Written by: Chuck Mattiucci, AIF® | Financial Advisor
When you read about different types of retirement plans, you are sure to run across the words “nonqualified” and “qualified.” These words have numerous implications on the way that these plans are run and both current and future taxation. As an employee, it is crucial that you understand how your retirement plan’s structure will affect your investments in the future.
What Are Qualified Retirement Plans?
The Employee Retirement Income Security Act governs qualified plans, commonly referred to as ERISA. There are numerous restrictions and requirements for these plans, such as limited investments, filing requirements, nondiscrimination, and other measures making them somewhat expensive to maintain. These plans include retirement plans such as 401(k) ‘s, 403(b) ‘s, IRAs, and pension plans, among other investments.
Employers often favor qualified plans as they provide beneficial tax breaks to the employer as well as the individual employees. For example, contributions to qualified plans are made directly from an employee’s paycheck and are made pre-tax. In addition, earnings accumulate on a tax-deferred basis, meaning that no taxes are paid until you begin to withdraw funds from the account. However, if distributions are made from the account for a nonqualified expense prior to the employee reaching a specified age (currently 59½), there are taxes and penalties.
What Are Nonqualified Plans?
Nonqualified plans are retirement plans offered by employers that ERISA does not govern. Since these plans are exempt from the discriminatory and top-heavy testing in qualified plans, they are often designed for executives whose needs are not entirely met by qualified plans. Nonqualified plans include group carve-out plans, deferred compensation plans, and others. Although it is not always the case, some types of nonqualified plans may allow the employee to defer taxation until retirement when they access the funds in their plan. In either case, the amount invested into a nonqualified plan is able to grow tax-deferred until it is accessed in retirement.
Speak With a Financial Advisor
Suppose you are interested in discussing the best option for your qualified or nonqualified retirement plan. In that case, financial advisors can help provide clarity and enable you to make the most beneficial decision based on your own goals and needs.
Chuck Mattiucci, AIF®
Senior Vice President
Fort Pitt Capital Group, LLC
680 Andersen Drive, Pittsburgh, PA 15220
(412) 921-1822 |
When determining what benefits packages you wish to offer your employees, you may have questions about how to economize your business expenditures while still attracting and retaining the best possible people to your organization. You may have heard about qualified and non-qualified pension plans, but may not understand the differences between the two. This is where talking with an experienced business and taxation lawyer can be advantageous. In the meantime, let’s break things down a bit.
QUALIFIED PENSION PLANS
The IRS designates certain pension and retirement plans as “qualified” and “non-qualified.” Qualified pensions and retirement funds are much more popular in America and include popular retirement and pension plans including 401(k)s and 403(b)s. A retirement or pension fund is “qualified” if it meets the federal standards promulgated by the Employee Retirement Income Security (ERISA).
Here is a list of the most popular qualified funds:
401(k)
403(b)s
Thrift Savings Plans
Savings Incentive Match Plans for Employees (SIMPLE) IRAs
Salary Reduction Simplified Employee Pensions (SARSEPs)
Tax Treatment
In a qualified retirement or pension plan, the employer and taxpayer may deduct the contributions made to the fund each year. Similarly, gains from a qualified account are not currently taxable income, either. Keeping these contributions in a qualified account allows the taxpayer to delay paying taxes on the income until he or she retires, and the fund begins distributing the income and gains.
This is typically advantageous for many taxpayers because their income will be lower during retirement and therefore, the effective tax rate on the money will be lower. For this reason, most retirement plans and pension funds are qualified plans. In exchange for its advantageous tax treatment, the Internal Revenue Service (IRS) does have several rules that limit the rights of taxpayers to utilize the money in qualified funds.
Contribution Limits
Qualified plans limit the deduction on contributions to a qualified plan each year. The exact contribution limit depends on several factors – including age and the type of qualified plan. For taxpayers under the age of 50, the maximum contribution that can be deducted for all qualified plans is $18,500 for 2018. Americans over the age of 50 can contribute more income each year. In 2018, the IRS will allow these older taxpayers to deduct a maximum of $24,500 per year.
