Definition

Qualified Retirement Plan

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What is Qualified Retirement Plan?

Qualified retirement plan is a retirement plan that allows certain tax advantage as it is recognized by the Internal Revenue Code (IRC) and the Employee Retirement Income Security Act. Benefits from the qualified plan may be offered by employers as it let them take tax deductions for any contributions they make to their employee’s account. Employee contributions allow tax-deferred growth until money is withdrawn. However, withdrawing contribution before retirement age can often result in tax penalties.

Some of the most common qualified retirement plans include 401(K)s, 403(b)s, profit sharing and Keogh (HR-10) plans, and it may allow for both employee and employer contributions. It is a tool that can help employers engage and retain quality employees.

Sometimes, assets such as shares, mutual funds, money market funds, and real estate are also held in a qualified retirement plan.

Understanding Qualified Retirement Plans

Qualified Retirement Plans are of two types: Defined Benefit and Defined contribution. There are some other plans that are a combination of defined benefit plan and defined contribution plan, the most common is known as Cash balance plan.

A defined benefit plan allows both employees and employers to contribute to an individual account, in which employers guarantees payout and save and invest properly to meet plan liabilities. It is established by the employer under the plan and bears all the investment and longevity risk. The value of the account changes over the time so an employee does not receive a fixed benefit on retirement. Some of its common examples are Profit sharing, 401(k), 403(b), money purchase plans or employer stock ownership.

Assets such as shares, mutual funds, stocks are also held in a qualified retirement plan.

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A defined contribution plan also known as DC plan is a type of retirement plan in which an employee and sometimes employer make a fixed monthly contribution. It is often based on a formula that consider years of service and one’s salary record.  The amount employees receive in defined contribution retirement plan depends on how well they save and earn through investment during their working years.

In this plan employee themselves bears all the investment and longevity risk.  Some of its popular examples include profit sharing plans, 401(k), Simplified Employee Pension (SEP) and Savings Incentive Match Plan for Employees (SIMPLE).

How does Qualified Retirement Plan Work

In order to be recognised by the IRC, Qualified retirement plans have to meet certain criteria. The key requirements are:

  • Participation: The qualified plans must be made available to workers when they have completed one year of service with a particular employer or on the date when they reach age 21.
  • Contribution Limits: The maximum contribution limit for 2020 to a defined contribution plan was the lower of US $57,000 and US $63,500 for workers aged 50 or over or 100% of compensation.

The maximum contribution limit to a defined contribution plan for 2021 is lower of US $58,000 and US $64,500 for workers aged 50 or over or 100% compensation. In 2020 and 2021, the maximum amount an employee may get in annual benefits and contributions cannot exceed US $230,000. Contribution limits are based on cost-of-living adjustments and they may increase in future.

  • Compensation limits: In 2021, the maximum compensation for an employee that can taken into account when computing employee benefits is US $290,000.
  • Operation in accordance with the plan document: The employer needs to make a document for the plan which must state types of contributions and benefits available to employee. The plan then has to work according to the document.
  • Elective deferral limits: In 2020 and 2021, the elective deferrals for 401(k) and other qualified plans that offer pre-tax and designated Roth contributions must not exceed US $19,500 and US $26,000 for age 50 or over. 

Benefits of Qualified Retirement Plan for employers

  • Tax-deductible contributions

Contributions by the employer on behalf of their employee are tax-deductable.  For a defined contribution plan, an employer may deduct up to 255 of the compensation contributed to employees.

  • Tax-free growth

The contribution in the qualified plans grows tax-free and allows business to make large investments.

  • Incentives

Employer may receive special tax credits and other incentives for starting and contributing to a qualified plan.

  • Recruitment value

Qualified retirement plans contribute to the employee’s future as an investment and attract employees towards employer, which help employer recruit and retain valuable workers.

Benefits of Qualified Retirement Plan for employees

  • Convenient

The employee does not have to schedule contribution as it is automatically deducted from the salary every month.

  • Tax Break

Contributions in qualified plans are most often tax-deferred for employees. Employee may cut final tax bill for the year by hundreds or thousands of dollars by making contributions with pre-tax dollars.

  • Assets grow tax-deferred

Contribution by the employee in a qualified plan continues to grow tax-deferred until the employee withdraws the amount. However contribution in taxed at income tax rate at the time of withdrawal.

  • Get diverse investments

Employee may choose from various qualified investment plans. Many plans also offer low-cost investments with access to professional investment advice and guidance.

  • Matching contribution

Qualified plan allow both employee and employer to contribute same amount every pay period. It aims to pay at least as much to employee’s qualified plan as needed to get the maximum match. 

  • Protection from Creditors

Qualified plan assets are often safe from collection actions under the Employee Retirement Income Security Act (ERISA).