Nonqualified & Traditional IRAs
Nonqualified retirement plans share some similarities with traditional IRAs in terms of their function and goals. However, the organization and taxation of assets in the two types of retirement plans differ substantially. Only employers can offer nonqualified plans, for example, and many of the income and contribution restrictions affecting traditional IRAs do not apply to nonqualified plan contributions.
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IRA Basics
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The IRA, which stands for “Individual Retirement Arrangement,” was created by Congress as a way for individuals who did not have access to a qualified company retirement plan to defer taxes on their salary and save for retirement on their own. The rules limit how much of your earned income you can defer each year, and they also limit the tax deductibility of your contribution if you earn too much (these amounts generally change each year).
Qualified Retirement Plan
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For a retirement plan to be considered qualified, it must meet certain guidelines and requirements established by both the IRS and the Employee Retirement Income Security Act (ERISA), made law in 1974. Employees who participate in plans that meet these qualifications, such as 401(k) and 403(b) plans, can generally take a tax deduction on the amount they contribute, and they get to defer taxes on the assets inside the qualified plan until they retire and begin taking distributions.
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Nonqualified Plan
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IRA income and contribution restrictions do not apply to nonqualified plans. As you might surmise, a nonqualified plan does not meet the guidelines and requirements established by ERISA, and neither participants nor their employer can take a tax deduction for the plan contributions. Employers typically create nonqualified plans so that highly compensated employees can defer income, along with the related income taxes, until they retire. Well-known types include Deferred Compensation plans and Executive Bonus plans.
Features
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You can roll over assets only from a qualified plan into an IRA. Once you remove assets from a nonqualified plan, you must pay income taxes on the amount withdrawn. An IRA, by contrast, allows you to continue deferring taxes on the assets in your (now former) qualified retirement plan until you retire and begin taking distributions. This situation presents a challenge to the participant of a nonqualified plan, since she risks giving up the deferred compensation if the company goes out of business, for example.
Effects
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For all the differences between a traditional IRA and nonqualified plans, someone with an IRA and someone with assets in a nonqualified plan share similar effects and goals. Both get to defer taxes on their assets as long as they remain in their respective plans, and both will pay income taxes on the full amount of the distribution, assuming all contributions made to the IRA were tax deductible. In addition, both expect to take distributions after retirement, when their income tax brackets will (presumably) be lower.
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References
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