In this article:
When it comes to saving for retirement, you have an array of options, from employer-sponsored plans to retirement accounts you open yourself. For many, a qualified retirement plan offered by their employer is their savings vehicle of choice. It's also a way for employers to attract and retain good employees.
Qualified retirement plans, such as 401(k)s, offer employees and employers unique tax benefits and adhere to IRS guidelines and federal laws that help protect participants.
How Qualified Retirement Plans Work
Qualified retirement plans must follow IRS regulations, and those sponsored by an employer must also comply with the federal Employee Retirement Income Security Act of 1974 (ERISA). Designed to protect employees' retirement savings, ERISA sets minimum standards for employers offering retirement plans. These include:
- Requiring plans to give participants information about plan features, funding and more
- Establishing minimum standards for plan funding, who can participate, when benefits vest and how they accrue
- Requiring plan fiduciaries to be accountable
- Allowing participants to sue for breaches of fiduciary duty
- Guaranteeing certain benefits if a plan is terminated
Qualified retirement plans come in two basic categories: defined benefit plans and defined contribution plans.
Defined Benefit Plans
Defined benefit plans guarantee a set retirement benefit for life. They include:
- Traditional pension plans: These plans guarantee employees a predetermined payment after retirement. That may be a guaranteed dollar amount or, more often, an amount based on a set formula that includes factors such as your salary, age and the amount of time you worked at the company.
For example, you might receive a percentage of your average wages for your past five years of employment multiplied by the number of years you worked for your employer. Typically, the employer makes most of the contributions to a defined benefit plan, although some plans allow or require employees to contribute as well.
- Cash balance pension plans: While a traditional pension guarantees set monthly payments during retirement, a cash balance plan guarantees a set account balance. Changing values of the plan's investments do not directly impact the benefit amounts promised to participants, and therefore the employer shoulders all the risk. Upon retirement, participants can take their account balance as a lump sum, with the option to roll it over into another investment vehicle, or can use the balance as an annuity and draw payments from it for life.
Today, defined benefit plans are commonly used by government employers, but they're relatively rare in the private sector. The Bureau of Labor Statistics reports that in 2019, 86% of state and local government workers had access to defined benefit plans, compared with just 16% of private-sector workers. Instead, private employers are more likely to offer defined contribution plans.
Defined Contribution Plans
Defined contribution plans don't promise employees a specific amount at retirement. Instead, they allow employees and/or employers to put money into a retirement account for the employee. The amount the employee ultimately receives depends on the performance of their investments.
Types of defined contribution plans include:
- 401(k) plans: The most popular type of employer-sponsored retirement plan, 401(k) plans allow employees to save a percentage of their pretax wages. Typically, the plan offers a choice of investments and employees can direct where their money goes. Money in 401(k) accounts isn't taxed until you withdraw it in retirement—when you are age 59½ or older—which is when your tax rate will likely be lower than during your working years. Many employers match 401(k) contributions up to a certain percentage of employee wages.
- 403(b) plans: Like 401(k) plans, 403(b) plans let employees invest pretax income that generally isn't taxed until the money is distributed in retirement. Also called tax-sheltered annuity plans, 403(b) plans are typically offered by public schools, tax-exempt organizations and churches. Most 403(b) plans sponsored by private, tax-exempt employers are qualified plans, but others (generally government or church plans) are not subject to ERISA.
- Profit-sharing plans: In this type of plan, employers contribute money to a separate account for each employee. (Employees usually cannot contribute.) Employers don't have to contribute every year, and there's no set amount they must contribute. However, they must have a set formula for dividing the contributions among employee accounts.
- Money purchase plans: In contrast to profit-sharing plans, these plans require employers to contribute annually on behalf of employees, and contributions are based on a fixed percentage of each eligible employee's wages. For instance, if the plan specifies the employer contributes 5% of each eligible worker's pay, the employer must do so each year. In some cases, employees can also contribute to money purchase plans.
- Simplified employee pension (SEP) plans: An employer opens a SEP-IRA account for each employee and contributes a percentage of the employee's compensation to the plan. Contributions can vary from year to year, but the percentage used must be equivalent for all employees. The money isn't taxed until it's withdrawn.
- Savings incentive match plan for employees (SIMPLE) IRAs: A SIMPLE IRA is designed for businesses with 100 employees or fewer. In this type of plan, employers have two options: They can either match employee contributions dollar-for-dollar up to 3% or they can make a 2% nonelective contribution for every employee earning $5,000 or more. (Employers can contribute even to employees who don't contribute to their SIMPLE IRAs.)
- Employee stock ownership plan (ESOP): ESOPs tie employee retirement funds to the performance of their employer's stock. The employer provides or purchases stock and places it in the ESOP account for employees, where the value grows tax-deferred.
What Is the Difference Between Qualified and Nonqualified Retirement Plans?
While most employers offer employees qualified retirement plans, nonqualified retirement plans may also be offered to highly paid executives. These plans, which don't have to adhere to ERISA standards, allow high-earning employees to save more than the IRS limits on qualified retirement plans. Nonqualified plans are essentially contracts with an employer, and can vary widely depending on the executive's needs. They're also riskier; participants could lose their money if the employer goes bankrupt or closes its doors.
For employers, there are important tax differences too. Contributions employers make to qualified plans are generally tax-deductible, but in nonqualified plans, employer contributions are made with after-tax money.
|Qualified Plans vs. Nonqualified Plans|
|Qualified Plan||Nonqualified Plan|
|IRS sets limits on contributions||No IRS limit on contributions|
|Must follow ERISA guidelines||Not governed by ERISA|
|Employer contributions are tax-deductible||Employer contributions aren't tax-deductible|
|Must be offered to all eligible employees||Offered only to select employees|
Build Your Financial Future
No matter what type of retirement plan your employer offers, participating can help you build a firm financial foundation for a comfortable retirement. Tucking away 15% of your annual compensation is a good benchmark, but even if you can't contribute that much, saving for retirement early helps you benefit from compound interest to potentially build a bigger nest egg.
Free credit monitoring from Experian keeps you on top of your credit score, monitors your spending and can spot potential fraud early, helping you maintain the good credit that's key to a financially secure retirement.