8.4 Qualified Plans, IRAs, and Retirement (TEFRA/SEP/401k)
Key Takeaways
- Qualified plans give pre-tax deductible contributions and tax-deferred growth but must satisfy ERISA nondiscrimination, vesting, and participation rules; non-qualified plans use after-tax dollars and may discriminate.
- Qualified/traditional IRA distributions are fully taxable ordinary income, with a 10% penalty before 59½ and RMDs beginning at age 73.
- ERISA (1974) sets fiduciary/vesting standards; TEFRA (1982) tightened limits and addresses top-heavy plans where key employees hold over 60% of benefits.
- SEP IRAs are employer-funded and simple for small business; SIMPLE IRAs add employee deferrals; 401(k)/403(b) are salary-deferral plans.
- Roth IRAs use after-tax contributions but offer tax-free qualified distributions and no lifetime RMDs; IRA contributions require earned income, and excess contributions face a 6% excise tax.
Qualified Plans, IRAs, and Retirement
A qualified plan meets IRS and ERISA requirements, earning powerful tax advantages: pre-tax (deductible) contributions, tax-deferred growth, and taxation only when distributions are taken. The trade-off is strict rules on contributions, nondiscrimination (the plan cannot favor highly compensated employees), vesting, and distributions.
Contrast with a non-qualified plan, which uses after-tax contributions, can discriminate (e.g., reward select executives), and need not be IRS-approved. The exam tests this fork constantly: qualified = deductible/discrimination-prohibited; non-qualified = after-tax/discrimination-allowed.
Qualified Plan Distribution Rules
Because contributions and growth were never taxed, distributions are fully taxable as ordinary income. Two timing rules dominate the exam:
- Premature distributions before age 59½ incur a 10% penalty on top of ordinary income tax (exceptions: death, disability, certain medical, qualified first-home for IRAs, etc.).
- Required Minimum Distributions (RMDs): must begin by April 1 following the year the owner reaches the statutory RMD age (73 under current law); failure triggers an excise penalty on the shortfall.
Roth accounts are the exception — qualified Roth distributions are tax-free, and Roth IRAs have no lifetime RMDs for the original owner.
TEFRA, ERISA, and Plan Framework
Several acts shape qualified plans and recur in exam vocabulary:
- ERISA (1974): the foundational law setting fiduciary, vesting, participation, funding, and reporting/disclosure standards for employer plans.
- TEFRA (1982): the Tax Equity and Fiscal Responsibility Act tightened contribution limits and addressed top-heavy plans (where key employees hold more than 60% of benefits, triggering minimum benefits for rank-and-file employees).
- Top-heavy testing ensures owners and key employees do not capture a disproportionate share of plan assets.
These frameworks all enforce the core qualified-plan promise: tax favoritism in exchange for fairness across the workforce.
Employer Plan Types
| Plan | Key Feature |
|---|---|
| 401(k) | Salary-deferral; employee elects pre-tax (or Roth) deferrals, often with employer match |
| 403(b) / TSA | Salary-reduction plan for public schools and 501(c)(3) nonprofits |
| SEP IRA | Simplified Employee Pension; employer-only contributions to employee IRAs; high limits, easy for small business |
| SIMPLE IRA | For small employers (≤100 employees); employee deferrals plus mandatory employer match |
| Defined benefit | Promises a specific retirement benefit; employer bears investment risk |
| Defined contribution | Benefit depends on contributions + investment results; employee bears risk |
A SEP is favored by small employers because only the employer contributes and setup is simple. Profit-sharing plans allow discretionary employer contributions tied to profits.
Individual Retirement Accounts (IRAs)
Traditional IRA: contributions may be tax-deductible (subject to income limits if covered by an employer plan); growth is tax-deferred; distributions are ordinary income; 10% penalty before 59½; RMDs apply at the statutory age.
Roth IRA: contributions are after-tax (never deductible), but qualified distributions — held 5 years and after 59½ (or death/disability/first home) — are completely tax-free, with no lifetime RMDs.
Key rules tested:
- Contributions require earned income (wages/self-employment), not investment income.
- Excess contributions are subject to a 6% excise tax per year until corrected.
- A spousal IRA lets a non-working spouse contribute based on the working spouse's income on a joint return.
Rollovers, Vesting, and Annuities in Plans
A direct rollover (trustee-to-trustee) moves funds between qualified plans/IRAs with no tax and no withholding. An indirect rollover (check paid to the participant) must be redeposited within 60 days, and the payer must withhold 20% — so the participant must replace that 20% from other funds to roll the full amount or face tax/penalty on the shortfall. Only one indirect IRA rollover per 12 months is allowed.
Vesting determines how much of the employer's contributions an employee keeps on leaving; employee deferrals are always 100% vested. Annuities are common funding vehicles inside qualified plans, but note the trap: an annuity's tax deferral inside an IRA is redundant — the IRA already provides deferral — so the annuity is chosen for its guarantees/payout options, not extra tax benefit.
Worked Example — Premature Traditional IRA Withdrawal
A 50-year-old withdraws $10,000 from a fully deductible traditional IRA (entire balance is pre-tax). She is in the 22% federal bracket.
| Item | Amount |
|---|---|
| Ordinary income tax (22% × $10,000) | $2,200 |
| 10% premature-distribution penalty | $1,000 |
| Total federal cost | $3,200 |
| Net cash retained | $6,800 |
Because the IRA was fully deductible, the entire $10,000 is taxable, and being under 59½ adds the 10% penalty. A Roth withdrawal of the same age/amount would differ: contributions come out tax- and penalty-free first; only earnings would be taxed/penalized.
Roth vs. Traditional — When Each Wins
The Roth/traditional choice turns on when you want to pay tax. A traditional IRA gives a deduction now and taxes withdrawals later — better if you expect a lower tax bracket in retirement. A Roth forgoes today's deduction but delivers tax-free qualified withdrawals — better if you expect a higher future bracket or want tax-free legacy assets, since Roth IRAs carry no lifetime RMDs.
A qualified Roth distribution requires both the 5-year holding period and a qualifying event (age 59½, death, disability, or first-home up to $10,000). Roth contributions (not earnings) can always be withdrawn tax- and penalty-free, because they were already taxed. High earners blocked from direct Roth contributions sometimes use a conversion (the so-called backdoor), which is itself a taxable event on pre-tax amounts converted.
Which statement correctly distinguishes a qualified from a non-qualified retirement plan?
A small business owner wants a retirement plan where only the employer contributes, with simple administration and high contribution limits. Which plan best fits?