What Are Qualified Retirement Plans?

Qualified retirement plans (QRPs) are employer-sponsored retirement plans that must meet certain rules put in place by the Internal Revenue Code (IRC) and the Employee Retirement Income Savings Act (ERISA). Because they comply with IRS regulations, QRPs can offer significant tax benefits to those saving for retirement.

Contributions to a QRP are not taxed in the year they are made, and earnings on these contributions are not taxed until you decide to withdraw them. These dual tax advantages empower your retirement savings to grow more rapidly compared to other types of savings accounts. However, it’s worth noting that a Roth 401(k) differs in this aspect, as it involves taxable contributions to a QRP.

But it’s important to remember that not all retirement plans are QRPs. While a QRP meets ERISA guidelines, a nonqualified retirement plan does not. However, there are certain benefits available with nonqualified retirement plans, and both types of plans can be part of an overall investment strategy to provide you with enough income to last through your retirement years.

There are two primary categories of QRPs: defined contribution plans and defined benefit plans. The difference between the two depends on who is making the majority of the contributions — the employee or the employer.

Defined benefit plans are the least common type of QRP, offered by only about 15% of private employers. These types of plans are funded entirely by the employer. Pensions are the best-known example of a defined benefit plan.

Defined contribution plans are considered the most common type, offered by about 66% of private employers. With a defined contribution plan, employees contribute a set amount of money, which is usually more than the employer contributes. Employers may also make contributions (as is the case with matching contributions), although the IRS does not require this.

You may be able to participate in one or more types of QRPs, depending on what your employer offers.

You’re likely familiar with 401(k) plans, as they’re the most well-known type of defined contribution plan offered by for-profit employers. Similar plans offered by nonprofit, religious and government employers are known as 403(b) plans, but we won’t discuss those in detail here.

With most 401(k) plans, employees choose a percentage of their salary to contribute on a pre-tax basis. Your contributions get deducted from your taxable income that same year, which can lower your tax burden.

Contributions to a 401(k) will get invested in one or more investment funds. Employers usually offer a variety of mutual funds to choose from, with different levels of risk and various management fees. For the most part, you will want to look for investments with low expense ratios and low fees.

As for the tax benefits of a 401(k) plan, both your contributions and earnings are tax-deferred, which means they won’t get taxed until you withdraw money in retirement.

Some employers choose to make regular contributions to their employees’ 401(k) plans, but it’s not required. In many cases, employers will match some — or all — of an employee’s contributions up to a certain amount. For example, an employer could match 50% of an employee’s annual contributions up to a maximum of 6% of their salary.

Keep in mind that there are annual limits on 401(k) contributions, and the IRS adjusts these limits each year to account for inflation. For 2023, the maximum amount an employee 49 or younger can contribute to their plan is $22,500. Employees 50 or older can make catch-up contributions of an additional $7,500. The maximum amount that both the employee and the employer can contribute in 2023 is $66,000.

An increasing number of employers offer Roth 401(k) plans, which behave a little differently than traditional 401(k) plans when it comes to how your contributions and earnings are taxed.

With a Roth 401(k) plan, you make contributions from income that has already been taxed, rather than on pre-tax income. This means that your contributions are not tax-deductible in the year they are made. But because you’re contributing after-tax income, you won’t pay taxes when you make a qualified withdrawal from a Roth plan in the future. Your earnings can also accumulate tax-free.

Essentially, you trade paying taxes at the beginning — at the time you make the contributions — for having tax-free withdrawals at the end. This is in contrast to a traditional QRP like a 401(k) plan, where taxes are deferred (and paid) when funds are withdrawn.

One nice feature of Roth plans is that in most cases, you can withdraw your contributions at any time, at any age, tax-free. But you’ll pay a 10% penalty if you withdraw your earnings before age 59.5 or before your account is at least 5 years old.

The annual limit on contributions to Roth plans is the same as for traditional plans: $22,500 for 2023, with additional catch-up contributions of $7,500 for those 50 or older. As with traditional plans, the maximum amount of combined contributions in 2023 is $66,000.

One thing to note is that it’s common for employer matches of Roth contributions to be made to a traditional plan, too, so you could end up with retirement savings in both types of plans. The recently signed SECURE Act 2.0 will change this and allow employers to make contributions into a Roth plan to match the employee’s contributions. While this rule change was effective on December 29th, 2022, it may take time for employers and record keepers to prepare for this change. Investment options in a Roth plan are usually the same as those available in a traditional plan since the employer chooses both plans.

