The Basics
The IRS is involved in your retirement planning because you likely have retirement accounts that come with some very attractive tax benefits. If you were to deposit your retirement funds into a regular investment account, you would pay taxes on contributions and annual taxes on all investment gains. Suppose you sold 100 shares of stock and made $1,000. You would pay taxes on that $1,000. It would be the same with any dividends you receive or any other capital gain, but retirement accounts are different. Depending on the type of retirement account you hold, you won’t pay any taxes on your gains until you withdraw the money, potentially decades in the future. That’s a lot more in your account for now. But history has proven that people will find it and take advantage of it if there’s a loophole. The IRS puts rules on these tax-advantaged retirement plans to close those loopholes.
Qualified Plans
If you have a 401(k), you have a qualified plan. Qualified plans fall under a set of laws that come from the Employee Retirement Income Security Act (ERISA). Employers like qualified plans because they get a tax break for any contributions they make for their employees. Your company may contribute a certain percentage of your income to your 401(k) as part of your benefit package. One of the reasons it makes those contributions is for the tax break it receives. When you make a contribution to a non-Roth 401(k) or an IRA, your employer makes those deposits on your behalf without taking out any taxes. This is called a “pre-tax contribution.” You don’t pay taxes on the investment gains from the account, either, until you make the withdrawals later in life. Employers must offer qualified plans to every employee as long as those employees meet a very minimal requirement: one year of full-time employment. There can’t be a difference in compensation levels. They can’t match upper-level executives at a higher rate if the company matches 1% of all other employees’ salaries. Everybody must be treated equally. You can’t take withdrawals until you’re at least age 59½ without incurring a hefty 10% penalty. Some plans also require that you begin taking withdrawals by the time you reach age 70½ or age 72, depending on your birth date. You’re not permitted to hold certain types of investments in qualified plans.
Non-Qualified Plans
Non-qualified plans are still part of your retirement package, but they don’t come with all the same rules as qualified plans. The good news is that these plans often still allow employees to defer taxes until retirement, but they aren’t deductible to the employer. And the employee sometimes has to pay taxes on the contributions right away. Non-qualified plans are often extra perks offered to higher level employees only, so there’s no rule that everybody must have the option to contribute. Non-qualified plans don’t have a maximum contribution amount. Employees and employers can contribute as much as they like. One of the reasons for non-qualified plans is that highly paid employees might have lower maximum contribution limits in their company retirement plan because of IRS rules about “highly compensated employees.” Non-qualified plans allow higher paid employees to save enough to retire and live a similar lifestyle as they currently enjoy.
