8.4 Qualified Plans, IRAs, and Retirement (TEFRA/SEP/401k)

Qualified Plans, IRAs, and Retirement

A qualified plan meets IRS and ERISA requirements and earns tax advantages: employer contributions are tax-deductible, earnings grow tax-deferred, and distributions are taxed as ordinary income when received. A non-qualified plan does not meet these requirements (and may discriminate in favor of executives), so contributions are not currently deductible. The exam tests the rules for IRAs, employer plans, and the key dates and penalties.

Qualified Plan Requirements

• Must be in writing and communicated to employees.
• Must be for the exclusive benefit of employees and their beneficiaries.
• Must be nondiscriminatory — cannot favor highly compensated employees or owners.
• Must have a vesting schedule and a defined formula for contributions/benefits.

Traditional and Roth IRAs

A Traditional IRA allows potentially tax-deductible contributions; earnings grow tax-deferred and all distributions are taxed as ordinary income. A Roth IRA is funded with after-tax dollars (no deduction), but qualified distributions — after age 59½ and a 5-year holding period — are entirely tax-free.

Penalties: distributions before age 59½ generally incur a 10% early-withdrawal penalty plus ordinary income tax. Excess contributions are penalized at 6% per year. Traditional IRA owners must begin Required Minimum Distributions (RMDs) by age 73; failure to take an RMD triggers a penalty on the shortfall.

Employer-Sponsored Plans — TEFRA, SEP, and 401(k)

• TEFRA (Tax Equity and Fiscal Responsibility Act of 1982): standardized contribution limits and parity rules between corporate and self-employed (Keogh/HR-10) plans, and clarified loan and top-heavy rules. On the exam, TEFRA is associated with equalizing qualified-plan treatment regardless of business form.
• SEP (Simplified Employee Pension): an employer funds contributions directly into employees' IRAs. It is easy to administer, the employer makes the contributions (employees do not defer salary), and it suits small businesses and the self-employed.
• 401(k): a cash-or-deferred arrangement letting employees defer pre-tax salary, often with an employer match. Salary deferrals are excluded from current income; distributions are taxed as ordinary income, with the 10% pre-59½ penalty applying to early withdrawals.

Worked Example — 401(k) Deferral

An employee earning $80,000 defers 6% of salary, and the employer matches 50% of deferrals up to 6%.

The $4,800 deferral is excluded from the employee's current taxable income; both amounts grow tax-deferred until distribution. Failing to defer at least up to the match is, in effect, leaving free money on the table — a planning point producers raise often.

Non-Qualified Deferred Compensation

Not every retirement vehicle is qualified. Non-qualified deferred compensation plans let an employer reward selected key executives without the nondiscrimination, vesting, and coverage rules of qualified plans. The trade-off: the employer cannot deduct the contribution until the executive actually receives the income, and the deferred amounts generally remain subject to the employer's creditors (the executive holds an unsecured promise).

Common forms include salary-reduction plans, salary-continuation (SERP) plans, and split-dollar arrangements. These are favored precisely because they can discriminate in favor of highly compensated employees, which qualified plans cannot do.

Putting It Together — Choosing a Plan

Small employers leaning toward simplicity choose SEP or SIMPLE plans; larger employers wanting employee deferrals choose 401(k); nonprofits use 403(b); and firms rewarding a few executives layer on non-qualified deferred comp. The producer's role is to match the plan's tax mechanics — deductibility, deferral, RMD timing, and penalty exposure — to the client's workforce and goals.

Other Key Plan Types

• SIMPLE plans (Savings Incentive Match Plan for Employees): for employers with 100 or fewer employees; employees defer salary and the employer must make a matching or nonelective contribution. Simpler than a 401(k) but with lower deferral limits.
• 403(b) / TSA (Tax-Sheltered Annuity): for employees of public schools and 501(c)(3) nonprofits; funded with pre-tax salary deferrals into annuities or mutual funds.
• Defined benefit plan: promises a specific retirement benefit (e.g., a pension formula); the employer bears the investment risk and funding obligation.
• Defined contribution plan: the contribution is defined (e.g., a 401(k)); the eventual benefit depends on investment performance and the employee bears the market risk.
• Keogh (HR-10): a qualified plan for self-employed individuals and unincorporated businesses; TEFRA largely equalized its limits with corporate plans.

Rollovers

A direct rollover (trustee-to-trustee) moves funds between plans with no tax and no withholding. A 60-day (indirect) rollover hands the money to the participant, who must redeposit it within 60 days; otherwise it is a taxable distribution. Worse, a plan distribution paid to the participant is subject to mandatory 20% federal withholding, and the participant must replace that 20% from other funds to complete a full rollover — a classic exam trap that argues for always using a direct rollover.

Vesting and the Tax Logic of Qualified Plans

Vesting is the employee's nonforfeitable right to employer contributions. Employee salary deferrals are always 100% vested immediately, but employer contributions can vest gradually under an approved schedule (for example, graded or cliff vesting). Once vested, those amounts belong to the employee even at termination.

The unifying tax theme across all qualified arrangements is EET — Exempt contribution, Exempt growth, Taxed distribution. Pre-tax dollars go in (deductible), grow tax-deferred, and are taxed as ordinary income on the way out. Because the government never taxed the contributions, it requires Required Minimum Distributions beginning at age 73 so the deferral cannot continue indefinitely; a missed RMD is penalized on the shortfall. Roth arrangements flip the timing (taxed contribution, tax-free qualified distribution, no lifetime RMD), which is why Roth is favored when the saver expects a higher tax bracket in retirement.