Qualified retirement plans meet all the stipulations laid out in the IRC to allow for tax-deferred contributions. For the most part, these plans include employer-sponsored plans such as 401(k)s, 403(b)s, and Keogh (H.R. 10) plans. Voluntary, employer-based retirement plans are governed by the Employee Retirement Income Security Act of 1974 (ERISA). These are standards set in order to provide protection for employees investing in the plans, including regulations for tax-deferred contributions. For example, if you have a 401(k) account through work, you are putting money into it on a regular basis with the expectation you will be able to use the money for your living expenses after you reach the age of 59 1/2. If you are having money taken out of each paycheck to put into your 401(k), it is taken out of your paycheck before you are taxed on it. That means you have deferred paying tax on that money until you decide to take it out of your 401(k) account. In exchange, you promise not to use the money until you reach retirement, and your employer promises to keep it in a separate account that keeps your money safe, no matter what may happen to the company down the road.
How Do Qualified Retirement Plans Work?
In order to be considered qualified, retirement plans have to meet certain criteria in the IRC. These pertain to participation, contribution limits, and other characteristics. Key plan requirements include:
Participation: Qualified plans generally must be made available to employees no later than the date on which they reach age 21 and after completing one year of service with the employer. Operation in accordance with the plan document: The employer has to prepare a plan document. It must state what types of contributions and benefits are available. The plan then has to work as it says it does. Compensation limits: The maximum compensation for each employee that can be taken into account when calculating employee benefits is $305,000 for 2022. Elective deferral limits: Elective deferrals must not exceed $20,500 in 2022 (or $27,000 if age 50 and older), up from $19,500 in 2021 ($26,000 if age 50 or older). This is the case for 401(k) and other qualified plans that allow them, including pre-tax and designated Roth contributions. Total contribution limits: For 2022, the maximum contribution to a defined contribution plan is the lesser of $61,000 ($67,500 if age 50 or over) or 100% of compensation. For 2021, the maximum is the lesser of $58,000 ($64,500 if age 50 or older) or 100% of compensation. The most that each employee may receive in annual benefits and contributions under a defined benefit plan cannot exceed $245,000 in 2022, up from $230,000 in 2021.
Types of Qualified Retirement Plans
A qualified plan can be either a defined benefit or a defined contribution plan. Defined contribution plans allow employers and employees to contribute to individual accounts that the employer establishes under the plan. The value of the account changes over time; you don’t receive a fixed benefit upon retirement. Common examples include 401(k), 403(b), profit-sharing, employer stock ownership, or money-purchase plans. Defined benefit plans pay a fixed monthly benefit in retirement. It is often based on a formula that takes into account years of service and salary history. Traditional pension plans have declined in popularity, but they remain good examples of defined benefit plans. There are other employer-sponsored retirement plans that do not qualify under the ERISA. These are called non-qualified plans. They come in various forms. In general, they are based on deferred income in some way; they are also most often aimed at executives. Qualified plans cannot be based on deferred compensation.
Benefits of Qualified Plans for Employers
These employer-sponsored plans provide advantages for businesses large and small. Here are some of those perks.
Tax-Deductible Contributions
Employer contributions made to a qualified retirement plan on behalf of their employees are tax-deductible. If you’re a sole proprietor, you can deduct the amount you contribute for yourself; it depends on the type of plan. Employers can deduct up to 25% of the compensation paid to eligible employees for a defined contribution plan. The deduction for contributions to a defined benefit plan requires an actuary to calculate your deduction limit.
Tax-Free Growth
Assets in the plan grow tax-free. Employers generally aren’t liable for taxes on contributions. For small business owners, qualified plans allow you to make large investments. You can also reap the gains in your own retirement without paying taxes on these gains during your career.
Incentives
Businesses may receive special tax credits and other incentives for starting a qualified plan. In most cases, qualifying employers with 100 or fewer employees and who had at least $5,000 in earnings can claim a tax credit. The amount is up to half the cost of setting up, running, and educating employees about qualified plans. The maximum is $500 per year.
Recruitment Value
The plans make employers more attractive to employees. Qualified retirement plans represent an investment in an employee’s future. That means these plans can play an influential role in helping employers recruit and retain valuable employees.
What It Means for Individual Investors
A 401(k), 403(b), or similar retirement plan may be the single most effective way to fund your nest egg. Here are several reasons:
It offers convenience. You don’t have to schedule contributions; you can make them automatically through deductions from your paycheck. Employees get a quick tax break. Taxes on employee contributions can most often be deferred until distribution in retirement. By making contributions with pre-tax dollars, you could cut your final tax bill for the year by hundreds or thousands of dollars. Assets grow tax-deferred. Employee contributions made to a qualified plan and any earnings will continue to grow; they’ll be sheltered from taxes until you withdraw funds. Distributions will generally be taxed at your income tax rate at the time of withdrawal. You could receive matching contributions. If your employer matches employee contributions, don’t miss out. Treat those matching contributions as free money that you will receive every pay period. Aim to contribute at least as much to your qualified plan as needed to get the maximum match. You get diverse investments. You’ll have several investment options to choose from, potentially including collective investment funds. Many plans provide low-cost investments with access to professional investment advice and guidance. You get protection from creditors. Plan assets are often safe from collection actions under the ERISA.
