Qualified vs. Nonqualified Retirement Plans: An Overview
A qualified retirement savings plan meets government guidelines that protect employee savings. Most such plans also grant special federal tax benefits to both the employee and employer.
A savings plan is "qualified" if it follows the rules of a key piece of legislation called The Employee Retirement Income Security Act (ERISA), enacted in 1974 to protect workers’ retirement income and guarantee transparency in pension plans.
Most qualified plans also get special tax treatment, such as a tax deferral on savings. This is a government policy aimed at encouraging employees to save towards their retirement costs.
A plan is not considered qualified if it does not fall under ERISA guidelines.
Some examples:
- Qualified plans include 401(k) plans, 403(b) plans, profit-sharing plans, and Keogh (HR-10) plans.
- Nonqualified plans include deferred-compensation plans, executive bonus plans, and split-dollar life insurance plans.
Of course, it gets complicated. Individual retirement accounts (IRAs) are not qualified plans because they are not set up by an employer and therefore don't fall under ERISA rules. They do, however, have special tax breaks for savers.
Key Takeaways
- A qualified retirement plan meets the guidelines set out by ERISA.
- Qualified plans "qualify" for government regulation and tax breaks.
- Nonqualified plans do not meet all ERISA stipulations.
- Nonqualified plans are generally offered to executives and other key personnel as extra incentives.
What Is a Qualified Retirement Plan?
Qualified retirement plans, such as the 401(k) savings plan, are "qualified" for special tax treatment. They are by definition offered only by employers and meet the requirements of ERISA.
An IRA is not considered qualified, although it includes tax breaks, because it is provided by financial institutions rather than employers.
In the case of a 401(k) and its many variations, employees may invest a portion of each of their paychecks up to annual limits set by the government. In a traditional plan, they invest pre-tax dollars, postponing payment of their income taxes until they withdraw their savings decades down the line. In a Roth plan, they pay the income taxes due at the time of their deposit but owe no further taxes on the money they accumulate.
The employer may or may not contribute a matching amount for the employee.
Defined Contribution Vs. Defined Benefit
A qualified plan may have either a defined contribution or a defined benefit structure.
- In a defined contribution plan, the employee manages the investment, and the total accumulated is theirs when they retire.
- In a defined-benefit plan, the employer manages the money and guarantees that the employee will receive a fixed payment in retirement. This is the increasingly rare traditional pension plan.
In either case, plan sponsors must meet ERISA guidelines regarding participation, vesting, benefit accrual, funding, and plan information disclosure.
What Is a Nonqualified Retirement Plan?
Nonqualified retirement plans are usually offered as an additional incentive for executives and other employees considered high-value. The plans are usually part of a benefits package.
Nonqualified plans are not eligible for tax-deferred benefits under ERISA. The contributions to nonqualified plans are taxed when the money is paid.
Qualified vs. Nonqualified: Key Differences
Qualified plans must be made available to all company employees. Nonqualified plans are offered only to some employees as a bonus.
The other main difference is in the tax treatment. Qualified plans offer tax benefits to both the employee and the employer. The employee defers taxes, while the employer can deduct any contributions it makes. Nonqualified plans do not have these tax advantages.
All employees who meet the eligibility requirements of a qualified retirement plan must be allowed to participate in it, and benefits must be proportionately equal for all participants.
A plan must meet several criteria to be considered qualified, including:
- Disclosure—Documents about the plan’s framework and investments must be available to participants upon request.
- Coverage—A specified portion of employees, but not all, must be covered.
- Participation—Employees who meet eligibility requirements must be permitted to participate.
- Vesting—After a specified length of employment, a participant’s right to the accumulated money is a nonforfeitable benefit.
- Nondiscrimination—Benefits must be proportionately equal in assignment to all participants to prevent excessive weighting in favor of higher-paid employees.
Nonqualified plans are often designed to meet the specific needs of the few employees who receive them. Qualified plans cannot be customized.
Advisor Insight
Thomas M. Dowling, CFA, CFP®, CIMA®
Aegis Capital Corp, Hilton Head, S.C.
A qualified retirement plan is included in Section 401(a) of the Tax Code and falls under the jurisdiction of ERISA guidelines. Employee and/or employer contributions are distinct from the employer’s balance sheet and are owned by the employee. There are more restrictions to a qualified plan, such as limited deferral amounts and employer contribution amounts. Examples of these are 401(k) and 403(b) plans.
A nonqualified plan does not fall under ERISA guidelines so it does not receive the same tax advantages. They are considered to be assets of the employer and can be seized by creditors of the company. If the employee quits, they will likely lose the benefits of the nonqualified plan. The advantages are no contribution limits and more flexibility. Executive Bonus Plan is an example.
How Many Americans Have Qualified Retirement Plans?
As of 2023, about 73% of civilian workers had access to retirement benefit plans, and 77% of the employees who had access chose to participate in the plans.
What Does 'Qualified Plan' Mean?
A "qualified" retirement plan is an employer-sponsored savings program that meets federal guidelines for accountability, equal access, and transparency. Qualified retirement plans offer tax advantages to both the employee and the employer.
The 401(k) plan and the 403(b) plan are examples.
Do Qualified Retirement Plan Savings Grow Tax-Free?
Yes. The money you pay into a qualified retirement plan grows tax-free until you withdraw it.
If you choose a traditional plan, you'll pay no income taxes on the money you pay in until you withdraw it. At that time, you'll owe income tax on both the principle and the accumulated profit.
If it's a Roth plan, you'll pay income tax on the money you put into your fund but you'll owe no further taxes on withdrawals.
The Bottom Line
Most employees are now familiar with the qualified retirement savings plan, whether or not they know it by that name. The 401(k) plan and its many variations like the 403(b) are employer-sponsored long-term savings plans that offer special tax advantages to participants. They also have to follow certain federal rules put in place to guarantee access to the plans and transparency in their management.
Nonqualified plans are less well known. They are bonus savings plans offered only to executives and other highly-valued employees as part of a larger incentives package. They do not come with tax breaks.
