Employers may offer employees two types of retirement plans — qualified and nonqualified. These plans are categorized based on whether they meet the guidelines set by The Employee Retirement Income Security Act (ERISA). Most retirement plans have benefits and tax savings opportunities, but they are not all the same.
An individual retirement account (IRA) is an alternative retirement savings plan that almost anyone can contribute to. While a traditional IRA is a nonqualified account, this guide can help you understand what types of accounts and other IRAs are qualified and how to navigate these retirement investments.
What Is a Qualified Retirement Plan?
A qualified retirement plan provided by employers must meet requirements under the Internal Revenue Code Section 401(a). Qualified retirement plans that fall under this eligibility are tax deductible. These plans aim to provide employees and their beneficiaries with retirement income.
A plan must meet the following criteria to be considered qualified:
- Documents about the plan’s framework and investments must be disclosed to participants upon request.
- A specified portion of employees must be covered. However, not all employees must be covered.
- Eligible employees must be permitted to participate.
- A participant’s right to a pension is a nonforfeitable benefit after a specified period of employment is met.
- Benefits must be proportionately equal in assignment for all participants.
Some plans allow contributions from employees and their employers. They often present certain tax deferral advantages until the employee withdraws the funds. Retirement plans or savings accounts that do not meet these requirements — or are not offered by an employer — are generally considered nonqualified. Here are the most common types of qualified retirement plans.
1. 401(k) Plans
Employees can participate in a 401(k) plan that takes a portion of their salary and places it into a retirement savings account. They can access a range of investment options with this plan.
Employers may match the amount of the employee’s paycheck going into the account, known as 401(k) matching. Contributions may be taxed upfront or at withdrawal. Deferred wages or elective deferrals aren’t subject to federal income tax withholding and won’t be reported as taxable income.
There are several types of 401(k) plans that have varying rules. These types include:
- Traditional 401(k) plans
- Roth 401(k) plans
- Safe harbor 401(k) plans
- SIMPLE 401(k) plans
2. 403(b) Plans
A 403(b) plan is similar to a 401(k) as a tax-advantaged way to save for retirement. Both plans allow employees to save for retirement by electing to have their employer make deductions to their payroll and contribute those wages to an individual account. As with a 401(k), employers may match part of the employee’s contribution. However, 403(b) plans are reserved for employees of tax-exempt organizations, including:
- Indian tribal governments
- Public schools, colleges, and universities
Certain organizations that offer 403(b) plans may allow employees who have worked for a specific period to make catch-up contributions. This means employees can contribute additional funds to their retirement account to cover the years they were not enrolled in the plan. In general, investment options are slightly more limited for this plan compared to a 401(k).
3. SIMPLE IRAs
A savings incentive match plan for employees, or SIMPLE IRA plan, is a retirement plan usually offered in small businesses with 100 or fewer employees. In this tax-deferred savings plan, employers can make a non-elective contribution of 2% of their employee’s salary to the individual retirement account. Or, employers can make a dollar-for-dollar contribution match of employee contributions to the plan for up to 3% of their salary.
As with 403(b) plans, employees with SIMPLE IRAs may be allowed to make catch-up contributions if they are age 50 or older. SIMPLE IRAs, as the name suggests, are relatively simple to enroll in as they have minimal paperwork requirements and low maintenance costs.
4. SEP IRAs
A simplified employee pension (SEP) is a type of plan that enables employers to contribute to IRAs for employees. This is one of the exceptions to the qualified plan rule, as the employer is allowed a tax deduction for contributions made to a SEP IRA and makes contributions to each eligible employee’s plan on a discretionary basis. Generally, SEP IRAs are considered a combination of a 401(k) and a traditional IRA. However, contribution limits are higher for SEP IRAs than for other IRAs.
Self-employed individuals can also use a SEP IRA. Smaller businesses tend to favor SEP IRAs because the requirements have a lower threshold, which includes being at least 21 years old with at least three years of employment. Additionally, the employer is not locked into any annual contribution requirements as with some other plans. Contributions to SEP IRAs are immediately vested, meaning the employee is entitled to all contributions right away.
5. Defined Benefit Plans
A defined benefit plan is a predetermined, fixed plan that is a bit more complex compared to other qualified retirement plans. In most retirement investment plans, the payout usually depends on investment returns. In a case where an employee receives poor investment returns with a defined benefit plan, the employer is responsible for making up the difference with a cash contribution.
Employers typically develop these plans by considering several employee factors, such as their salary and employment history. Unlike a 401(k) plan, employees with a defined benefit plan cannot withdraw funds early. Taxpayers benefit from either a lump sum at a predetermined age or a lifetime annuity.
6. Defined Contribution Plans
A defined contribution plan — such as a 401(k) or 403(b) — allows employees to contribute a fixed amount of pretax dollars to a retirement account. The employer or sponsor company can match a portion of the employee’s contributions, but restrictions limit when and how employees can withdraw funds.
Contributions grow tax-deferred until the employee withdraws the funds. Unlike a defined benefit plan — where retirement income is guaranteed — defined contribution plans are self-directed.
Are IRAs Considered Qualified Retirement Plans?
A SEP IRA — a form of a traditional IRA — is considered a qualified retirement plan through employers. Traditional and Roth IRAs are generally not considered qualified retirement plans. Unlike a 401(k), traditional and Roth IRAs are self-managed and not offered by employers. With a self-directed IRA, the individual chooses where to keep the account and decides which investment avenues they want to pursue.
