11.3 Employer Plans: 401(k), 403(b), SEP, SIMPLE, Pension/Profit-Sharing
Key Takeaways
- Defined benefit plans promise a set benefit with employer-borne investment risk; defined contribution plans fix only the input and place investment risk on the employee.
- 401(k) plans serve for-profit employers and 403(b)/TSAs serve schools and 501(c)(3) charities, both as salary-reduction plans with optional matches.
- SEPs are employer-funded into employee IRAs; SIMPLE plans (100 or fewer employees) require an employer match (about 3%) or a 2% nonelective contribution.
- Employee elective deferrals are always 100% vested, while employer matches follow the plan's vesting schedule.
- Profit-sharing contributions are discretionary and can vary or be skipped, distinguishing them from a fixed defined benefit pension obligation.
Employer-Sponsored Qualified Plans
Employer plans split into two structural families. A defined benefit (DB) plan promises a specific future benefit (e.g., a monthly pension) — the employer bears the investment risk. A defined contribution (DC) plan specifies only the contribution going in; the final balance depends on investment results — the employee bears the investment risk.
Most modern plans tested on the exam are defined contribution. Match each named plan to its sponsor type and quirks.
Plan Comparison Table
| Plan | Typical sponsor | Who funds it | Key trait |
|---|---|---|---|
| 401(k) | For-profit employer | Employee deferrals + optional employer match | Salary-reduction DC plan |
| 403(b) / TSA | Schools, nonprofits, 501(c)(3) | Employee deferrals (+ match) | Tax-sheltered annuity for public/charitable workers |
| SEP | Small business / self-employed | Employer only | Simplified Employee Pension; high limit, easy setup |
| SIMPLE | Employer with ≤100 employees | Employee + mandatory employer | Savings Incentive Match Plan; lower limits |
| Defined benefit pension | Larger/older employers | Employer | Promises a fixed retirement benefit |
| Profit-sharing | Any employer | Employer (discretionary) | Contribution can vary or skip in lean years |
401(k) and 403(b)
A 401(k) is a salary-reduction defined-contribution plan: the employee elects to defer part of pay pre-tax (or as a Roth 401(k) after-tax), and many employers add a matching contribution. A 403(b), also called a tax-sheltered annuity (TSA), is the equivalent for employees of public schools and tax-exempt 501(c)(3) charities.
Match trap: an employer match is employer money, so it follows the plan's vesting schedule, while the worker's own elective deferrals are always 100% vested. Both plans permit age-50 catch-up contributions and impose the same 10% pre-59½ early-withdrawal penalty seen with IRAs.
SEP and SIMPLE Plans
- A Simplified Employee Pension (SEP) is funded entirely by the employer into each eligible employee's IRA. It is popular with the self-employed because of a high contribution ceiling and minimal paperwork. Employees cannot make elective salary deferrals into a traditional SEP.
- A Savings Incentive Match Plan for Employees (SIMPLE) is for employers with 100 or fewer employees. Employees defer salary and the employer must contribute, typically either a dollar-for-dollar match up to 3% of pay or a 2% nonelective contribution for all eligible employees.
Exam trap: a SIMPLE requires an employer contribution; a profit-sharing plan's contribution is discretionary and can be zero in a bad year.
Pension and Profit-Sharing Plans
A defined benefit pension computes a promised benefit from a formula — commonly years of service × a percentage × final average salary. Worked example: 30 years of service × 2% × $80,000 final average salary = $48,000 per year in retirement. The employer must fund whatever it takes to deliver that promise, and must hire an actuary.
A profit-sharing plan is a DC plan where the employer makes discretionary contributions out of profits; it may contribute a lot, a little, or nothing in a given year, as long as contributions are recurring and substantial over time. This flexibility is its defining exam feature versus a fixed pension obligation.
Distributions and Loans from Employer Plans
Employer-plan distributions follow the same tax skeleton as IRAs: pre-tax money is taxed as ordinary income on withdrawal, and the 10% early-withdrawal penalty applies before age 59½. Two employer-specific wrinkles are tested. First, an employee who separates from service in or after the year they turn 55 can take penalty-free distributions from that employer's 401(k) — the so-called rule of 55, which does not apply to IRAs.
Second, many 401(k) and 403(b) plans permit participant loans. A loan is not a taxable distribution if it is repaid on schedule, but if the employee defaults or leaves the job with a balance outstanding, the unpaid amount is treated as a taxable distribution subject to the early-withdrawal penalty.
Matching the Plan to the Employer — Exam Strategy
Most employer-plan questions are identification problems disguised as scenarios. Read for three clues: who the employer is, who funds the plan, and whether the benefit or the contribution is fixed.
| Clue in the question | Likely plan |
|---|---|
| Public school or charity, salary reduction | 403(b) / TSA |
| Self-employed, employer-only, high limit | SEP |
| Small employer (≤100), required match | SIMPLE |
| Promised monthly benefit, actuary, employer risk | Defined benefit pension |
| Discretionary employer contribution from profits | Profit-sharing |
When two answers seem close, decide whether the employee or the employer carries the investment risk — that single distinction separates defined contribution from defined benefit and resolves most traps.
Rollovers Between Employer Plans and IRAs
When an employee leaves a job, the vested balance can usually be moved without tax through a direct rollover into an IRA or a new employer's plan. The trap is the cash-out: if the former employer sends the money to the employee instead of to the new custodian, a mandatory 20% federal withholding applies to the taxable portion of an eligible rollover distribution.
The employee then has 60 days to redeposit the funds, but to roll over the full original amount they must replace the withheld 20% out of pocket; otherwise that 20% is treated as a taxable distribution. Steering clients toward direct, trustee-to-trustee rollovers avoids both the withholding and the 60-day risk — a practical point the exam frames as the producer's best recommendation.
A public high-school teacher wants a salary-reduction retirement plan offered specifically to employees of educational and 501(c)(3) charitable organizations. Which plan applies?
Under a defined benefit pension formula of 1.5% × years of service × final average salary, what annual retirement benefit does an employee with 40 years of service and a $60,000 final average salary receive?