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

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

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)

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.

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.