also claim these plans. So, the chances of losing all benefits if the company goes bankrupt are high. However, these plans are more flexible than qualified plans. The IRS decides the contribution and withdrawal limits in a qualified plan. A non-qualified plan follows no specific rules for contribution and withdrawal.
Qualified retirement plan 401(k) vs non-qualified plans – which is better?
Qualified and non-qualified accounts can have different pros and cons for employees and employers. Find out what these are:
1. For employees
Both accounts can have benefits for employees. A qualified retirement account can help an employee save tax and plan for their retirement in a more structured manner. Since ERISA and IRS govern these plans, there is a sense of security and reliability. For instance, to help people cope with the repercussions of the Covid-19 pandemic, the CARES Act was introduced that waived the 10% penalty for early withdrawals from a 401(k) and an IRA.
A major advantage for employees using qualified plans is that the company’s creditors cannot seize them. Moreover, since the employer may match the contribution as in the case of a 401(k), the employee can reach their goals sooner. The tax benefits can further help in savings and maximizing the account’s returns.
Additionally, qualified contribution plans offer a lot of control to the employee. The employee can decide the investments, asset allocation, and more. On the other side, qualified benefit plans offer a guaranteed income for life for assured financial security.
Non-qualified plans can also offer benefits to employees. Unless the company’s creditors seize them or the employee leaves the company, the plan can be an asset.
2. For employers
Qualified plans can help employers lower their tax output. If the company has 100 or fewer employees, it can also get a tax credit. Moreover, since these plans are offered to all employees irrespective of their income, role, or designation, it helps to ensure better productivity and keep employees happy for a long time. A qualified plan is an excellent incentive that most companies use to retain employees. And even though the employer may not be able to claim a tax deduction on their contributions towards a non-qualified plan, this can be a good way to ensure employee satisfaction nevertheless.
A qualified retirement plan 401(k) and a non-qualified retirement plan can be significant measures taken by companies to improve job satisfaction for employees. They significantly benefit the employee and help them create wealth for their future years after retirement. However, a qualified plan can be more dependable. A combination of qualified and non-qualified accounts can be ideal. If not, it may be advised to have at least one qualified retirement plan in your portfolio to ensure that you have a financial safety net to fall back on in your golden years.
Did you contribute to a qualified retirement plan yet? If yes, you can consult with a financial advisor to know more about the investments for your 401(k). Use Paladin Registry’s free advisor match tool and get matched with 1-3 qualified advisors who may be able to help you with your unique financial goals and requirements.
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The blog articles on this website are provided for general educational and informational purposes only, and no content included is intended to be used as financial or legal advice. A professional financial advisor should be consulted prior to making any investment decisions. Each person's financial situation is unique, and your advisor would be able to provide you with the financial information and advice related to your financial situation.