11.3 Employer Plans: 401(k), 403(b), SEP, SIMPLE, Pension/Profit-Sharing
Key Takeaways
- Defined benefit (pension) plans promise a formula-based benefit and put investment risk on the employer; defined contribution plans promise only a contribution and shift risk to the employee.
- 401(k) plans allow pre-tax (or Roth) salary deferrals — $23,500 in 2025 — often with an employer match; safe harbor designs automatically pass ADP/ACP testing.
- 403(b) tax-sheltered annuities serve public schools and 501(c)(3) nonprofits and offer a special 15-years-of-service catch-up.
- Simplified Employee Pension (SEP) plans are employer-funded only, capped at the lesser of 25% of pay or the annual additions limit, with minimal paperwork.
- Savings Incentive Match Plan for Employees (SIMPLE) plans suit employers with 100 or fewer workers, with a $16,500 deferral and a mandatory match or nonelective contribution.
Defined Benefit vs. Defined Contribution
Employer plans divide into two families, and knowing who carries the investment risk is the single most-tested point.
| Feature | Defined Benefit (DB) | Defined Contribution (DC) |
|---|---|---|
| What is promised | A specific retirement benefit | Only the contribution amount |
| Investment risk | Employer | Employee |
| Benefit known in advance? | Yes (formula) | No (depends on returns) |
| Funding | Actuarially determined | Fixed or discretionary |
| Pension Benefit Guaranty Corporation (PBGC) insured? | Yes | No |
| Examples | Traditional pension | 401(k), profit-sharing, SEP |
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
| Item | Amount |
|---|---|
| Employee elective deferral | $23,500 |
| Catch-up (age 50+) | $7,500 |
| Total annual additions (all sources) | $70,000 |
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)
| Feature | Detail |
|---|---|
| Who funds it | Employer only |
| Limit (2025) | Lesser of 25% of pay or $70,000 |
| Employee deferrals | Not allowed |
| Paperwork | No Form 5500 |
Savings Incentive Match Plan for Employees (SIMPLE)
| Feature | Detail |
|---|---|
| Employer size | 100 or fewer employees |
| Employee deferral (2025) | $16,500 |
| Catch-up (age 50+) | $3,500 |
| Employer choice | Match up to 3% of pay OR 2% nonelective for all |
| Early penalty | 25% if withdrawn within first 2 years |
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.
| Plan | Contribution Style | Risk to Employer |
|---|---|---|
| Profit-sharing | Flexible / discretionary | Low |
| Money purchase | Mandatory fixed % | Higher (must pay) |
| Defined benefit | Actuarially required | Highest |
Exam Tip: "Flexibility" is the keyword for profit-sharing; "mandatory fixed percentage" signals money purchase.
A nonprofit hospital that is a 501(c)(3) organization wants to offer its nurses a salary-deferral retirement plan with a special catch-up for employees with 15+ years of service. Which plan is designed for this employer?
An employer establishes a plan that promises each retiree '2% of final-average salary multiplied by years of service' and bears all investment risk to fund that promise. What type of plan is this?
SEP and SIMPLE Side by Side
| Feature | SEP IRA | SIMPLE IRA |
|---|---|---|
| Best for | Self-employed / small employer | Employer with <=100 employees |
| Who contributes | Employer only | Employee deferrals + employer match/nonelective |
| Employer match | Not required | Required (match up to 3% or 2% nonelective) |
| Vesting | Immediate | Immediate |
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.
Which employer retirement plan is funded entirely by employer contributions and allows no employee salary deferrals?
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.
| Money Type | Taxed When Distributed? |
|---|---|
| Pre-tax deferrals + earnings | Yes, as ordinary income |
| Qualified Roth | No (tax-free) |
| After-tax basis | Return of basis tax-free |
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.