8.4 Qualified Plans, IRAs, and Retirement (TEFRA/SEP/401k)
Key Takeaways
- Qualified plans give deductible/pre-tax contributions and tax-deferred growth, but distributions are ordinary income.
- Pre-tax funding means basis is usually zero, so the full distribution is taxable.
- TEFRA introduced top-heavy testing (key employees >60% of benefits) and Keogh-corporate parity.
- Traditional IRAs are tax-deferred with RMDs at 73; Roth IRAs use after-tax dollars for tax-free qualified withdrawals and no lifetime RMDs.
- SEP funds employee IRAs, 403(b)/TSA serves schools and nonprofits, and Keogh covers the self-employed; a 10% penalty applies before 59½.
Qualified Plans, IRAs, and Retirement
Qualified retirement plans receive favorable tax treatment in exchange for meeting IRS and ERISA standards. The exam tests the qualified-vs-nonqualified distinction, contribution and distribution rules, and the alphabet soup of plan types (IRA, SEP, SIMPLE, 401(k), 403(b), TSA, Keogh).
Qualified vs. Nonqualified Plans
A qualified plan meets IRC requirements and ERISA, giving it four tax advantages:
- Employer contributions are tax-deductible.
- Contributions are not currently taxable to the employee.
- Earnings grow tax-deferred.
- Distributions are taxed as ordinary income when received.
| Feature | Qualified | Nonqualified |
|---|---|---|
| IRS/ERISA approval | Required | Not required |
| Contributions deductible | Yes | No |
| Coverage | Must be nondiscriminatory | Can favor key employees |
| Funded with | Pre-tax dollars | After-tax dollars |
Because contributions are pre-tax, the cost basis is usually zero, so the entire distribution is taxable.
TEFRA and Top-Heavy Rules
TEFRA (1982) tightened qualified-plan rules, introducing top-heavy testing: if more than 60% of plan benefits accrue to key employees, the plan must provide minimum contributions/benefits to rank-and-file employees. TEFRA also reduced contribution limits and required parity between corporate plans and Keogh (HR-10) plans for the self-employed.
Which of the following is NOT a tax advantage of a qualified retirement plan?
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.
Roth IRA: contributions are after-tax (nondeductible), but qualified distributions — including earnings — are tax-free. No required minimum distributions during the owner's lifetime.
Key IRA rules tested heavily:
- Early withdrawal penalty: 10% on distributions before age 59½ (exceptions: first home up to $10,000, qualified education, death, disability).
- Required Minimum Distributions (RMDs): traditional IRAs must begin RMDs by age 73 (SECURE 2.0); a 25% excise tax applies to amounts not withdrawn.
- Rollover: a 60-day window to redeposit a distribution; one indirect rollover per 12 months.
Employer-Sponsored Plans
| Plan | Key feature |
|---|---|
| SEP | Simplified Employee Pension — employer funds employee IRAs; high limits; easy admin |
| SIMPLE | For small employers (≤100 employees); employee defers with employer match |
| 401(k) | Cash-or-deferred arrangement; employee elective deferrals, often matched |
| 403(b)/TSA | Tax-sheltered annuity for public schools and 501(c)(3) nonprofits |
| Keogh (HR-10) | Qualified plan for self-employed/unincorporated businesses |
| Profit-sharing | Discretionary employer contributions tied to profits |
SEP and 401(k) Mechanics
A SEP lets an employer contribute to each eligible employee's IRA, with much higher limits than a personal IRA and minimal paperwork — popular with small businesses and the self-employed.
A 401(k) allows pre-tax elective deferrals; many include an employer match (e.g., 50% of the first 6% of pay). Distributions before 59½ trigger the 10% penalty, and RMDs apply. A designated Roth 401(k) option allows after-tax deferrals with tax-free qualified withdrawals.
Which retirement vehicle allows a small employer to make contributions directly into each eligible employee's IRA with minimal administrative requirements?
