11.3 Employer Plans: 401(k), 403(b), SEP, SIMPLE, Pension/Profit-Sharing
Key Takeaways
- Defined benefit (pension) plans put investment risk on the employer; defined contribution plans (401(k), profit-sharing, SEP, SIMPLE) put it on the employee.
- A 401(k) allows pre-tax salary deferrals with frequent employer matching; contribute up to the match to avoid leaving money behind.
- SEP plans are employer-funded only; SIMPLE plans require both employee deferrals and a mandatory employer contribution and cap at 100 employees.
- 403(b) Tax-Sheltered Annuities serve only public schools and 501(c)(3) nonprofits.
- All these qualified employer plans share the age-73 RMD rule and the 10% pre-59½ early-withdrawal penalty.
Defined Benefit vs. Defined Contribution
Employer qualified plans split into two families. A defined benefit (DB) plan — a traditional pension — promises a specific monthly benefit at retirement (often based on salary and years of service); the employer bears the investment risk and must fund whatever it takes to deliver the promise. A defined contribution (DC) plan specifies only what goes in (the contribution); the final benefit depends on investment performance, so the employee bears the investment risk.
Profit-Sharing Plans
A profit-sharing plan is a defined contribution plan letting an employer contribute a discretionary share of profits to employees' accounts. Contributions can vary year to year and may even be zero in a bad year, giving the employer flexibility. The contribution is allocated to participant accounts under a set formula, and the plan must still satisfy nondiscrimination rules. Profit-sharing is the conceptual parent of the cash-or-deferred 401(k).
The 401(k) Plan
A 401(k) plan is a defined contribution, cash-or-deferred arrangement that lets employees elect to defer part of their salary pre-tax (or as designated Roth, after-tax). Employers often add a matching contribution. Salary deferrals grow tax-deferred; traditional 401(k) distributions are taxed as ordinary income, and pre-59½ withdrawals face the 10% penalty.
- Employee elective deferral limit is set annually by the IRS, with a catch-up for age 50+.
- A common match is 50% of deferrals up to 6% of pay ("50 cents on the dollar").
Worked 401(k) Match Example
Worked example: Dev earns $80,000 and his employer matches 50% of contributions up to 6% of salary.
- 6% of $80,000 = $4,800 (the matchable ceiling)
- Employer match = 50% of $4,800 = $2,400
If Dev contributes only 3% ($2,400), the match is 50% of $2,400 = $1,200 — he leaves $1,200 of free money on the table. To capture the full $2,400 match, Dev must contribute at least 6% of pay. This "contribute up to the match" rule is a frequent application question.
403(b), SEP, and SIMPLE Plans
The exam expects you to match each plan to its target employer.
| Plan | Who uses it | Key feature |
|---|---|---|
| 403(b) / TSA | Public schools, 501(c)(3) nonprofits | Tax-sheltered annuity; salary-reduction deferrals |
| SEP (Simplified Employee Pension) | Small employers, self-employed | Employer funds IRAs; high contribution limit; easy admin |
| SIMPLE (Savings Incentive Match Plan for Employees) | Employers with 100 or fewer employees | Employee defers; required employer match or contribution |
| Keogh (HR-10) | Self-employed / unincorporated | Plan for sole proprietors and partners |
Distinguishing the Small-Employer Plans
SEP plans are employer-only funded — the employer deposits money into each eligible employee's IRA — and carry a much higher contribution limit than a regular IRA, making them popular with the self-employed. A SIMPLE plan, by contrast, requires employee salary deferrals plus a mandatory employer contribution (typically a dollar-for-dollar match up to 3% of pay, or a 2% nonelective contribution) and is limited to employers with 100 or fewer employees. A 403(b) (also called a Tax-Sheltered Annuity, TSA) serves only nonprofit and public-education employees and is funded mainly through pre-tax salary reduction.
Distributions, Rollovers, and Plan Loans
When an employee leaves, a vested account balance can roll to an IRA or new employer plan; a direct rollover avoids the mandatory 20% withholding that applies to cash distributions. Many 401(k) and 403(b) plans permit participant loans, typically up to the lesser of $50,000 or 50% of the vested balance, repaid with interest — a loan is not a taxable distribution unless it defaults. Hardship withdrawals may be allowed for immediate needs but are still taxable and usually carry the 10% penalty if the participant is under 59½.
Eligibility, Vesting, and Top-Heavy Rules
Employer plans inherit ERISA's eligibility ceiling — an employer may require age 21 and one year of service before participation. Vesting schedules apply to employer contributions; employee salary deferrals are always 100% immediately vested. A plan that tilts too heavily toward owners and officers is top-heavy and must give rank-and-file employees accelerated vesting and minimum contributions. These integrity rules are exactly what nonqualified executive plans avoid by giving up the tax deduction and ERISA shelter.
Common Traps
Watch these distinctions: a pension is defined benefit (employer risk), while 401(k), profit-sharing, SEP, and SIMPLE are defined contribution (employee risk). A SEP is employer-funded only; a SIMPLE requires both employee and employer money. A 403(b) is restricted to nonprofits and schools — a for-profit corporation cannot offer one. All these qualified plans share the age-73 RMD rule and the 10% early-withdrawal penalty before 59½.
An employee earning $90,000 participates in a 401(k) that matches 50% of contributions up to 6% of salary. If the employee contributes 6%, what is the employer's matching contribution?
Which qualified plan is available only to employees of public schools and 501(c)(3) nonprofit organizations?