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

Qualified vs. Non-Qualified Plans

A qualified plan meets IRS and ERISA requirements and receives favorable tax treatment: contributions are tax-deductible (pre-tax), earnings grow tax-deferred, and distributions are taxed as ordinary income in retirement. A non-qualified plan is funded with after-tax dollars and does not meet ERISA's nondiscrimination rules — only earnings are tax-deferred.

Hallmarks of a Qualified Plan

• IRS approval and a written plan document.
• Nondiscrimination — cannot favor highly compensated employees or owners.
• Vesting — employer contributions vest on a schedule (e.g., 3-year cliff or 2-to-6-year graded).
• Contribution limits set annually by the IRS.

The exam emphasizes the tax flow: pre-tax in, tax-deferred growth, ordinary-income out, with a 10% penalty on distributions before age 59 1/2 and required minimum distributions (RMDs) beginning at age 73.

Common Plan Types

SEP IRAs and SIMPLE Plans

A SEP (Simplified Employee Pension) lets an employer contribute to each eligible employee's IRA. Contributions are employer-made, deductible, and discretionary year to year — popular with self-employed producers because of high limits and minimal paperwork.

A SIMPLE IRA suits small employers and requires either a matching or a fixed non-elective employer contribution.

TEFRA and Plan History

TEFRA (Tax Equity and Fiscal Responsibility Act of 1982) tightened the rules on qualified plans — reducing contribution limits, adding top-heavy plan rules, and pulling Keogh limits closer to corporate plan limits. The exam may simply ask you to associate TEFRA with the introduction of top-heavy rules (special vesting/minimum-benefit rules when key employees hold more than 60% of plan assets).

Traditional vs. Roth IRAs

Individual Retirement Accounts let individuals save for retirement outside an employer plan.

Worked Example: Excess Contribution Penalty

If an individual contributes more than the annual IRA limit, the excess contribution is subject to a 6% excise tax for each year it remains in the account. Contribute $1,000 over the limit and leave it in: the penalty is $60 per year until corrected.

Distribution Rules That Get Tested

• Premature distribution (before 59 1/2): 10% penalty plus ordinary income tax, with exceptions for death, disability, first-home (up to $10,000), and qualified education.
• RMDs must begin by April 1 following the year the owner turns 73; failure to take an RMD triggers an excise penalty on the shortfall.
• Roth qualified distributions require the account be held 5 years AND the owner be 59 1/2 (or death/disability/first home).

Rollovers vs. Transfers

Moving retirement money is heavily tested. A direct trustee-to-trustee transfer moves funds between custodians with no tax and no limit on frequency. An indirect (60-day) rollover pays the funds to the participant, who must redeposit within 60 days or the distribution becomes taxable plus penalty; employer plans must also withhold 20% on the distributable amount. Only one indirect IRA-to-IRA rollover is allowed per 12-month period across all IRAs.

Beneficiary and Survivor Rules

Qualified plan distributions to a surviving spouse can be rolled into the spouse's own IRA, continuing deferral. Non-spouse beneficiaries generally must empty an inherited account within 10 years under current rules. A qualified plan generally requires a qualified joint-and-survivor annuity (QJSA) as the default payout for married participants, and the spouse must consent in writing to waive it.

Defined Benefit vs. Defined Contribution

In a defined benefit plan the employer bears the investment risk and promises a formula-based benefit; in a defined contribution plan (401(k), profit-sharing) the employee bears the investment risk and the account value at retirement is whatever the contributions plus earnings produce. This risk-shift is a common exam contrast.

IRA Types and Contribution Mechanics

The exam tests the contrast between a Traditional IRA (contributions may be tax-deductible, growth tax-deferred, distributions fully taxable, RMDs begin at the statutory age) and a Roth IRA (contributions are after-tax and non-deductible, growth is tax-free, qualified distributions are tax-free, and no lifetime RMDs). Both impose a 10% early-withdrawal penalty before age 59 1/2 with limited exceptions (first home, qualified education, disability, certain medical costs).

Employer Plans: 401(k), 403(b), SEP, and SIMPLE

A 401(k) allows pre-tax (or Roth) salary deferral, often with employer match; a 403(b) is the tax-sheltered annuity equivalent for public-school and nonprofit employees; a SEP lets employers contribute to employee IRAs; and a SIMPLE suits small employers with mandatory employer contributions. All defer tax on growth and tax distributions as ordinary income.

Worked Penalty Calculation

A 45-year-old withdraws $20,000 from a Traditional IRA for non-exempt personal use. The withdrawal is added to ordinary income and incurs a 10% penalty of 0.10 x $20,000 = $2,000, on top of income tax on the full $20,000. Had it been a Roth IRA, the portion representing his contributions could come out tax- and penalty-free, but the earnings withdrawn early would face both tax and the 10% penalty.

ERISA Protections and Nondiscrimination

Qualified plans must follow ERISA: written plan documents, IRS approval, nondiscrimination in favor of highly compensated employees, vesting schedules, and fiduciary duties for plan trustees.

Additional Exam Traps

• Roth distributions are tax-free and have no lifetime RMDs; Traditional are taxable with RMDs.
• The 10% penalty applies before 59 1/2 unless an exception applies.
• Qualified-plan distributions are ordinary income, never capital gains.