Qualified vs Non-Qualified Accounts
Qualified and non-qualified accounts are employer-sponsored retirement plans that offer some tax advantages. Qualified retirement plans are regulated under the Employee Retirement Income Security Act
(ERISA). The 1974 ERISA offers important protections for workers’ retirement accounts. Qualified accounts include 401(k) and profit-sharing plans. Individual retirement accounts (IRA) and government employee plans, while not covered under ERISA rules, offer similar tax benefits to qualified accounts.
Non-qualified plans are employer plans tailored for use by key employees. They’re exempt from ERISA-type testing, which includes tests for discrimination and for top-heavy benefits (benefits that predominantly favor top-paid executives). There are four major categories of non-qualified accounts. In general, contributions to these accounts are not tax-deductible to employer or employee.
However, contributions can grow tax-deferred under these plans until the money is withdrawn. Unlike qualified account, some non-qualified plans do not require mandatory distributions.
The four major non-qualified employer plan types are:
- Executive bonus plans: with this plan, the employer issues a life insurance policy to an executive. The employer pays the premiums, which are considered part of the executive’s bonus. Employers can deduct contributions, but the executive can’t
- Salary continuation plan: the plan funds an executive’s benefit should the executive retire, become disabled or dies. The employer makes the contributions to the plan
- Split-dollar life insurance plans: the employer provides a permanent life insurance policy to an executive or key employee. Employer and employee share ownership of the policy. At death, the employee’s beneficiaries receive most of the death benefit. The employer receives a pro rata portion of the death benefit
- Group carve-out plans: this is another life insurance plan. In it, the employer carves out an employee’s group life insurance in excess of $50,000 and replaces it with an individual insurance contract. The employer pays the premium on the individual policy
Typically, these plans need not have any limit on contributions - the employer sets the rules on maximum contributions.
ERISA employer plans come in two varieties: Defined benefit and defined contribution. In both types, ERISA sets minimum standards for participation, vesting, funding, benefit accrual, management responsibilities and employee rights of redress.
Qualified Defined Contribution Plans
These ERISA-type plans allow employees to defer income by contributing it into the plan. The main type is the 401(k) plan, available for most employees. Note that 403(b) and 457 plans for government employees are similar but are not covered by ERISA. However, some 403(b) plans for private sector tax-exempt organizations may be covered by ERISA.
In 2019, the 401(k)/403(b) plans allow you to defer $19,000 of your income, or $25,000 if you are at least 50 years’ old. In addition, your employer can kick in money that brings the total contribution to $56,000 (or $62,000 for age 50+). Traditional and Roth accounts are available. In a traditional account, all withdrawals are taxable, and you might trigger a 10% penalty by withdrawing money before age 59 ½, although there are a handful of exceptions. Furthermore, you must begin taking required minimum distributions from a traditional account starting at age 70 ½.
Roth accounts allow you to withdraw contributions at any time without tax or penalty. However, you’ll have to pay both for earnings withdrawn during the account’s first five years. You’ll pay tax and might have to pay a penalty on earnings withdrawn before age 59 ½, subject to some exceptions. Roth accounts have no required minimum distributions during the owner’s lifetime.
In a Solo 401(k) plan, the employee is self-employed, so that the same individual makes employee and employee contributions. Special payroll tax calculations are required that affect total allowable contributions.
If allowed by the employer, you can borrow up to $50,000 from your qualified account tax-free. However, you must pay it back, with interest, within a set time period or else the remaining loan balance will be taxed (and perhaps penalized) as a distribution.
- Profit-sharing plans are usually combined with 401(k) plans but need not be. In a stand-alone profit-sharing plan, only the employer makes contributions and does so at its discretion
- Money purchase plans have required minimum contributions for employers, a percentage of each employee’s pay. They differ from profit-sharing plans, in which the employer contributions are discretionary
- Employee Stock Ownership Plans (ESOPs) are qualified stock bonus plans, with or without a money purchase component. Contributions are invested in qualifying employer securities
Qualified Defined Benefit Plans
In a defined benefit plan, your benefits are predefined, based upon your tax-deductible contributions. These pension plans are guaranteed by the Pension Benefit Guaranty Corporation should the employer terminate the plan or go out of business. You can deduct contributions up to $300,000 per year into the pension plan.
There are IRA plans for individuals as well as employer-based IRAs.
IRA plans for individuals are not tied to an employer. Instead, you contribute income up to the annual limit. In 2019, that limit is $6,000 (or $7,000 for those of age 50+). Contribution and distribution rules closely mimic those for 401(k)s, although the penalty exceptions differ slightly. Also, you cannot borrow from an IRA. Traditional and Roth accounts are available.
There are several types of employer-based IRA-type accounts:
- SIMPLE IRA Plans (Savings Incentive Match Plans for Employees)
- SEP Plans (Simplified Employee Pension)
- SARSEP Plans (Salary Reduction Simplified Employee Pension)
- Payroll Deduction IRA
These plans are similar in their overall architecture but differ in the details. To learn more about these, see this IRS webpage