In addition to 401(k) plans and Roth 401(k) plans, there are a few other qualified retirement plan options that employers may offer.

Pension plans are the most well-known type of defined benefit QRP, but they are much less common now than in the past. Pensions pay out a monthly benefit that gets calculated based on the employee’s salary and how long they worked for the employer.

Profit-sharing plans are another option, but in this case, the employer pays a percentage of the company’s profits to employees. The downside is that if the company loses money or doesn’t make as much profit in certain years, employees receive little to no contributions.

Simplified Employee Pension (SEP) IRAs are designed for small businesses and allow employers to make contributions on behalf of their employees. While employers can contribute up to 25% of the employee’s compensation to a SEP IRA, employees are not allowed to contribute to it at all.

Small businesses with fewer than 100 employees may opt for a retirement plan known as a Simple (Savings Incentive Match Plan for Employees) IRA plan. With this type of plan, the employer can contribute up to 3% of the employee’s compensation and the employee can also make contributions of their own.

Government-sponsored retirement plans are specifically designed for workers at the federal, state or local level of government. A common type of government-sponsored plan is the Thrift Savings Plan (TSP), which allows employees to make contributions of their own and also receive contributions from the employer. Federal employees (and some state and local employees) may also participate in a pension plan that pays out a monthly retirement benefit.

We’ve covered many types of QRPs so far, all of which follow IRC and ERISA guidelines for employers to offer significant tax benefits to their employees.

But there are other types of retirement plans — called nonqualified retirement plans — that operate outside the normal employee-employer relationship. These nonqualified plans allow any taxpayer to save for retirement on a tax-advantaged basis, but the contribution limits are much lower than they are for QRPs. Below are a few examples of nonqualified plans you may choose to invest in.

If your employer doesn’t offer a traditional 401(k) or another retirement option, you may decide to invest in an individual retirement account (IRA). Technically, both traditional IRAs and Roth IRAs are considered nonqualified retirement plans.

A traditional individual retirement account (IRA) allows you to contribute money on a pre-tax basis so that it gets deducted from your income in the year that you make the contribution. Your earnings grow on a tax-deferred basis, and you only pay taxes on your contributions and earnings when you withdraw them.

The maximum you can contribute in 2023 to a traditional IRA is $6,500, with an additional catch-up contribution of $1,000 if you’re 50 or older.

A Roth IRA allows you to make contributions on an after-tax basis. The primary advantage of a Roth IRA compared to a traditional IRA is that qualified withdrawals of both contributions and earnings are tax-free. You can also typically withdraw your own Roth contributions (but not the earnings) tax-free at any age. The contribution limits for the Roth IRA are the same as the Traditional IRA.

A qualified retirement plan is a significant benefit offered by employers, and it can have a major impact on your ability to save enough money for retirement. Whether you’re evaluating your own plan or comparing benefit packages offered by two employers, it’s important to understand how a qualified retirement plan works and ask yourself a few questions.

Does the employer match your contributions, and if so, how much will they contribute each year? Are there enough investment options to choose from, and are the expense ratios of those investments reasonable?

Features can vary significantly among plans, and plans may have different policies and rules that could make it difficult for you to participate or not worth the effort at all.

Your retirement needs are likely different from those of your coworkers, so you should focus on your own retirement goals when assessing any plan.

Once you’ve chosen a QRP and signed up through your employer, you’ll receive many documents that explain how the plan works, your investment options and the next steps.

The most important document you’ll want to review is the Summary Plan Description (SPD), which includes details about your specific plan and the fees. You’ll want to review your statements on at least a yearly basis to make sure the plan is financially healthy — and to see if your investments need any adjustments.

When reviewing your QRP, make sure you make note of how long you’ll have to wait until you’re fully vested in the plan. Being fully vested means the money in the plan belongs to you, regardless of whether you remain an employee at the company or leave to work somewhere else. For example, a plan could have a 3-year vesting schedule, which would require you to stay with the employer for 3 years in order to keep the employer’s contributions in your account.

Some vesting schedules use a cliff approach, which means that the employee is fully vested after the specified length of employment but would not be able to keep the funds if they left before then. As you plan your career and perhaps look for other jobs, consider the timing of your departure so you can keep as much money in your retirement savings account as possible. Leaving a company before you’re fully vested could mean losing out on thousands of dollars.

If you’re planning for retirement, there are several factors you should consider. What do you want your lifestyle to look like during retirement? Will you want more money to spend on travel, or will you downsize to a smaller home and need less spending money? Think about when you might want to retire, especially if retiring early is your goal.

