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What Are Qualified Retirement Plans?
by Ben Bontekoe
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Overview
Retirement plans provide workers income during their retirement, funded by contributions from the individuals and their employers during their working years. Qualified retirement plans are those that meet the many requirements established by the Internal Revenue Code, which allows them to provide significant tax benefits to both the employees and their employers. Income taxes on contributions to qualified plans can be deferred until the money is used in retirement.
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Function
A qualified retirement plan provides a tax-advantaged way to save for retirement. Contributions to the plan are made on a pre-tax basis, earnings on investments grow tax-deferred and no taxes are paid until money is withdrawn from the account in retirement. Qualified plans allow employees to accumulate retirement funds through a combination of their own contributions and those of their employer, while the deferral of taxes allows the account to grow more quickly.
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Types
Defined benefit plans are funded by an employer---the most common type is an employee pension. The employee makes no contributions, and the benefit received is considered defined because it is a specific amount determined ahead of time. The amount received is usually based on a combination of age, salary and years of service. In a defined contribution plan, like a 401k, the employee contributes a predetermined amount, but the final benefit received is not defined.
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Benefits
Funds in a qualified plan are withdrawn when you are in retirement, when in many cases you have lower income and are in a lower tax bracket. Qualified plans offer the opportunity to defer higher taxes now in the hopes of paying them at a lower rate in the future. Funds in a plan can typically be rolled over into a Traditional IRA (a type of qualified plan) if you leave your employer, allowing the money to continue to grow tax-deferred.
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Features
Many qualified retirement plans offer the opportunity to borrow some of the money accumulated in the plan without penalty in certain specific instances. These include certain medical expenses, higher education tuition and the purchase of a first home. While you will be required to pay back the loan with interest, all payments are going back into your retirement plan. However, if you leave your job for any reason before the loan is repaid, you will be responsible for taxes and penalties on the outstanding balance.
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Warning
Because qualified plans are intended to provide retirement savings, you will be charged a ten percent penalty (in addition to any applicable taxes) if you attempt to withdraw money before age 59 ½, other than approved loans as discussed above. Most plans will also require you to begin taking taxable minimum distributions once you reach a certain age, often 70 ½, regardless of whether you need the money. This will reduce the amount you may be able to leave to your heirs.
