Saving for retirement is an important financial goal and there are different options when it comes to where to invest. A qualified retirement plan can make it easier to build wealth for the long term, while enjoying some significant tax benefits.
Qualified retirement plans must meet Internal Revenue Code standards for form and operation under Section 401(a). If you have a retirement plan at work, it’s most likely qualified. But not every retirement account falls under this umbrella and those that don’t are deemed “non-qualified.”
So just what is a qualified retirement plan and how is it different from a non-qualified retirement plan?
Understanding the nuances of these terms can help you better shape your retirement plan for growing wealth.
What Is a Qualified Retirement Plan?
Qualified retirement plans allow you to save money for retirement from your income on a tax-deferred basis. These plans are managed according to Employment Retirement Income Security Act (ERISA) standards.
The IRS has specific rules for what constitutes a qualified retirement plan and what doesn’t. Public employers can set up a qualified retirement plan as long as these conditions are met:
• Employer contributions are deferred from income tax until they’re distributed and are exempt from social security and Medicare tax
• Employer contributions are subject to FICA tax
• Employee contributions are subject to both income and FICA tax
Following those guidelines, qualified retirement plans can include:
• Defined benefit plans (such as traditional pension plans)
• Defined contribution plans (such as 401(k) plans)
• Employee stock ownership plans (ESOP)
• Keogh plans
Section 403(b) plans, which you might have access to if you’re a public school or tax-exempt organization employee, mimic some of the characteristics of qualified retirement plans. But because of the way employer contributions to these plans are taxed the IRS doesn’t count them as qualified plans. The same is true for section 457(b) plans, which are available to public employees.
Defined Benefit vs Defined Contribution Plans
When talking about qualified retirement plans and how to use them to invest for the future, it’s important to understand the distinction between defined benefit and defined contribution plans.
ERISA recognizes both types of plans, though they work very differently. A defined benefit plan pays out a specific benefit at retirement. This can either be a set dollar amount or payments based on a percentage of what you earned during your working career.
This type of defined benefit plan is most commonly known as a pension. If you have a pension from a current (or former) employer, you may be able to receive monthly payments from it once you retire, or withdraw the benefits you’ve accumulated in one lump sum. Pension plans can be protected by federal insurance coverage through the Pension Benefit Guaranty Corporation (PBGC).
Defined contribution plans, on the other hand, pay out benefits based on how much you (and your employer, if you’re eligible for a company match) contribute to the plan during your working years. The amount of money you can defer from your salary depends on the plan itself, as does the percentage of those contributions your employer will match.
Defined contribution plans include 401(k) plans, 403(b) plans, ESOPs and profit-sharing plans. With 401(k)s, that includes options like SIMPLE and solo 401(k) plans. But it’s important to note that while these are all defined contribution plans, they’re not all qualified retirement plans. Of those examples, 403(b) plans wouldn’t enjoy qualified retirement plan tax benefits.
What Is a Non-Qualified Retirement Plan?
Non-qualified retirement plans are retirement plans that aren’t governed by ERISA rules or IRC Section 401(a) standards. These are plans that you can use to invest for retirement outside of your workplace.
Examples of non-qualified retirement plans include:
• 403(b) plans
• 457 plans
• Deferred compensation plans
• Self-directed IRAs
• Executive bonus plans
While these plans can still offer tax benefits, they don’t meet the guidelines to be considered qualified. But they can be useful in saving for retirement, in addition to a qualified plan.
Traditional and Roth Individual Retirement Accounts
Traditional and Roth IRAs allow you to invest for retirement, with annual contribution limits. For 2021 and 2022, the maximum amount you can contribute to either IRA is $6,000, or $7,000 if you’re over 50.
Traditional IRAs allow for tax-deductible contributions. These accounts are funded using pre-tax dollars. When you make qualified withdrawals in retirement, they’re taxed at your ordinary income tax rate. IRAs do have required minimum distributions (RMD) starting at age 72.
Roth IRAs don’t offer the benefit of a tax deduction on contributions. But they do allow you to withdraw money tax-free in retirement. Unlike traditional IRAs, Roth IRAs do not have RMDs, meaning you don’t have to withdraw money until you want to.
A self-directed IRA is another type of IRA you might consider if you want to invest in stock or mutual fund alternatives, such as real estate. These IRAs require you to follow specific rules for how the money is used to invest, and engaging in any prohibited transactions could result in the loss of IRA tax benefits.
Advantages of Qualified Retirement Plans
Qualified retirement plans can benefit both employers and employees who are interested in saving for retirement.
On the employer side, the benefits include:
• Being able to claim a tax deduction for matching contributions made on behalf of employees
• Tax credits and other tax incentives for starting and maintaining a qualified retirement plan
• Tax-free growth of assets in the plan
Additionally, offering a qualified retirement plan, such as a 401(k), can also be a useful tool for attracting and retaining talent. Employees may be more motivated to accept a position and stay with the company if their benefits package includes a generous 401(k) match.
Employees also enjoy some important benefits by saving money in a qualified plan. Specifically, those benefits include:
• Tax-deferred growth of contributions
• Ability to build a diversified portfolio
• Automatic contributions through payroll deductions
• Contributions made from taxable income each year
• Matching contributions from your employer (aka “free money”)
• ERISA protections against creditor lawsuits
Qualified retirement plans can also feature higher contribution limits than non-qualified plans, such as an IRA. If you have a 401(k), for example, you can contribute up to $20,500 for the 2022 tax year, with an additional catch-up contribution of $6,500 for individuals 50 and older.
If you’re able to max out your annual contribution each year, that could allow you to save a substantial amount of money on a tax-deferred basis for retirement. Depending on your income and filing status, you may also be able to make additional contributions to a traditional or Roth IRA.
Making Other Investments Besides a Qualified or Non-Qualified Retirement Plan
Saving money in a qualified retirement plan or a non-qualified retirement plan doesn’t prevent you from investing money in a taxable account. With a brokerage account, you can continue to build your portfolio with no annual contribution limits. The trade-off is that selling assets in your brokerage account could trigger capital gains tax at the time of the sale, whereas qualified accounts allow you to defer paying income tax until retirement.
But an online brokerage account could help with increasing diversification in your portfolio. Qualified plans offered through an employer may limit you to mutual funds, index funds, or target-date funds as investment options. With a brokerage account, on the other hand, you may be able to trade individual stocks or fractional shares, exchange-traded funds, futures, options, or even cryptocurrency. Increasing diversification can help you better manage investment risk during periods of market volatility.
While a qualified retirement plan allows investors to put away pre-tax money for retirement, a non-qualified plan doesn’t offer tax-deferred benefits. But both can be important parts of a retirement saving strategy.
Regardless of whether you use a qualified retirement plan or a non-qualified plan to grow wealth, the most important thing is getting started. Your workplace plan might be an obvious choice, but if your employer doesn’t offer a qualified plan, you do have other options.
In fact, if you have a qualified plan such as a 401(k) with a previous employer, you may want to consider moving it to a rollover IRA. Doing a 401(k) rollover, as it’s called, can help you resume your retirement savings.
SoFi makes the rollover process seamless. There are no rollover fees or taxes, and you can complete your 401(k) rollover without a lot of time or hassle.
The information provided is not meant to provide investment or financial advice. Also, past performance is no guarantee of future results.
Investment decisions should be based on an individual’s specific financial needs, goals, and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC registered investment advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.sofi.com/legal. Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or prequalification for any loan product offered by SoFi Bank, N.A.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.