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 favorable tax treatment: contributions are tax-deductible (pre-tax), earnings grow tax-deferred, and distributions are fully taxable as ordinary income because there is no after-tax basis. A non-qualified plan uses after-tax dollars, so only the earnings are taxed on distribution.

Qualified Plan Requirements

• Must be in writing, permanent, 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 meet vesting and eligibility standards under ERISA.

Common Qualified Plan Types

• Defined benefit: promises a specific retirement benefit (e.g., 60% of final salary); the employer bears the investment risk.
• Defined contribution: the contribution is fixed but the benefit varies with investment results; the employee bears the risk.
• 401(k): a salary-reduction defined-contribution plan; employees defer pre-tax salary, often with an employer match.
• SEP (Simplified Employee Pension): the employer contributes to each employee's own IRA; popular with small businesses and the self-employed for its high limits and simple administration.
• 403(b)/TSA: for public schools and nonprofits; Keogh (HR-10) for self-employed.

Individual Retirement Accounts (IRAs)

Traditional vs Roth

Penalties and Timing

• 10% premature distribution penalty on traditional-IRA withdrawals before age 59½ (exceptions: death, disability, qualified first-home, higher education, etc.).
• RMDs must begin by April 1 following the year the owner turns 73; failure triggers an excise penalty.
• Excess contribution over the annual limit is penalized 6% per year until corrected.

TEFRA and Funding with Life Insurance

The Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982 tightened qualified-plan rules and limited how life insurance can be used inside a qualified plan. Life insurance in a qualified plan must be incidental to the plan's primary retirement purpose.

The Incidental Limits

• Whole life: premiums for life insurance may not exceed 50% of the total plan contributions for that participant.
• Term or universal life: the limit is 25% of contributions.
• The pure insurance (P.S. 58) cost of the death benefit is currently taxable to the participant each year.

Worked example. A participant's annual plan contribution is $20,000. Using whole life, no more than $10,000 (50%) may fund life insurance; using term, no more than $5,000 (25%). Exceeding these incidental limits disqualifies the plan.

Exam trap: Remember 50% whole life / 25% term, and that distributions from any qualified plan are 100% taxable because contributions were pre-tax.

Rollovers and the 60-Day Rule

A participant leaving a job can preserve tax deferral by rolling over plan assets into an IRA or new employer plan. A direct (trustee-to-trustee) rollover moves funds without withholding and is the safe choice. An indirect rollover pays the participant, who must redeposit the funds within 60 days or the distribution becomes taxable — and the plan must withhold 20% for federal tax on eligible rollover distributions.

SIMPLE Plans and Vesting

A SIMPLE IRA suits employers with 100 or fewer employees, allowing salary-deferral contributions with a required employer match — simpler than a 401(k). Qualified plans must follow vesting schedules that determine when employer contributions become non-forfeitable; employee deferrals are always 100% vested immediately.

Roth Conversions and Distribution Timing

Funds in a Traditional IRA may be converted to a Roth IRA by paying ordinary income tax on the converted amount now, in exchange for tax-free qualified withdrawals later. A Roth qualified distribution requires the account to be open five years and the owner to be 59½ (or meet death/disability/first-home exceptions). These timing rules are heavily tested alongside the 10% penalty and RMD age of 73.

ERISA Eligibility and Nondiscrimination

ERISA sets minimum standards a qualified plan must satisfy. An employer generally may require an employee to be at least age 21 and to complete up to one year of service before participating. These rules, combined with nondiscrimination and coverage tests, prevent a plan from being structured to benefit only owners and highly compensated employees while excluding rank-and-file workers.

Worked Example — Taxation of a Distribution

A retiree takes a $40,000 distribution from a traditional 401(k) at age 60. Because every dollar went in pre-tax and grew tax-deferred:

The full $40,000 is ordinary income, but no penalty applies because the retiree is past 59½.

Comparison Table — Plan Types

Across all traditional qualified vehicles the punchline is identical: deduct now, defer growth, and pay ordinary income tax on the full distribution later.