11.3 Employer Plans: 401(k), 403(b), SEP, SIMPLE, Pension/Profit-Sharing

Employer-Sponsored Plans

Employer plans divide into defined contribution (DC) and defined benefit (DB) designs. In a DC plan the contribution is fixed and the eventual benefit depends on investment results — the employee bears investment risk. In a DB plan the benefit (often a pension formula) is fixed and the employer bears the funding risk and must meet minimum funding standards.

The most-tested DC plans are the 401(k), 403(b), SEP, SIMPLE, and profit-sharing plans; the classic DB plan is the traditional pension.

401(k) and 403(b) Salary-Deferral Plans

A 401(k) is a cash-or-deferred arrangement for for-profit employers; employees defer salary pre-tax (or Roth), often with an employer match. A 403(b) (tax-sheltered annuity) is the parallel plan for public schools and 501(c)(3) tax-exempt organizations and is funded with annuities and mutual funds.

Trap: Employee deferrals plus the employer match count toward the annual additions limit ($70,000); the $23,500 cap applies to the employee deferral only.

SEP and SIMPLE Plans for Small Employers

Small businesses and the self-employed use simplified plans that avoid heavy administration.

• SEP (Simplified Employee Pension) — the employer alone contributes, up to 25% of compensation (capped at the annual additions limit). Money goes into each employee's IRA; employees are always 100% vested.
• SIMPLE (Savings Incentive Match Plan for Employees) — for employers with 100 or fewer employees. Employees defer, and the employer must either match up to 3% or contribute a 2% nonelective amount. Deferrals are lower than a 401(k).

Profit-Sharing and Pension Plans

A profit-sharing plan is a DC plan where the employer makes discretionary contributions (it may skip a bad year) allocated by a set formula. A money-purchase pension is a DC plan with a mandatory fixed contribution percentage each year.

A traditional defined benefit pension promises a formula benefit — for example, 1.5% × years of service × final average salary. The employer funds whatever is actuarially required and bears the investment risk.

Worked example: 30 years of service and a $80,000 final average salary at a 1.5% multiplier yields an annual pension of 0.015 × 30 × $80,000 = $36,000.

Rollovers, Distributions, and Taxation

When a worker leaves, plan balances can move to preserve tax deferral. The exam distinguishes two methods:

Trap: In an indirect rollover the plan withholds 20%, yet the owner must redeposit the full amount within 60 days to avoid tax and the 10% penalty — the withheld 20% must be replaced from other funds and recovered at tax time. Distributions are otherwise taxed as ordinary income, with the 10% early-withdrawal penalty before age 59½ and RMDs at age 73.

Defined Benefit Funding and PBGC

Because a defined benefit pension promises a fixed formula benefit, the employer must contribute whatever an actuary determines is needed to fund the promise, regardless of market performance. This is why DB plans are subject to ERISA's minimum funding standards and far more administration than DC plans.

Most private DB pensions are insured by the Pension Benefit Guaranty Corporation (PBGC), a federal agency that pays a capped benefit if the plan fails. DB plans suit older owners who want large, predictable contributions late in a career; DC plans suit younger, mobile workforces who value portability and individual accounts.

Distinguishing DC Plans on the Exam

Students lose points by blurring the discretionary versus mandatory line. A profit-sharing plan lets the employer choose whether and how much to contribute each year, which fits businesses with uneven cash flow. A money-purchase plan locks in a mandatory fixed percentage every year, so the employer must contribute even in a down year.

Likewise, separate the funding parties: SEP is employer-only, SIMPLE requires both employee deferrals and an employer match or nonelective contribution, and a 401(k) is employee-driven with an optional match. Anchor each plan to its sponsor type and contribution source.

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