8.4 Qualified Plans, IRAs, and Retirement (TEFRA/SEP/401k)
Key Takeaways
- Qualified plan contributions are pre-tax/deductible and grow tax-deferred; all distributions are taxed as ordinary income.
- Premature distributions before age 59 1/2 trigger a 10% penalty unless an exception applies.
- Traditional IRA contributions may be deductible; Roth IRA contributions are after-tax but qualified withdrawals are tax-free.
- SEP and SIMPLE plans are simplified employer plans; a SEP is funded only by the employer, a SIMPLE allows employee deferrals plus an employer match.
- A direct trustee-to-trustee rollover avoids the mandatory 20% withholding that applies to a 60-day indirect rollover.
Qualified Plans, IRAs, and Retirement
Retirement plans are either qualified (IRS-approved for favorable tax treatment) or non-qualified. The exam centers on the tax timing: when contributions are deductible, how growth is treated, and how distributions are taxed and penalized.
Qualified vs. Non-Qualified
| Feature | Qualified Plan | Non-Qualified Plan |
|---|---|---|
| Contributions | Pre-tax / deductible | After-tax |
| Growth | Tax-deferred | Tax-deferred (annuity) |
| Distributions | 100% ordinary income | Only gain is taxed |
| IRS approval / ERISA | Yes | No |
| Discrimination rules | Must be nondiscriminatory | Can favor key employees |
A qualified plan must be in writing, permanent, for the exclusive benefit of employees, and nondiscriminatory. Because contributions were never taxed, the entire distribution is taxable as ordinary income.
Individual Retirement Arrangements (IRAs)
- Traditional IRA: contributions may be tax-deductible (subject to income/active-participant limits); growth is tax-deferred; withdrawals are fully taxable as ordinary income.
- Roth IRA: contributions are after-tax (never deductible); qualified withdrawals — after age 59 1/2 and a 5-year holding period — are completely tax-free.
- Excess contributions are subject to a 6% excise tax each year they remain.
Employer-Sponsored Plans
- 401(k): employee elective deferrals (pre-tax or Roth) often with an employer match; defined contribution.
- 403(b) / TSA: for public schools and 501(c)(3) nonprofits; tax-sheltered annuity.
- SEP (Simplified Employee Pension): employer-only contributions into employees' IRAs; high limits, simple administration.
- SIMPLE plan: for small employers (generally <=100 employees); allows employee salary deferrals plus a required employer match — the key difference from a SEP, which has no employee deferral.
Distribution Rules
Premature distribution penalty. A distribution before age 59 1/2 is subject to a 10% federal penalty on top of ordinary income tax, unless an exception applies (death, disability, qualifying medical expenses, first-home up to $10,000 for IRAs, substantially equal periodic payments, higher-education for IRAs).
Required Minimum Distributions (RMDs). Traditional plans and IRAs must begin RMDs by the required beginning date (currently age 73 under recent SECURE Act rules). Failure to take an RMD triggers a steep excise tax on the shortfall. Roth IRAs have no RMDs during the owner's lifetime.
Rollovers: The 20% Withholding Trap
Moving money between plans can be done two ways:
| Method | Withholding | Risk |
|---|---|---|
| Direct (trustee-to-trustee) | None | No tax, funds never touch the participant |
| Indirect (60-day) | Mandatory 20% withheld | Must redeposit full amount within 60 days or it is taxed |
Exam trap: in a 60-day indirect rollover, the plan must withhold 20%, yet to avoid tax the participant must redeposit the full original amount (making up the 20% from other funds) within 60 days. The direct rollover avoids this entirely.
Worked Example: Early Distribution
A 40-year-old takes a $20,000 distribution from a traditional 401(k) (all pre-tax). The amount is fully taxable as ordinary income, AND a 10% penalty applies: $20,000 x 10% = $2,000 penalty, plus income tax at the participant's marginal rate. No penalty exception was met.
TEFRA Context
The Tax Equity and Fiscal Responsibility Act (TEFRA, 1982) tightened the rules that distinguish life insurance and annuities from pure investments and standardized the LIFO treatment and annuity recovery rules now tested on the national exam. It is the legislative backdrop for treating over-funded contracts and pre-59 1/2 distributions as penalized.
Defined Benefit vs. Defined Contribution
Qualified employer plans fall into two structural families, and the exam expects you to tell them apart.
| Feature | Defined Benefit | Defined Contribution |
|---|---|---|
| What is promised | A specific retirement benefit (e.g., % of salary) | A contribution amount; benefit depends on returns |
| Investment risk | Borne by employer | Borne by employee |
| Examples | Traditional pension | 401(k), profit-sharing, SEP, money purchase |
| Funding certainty | Actuarially determined | Account balance at retirement |
A defined benefit plan promises an outcome and the employer bears investment risk; a defined contribution plan promises only an input, and the employee bears market risk. 401(k), 403(b), SEP, SIMPLE, and profit-sharing plans are all defined contribution.
Roth vs. Traditional Decision
The traditional-versus-Roth choice turns on when the tax is paid. Traditional contributions are deducted now and taxed at withdrawal — favorable if the saver expects a lower bracket in retirement. Roth contributions are taxed now and grow tax-free — favorable if the saver expects a higher future bracket or wants to avoid lifetime RMDs. A Roth conversion from a traditional IRA is a taxable event in the year of conversion but creates future tax-free growth. Nonqualified Roth withdrawals (before the 5-year/59 1/2 test) tax only the earnings, not the after-tax contributions.
Vesting and ERISA Protections
Qualified plans are governed by ERISA, which imposes fiduciary duties, reporting, and vesting schedules. Employee elective deferrals are always 100% vested immediately; employer contributions may vest on a graded or cliff schedule, meaning the employee earns ownership of the employer money over time. A participant who leaves before fully vesting forfeits the unvested employer portion. ERISA also requires a summary plan description be given to participants — a common exam fact.
Key Takeaways
- Qualified plan distributions are 100% ordinary income because contributions were pre-tax.
- Distributions before 59 1/2 carry a 10% penalty unless an exception applies; RMDs begin at age 73 (Roth IRAs are exempt).
- Roth IRA contributions are after-tax; qualified withdrawals (59 1/2 + 5 years) are tax-free.
- A SEP is employer-funded only; a SIMPLE adds employee deferrals plus an employer match.
- A direct trustee-to-trustee rollover avoids the mandatory 20% withholding of a 60-day indirect rollover.
Which statement correctly distinguishes a SEP from a SIMPLE plan?
A participant requests an indirect (60-day) rollover of $50,000 from a qualified plan. What happens and how can mandatory withholding be avoided?