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

Qualified vs Non-Qualified Plans

A qualified plan meets IRS and ERISA requirements and earns special tax treatment: contributions are generally tax-deductible (pre-tax), earnings grow tax-deferred, and distributions are taxed as ordinary income when received. A non-qualified plan does not meet those requirements — contributions are not deductible, but earnings still grow tax-deferred.

Qualified plans must satisfy nondiscrimination rules so they don't unfairly favor highly compensated employees, and they have contribution limits, vesting schedules, and reporting duties under ERISA.

For the exam, hold onto the three-part tax pattern of a qualified plan: deduct going in, defer while growing, and pay ordinary income tax coming out. Non-qualified plans break only the first leg — no deduction — but still defer growth. This single pattern resolves most retirement-taxation questions on the test.

Traditional vs Roth IRA

The Traditional IRA allows tax-deductible contributions (subject to income/active-participant limits); growth is tax-deferred and distributions are fully taxable as ordinary income. The Roth IRA uses after-tax contributions (no deduction), but qualified distributions are entirely tax-free, including earnings.

A Roth qualified distribution requires the account be held 5 years and the owner be 59½ (or death, disability, or first-home up to $10,000). Traditional IRAs require RMDs starting at age 73; Roth IRAs have no RMDs during the owner's lifetime.

IRA Contribution Rules and Penalties

Key numeric traps tested on the exam:

• Early withdrawal before 59½ from a Traditional IRA: ordinary income tax plus a 10% penalty (exceptions: death, disability, qualified higher education, first home up to $10,000, certain medical).
• Excess contribution penalty: 6% per year on amounts over the limit.
• RMD failure: historically a steep excise tax (reduced by SECURE 2.0) on the shortfall.
• Contributions require earned income; you cannot contribute more than you earn.

SEP and SIMPLE Plans

A SEP (Simplified Employee Pension) is an employer-funded plan using IRAs. The employer makes contributions directly to each eligible employee's SEP-IRA; employees do not contribute. SEPs allow much higher contributions than a regular IRA and are popular with small businesses and the self-employed.

A SIMPLE plan (Savings Incentive Match Plan for Employees) is for small employers (generally ≤100 employees). Employees defer salary and the employer matches (or makes a nonelective contribution). Both SEP and SIMPLE are easier to administer than a full 401(k).

401(k) and 403(b) Plans

A 401(k) is an employer-sponsored defined contribution plan where employees make elective salary deferrals (pre-tax, or Roth after-tax), often with an employer match. Investment risk falls on the employee, and the eventual benefit depends on contributions plus investment performance.

A 403(b) (tax-sheltered annuity, TSA) is the equivalent for public schools and 501(c)(3) nonprofits. Both defer current income tax on contributions and earnings until distribution. Contrast with a defined benefit pension, which promises a formula-based benefit and places investment risk on the employer.

TEFRA and the Tax-Code Backdrop

The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) is the law agents must recognize for two reasons: it established the LIFO tax treatment for non-qualified annuity withdrawals (gain taxed first) and tightened rules around tax-deferred vehicles. TEFRA, together with TAMRA 1988 (MEC rules) and ERISA, forms the framework that distinguishes legitimate tax-deferral from abusive tax-sheltering.

Remember the pairing: TEFRA → annuities/LIFO; TAMRA → life insurance/MEC 7-pay test.

Retirement Plan Comparison

Rollovers, Transfers, and the 60-Day Rule

Moving qualified money between plans avoids current tax if done correctly. A direct (trustee-to-trustee) transfer moves funds without the owner taking possession — no withholding, no limit. An indirect rollover pays the owner, who must redeposit within 60 days or the distribution becomes taxable (plus penalty if under 59½).

Trap: indirect rollovers from an employer plan trigger 20% mandatory withholding, and the owner must make up that 20% from other funds to roll the full amount. There is also a one-rollover-per-12-months limit on IRA-to-IRA indirect rollovers.

Vesting, ERISA, and Defined Benefit Plans

Vesting is the employee's nonforfeitable right to employer contributions. Employee deferrals are always 100% vested; employer contributions may vest on a cliff (e.g., fully after 3 years) or graded schedule. ERISA sets fiduciary, reporting, and participation standards for private qualified plans.

A defined benefit (DB) pension promises a formula-based monthly benefit (e.g., 1.5% × years × final-average salary) and places investment and longevity risk on the employer. A defined contribution (DC) plan promises only the account balance, shifting risk to the employee — the dominant model today.

Qualified-Plan Tax Mechanics and the 10% Penalty

A qualified plan earns favorable tax treatment by meeting IRS/ERISA rules: employer contributions are deductible, growth is tax-deferred, and all distributions are taxed as ordinary income because contributions were pre-tax. A nonqualified plan uses after-tax money, so only the earnings are taxed at distribution.

Distribution Timing Rules

Worked trap: a participant who takes a $50,000 401(k) distribution at age 50 (no exception) owes ordinary income tax plus a $5,000 (10%) penalty. Note the 20% mandatory withholding on an eligible rollover paid to the participant - to roll the full amount, they must replace the withheld 20% from other funds within 60 days, or that portion is taxed and penalized. A direct trustee-to-trustee transfer avoids both the withholding and the 60-day risk, which is why it is the recommended method.