Distributions, Penalties, and Plan-Type Distinctions
Required Minimum Distributions (RMDs)
Pre-tax qualified accounts (traditional IRA, SEP, SIMPLE, 401(k), 403(b)) require RMDs beginning at age 73 under SECURE 2.0. Failing to take the RMD triggers a 25% excise tax on the shortfall (reduced to 10% if corrected promptly). Roth IRAs have no lifetime RMDs; Roth 401(k)s no longer require RMDs starting in 2024.
The 10% Early-Distribution Penalty
Distributions before age 59½ incur a 10% penalty on the taxable amount, with exceptions:
- Death or total disability
- Substantially equal periodic payments (72(t))
- First-time home purchase (IRA only, up to $10,000)
- Qualified higher-education expenses (IRA only)
- Separation from service at age 55+ (employer plans only)
SIMPLE vs. SEP vs. 401(k)
| Plan | Employer size | Employee defers? | Notes |
|---|---|---|---|
| SEP | Any | No (employer only) | Easy setup; funds employee IRAs |
| SIMPLE | ≤100 employees | Yes, with match | Lower limits than 401(k); 25% penalty in first 2 years |
| 401(k) | Any | Yes, often matched | Vesting schedules; Roth option available |
403(b) / Tax-Sheltered Annuity (TSA)
A 403(b) (also called a TSA) is available only to employees of public schools and 501(c)(3) tax-exempt organizations. Contributions are pre-tax salary reductions; growth is tax-deferred; distributions are ordinary income with the 10% pre-59½ penalty and RMDs at 73.
Keogh (HR-10) Plans
A Keogh is a qualified plan for self-employed individuals and unincorporated businesses. Contributions are deductible and grow tax-deferred. If the self-employed owner has employees, they must generally be covered on a comparable basis.
Trap: Roth accounts are funded with after-tax dollars — there is no upfront deduction, but qualified withdrawals (held 5 years and after 59½) are entirely tax-free, the reverse of traditional accounts.
Qualified vs. Non-Qualified Plans and the ERISA Tests
A qualified plan meets IRS/ERISA requirements and earns tax advantages: employer contributions are tax-deductible, earnings grow tax-deferred, and distributions are taxed as ordinary income when received. Qualified plans must be nondiscriminatory (cannot favor highly compensated employees), have a vesting schedule, be in writing and permanent, and meet coverage/participation tests. A non-qualified plan (e.g., deferred compensation, executive bonus) can discriminate and lacks the upfront deduction, trading flexibility for fewer tax breaks.
IRA Rules and 2026 Limits
- Traditional IRA — contributions may be tax-deductible; growth is tax-deferred; distributions are taxable; 10% penalty before 59½; RMDs begin at age 73.
- Roth IRA — contributions are after-tax (not deductible); qualified distributions are tax-free; no RMDs during the owner's lifetime; subject to income phase-outs.
- The 2025/2026 IRA contribution limit is $7,000 ($8,000 with the age-50 catch-up). Excess contributions face a 6% excise tax.
Employer Plan Types
| Plan | Key Feature |
|---|---|
| 401(k) | Salary-deferral, often with employer match; 2026 elective deferral ~$23,500 + catch-up |
| 403(b) (TSA) | For public-school and 501(c)(3) employees; salary reduction |
| SEP IRA | Employer-funded, simple for small business/self-employed |
| SIMPLE IRA | <100 employees; employee defer + required employer match |
| Defined benefit | Promises a formula-based pension; employer bears investment risk |
| Defined contribution | Promises only the contribution; employee bears investment risk |
Rollover Worked Trap
A direct trustee-to-trustee rollover moves funds with no withholding. A 60-day (indirect) rollover triggers a mandatory 20% federal withholding on the distribution; to complete a full tax-free rollover the participant must replace the withheld 20% from other funds within 60 days, or that 20% becomes a taxable distribution (plus a 10% penalty if under 59½). Only one 60-day IRA rollover is allowed per 12 months — a recurring exam item.