Tax-qualified retirement plans vs. non-tax-qualified retirement plans: Differences explained

When you're reviewing your retirement plan options, you may come across language that calls certain ones "qualified" or "nonqualified." While many people casually use these terms to refer to retirement vehicles that are either tax-deferred or not, they're rooted in IRS tax criteria and apply specifically to how employer-sponsored plans operate. Qualified plans can have certain tax advantages for their participants that nonqualified plans provided by employers don't.

Here's what you need to know about the main differences and how to navigate what qualified vs. nonqualified retirement plans may mean for you.

It's important to clarify that among the various types of retirement accounts, two popular options, traditional and Roth IRAs, are neither qualified nor nonqualified retirement plans. Since they're not sponsored by employers, they're not subject to IRS rules on employee retirement security. But this doesn't mean they're not an important part of a retirement strategy.

You can invest in IRAs on your own, and they provide many of the same tax advantages as qualified retirement plans. They're great for supplementing your employer-sponsored plan and can be especially valuable if you don't have a workplace retirement savings.

An annuity actually can be qualified or nonqualified. If you purchase it as an investment within your qualified employer-sponsored retirement plan or in an IRA, it's qualified. If you buy it on your own with after-tax money, it's nonqualified.

Regardless, having IRAs and annuities in addition to qualified plan contributions can allow you to make a tax-efficient strategy for your savings goals.

A qualified retirement plan meets specific criteria outlined in Section 401(a) of the Internal Revenue Code to comply with The Employee Retirement Income Security Act of 1974 (ERISA). This allows for the plan to have tax advantages for both the employer and plan participants.

• 401(k). A 401(k) is a defined contribution plan commonly offered by private employers. It may be designated for traditional (tax-deferred) or Roth (after-tax) contributions.

• 403(b). A 403(b) plan is similar to a 401(k) plan but is typically offered by schools, churches, hospitals and other nonprofit employers. They also have traditional and Roth options.

• SEP and SIMPLE IRAs. Although not a qualified retirement plan subject to ERISA, Simplified employee pension (SEP) IRAs and Savings Incentive Match Plan for Employees (SIMPLE) IRAs allow employers to contribute to an IRA on behalf of their employees. These allow for much higher contributions than non-employer IRAs and can be traditional or Roth.

• Keogh plan. Also called HR-10 plans, Keogh plans are specifically designed for self-employed individuals and are intended to provide them with the same retirement savings opportunities as someone who works for a company.

The requirements for qualified retirement plans cover a broad range of areas that set forth how the plan operates, with the general principle being that the plan must provide a fair and equitable benefit to all employees. Here's a look at some of the main elements of a qualified retirement plan:

The employer does not have to make the plan available to every employee. However, they can't restrict participation by age or number of years working for the employer beyond the later of the employee's 21st birthday or completion of one year of employment.

Employers often match employee contributions in workplace retirement plans. When they do, they may require a vesting period before those matching contributions fully belong to the employee. If the employee leaves before they vest, they will lose some or all of those matching contributions.

Qualified plans can't have a vesting schedule longer than three years if vesting all at once or six years if vesting is graduated to happen a bit at a time.

Qualified plans must limit employee elective deferrals to an IRS-approved limit. In 2024, employees can contribute $23,000 plus an additional $7,500 if they are at least 50 through elective deferral. However, contribution limits vary by plan type.

Withdrawals taken from a qualified plan before the participant reaches 59½ are generally subject to a 10% penalty, though there are some exceptions. Many qualified plans also are subject to required minimum distributions once the participant reaches a specified age and is no longer employed with the sponsoring employer.

The plan sponsor has to provide certain details about the plan to comply with the IRS requirements. That's why plan descriptions often include:

• Participation qualifications
• How contributions are made
• Investment options
• Plan expenses
• Explanation of matching and vesting

Having this information readily available aims to ensure benefits are distributed fairly to all eligible employees under the plan and not tilted based on discrimination or in favor of highly compensated employees.

The main feature of qualified plans is that they can offer significant tax advantages for your retirement savings:

• Employees can deduct their contributions and then enjoy tax-sheltered growth on the investments within the plan. Earnings may grow tax-deferred, or tax-free, if the employee utilizes a Roth account.
• Employers also get to deduct their matching contributions, but employees do not have to claim these amounts as their income.

Additionally, ERISA provides significant creditor protection. In the event of bankruptcy, claims cannot be made against money held inside qualified retirement plans.

Nonqualified plans do not meet the ERISA guidelines to become qualified. Because they do not meet the qualification criteria, they do not provide the same tax benefits or creditor protections that qualified plans do. That means employers cannot deduct their contributions to participants' accounts until that contribution becomes taxable to the employee.

• Deferred compensation plans. These allow key executives to defer a portion of their compensation, such as a bonus, into a later year. Doing so defers the tax liability as well.
• Split-dollar life insurance. The employer typically will pay most or all of the premium for a cash value life insurance policy on the employee. The company usually will receive a payout from the policy at least equal to the premiums they have paid at the time of the employee's death. The premiums are partially taxable to the employee.
• Executive bonus plans. Similar to a split-dollar life insurance plan, but the employee receives the entire benefit. With this arrangement the premiums are taxable to the employee as a bonus.
• Group carve-out plans. These are also life insurance-based plans. They provide additional coverage beyond the basic limit offered to all employees in the group plan. The cost of the additional coverage is taxable to the employee.

Because nonqualified plans do not meet ERISA guidelines, they do not have to pass the coverage and nondiscrimination tests. An employer can choose to offer a nonqualified plan over a qualified plan to provide more benefits to highly compensated employees, such as key executives.

In summary, qualified plans offer distinct tax advantages over nonqualified plans, but plans must follow a few rules to achieve and maintain their qualified status.

• Qualified plans are better for non-highly compensated employees as these plans require the employer to ensure that benefit distribution is equitable. Qualified plans cannot disproportionately benefit highly compensated employees or key executives.
• Benefits provided under a nonqualified plan typically are not tax-deductible to the employer until they become taxable to the employee receiving the benefit. However, they allow the company to provide greater benefits to highly compensated employees.

The differences between categorizing employer retirement plans as qualified or not comes down to taxes and compliance. Qualified plans that meet certain requirements for employee participation can provide valuable tax benefits to employers and employees. Nonqualified plans are ones that don't meet these requirements, and while that means they don't get the same tax advantages or creditor protections as qualified plans, they offer employers flexibility in selecting who can participate.

Contributing to an employer plan isn't your only option for building up retirement income. In fact, it can be wise to complement your workplace savings with IRAs and annuities that give some options for investment growth and taxation. Consider meeting with a Thrivent financial advisor to talk through how to maximize your qualified or nonqualified retirement plan and use other strategies to reach your financial goals.