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

Defined Benefit vs. Defined Contribution

Employer plans divide into two families, and knowing who carries the investment risk is the single most-tested point.

A defined benefit (pension) plan might promise "1.5% x final-average salary x years of service." The employer must contribute whatever the actuary says is needed, so a market downturn is the employer's problem. In a defined contribution plan the worker's nest egg rises and falls with the markets.

The 401(k) Plan

The 401(k) is the dominant private-sector DC plan. Employees elect to defer salary pre-tax (or after-tax into a Roth 401(k)), and employers commonly match.

2025 401(k) Figures

Safe Harbor Designs

A safe harbor 401(k) sidesteps ADP/ACP nondiscrimination testing if the employer makes a guaranteed contribution, such as:

• Basic match: 100% of the first 3% deferred, plus 50% of the next 2%, or
• Nonelective: 3% of pay for every eligible employee.

Worked example: Tomas earns $80,000 and defers 5%. Under the basic safe-harbor match he receives 100% x 3% ($2,400) plus 50% x 2% ($800) = a $3,200 employer contribution.

403(b) Tax-Sheltered Annuities

The 403(b), historically a Tax-Sheltered Annuity (TSA), serves a narrow audience:

• Public school employees (K-12 and universities),
• Employees of 501(c)(3) tax-exempt nonprofits, and
• Certain churches and ministers.

Deferral limits mirror the 401(k) ($23,500 in 2025), but a 403(b) adds a unique 15-years-of-service catch-up of up to $3,000 per year (lifetime cap $15,000) for long-tenured employees of eligible employers. Investments are limited to annuities and mutual-fund custodial accounts.

Trap: A public school teacher participates in a 403(b), not a 401(k). Watch for answer choices that swap the two.

SEP and SIMPLE Plans

Small employers favor two streamlined IRA-based plans.

Simplified Employee Pension (SEP)

Savings Incentive Match Plan for Employees (SIMPLE)

Worked example: A SIMPLE participant earning $50,000 who defers 3% gets a dollar-for-dollar $1,500 match. The same person leaving the SIMPLE within two years and cashing out faces a 25% penalty instead of the usual 10%.

Profit-Sharing and Money Purchase Plans

Two classic DC designs round out the employer toolbox.

• Profit-sharing plan: employer contributions are discretionary. The company can skip a contribution in a lean year. Allocations are capped at 25% of covered payroll and $70,000 per participant.
• Money purchase plan: the employer commits to a fixed percentage each year — even in bad years — making it more rigid than profit-sharing.

Exam Tip: "Flexibility" is the keyword for profit-sharing; "mandatory fixed percentage" signals money purchase.

SEP and SIMPLE Side by Side

Both are easy-to-administer IRA-based plans with immediate vesting. A SEP is funded entirely by the employer; a SIMPLE allows employee salary deferrals plus a mandatory employer contribution. Contributions are pre-tax and grow tax-deferred until withdrawal.

403(b) Eligibility and the Roth 401(k)

A 403(b) (tax-sheltered annuity) is available only to employees of public schools, 501(c)(3) nonprofits, and certain church organizations. Historically funded with annuities and mutual funds, it works much like a 401(k) for deferral and taxation.

Many 401(k) and 403(b) plans now offer a Roth option: contributions are after-tax, but qualified distributions (account held 5 years and owner age 59 1/2) are tax-free, mirroring the Roth IRA. Pre-tax (traditional) deferrals reduce current taxable wages but produce fully taxable distributions later.

Exam Tip: Match the plan to the employer 401(k) for for-profit firms, 403(b) for schools/nonprofits, SEP/SIMPLE for small employers and remember employer contributions are pre-tax and immediately growing tax-deferred.

Vesting and Taxation of Distributions

Employee salary deferrals are always 100% vested; employer contributions may follow a vesting schedule (e.g., 3-year cliff or 2-to-6-year graded). Pre-tax contributions and earnings are taxed as ordinary income when distributed; qualified Roth account distributions are tax-free.

Pre-age-59 1/2 distributions usually incur the 10% early-withdrawal penalty unless an exception applies, and traditional accounts are subject to RMDs at the applicable age.

Exam Tip: Employee deferrals vest immediately; employer money can be on a vesting schedule. Pre-tax distributions are ordinary income with possible 10% penalty before 59 1/2.