Luisa Rollenhagen is a journalist and investor who writes about financial planning for Wealthsimple. She is a past winner of the David James Burrell Prize for journalistic achievement and her work has been published in GQ Magazine and BuzzFeed. Luisa earned her M.A. in Journalism at New York University and is now based in Berlin, Germany.
What is a Qualified Retirement Plan
One of the main reasons people start investing is because they’ve begun thinking about their future, more specifically about that yearned-for pot of gold at the end of the rainbow: retirement. Depending on your financial habits and the current state of your bank account, the concept of retirement can sound like long-awaited relief or like the trigger for your next panic attack. If you’re more in the latter camp, the good news is that the best time to start saving for retirement is right now! So you’re not too late! And in order to encourage saving for retirement and making it as painless as possible, the government has created some incentives, usually in the form of tax benefits.
In essence, that’s what a qualified retirement plan is: any retirement plan that meets specific Internal Revenue Code requirements. If you want to get really specific, plan needs to meet the requirements set out in Section 401(a) of the U.S. tax code. Simple, right? These include 401(k)s, 403(b)s, TSPs, 457 Plans, Solo 401(k)s, SEP IRAs, Traditional IRAs, and Roth IRAs. In most cases, the tax benefit that you receive from these plans come in the form of tax deferrals, either for employer contributions or for your own contributions. What that means is that the government won’t tax any money you deposit in the account up to the yearly maximum contribution, and you only pay income taxes on funds in the year they are withdrawn. The most common qualified retirement plans are the ones where employers contribute a set amount that matches your contributions.
Is a 401(k) a qualified retirement plan?
Yes it is! A typical 401(k) allows your employer to match some percentage of your annual contribution to the account. The catch here is that a 401(k) is run by your employer, so you have limited control over how the money is managed.
We’ll get more into the different kinds of qualified retirement plans in a minute, but before we do that, let’s cover what actually isn’t a qualified plan.
What is a non-qualified retirement plan
Simply put, a non-qualified retirement plan is a tax-deferred plan that falls outside of the Employee Retirement Income Security Act. In 1974, this act was passed in order to protect retirement assets by ensuring that qualified plans adhere to rules that do not misuse the assets in the plan, while also being obligated to provide free information about the plan and what your options are for using it. The Act basically just establishes a set of rules and guidelines that plans must follow closely in order to qualify, and if they don’t, then they’re classified as “non-qualified.”
That doesn’t mean non-qualified plans aren’t trustworthy. It just means that they’re not as comprehensive as qualified plans, or don’t offer blanket coverage. Usually, they’re designed to cover specialized retirement needs for key executives and other select employees. They’re also way more uncommon than qualified retirement plans.
Qualified retirement plan types
Now that we got the non-qualified plans out of the way, let’s go back to the ones that probably are most relevant to you, unless you’re some hot-shot CEO. They’re usually split into two categories: individual retirement plans and group retirement plans.
Individual retirement plans include IRAs (including Roth and SEP), as well as Solo 401(k)s. These are accounts which you can set up and contribute toward yourself, usually directly through the website of the financial institutions that offer them. IRAs work like 401(k)s for individuals, except that you can invest your savings as you see fit. A Simplified Employee Pension (SEP) is another option for individuals, and are specifically designed as a 401k alternative for those who are self-employed. SEPs also have a much higher contribution limit than any other retirement plan, which refers to the amount you can contribute to your account, tax-free, per year.
Group retirement accounts, such as 401(k)s and 403(b)s are more costly to set up, and require more paperwork, since they’re used to cover a greater amount of people. That’s why they tend to be administered by an employer as opposed to an individual.
Is TSP a qualified retirement plan?
It is, but it’s only available to federal employees (TSP stands for “Thrift Savings Plan,” by the way). It works pretty similarly to a 401(k), but acts on a federal instead of a private level and covers current and retired federal employees.
Is a Roth IRA a qualified retirement plan?
Bingo! The Roth IRA also offers tax benefits, but works a little bit differently than a traditional IRA. Any contributions you make out of your income are taxable now—but any gains you make between now and your retirement won’t be taxed upon withdrawal.
How to set up a qualified retirement plan
Now that you’ve seen all your options, it’s time to choose! If you’re currently working for an employer who offers a 401(k) option, that’s obviously the quickest and easiest way to start building up some retirement savings, especially if your employer matches some or even all of your contribution. It also doesn’t really require much additional set-up on your part.
If you’re interested in setting up an individual retirement plan such as an IRA, you can go directly through the financial institution where you want to have the account and set up deposits from your regular checking account. You can contribute to a traditional IRA whether or not your participate in another retirement plan through your employer or business. For 2018, the contribution limit to a traditional IRA is $5,500, which means that you could put away that annual amount without getting taxed on it if you contribute the maximum.
It’s pretty much the same process to set up a Roth IRA, with the only difference being that you’ll see tax benefits at retirement, not beforehand, since the income you contribute is taxable but withdrawals that you make during retirement are not. Also, unlike a traditional IRA, not everyone is eligible for a Roth IRA. Your income (or joint income, if you’re signing up with your spouse) has to be below a certain level. If you’re single, you must make less than $118,000 to fully contribute to a Roth IRA. If you make more than that, you can’t contribute the full $5,500 and need to contribute on a sliding scale instead, based on your income.
Then finally there’s the SEP IRA, which is available for small businesses and the self-employed and is supposed to work like a 401(k). Since more and more Americans are either fully or partially making their money through the notorious gig economy, this IRA is a great option to not be at a disadvantage when it comes to retirement savings. That also means that you can contribute much more to the account than you could with a traditional IRA (up to 25% of your income or $54,000, whichever comes first), since you don’t have the option of an employer matching your contribution. Well, you could match your own contributions since you’re your own employer, but that’s not as fun. Signing up for an SEP IRA is just as easy as signing up for any other IRA.
Like we said, the best time to start planning for retirement is right now. At Wealthsimple, you can choose from all of the most common individual qualified retirement plans at low fees and with professional, individualized advice. And if you want to switch from your current IRA to Wealthsimple, we’ll even cover the transfer fees. Start planning today.