Whether your retirement plan is qualified or nonqualified depends on whether it meets federal guidelines protecting retirement income and providing transparency to account information. Qualified plans are offered to most employees, while nonqualified plans are customizable and commonly geared toward executives.
Qualified Retirement Plans
Image via Flickr by 401(K) 2013
Qualified retirement plans offer protection of employee investments as well as a degree of transparency into the details of the plan, such as investments, performance, and fees. Examples of qualified plans include 401(k), 403(b), profit-sharing, and tax-deferred pensions known as Keogh plans. Qualified plans are also eligible for tax benefits that aren’t available for nonqualified plans.
All qualified plans meet the Employee Retirement Income Security Act (ERISA) guidelines that were established in 1974 to protect workers’ retirement plans and provide access to information about those plans.
Under qualified plans, employees commonly invest pre-tax dollars, allowing their investments to grow tax-deferred into retirement while providing lower income taxes. Some plans allow a combination of pre-tax and after-tax investments, helping investors who want to reduce their tax burden now, or those who want tax-free growth and reduced taxes in retirement.
Qualified plans can have either a defined contribution structure or a defined benefit structure. Under defined-contribution structuring, employees choose their investments based on their needs and bear the risk of investing; with defined-benefit plans, employers take on more risk by guaranteeing a specified payout upon retirement. Defined-benefit plans are more commonly known as pension plans, which are employer-funded. Employers have been shifting to defined contribution plans, which rely on employees to contribute and make investment decisions. Pensions are becoming uncommon in the private sector, but are more available in government jobs.
ERISA regulations guide eligibility to participate in qualified plans, vesting schedules that determine when an employee owns the employer contributions, benefit accrual, how the plans are funded, and how plan information is disclosed. Employers typically match employee contributions to a certain percentage in defined contribution plans, most commonly a 401(k) plan.
Nonqualified Retirement Plans
Nonqualified retirement plans don’t meet ERISA guidelines, but this type of plan is geared toward executives and key corporate employees whose needs may not be covered by ERISA-compliant plans. Examples of nonqualified plans include deferred compensation plans, executive bonus plans, and split-dollar life insurance plans.
Nonqualified plans don’t offer the protection that qualified plans provide to their holders. Deferred compensation benefits can be structured as nonqualified and provide tax benefits since the income, and corresponding taxes aren’t paid until the employee retires; a risk in such plans is the loss of compensation should the company go bankrupt. Another example of a nonqualified plan, split-dollar life insurance, can benefit key employees, providing compensation in the form of a whole life insurance policy that builds value.
Many investors already have nonqualified plans, even if they aren’t executives. Individual retirement accounts (IRAs) and after-tax investments in Roth IRAs aren’t employer-sponsored or qualified plans. IRAs and other stock investments offer investors unlimited options to diversify their nest eggs.
What Are Key Considerations for Qualified Plans?
Qualified retirement plans meet most employees’ needs. Employees eligible to participate in qualified retirement plans must be allowed to enroll, and benefits must be equal for all participants. Plan benefits include the employer match of employee contributions and the selection of available investment options.
Qualified plans have to meet ERISA criteria, which includes:
- Available documentation on how the plan is structured and where it invests money.
- Eligibility and coverage for employees who meet requirements.
- Vesting schedules define when employees become full owners of the employer’s contribution or when they become eligible for a pension.
- Distributions and mandatory distributions follow IRS rules.
- Assets that are protected from company creditors.
- Participants able to take loans against their holdings if allowed by the plan.
- Employer and employee tax deductions on deferrals on the year of pre-tax contributions.
- Ability to roll over into an IRA if an employee leaves.
- Equality in providing the same set of benefits proportionally to employees regardless of income.
- Limits on pre-tax contributions or deferred income.
Qualified plans are more restrictive than nonqualified plans, with limits to employer contributions and deferral amounts.
Where Are Key Considerations for Nonqualified Plans?
Nonqualified retirement plans are more geared toward executives and other key employees, offering special features and tax benefits. They are highly customizable, unlike qualified plans that must be offered on the same terms to all employees who meet eligibility guidelines. Special bonus plans and other custom packages can help recruit and retain top executives.
Nonqualified plans don’t receive as many tax advantages as qualified plans and are legally considered assets of the employer. Employees may lose their nonqualified benefits if a company files bankruptcy or if the employee leaves the company.
Nonqualified plans have several unique characteristics:
- Eligibility is limited to certain employees or job titles.
- Deferred compensation (until retirement) is unlimited.
- Multiple options for distribution of funds.
- The plan, not the IRS, sets mandatory distributions.
- Assets not protected from the company’s creditors.
- Loans against the plan are unavailable.
- Employer and employee tax deductions on income deferrals at the distribution of funds.
- Ineligibility to roll into an IRA if an employee leaves.
Diversified retirement portfolios with a blend of products and investments protect investors from market fluctuations, changes in employment, and other factors over the years. A mix of pre-tax and after-tax investments helps investors meet their unique needs by optimizing tax laws to help them with current and future tax bills.
Qualified plans help create a level playing field for employees to access benefits like employer match on a 401(k) plan and investment options protected through federal guidelines. Qualified plans offer rollover options for employees who leave a company and are protected from that company’s creditors. On the other hand, nonqualified plans aren’t protected from the employer’s creditors and don’t follow employees who leave. Nonqualified plans are highly customizable for executives and other key personnel, making them solid tools for attracting and retaining staff.
Contact 3D Partners Wealth Advisors for expert advice on making your long-term financial vision a reality through maximizing returns, limiting risks, and optimizing tax benefits.