What is a Qualified Retirement Plan?
A qualified retirement plan is an employer-sponsored retirement plan that meets the requirements of the Internal Revenue Code and the Employee Retirement Income Security Act, making it eligible for certain tax benefits. Those can include tax deductions for employer and employee contributions and tax-deferral of investment gains.
A 401(k) plan is a qualified retirement plan. It also is categorized as a defined-contribution plan. 401(k) plans are generally employer-sponsored retirement plans that allow employees to contribute a portion of their salary pre-tax. Allocations are made to various investment vehicles, which enable funds to grow tax-deferred. Once the funds are drawn upon in retirement, taxes must be paid. Many employers choose to match employees’ contributions to their sponsored 401(k) accounts up to a certain percentage or dollar amount. The benefit of a match is to improve the employee benefit as well as to help increase the employer’s tax deduction.
A profit-sharing plan is a retirement plan that gives employees a share in the profits of a company. In this type of plan, also known as a deferred profit-sharing plan (DPSP), an employee receives a percentage of the company’s profits based on its annual or quarterly earnings. Profit-sharing is discretionary and often combined with a 401(k) to add an additional layer of tax savings for the business in profitable years or as owners get closer to retirement. Vesting schedules are often used as an incentive to keep employees from leaving and takings these contributions since unvested contributions will be forfeited.
With defined-benefit plans, employers calculate benefits on factors including salary history and length of employment. A defined-benefit plan specifies a promised monthly benefit at retirement. These plans can either state a specific dollar amount or calculate the benefit based on a formula. Defined-Benefit plans are what people think of when they hear the term “company pension”. This type of plan can be added as a third-tier tax savings vehicle. A defined benefit plan is often combined with a 401(k) and Profit-sharing to increase tax savings and is also often used to help business owners ramp up their retirement savings up to a max of $230,000 extra each year (ie. 2021)
A cash balance plan is a type of qualified plan. In a cash balance plan, participants each have an account. These plans grow annually based on contributions and interest credits. Employers can offer cash balance plans in conjunction with other kinds of retirement plans. Cash balance plans can be a good solution for someone looking for more significant tax deductions and accelerated retirement savings.
ESOP, or Employee Stock Ownership Plan, is an employee benefit plan that works similarly to a profit-sharing plan. An ESOP is a trust fund set up by a company to contribute shares of its own stock or cash to buy existing shares. ESOPs provide significant tax benefits for companies. An ESOP can also provide a tax-efficient way for a business owner to begin the exit from their business.