What are the types of qualified retirement plans?

A qualifying retirement plan is simply a plan that meets the requirements set forth in Section 401(a) of the US Tax Code. That doesn’t mean there aren’t other types of plans available to build your nest egg. However, most retirement savings programs offered by employers are qualified plans since contributions are tax deductible. There are several types of qualified plans, although some are more common than others.

Key points

  • Qualified retirement plans must meet the requirements of Section 401(a) of the US Tax Code, which means contributions are tax deductible.
  • A defined contribution plan is based on employer and employee contributions that accrue over time.
  • A common type of defined contribution plan is a 401(k) or a 403(b) if the employer is a nonprofit, but profit-sharing plans also exist.
  • Today, there are fewer defined benefit plans, such as pensions, that provide workers with a fixed amount upon retirement.

Defined contribution plans

The most common type is a defined contribution plan, which means that the employer and/or employee pay a certain amount into the employee’s individual account and the total account balance depends on the amount of these contributions and the rate at which the account bears interest.

Examples of defined contribution plans include a 401(k) or a 403(b) if the company is a non-profit organization. For the most part, these plans are tax-deferred, meaning contributions are made in pre-tax dollars, and the employee pays income tax on the funds in the year they are withdrawn. Also, earnings in these plans grow tax-free.

Unlike other types of retirement plans, a 401(k) allows the employee to borrow a percentage of their funds in the plan. However, early withdrawals before the age of 59 1/2 will incur a 10% penalty from the Internal Revenue Service (IRS) in addition to income taxes on the distribution.

Employer correspondence

In a defined contribution plan, employees contribute a percentage of their compensation each year, and employers have the flexibility to choose the type of contribution they make.

In other words, the employer may not be required to contribute at all, in which case the funds accrual depend on how much the employee chooses to contribute and how much that money earns. However, in many plans, employers contribute a set amount or match the employee’s contribution up to a certain percentage of their salary.

Contribution Limits

The IRS has established annual contribution limits for 401(k)s. For 2022, the maximum contribution limit for a 401(k) — as an employee — is $20,000 (which will increase to $22,500 in 2023). If you’re 50 or older, you can make an additional $6,500 recovery grant in 2022 (which will increase to $7,500 in 2023). In other words, if you’re 50 or older, your annual limit on total 401(k) contributions is $27,000 for 2022 and $30,000 for 2023.

The IRS also sets limits for total contributions, both employees and employers, to a defined contribution plan. For 2022, an employee’s annual plan contributions cannot exceed $61,000 or $67,500, including catch-up contributions for employees age 50 and older. For 2023, the contributions increase to $66,000 and $73,500, respectively. However, most employers do not contribute the maximum amount to an employee’s retirement plan.

Even if you participate in an employment-qualified retirement plan, such as a 401(k), financial experts also recommend opening a traditional or Roth IRA to boost your retirement savings.

Defined benefit plans

The other type of qualified plan is called a defined benefit plan. These plans are increasingly rare. Defined benefit means that the plan stipulates that a certain amount is owed to the account holder upon retirement, regardless of employer or employee contributions or the welfare of the company. These plans are usually pensions or annuities.

In a retirement plan, the employee receives a certain amount each year after retirement based on salary, years of service, and a predetermined percentage. The burden is on the employer to pay contributions to the plan calculated to accrue the amount necessary upon the employee’s retirement.

With an annuity plan, the account holder receives a fixed amount each year after retirement, usually until death. Some plans have a shorter benefit period, and some include surviving spouse benefits after the account holder’s death. Again, it is the employer’s responsibility to pay the plan contributions which provide for the payment of these benefits down the road.

IRAs are tax-advantaged retirement savings plans that are funded by earnings, but are set up by individuals, not employers, and are not classified as qualified retirement plans.

More ways to save for retirement

On the other end of the spectrum, profit-sharing plans are based solely on contributions made by the employer, at their sole discretion. This type allows employers to contribute more during years when the business is doing well, but also allows them to contribute little or nothing in years when it is not.

A subset of this type of plan is a stock bonus plan in which employer contributions are paid in the form of company stock. Again, this can be great if the business is doing well by the time you’re ready to retire.

Roth and traditional IRAs

However, it can also mean that you have to start contributing to an individual plan like an individual retirement account (IRA) or a Roth IRA to ensure you’re covered should the business fail. Both the Roth and traditional IRA increase your tax-free earnings, but traditional IRAs give you a tax break in contribution years, but retirement withdrawals are taxed. However, Roth doesn’t give any upfront tax deductions, but withdrawals in retirement are tax-free.

The annual contribution limit to a Roth and Traditional IRA is $6,000 for 2022 and $6,500 for 2023. For those age 50 and older, a Recovery Contribution in the amount of $1,000.

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