Retirement plans come in all shapes and sizes. Whether you're selecting a plan through an employer years ahead of when you intend to retire or you're securing a plan privately through an insurer, it's important to know what you're dealing with. To that end, you may be asking yourself: What is a qualified retirement plan, and how does it differ from a non-qualified plan?
Non-qualified plans in the workplace are typically reserved for highly compensated employees, but no matter your situation, it's helpful to understand the differences between these two types of plans and how each can affect your finances. Here's what you need to know about qualified and non-qualified retirement plans so you can make the best decisions for your finances now and in the future.
To understand qualified retirement plans, we must begin with the Employee Retirement Income Security Act (ERISA) of 1974. ERISA is a federal law put in place to protect Americans' retirement assets from mismanagement or abuse. Retirement plans that meet ERISA requirements are known as qualified retirement plans.
Under ERISA, qualified retirement plans must meet several important guidelines:
- Minimum standards: ERISA sets minimum standards for plan participation, vesting rules and requirements, funding of the plans and benefit accrual for plan participants. Under ERISA, employers must allow participation in a fair and equal manner, rather than picking and choosing which employees may participate.
- Fiduciary responsibility: The law also requires anyone with discretionary authority over a plan's management or assets to accept fiduciary responsibility, which legally requires the fiduciary to act solely in the financial interests of the plan's participants. Any fiduciary who does not act in accordance with this legal and ethical standard may be responsible for restoring losses to the plan.
- Plan participant rights: Under ERISA, there is a grievance and appeals process for participants who need to access benefits from their plan and have been unable to do so. Participants also have the right to sue their plan for breaches of fiduciary duty.
- Disclosure: Plans must also provide information about the plan, including details about the plan's features and funding, to all participants on a regular basis.
- Guarantee of defined benefits: ERISA guarantees payment of certain benefits, even if a defined benefit plan is terminated.
While these ERISA guidelines were created to protect plan participants, there is also an important tax benefit provided under ERISA: In addition to allowing plan participants to fund qualified retirement plans with tax-deferred contributions, employers offering qualified retirement plans may also deduct their own contributions to employees' plans from their business' taxes.
What Is a Qualified Retirement Plan?
ERISA defines the specific requirements and benefits of a qualified retirement plan, but what is a qualified retirement plan, exactly?
In general, ERISA covers most employer-sponsored retirement plans, which means most employer-sponsored plans are qualified plans. However, not all employer-sponsored retirement plans must meet ERISA guidelines, and those that do not are non-qualified. Specifically, government employee plans and plans administered by churches are not covered by ERISA and are therefore non-qualified.
A 401(k) is the most common type of qualified retirement plan, but pensions and profit-sharing plans are also qualified. Qualified retirement plans may be categorized as either defined benefit or defined contribution.
Defined Benefit Plans
Defined benefit plans (also known as pensions) provide retirement benefits based on a formula that takes into account the employee's salary, their length of service and other employment factors. Such plans do not allow the employee to access funds whenever they want upon reaching retirement age, as is the case with a 401(k). Instead, they provide either a lifetime annuity payment or, in some cases, a lump sum payment upon reaching a certain age defined by the plan. Employers may deduct their contributions to defined benefit plans from their taxes.
Defined Contribution Plans
While defined benefit plans used to be the norm, defined contribution plans are much more common these days. With this kind of plan, which includes 401(k) plans, 403(b) plans and profit-sharing plans, employees contribute to the account for their specific retirement needs in the future. Employers may offer contributions to their employees' defined contribution plans, although it is not required.
Both employees and employers can deduct their contributions from their taxes, but employee contributions are specifically tax-deferred. This means employees will have to pay taxes when they take distributions from their qualified plans in the future — but if they wait to take those distributions until after they have reached age 59.5, they will only owe taxes on the principal, or the amount of money that was initially invested.
What Is a Non-Qualified Retirement Plan?
Any tax-deferred retirement plan that is not covered by ERISA is considered a non-qualified retirement plan. For instance, individual retirement accounts (IRAs) are not employer-sponsored and are therefore non-qualified. However, when you hear about non-qualified retirement plans in the workplace, it is generally in reference to more specific types of plans that allow employers to create custom benefits for certain employees. Since ERISA requires plan participation minimums for qualified retirement plans, employers who wish to provide specific benefits for executives or customized benefits to all employees may choose non-qualified plans.
Some of the most common non-qualified retirement plans include:
- Deferred compensation plans: This type of plan defers current compensation until retirement. Most deferred compensation plans also defer income tax until the compensation is paid. For some individuals, deferred compensation can provide retirement income and reduce current tax burden. In many cases, employees who use a deferred compensation plan will defer money that is paid as bonuses.
- Executive bonus plans: With these plans, employers purchase a permanent life insurance policy for an executive and use employer funds to pay the premiums. The payment of the premiums is considered a bonus. While the executive will have to pay taxes on the bonus (since it is considered income), the insurance will accrue cash value, which the executive may access tax-free in retirement via withdrawals or loans from the policy. The employer may also be able to deduct the cost of the bonus as a business expense.
- Split-dollar plans: Like executive bonus plans, split-dollar plans provide the employee with a permanent life insurance policy. In this case, however, the employer and the employee split the ownership of the policy, as well as the costs. At the termination of the policy (either due to the employee's death or the arrival of a mutually agreed-upon date), both the employer and the employee receive a portion of the benefit.
- Group carve-out plan: Employers who want to provide key employees with additional life insurance beyond the group term life insurance policy can use a group carve-out plan to do so. The employee would retain $50,000 of the ordinary group term life insurance coverage, while the employer purchases an individual permanent life insurance policy for a higher amount. This permanent policy will generally be portable, and because it accrues cash value, it can offer the employee income in retirement.
Choosing the Right Plan for You
There are a number of good reasons to opt for a qualified retirement plan, including the tax benefits (for both you and your employer) and the protections offered to you through ERISA. But the fact of the matter is that you are much more likely to encounter a qualified retirement plan in your workplace. For most workers, qualified plans are either all that their employer offers or all that they have access to at work. Other than individual retirement plans, such as IRAs, most of the retirement plans available to the average worker are qualified.
However, there are potential benefits to non-qualified retirement plans that employees should be aware of. Since employers offering non-qualified plans are often trying to meet the specific needs of their employees, they can be a savvy addition to your retirement plan as a whole. Just know that there are fewer required protections in place for non-qualified retirement plans.
Equipped with this knowledge, take some time to think about which type of plan is right for you. Contact a financial advisor for additional help with designing a retirement plan that will enable you to achieve your goals in your Golden Years.