8.4 Qualified Plans, IRAs, and Retirement (TEFRA/SEP/401k)
Key Takeaways
- Qualified plans offer deductible employer contributions, pre-tax employee contributions, and tax-deferred growth in exchange for nondiscrimination, vesting, and ERISA reporting.
- TEFRA introduced top-heavy testing: a plan is top-heavy when more than 60% of assets belong to key employees.
- SEP IRAs are employer-funded for small businesses; 457(b) plans offer a special pre-retirement catch-up and avoid the 10% early-distribution penalty (governmental).
- The 2025 combined Traditional/Roth IRA limit is $7,000 ($1,000 catch-up at 50+); 401(k) elective deferral is $23,500 ($7,500 catch-up).
- RMDs begin at age 73 for Traditional IRAs and most qualified plans; Roth IRAs have no lifetime RMDs and offer tax-free qualified distributions.
What Makes a Plan "Qualified"
A qualified plan meets IRS and ERISA requirements and therefore earns powerful tax advantages: employer contributions are tax-deductible, employee contributions are pre-tax, and earnings grow tax-deferred until distribution. In exchange, the plan must satisfy nondiscrimination, coverage, vesting, and reporting rules so it does not favor highly compensated employees.
Core Qualified-Plan Requirements
- Nondiscrimination: the plan cannot favor highly compensated or key employees.
- Vesting: employer contributions must vest under an approved schedule (e.g., 3-year cliff or 2-to-6-year graded). Employee contributions are always 100% vested immediately.
- Eligibility: generally age 21 and one year of service.
- ERISA reporting: a Summary Plan Description (SPD) must be provided to participants.
- Funding standards: the plan must be funded through a trust or insurance contract, segregating assets from the employer.
These rules exist because the favorable tax treatment is a federal subsidy; in return, Congress requires that rank-and-file workers — not just owners and executives — actually benefit. A plan that fails these tests can be disqualified, retroactively making employer contributions taxable to employees and stripping the deduction.
TEFRA (1982) tightened qualified-plan rules and introduced top-heavy testing. A plan is top-heavy when more than 60% of plan assets belong to key employees, triggering minimum-contribution and faster-vesting requirements for non-key employees.
Defined Benefit vs. Defined Contribution
| Feature | Defined Benefit | Defined Contribution |
|---|---|---|
| Promises | A fixed retirement benefit | A fixed contribution |
| Investment risk | Employer | Employee |
| Examples | Traditional pension | 401(k), profit-sharing, money-purchase |
Types of Qualified Plans
- 401(k): employee elective deferrals (pre-tax or Roth), often with an employer match. 2025 elective deferral limit: $23,500, plus a $7,500 catch-up for age 50+.
- 403(b) (TSA): for public schools and 501(c)(3) nonprofits; similar to a 401(k).
- 457(b): for state/local government and certain tax-exempt employers. Its catch-up is unique — a participant within 3 years of normal retirement age may use a special catch-up to roughly double the limit, and (because it is not technically a qualified plan) early distributions from a governmental 457(b) avoid the 10% penalty.
- SEP IRA (Simplified Employee Pension): the employer contributes to each employee's IRA; ideal for small businesses and the self-employed. Higher employer limits, minimal paperwork.
- SIMPLE IRA: for employers with 100 or fewer employees; allows employee deferrals plus a mandatory employer match.
- Profit-sharing / money-purchase: employer-funded defined contribution plans.
Individual Retirement Accounts (IRAs)
| Traditional IRA | Roth IRA | |
|---|---|---|
| Contributions | May be deductible | After-tax (never deductible) |
| Growth | Tax-deferred | Tax-free |
| Qualified distributions | Taxable | Tax-free |
| RMDs | Begin at age 73 | None during owner's life |
| Income limits | Deduction phases out if covered by a plan | Contribution phases out at higher income |
2025 combined IRA contribution limit: $7,000, plus a $1,000 catch-up for age 50+. The limit is combined across Traditional and Roth — you cannot contribute the full amount to each.
Distribution Rules and Penalties
- 10% early-withdrawal penalty applies to taxable distributions before age 59½, with exceptions (death, disability, first-home up to $10,000, qualified education, substantially equal periodic payments, certain medical).
- Required Minimum Distributions (RMDs): Traditional IRAs and most qualified plans must begin RMDs at age 73. Failure to take an RMD historically carried a 50% excise tax on the shortfall (reduced to 25%, or 10% if promptly corrected, under SECURE 2.0).
- Roth qualified distribution: tax-free if the account is 5 years old AND the owner is 59½ (or death, disability, first home).
Worked Example: Deductibility Trap
Sarah, age 45, is covered by her employer's 401(k) and earns above the phase-out range. She contributes $7,000 to a Traditional IRA. Because she is an active participant in a workplace plan and her income is high, her Traditional IRA deduction is phased out — she may still contribute, but it becomes a nondeductible contribution. A Roth (if she is under the Roth income limit) is often the better choice.
Rollovers and the SECURE Act
Moving retirement money between plans is tax-free if done correctly. A direct rollover (trustee-to-trustee) avoids withholding entirely. An indirect rollover (a check paid to the participant) triggers a mandatory 20% withholding on qualified-plan distributions and must be completed within 60 days, or it becomes a fully taxable distribution plus a possible penalty.
The SECURE Act pushed the RMD age to 73 and eliminated the lifetime "stretch" for most non-spouse beneficiaries, who now must empty an inherited account within 10 years. Eligible designated beneficiaries — a surviving spouse, minor child, disabled or chronically ill person, or someone not more than 10 years younger — may still use the life-expectancy stretch. SECURE 2.0 also reduced the missed-RMD excise tax from 50% to 25% (10% if corrected promptly).
Qualified vs. Nonqualified and Required Minimum Distributions
A qualified plan meets ERISA/IRS rules for favorable tax treatment: contributions are generally pre-tax (deductible), growth is tax-deferred, and all distributions are taxed as ordinary income because nothing was taxed going in. A nonqualified plan uses after-tax dollars, so only the earnings are taxed at withdrawal.
| Feature | Qualified | Nonqualified |
|---|---|---|
| Contributions | Pre-tax / deductible | After-tax |
| Taxed at distribution | Entire distribution | Earnings only |
| RMDs apply | Yes | No (except inherited) |
| IRS approval / nondiscrimination | Required | Not required |
Required Minimum Distributions (RMDs) must begin from traditional IRAs and qualified plans by April 1 following the year the owner turns 73 (SECURE 2.0). Missing an RMD triggers an excise tax (reduced to 25%, or 10% if corrected promptly). Roth IRAs have no RMDs during the owner's life and offer tax-free qualified withdrawals after 59 1/2 and a 5-year holding period.
A plan is considered "top-heavy" under TEFRA when what percentage of plan assets belongs to key employees?
Sarah, age 45, is an active participant in her employer's 401(k) and has high income above the IRA deduction phase-out. She contributes $7,000 to a Traditional IRA. What is the result?