Planning for retirement isn’t something you do once — you’ll need to revisit your plan and your goals often, especially as your life circumstances change. For example, if you have children, you might decide to move closer to them or that you want to provide financial support. Both of these decisions could affect the amount of money you’ll need to live comfortably in retirement.

Health care expenses are often a huge chunk of a retiree’s budget, and if you have specific medical concerns, plan for how you’ll pay for those needs once you’re no longer working.

Once you have a good sense of where you want to be in retirement, think about how your retirement plan can help you get there. To do this, you’ll need a good understanding of your risk tolerance: how much risk are you willing (and able) to take on to achieve the rate of return needed to reach your savings goals? The amount of time you have until you retire will play a role in this process because you won’t want to put your money in high-risk investments too close to retirement.

Knowing how much you need to save will help you decide how much you need to contribute to a qualified retirement plan. During your working years, you’ll likely need to adjust your QRP. One rule of thumb is to increase your contributions each time you get a raise and continue doing so until you reach the maximum annual contribution limit. As you get closer to retirement age, you can adjust your investments to include more lower-risk investments (like bonds) and fewer higher-risk investments (such as stocks).

All things considered, you will probably want to have your retirement savings in more than one investment vehicle. For example, many retirees have several buckets from which to draw income. These may include a qualified retirement plan from a previous employer, a nonqualified plan like a Roth IRA to provide tax-free income in retirement, a taxable brokerage account, an annuity to provide regular income and Social Security benefits. Consider the big picture and allocate your funds accordingly. A financial advisor can help you come up with a formal plan to achieve your desired retirement income.

As a rule, you should only make withdrawals from your QRP once you reach retirement age. For most QRPs, the minimum age to make a penalty-free withdrawal is 59 ½ years. You’ll need to think carefully about how much you’ll withdraw on a regular basis, as you’ll need your savings to last you through retirement.

The IRS has specific rules about the minimum amount that you must withdraw from your retirement savings accounts each year once you reach a certain age. They refer to these as required minimum distributions (RMDs).

The tradeoff for the tax benefits you receive when you invest in a QRP is that you agree to take required minimum distributions (RMDs) once you reach a certain age. Laws around RMDs have changed frequently, but for the most part, you’ll need to start taking minimum distributions from your account once you turn 72 (or at 73, if you turned 72 after Dec. 31, 2022).

The amount of the RMD depends on a few factors, including the starting balance in your account and your age. You’ll want to calculate your RMD accurately and time your first withdrawal just right to avoid any penalties. If you fail to take your RMD at the correct time, you may be assessed a 50% excise tax on the amount you didn’t take out.

It’s important to note that starting in 2024, RMDs are not required if you have a Roth IRA or a Roth 401(k) plan.

There are several strategies to consider for how and when to make withdrawals from your retirement account.

The first option is a lump-sum withdrawal, where you take out a large amount of money — or even the entire balance — at one time. While this is the simplest option, it’s likely to come with the largest tax bill. You also want to be careful about the timing of the lump-sum withdrawal so you don’t take out your hard-earned savings when the stock market is at its lowest point.

Another option is a periodic distribution, which can take place at specified intervals of time (monthly, quarterly or annually). This method is often used for pension or annuity payments. With periodic distributions, the amount of the payment can even be adjusted based on your life expectancy. This is known as the substantially equally periodic payments (SEPP) method.

The last option is a systematic withdrawal, where you select a certain amount that allows as much money as possible to remain invested. When deciding on the amount, research shows that following the 4% rule — where retirees withdraw 4% of their retirement savings each year — will allow your savings to last for 30 years.

You can minimize the effect that taxes will have on your withdrawals in retirement by carefully planning out how and when to take money out of your account.

A common strategy starts with pulling money out of any taxable accounts — like a brokerage account — first. Because the contributions and earnings held in a taxable account have already been taxed, when you withdraw funds, you’ll only pay taxes on capital gains at the lower capital gains tax rate.

Once your taxable accounts are spent, you’ll next withdraw from any tax-deferred accounts such as a pre-tax 401(k) plan or a traditional IRA. This is where you’re likely to get the biggest tax hit, since you would pay taxes on the entire amount of the withdrawal.

Finally, save any tax-free accounts like a Roth IRA for the last withdrawal, since these won’t incur any taxes — and won’t bump you into the next higher tax bracket (with a higher tax rate). You’ll want to pay close attention to your total taxable income to make sure you’re not paying more in taxes than you need to. This is where consulting with a certified public accountant (CPA) or other tax professional can come in handy.