Qualified vs. Nonqualified Retirement Plans: An Overview
Employers create qualified and nonqualified retirement plans with the intent of benefiting employees. The Employee Retirement Income Security Act (ERISA), enacted in 1974, was intended to protect workers’ retirement income and provide a measure of information and transparency.
In simple terms, a qualified retirement plan is one that meets ERISA guidelines, while a nonqualified retirement plan falls outside of 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.
The tax implications for the two plan types are also different. With the exception of a simplified employee pension (SEP), individual retirement accounts (IRAs) are not created by an employer and thus are not qualified plans.
Key Takeaways
- A qualified retirement plan meets the guidelines set out by ERISA.
- Qualified plans qualify for certain tax benefits and government protection.
- Nonqualified plans do not meet all ERISA stipulations.
- Nonqualified plans are generally offered to executives and other key personnel whose needs cannot be met by an ERISA-qualified plan.
What Is a Qualified Retirement Plan?
Qualified retirement plans are designed to meet ERISA guidelines and, as such, qualify for tax benefits on top of those received by regular retirement plans, such as IRAs. In some cases, employers deduct an allowable portion of pretax dollars from the employee’s wages for investment in the qualified plan. The contributions and earnings then grow tax deferred until withdrawal.
A qualified plan may have either a defined-contribution or defined-benefit structure. In a defined-contribution plan, employees select investments, and the retirement amount will depend on the decisions they made. With a defined-benefit plan, there is a guaranteed payout amount and the risk of investing is borne by the employer.
Plan sponsors must meet a number of guidelines regarding participation, vesting, benefit accrual, funding, and plan information to qualify their plans under ERISA.
What Is a Nonqualified Retirement Plan?
Many employers offer primary employees nonqualified retirement plans as part of a benefits or executive package. Nonqualified plans are those that are not eligible for tax-deferred benefits under ERISA. Consequently, deducted contributions for nonqualified plans are taxed when the income is recognized. In other words, the employee will pay taxes on the funds before they are contributed to the plan.
Qualified vs. Nonqualified: Key Differences
The main difference between the two plans is the tax treatment of deductions by employers, but there are also other differences. Qualified plans have tax-deferred contributions from the employee, and employers may deduct amounts they contribute to the plan. Nonqualified plans use after-tax dollars to fund them, and in most cases employers cannot claim their contributions as a tax deduction.
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 plan 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 duration of employment, a participant’s right to a pension 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 offered to key executives and other select employees. They can be designed to meet the specific needs of these employees, while qualified plans cannot do so.
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.
FAQs
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.
What is the difference between a qualified and nonqualified retirement plan? ›
One of the key differences between qualified and nonqualified retirement plans lies in their eligibility requirements. Qualified plans must meet nondiscrimination rules, ensuring that they offer participation to a wide range of employees, not just highly compensated individuals.
What is the benefit of a non-qualified plan? ›
A nonqualified plan can provide deferred payments at a specified future date, allowing you to save for certain life events, such as a child's college education.
What are the disadvantages of qualified retirement plans? ›
While qualified retirement plans offer numerous advantages, they also come with certain drawbacks. Distributions from these plans are typically taxed as ordinary income, not as potentially lower long-term capital gains.
Does a nonqualified retirement plan need IRS approval? ›
No IRS Approval Required
Non-qualified retirement plans do not require IRS approval, which allows for greater flexibility in plan design and administration. This can be particularly advantageous for employers seeking to offer unique and competitive retirement benefits to their top employees.
What are examples of non-qualified plans? ›
There are four major types of nonqualified plans:
- Deferred-compensation plans.
- Executive bonus plans.
- Split-dollar life insurance plans.
- Group carve-out plans.
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.
What is a disadvantage to a nonqualified plan? ›
Limited Immediate Access: One drawback of NQDCPs is the lack of immediate access to deferred funds. Compensation remains inaccessible until the agreed-upon payout date or triggering event, such as retirement, disability, or separation from service.
What are the advantages of a qualified retirement plan? ›
Tax Benefits of Qualified Retirement Plans
With defined-contribution plans, employees can take a tax deduction for their contributions, reducing their taxable income and, therefore, their taxes for the year. They'll pay tax on that income only when they later withdraw it, usually in retirement.
Do I have to pay taxes on a non-qualified annuity? ›
If it's a qualified annuity, the money you invested was pre-tax, and 100% of your withdrawals will be taxable. However, if your annuity is nonqualified, you invested using after-tax dollars and pay taxes on the earnings portion of withdrawals. You'd then receive the principal tax-free.
Common examples of qualified retirement plans include but are not limited to:
- 401(k) plans.
- 403(b) plans.
- Savings Incentive Match Plan for Employees (SIMPLE) IRAs.
- Simplified Employee Pension (SEP) IRAs.
- Salary Reduction Simplified Employee Pension (SARSEP) Plans.
- Profit-sharing plans.
No, an IRA is not a qualified retirement plan. It is a nonqualified retirement plan because it is not offered by an employer. This applies to both traditional and Roth IRAs.
Who can be excluded from a qualified retirement plan? ›
The reason is that the IRS considers any exclusion that is tied to service to be a minimum service requirement, and tax-qualified retirement plans generally may not, except as explained in the first and second bullet points, exclude employees who are at least 21 years old and have completed one year of service (or, in ...
What is the key difference between a qualified plan and a nonqualified plan? ›
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.
What are the benefits of a non-qualified retirement plan? ›
Nonqualified retirement plans are savings vehicles that are not subject to the rules of the Employee Retirement Income Security Act (ERISA). They do not replace tax-qualified plans like 401(k)s, but they can offer additional employer-sponsored incentives for high-ranking personnel and key executives.
Do nonqualified plans reduce taxable income? ›
Nonqualified deferred compensation plans (NQDC) allow pretax compensation to be deferred by an employee, thereby lowering his or her current taxable compensation and delaying payment to a later year (e.g., retirement).
What is better qualified or non-qualified annuity? ›
Qualified annuities offer tax advantages upfront but come with more restrictions. Nonqualified annuities provide more flexibility and a lower tax burden in retirement but without immediate tax benefits.
What makes a retirement plan qualified? ›
A qualified retirement plan refers to employer-sponsored retirement plans that satisfy requirements in the Internal Revenue Code for receiving tax-deferred treatment. Most retirement plans offered by employers qualify including defined contribution plans like 401k plans and defined benefit plans like pensions.
Is a Roth 401k qualified or nonqualified? ›
If you take a distribution from your designated Roth account before the end of the 5-taxable-year period, it is a nonqualified distribution.