However, nonqualified plans offer many of the same tax and retirement savings benefits as qualified plans.
Contributions to a traditional IRA are tax-deductible, so contributing to the plan can lower your taxable income for that tax year. With a traditional IRA, withdrawals are taxed.
Roth IRAs do not give investors tax deductions for contributions. Unlike a traditional IRA, investors pay the tax bill for Roth IRA contributions upfront, so qualified withdrawals are tax-free.
You can invest in both a traditional and Roth IRA as long as you’re eligible.
Required Minimum Distributions and Contribution Limits for Retirement Plans
When deciding which retirement plan or savings account to invest in, it’s important to know the requirements and limits. At a certain age, you must begin to withdraw the funds from your retirement accounts. This is known as required minimum distributions, which applies to the following plans:
- SEP IRAs
- 401(k) plans
- 403(b) plans
- SIMPLE IRAs
- Traditional IRAs
- Roth IRA beneficiaries
- Other defined contribution plans
These distributions mean the investor must take a certain amount of money out of their account each year. Investors can withdraw more than the minimum amount if they wish.
Most plans require you to start taking money from your retirement plan account by age 72 or 73. Roth IRAs are an exception, as these accounts do not require withdrawals until the owner dies. Any beneficiaries of a Roth IRA, however, must abide by the required minimum distribution rules. Qualified distributions from Roth IRAs are not included in your taxable income.
Most retirement plans also have contribution limits, restricting how much employees and employers can contribute to a savings account. Contribution limits vary depending on the type of plan. The following limitations apply to 2023 but are subject to change each year:
- IRAs: Investors cannot contribute more than $6,500 annually to their IRA accounts. They may contribute up to $7,500 if they’re over the age of 50.
- 401(k) plans: Employees who make elective deferrals for this type of plan cannot contribute more than $22,500. The combination of all deferrals and employer contributions cannot exceed $66,000 or 100% of the employee’s annual compensation.
- SEP IRAs: Employers cannot contribute more than $66,000 or 25% of the employee’s compensation to a SEP IRA.
- SIMPLE IRAs: Employees cannot contribute more than $15,500 of their salary to a SIMPLE IRA.
- 403(b) plans: Employee elective deferrals cannot exceed $22,500 annually. Individuals aged 50 or older may make additional catch-up contributions of $7,500. As with 401(k) plans, the total of all deferrals and employer contributions cannot exceed $66,000 or 100% of the employee’s annual compensation.
The Pros and Cons of Having an IRA and Qualified Retirement Plan
Taxpayers can boost retirement savings by investing in both qualified and nonqualified plans. For example, even if you’re enrolled in a qualified retirement plan through your employer, you can still open and contribute to an IRA on your own. In a defined contribution plan — such as a 401(k) or a 403(b) — you, your employer, or both contribute a fixed amount to your account.
These plans are tax-deferred, meaning contributions to the accounts are made with pretax dollars. Additionally, the earnings in defined-contribution plans grow tax-free. Employees with a 401(k) can further benefit from the ability to borrow a portion of the funds. Some defined contribution plans allow employers to match up to a certain percentage of the employee’s salary.
Some disadvantages of certain qualified retirement plans include penalties for early withdrawals and paying income taxes on withdrawals. Some qualified retirement plans also have filing and limited investment requirements.
Investing in an IRA and participating in a qualified retirement plan through your employer can increase your retirement benefits and savings. A traditional or Roth IRA includes tax-free growth on earnings. While a Roth IRA does not offer tax-deductible contributions, withdrawals are tax-free.
Alternatively, traditional IRAs provide investors with a tax deduction for the year of contributions, but all withdrawals are taxed. Deductions are based on income level. Contribution limits mean you can generally contribute less to an IRA than some qualified retirement plans. However, investing in an IRA allows for more flexibility in regard to investment opportunities.
Real Estate in an IRA or Qualified Retirement Plan
The Internal Revenue Service (IRS) and ERISA have set guidelines to prohibit investors from making contributions of real estate to some pension plans. These guidelines do not prevent investors from holding real estate in an IRA, 401(k), and other qualified plans. Investors can use this strategy to diversify into real estate without gaining the responsibilities of a landlord.
Investors need a custodian to fill out the paperwork and complete the rollover. Those with a modest amount in an IRA or 401(k) can get a loan to purchase real estate. However, this can often be difficult, as not all banks will provide a loan for this investment. Investors can potentially further their retirement benefits by investing in passive real estate. You can use a portion of your retirement funds to invest in many types of income-producing properties, including:
You can avoid the hassle of trying to get a loan approved by investing in a real estate investment trust (REIT). A REIT invests in larger real estate assets using an investor pool. REIT investing can generate passive income and help you avoid the management duties of a landlord. When you invest in a REIT through an IRA, your portion of rental income generated from the REIT will be paid into your IRA.
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Investing in your future is an essential strategy. Even if you have a retirement plan through your job, opening an IRA expands your investment options. At 1031 Crowdfunding, it’s our goal to simplify complex investment processes. Our knowledgeable team has experience with a wide range of investment situations. We can guide you through potential options and leave you with more time to focus on top priorities.
We offer our clients a wide array of services for IRAs, 1031 exchanges, and REIT investing. Our state-of-the-art investment platform enables you to access alternatives like real estate through your IRA. We invite you to create an investment account with us or learn more about investing in IRAs.
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