What Is a Qualified Retirement Plan?
A qualified retirement plan is a plan that meets the requirements of Internal Revenue Code Section 401(a) laid down by the Internal Revenue Service (IRS). Unlike unqualified retirement plans, a qualified retirement plan is eligible to receive certain tax benefits.
The employer sets up a qualified retirement plan on behalf of the company’s employees. These retirement plans offer benefits to the employees, and hence it is one of the tools that can help employers attract and retain talented employees.
Understanding Qualified Retirement Plans
Qualified plans are of two main types: defined contribution and defined benefit. There are some plans which are a combination of both; the most common example of a combination qualified plan is a cash balance plan.
Defined benefit plans offer employees a guaranteed payout while placing the risk on the employer to save and invest properly to meet plan liabilities. An example of a defined benefit plan is the traditional annuity-type pension.
Under defined contribution plans, the retirement amount that employees receive depends on how well they save and invest during their working years. This plan places the risk of investment and longevity on the employee. A popular example of a defined contribution plan is 401(k).
Other examples of qualified plans include:
- 403(b) plans
- Profit-sharing plans
- Money purchase plans
- Salary Reduction Simplified Employee Pension (SARSEP)
- Employee stock ownership (ESOP) plans
- Savings Incentive Match Plan for Employees (SIMPLE)
- Simplified Employee Pension (SEP)
Qualified Retirement Plan and Investing
Qualified plans, depending on the type of the plan, only allow certain types of investments, and typically include real estate, publicly traded securities, money market funds, and mutual funds. Alternative investments, like private equity and hedge funds are increasingly being considered. Some of them are already available, pre-packaged into target-date funds.
Qualified retirement plans also specify details like when to make distributions; when the employee reaches the retirement age defined by the plan; when the employee becomes disabled; when the plan is terminated and cannot be replaced by another qualified plan, or what happens when an employee dies (the beneficiary receives the contributions in this case).
Qualified Retirement Plan and Taxes
Qualified retirement plans give tax breaks for the contributions employers make for their employees. The plans also allow employees to defer a portion of their salaries into the plan and reduce their taxable income and hence reduce their income tax liability.
Employees can take early distributions from their qualified plans before they reach the retirement age, but the distributions are subjected to taxes and penalties. Therefore, taking an early distribution is often an unwise decision.
The new CARES ACT incorporated some very important changes for this year. No one knows if it will end at the end of 2020 or be extended. One of the changes is the new ability to take an early distribution, up to $100,000 without the IRS 10% penalty for people under the age of 59 ½. There are two options for the person receiving the distribution. They can ask their workplace plan administrators to directly roll over the distribution to their IRA or self-directed 401 (k) and take advantage of broader investment choices. The second option is to take the distribution directly. Normally, the taxes on this type of distribution are taxed the following year, but the new law lets you spread the taxes over a three year period. Another feature of this option is if you use the money and then return it within three years – no tax due!
Some qualified retirement plans allow employees to borrow from the plan. But there strict rules about loan repayments. For example, if you take a loan from your plan, you will need to repay it to your plan, within a certain number of years, along with interest. And if you leave your job, the loan you took from your qualified retirement plan has to be repaid immediately.
Once again, the CARES ACT has made some changes. Under the old rule, you were allowed to borrow up to 50% of the plan’s value up to $50,000. The new rule allows you to borrow 100% of the plan’s value up to $100,000. The same 5-year payback rule is still in place unless the loan is for the purchase of a primary residence then has a 15 year payback period.