Penalty for Early Withdrawal
While the IRS allows taxpayers to withdraw from a qualified fund at any time, it does impose a hefty fine for any withdrawals before the taxpayer reaches the age of 59.5. Called “early distributions” by the IRS, any distribution before this age cutoff will incur a 10 percent penalty. In addition to this penalty, the taxpayer will still be required to pay federal income tax on the distribution.
There are, however, several notable exceptions that can allow a taxpayer to dodge the 10 percent penalty (but not the income tax). The penalty will not apply if:
The taxpayer is permanently disabled.
The taxpayer is a member of the military serving active duty for at least six months.
The taxpayer has incurred medical expenses that constitute more 10 percent of his or her taxable income that year.
The taxpayer has passed away before 59.5, the beneficiaries of the fund will not be taxed on the early distribution.
Required Mandatory Distributions
When a taxpayer reaches the age of 70.5 then he or she must begin receiving distributions from a qualified fund. The exact amount depends on the type of fund and the amount of money in the fund.
NON-QUALIFIED PENSION PLANS
Non-qualified plans, on the other hand, do not meet the ERISA requirements. For this reason, non-qualified funds offer more flexibility for employers but also limit the tax benefits.
Here is a list of popular non-qualified funds:
Certificates of Deposits
Annuities
Mutual Funds
Money Markets
Savings
In comparison to qualified funds where the employer can immediately deduct any contribution to the pension or retirement fund, employers may not deduct any contributions to a non-qualified plan until the contribution is distributed to the employee. In addition to the difference on contribution limits, qualified and non-qualified plans also differ in their eligibility, participation, and reporting requirements.
Eligibility
Under ERISA, a qualified plan must be available to all employees over a certain age. Typically, employers must make the retirement plan available to all employees over 21 that have been employed by the business for at least one year. Unqualified plans, on the other hand, can be offered to a small group of employees, or even just a single employee.
Participation
Qualified plans are required to offer the same level of benefits to all employees, regardless of compensation. There is no similar requirement for unqualified plans, which can offer different benefit levels to employees depending on their compensation, department, or position.
Reporting Requirements
ERISA imposes strict reporting requirements for any qualified plan. Every year, the employer must file with the IRS and distribute an annual report to all participants that summarizes the fund’s performance in the previous year. The reporting requirements for unqualified plans are simpler– employers only need to file a single form with the U.S. Department of Labor.
For these reasons, non-qualified plans offer much more flexibility for employers in exchange for less favorable tax treatment. Consequently, unlike the more-popular qualified plans, non-qualified retirement plans and pension funds serve a more limited function. In practice, non-qualified funds are typically used as a method of “deferred compensation” for high-level business executives.
Qualified or Non-Qualified Pension Plans- What is Right for Your Business?
In short, qualified pension plans are the most common type of retirement plan and are given more preferential treatment in the tax code. Non-qualified plans, on the other hand, have much less stringent requirements and consequently less favorable tax treatment. In contrast to qualified plans which must be available company-wide, the less popular, non-qualified plans are typically used as compensation for executives.
If you have questions about how to structure your benefit plans, schedule a consult with business and taxation attorney Stephen Thienel today. Mr. Thienel has decades of experience assisting clients in crafting benefit plans for businesses throughout, Maryland, Virginia, and the District of Columbia.
This Blog/Web Site is made available by Stephen Thienel and Thienel Law, LLC for educational purposes only as well as to give you general information and a general understanding of the law, not to provide specific legal advice. By using this blog site you understand that there is no attorney-client relationship between you and Stephen Thienel and Thienel Law, LLC. The Blog/Web Site should not be used as a substitute for competent legal advice from a licensed professional attorney in your state