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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Qualified Retirement Plan

What it is:

A qualified retirement plan is a plan to which the IRS grants specific tax benefits.

How it works (Example):

The myriad of exact requirements for qualified retirement plans are in the Internal Revenue Code section 401(a) and the Employee Retirement Income Security Act of 1974 (ERISA). But in general, the IRS deems defined benefit plans and defined contribution plans as qualified retirement plans (though hybrid plans, which combine elements of the two, are also acceptable in some cases).

This means that employers generally can deduct contributions they make to retirement plans on behalf of their participants, and plan participants can exclude their contributions from their taxable income. Additionally, the earnings on the retirement plan funds are usually not taxable until they are withdrawn (and sometimes not taxed at all). Sometimes participants can delay taxation even more if they move those funds into other tax-deferred investments such as Individual Retirement Accounts (IRAs).

Defined benefit plans are usually known as pension plans; defined contribution plans are often in the form of 401(k) plans, 403(b) plans, money purchase pension plans, or profit-sharing plans.

Why it Matters:

Knowing whether a retirement plan is a qualified retirement plan is important, because having one entitles the participant to certain tax advantages that are not available to people saving for their retirement by other means. Given that tax deductions, tax credits, and tax deferrals can create significant differences in retirement income when compounded over several years or even decades, finding a qualified retirement plan is one of the most important things an investor can do to ensure adequate income after he or she stops working. 

Of course, qualified retirement plans do have their limitations, namely that the funds are often unavailable to the investor until he or she retires and sometimes are limited in terms of allowed investments.

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