8.4 Qualified Plans, IRAs, and Retirement (TEFRA/SEP/401k)
Key Takeaways
- Qualified plans offer deductible/pre-tax contributions and tax-deferred growth, but distributions are 100% ordinary income.
- Plans must be nondiscriminatory, in writing, permanent, and for the exclusive benefit of employees; TEFRA aligned self-employed and corporate plan limits.
- SEPs are employer-funded into employee IRAs; 401(k)s allow pre-tax salary deferrals with catch-up at 50+ and employer match.
- Traditional IRAs tax distributions and require RMDs at 73; Roth IRAs grow tax-free, have no lifetime RMDs, and need 5 years + age 59 1/2 to be qualified.
- Indirect (60-day) rollovers of qualified plans trigger 20% mandatory withholding; direct trustee-to-trustee rollovers avoid it.
What Makes a Plan 'Qualified'
A qualified retirement plan meets IRS requirements (chiefly ERISA and IRC Section 401) and earns major tax advantages. The hallmarks tested on the exam:
- Contributions are tax-deductible to the employer (and pre-tax for employees), reducing current taxable income.
- Earnings grow tax-deferred inside the plan.
- Distributions are 100% taxable as ordinary income because the money went in pre-tax (zero basis).
- Plans must be nondiscriminatory — they cannot favor highly compensated employees or owners; they must follow IRS coverage and participation rules.
- The plan must be in writing, permanent, and communicated to employees, for the exclusive benefit of employees and beneficiaries.
TEFRA (Tax Equity and Fiscal Responsibility Act of 1982) tightened contribution and deduction limits and aligned the treatment of corporate and self-employed (Keogh/HR-10) plans, ending the prior advantage corporations had over the self-employed.
Types of Qualified and Employer Plans
| Plan | Key Feature |
|---|---|
| Defined benefit (pension) | Promises a specific retirement benefit; employer bears investment risk |
| Defined contribution | Benefit depends on contributions + investment returns; employee bears risk |
| 401(k) | Employee salary-deferral plan, often with employer match |
| 403(b) / TSA | Tax-sheltered annuity for public schools and 501(c)(3) nonprofits |
| 457 plan | Deferred comp for government and tax-exempt employees |
| SEP IRA | Simplified Employee Pension; employer contributes to employees' IRAs |
| SIMPLE IRA | For small employers (<=100 employees); employee defers + employer match |
| Keogh (HR-10) | Plan for self-employed / unincorporated businesses |
SEP and 401(k) Specifics
A SEP lets an employer contribute directly to each eligible employee's IRA — simple to administer, much higher limits than a regular IRA, and 100% employer-funded. A 401(k) allows pre-tax employee salary deferrals up to the annual IRS elective-deferral limit, plus catch-up contributions at age 50+, frequently with an employer matching contribution that vests over time.
Why are distributions from a traditional qualified plan such as a 401(k) generally 100% taxable as ordinary income?
Traditional vs. Roth IRAs
Individual Retirement Accounts let individuals save outside an employer plan. The two flavors differ on when the tax is paid:
| Feature | Traditional IRA | Roth IRA |
|---|---|---|
| Contributions | May be tax-deductible | Never deductible (after-tax) |
| Growth | Tax-deferred | Tax-free |
| Qualified distributions | Fully taxable as ordinary income | Tax-free |
| Required Minimum Distributions | Yes, begin at age 73 | None during owner's lifetime |
| Early-withdrawal penalty | 10% before 59 1/2 (with exceptions) | 10% on earnings before 59 1/2 |
Roth qualified distribution rule: Withdrawals are tax-free only if the account has been open 5 years AND the owner is 59 1/2 (or death/disability/first-home up to $10,000). Roth contributions (basis) can always be withdrawn tax- and penalty-free because they were already taxed.
RMDs, Penalties, and Rollovers
Required Minimum Distributions (RMDs)
Traditional IRAs and most qualified plans require RMDs beginning at age 73 (per SECURE Act 2.0). Failing to take an RMD historically triggered a steep excise tax on the shortfall (now 25%, reducible to 10% if corrected promptly). Roth IRAs have no lifetime RMDs.
10% Early-Withdrawal Penalty Exceptions
Distributions before 59 1/2 generally incur a 10% penalty on top of ordinary income tax, unless an exception applies:
- Death or total disability of the owner
- Qualified first-time home purchase (up to $10,000, IRA)
- Qualified higher-education expenses (IRA)
- Substantially equal periodic payments (72(t))
- Medical expenses above the AGI threshold
Rollover Trap
A direct (trustee-to-trustee) rollover avoids withholding. A 60-day (indirect) rollover triggers mandatory 20% withholding on qualified-plan distributions, and the full amount must be redeposited within 60 days or the shortfall is taxed and penalized.
Contribution Mechanics and SIMPLE vs. SEP
Understanding which plan fits which employer is heavily tested:
- SEP IRA: Best for small businesses and the self-employed. Only the employer contributes (no employee deferrals), but limits far exceed a regular IRA. Contributions are discretionary year to year and immediately 100% vested.
- SIMPLE IRA: For employers with 100 or fewer employees and no other qualified plan. Employees defer salary; the employer must either match up to 3% of compensation or make a 2% nonelective contribution to all eligible employees.
- Defined benefit: Promises a formula-based monthly benefit; the employer bears investment risk and an actuary sets funding.
- Defined contribution: The account balance is whatever contributions plus investment performance produce; the employee bears the risk.
Trap: A SEP has no employee salary-deferral feature, while a SIMPLE and a 401(k) do — confusing these is a frequent exam error. Catch-up contributions become available the year an employee turns 50.
Funding Retirement with Annuities and Beneficiary Rules
Annuities are common funding vehicles inside qualified plans (403(b) tax-sheltered annuities are entirely annuity-based). When an annuity funds a qualified plan, the annuity's own tax-deferral is redundant — the plan already defers tax — so suitability hinges on the annuity's guarantees, fees, and income options rather than its tax shelter.
Upon a participant's death, beneficiary rules differ from non-qualified contracts:
- A surviving spouse may roll the inherited plan/IRA into their own IRA, deferring distributions until their own age 73.
- Most non-spouse beneficiaries must empty an inherited IRA within 10 years (the SECURE Act 10-year rule), replacing the old lifetime 'stretch.'
- Distributions to beneficiaries from a traditional plan remain ordinary income; there is no income-tax-free death benefit as with life insurance.
An agent recommending a rollover must compare fees, surrender charges, and protections, documenting suitability.
Maria, age 60, takes a $50,000 distribution from her Roth IRA. She opened the Roth 7 years ago. What is the tax consequence?