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

Qualified vs. Non-Qualified Retirement Plans

A qualified plan meets IRS and ERISA requirements and earns favorable tax treatment: employer contributions are tax-deductible, earnings grow tax-deferred, and employees defer tax until distribution. The trade-off is strict rules on nondiscrimination, vesting, contribution limits, and distributions. A non-qualified plan (such as deferred compensation or a top-hat plan) can favor select executives and skip many rules, but employer contributions are generally not deductible until benefits are paid.

Key Qualified-Plan Characteristics

• Pre-tax contributions reduce current taxable income.
• Tax-deferred growth until withdrawal.
• Fully taxable distributions as ordinary income (no basis when funded entirely pre-tax).
• 10% early-withdrawal penalty before age 59½ (exceptions: death, disability, certain medical, separation from service at 55+).
• Required Minimum Distributions (RMDs) must begin by April 1 following the year the owner reaches the applicable RMD age. A missed RMD historically triggered a steep excise penalty.

These mirror annuity and MEC penalty themes — pre-59½ access is consistently penalized.

Common Plan Types

A SEP (Simplified Employee Pension) is employer-funded into employee IRAs and is popular with the self-employed because of its high contribution ceiling and minimal administration.

TEFRA and the Regulatory Backdrop

The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) is frequently tested as the law that tightened the tax treatment of contributions and distributions, equalized contribution limits between corporate plans and Keogh/HR-10 plans, and (alongside later acts) reinforced the 10% premature-distribution concept. It is part of a chain of legislation — ERISA (1974) established participation, vesting, and fiduciary standards; TEFRA (1982) tightened limits; and TAMRA (1988) later created the MEC. Recognize TEFRA as the parity and tightening statute for retirement plan contribution limits.

Traditional vs. Roth IRAs

• Traditional IRA: contributions may be tax-deductible; growth is tax-deferred; distributions are fully taxable; 10% penalty before 59½; RMDs apply.
• Roth IRA: contributions are after-tax (nondeductible); qualified distributions are entirely tax-free (account open 5 years and owner 59½+); no RMDs during the owner's lifetime.

Both share an annual contribution limit (with catch-up contributions at 50+). Roth eligibility phases out at higher incomes. The exam contrasts 'pay tax now' (Roth) versus 'pay tax later' (Traditional).

Worked Distribution Example

A 50-year-old takes a $20,000 distribution from a Traditional IRA funded entirely with deductible (pre-tax) contributions. Because there is no basis, the entire $20,000 is taxable as ordinary income. The owner is under 59½ with no exception, so a 10% penalty applies: $20,000 × 10% = $2,000.

Total cost beyond ordinary income tax = $2,000 penalty. Contrast a Roth: a qualified $20,000 Roth distribution (5-year rule met, age 59½+) would be entirely tax-free and penalty-free, because the contributions were already taxed and qualified earnings escape tax.

ERISA: Participation, Vesting, and Fiduciary Duty

ERISA (1974) sets the federal floor for qualified plans and is heavily tested. Core protections include:

• Eligibility/participation: an employee generally must be allowed to participate at age 21 with one year of service.
• Vesting: rules guarantee that employees gain a nonforfeitable right to employer contributions over time (employee salary deferrals are always 100% vested immediately).
• Nondiscrimination: plans may not unduly favor highly compensated employees.
• Fiduciary standard: plan trustees must act prudently and solely in participants' interest.
• Reporting and disclosure: participants receive a Summary Plan Description.

ERISA does not apply to government or church plans, and most individual (non-employer) IRAs fall outside it.

Rollovers and Distribution Timing

When leaving an employer, a participant can move qualified money without current tax via a rollover. A direct (trustee-to-trustee) rollover avoids withholding entirely. A 60-day (indirect) rollover sends funds to the participant first; the plan must withhold 20% for taxes, and the participant has 60 days to deposit the full amount (replacing the withheld 20% from other funds) into another qualified plan or IRA — or the shortfall is taxed and possibly penalized.

Distribution options at retirement include lump sum, periodic installments, or annuitization. A lump sum is fully taxable in the year received unless rolled over, which is why rollovers are the default planning move. RMDs cannot be rolled over.

Traditional vs. Roth and Plan Types

The exam expects a clean contrast between traditional and Roth treatment. Traditional IRA and 401(k) contributions are pre-tax (or deductible), grow tax-deferred, and are fully taxed as ordinary income on withdrawal, with RMDs required once the owner reaches the applicable age. Roth contributions are after-tax, so qualified withdrawals of both contributions and earnings are entirely tax-free, and a Roth IRA has no lifetime RMD for the original owner.

Work a comparison: $7,000 placed in a traditional IRA lowers this year's taxable income but produces taxable withdrawals in retirement, while the same $7,000 in a Roth gives no deduction now but tax-free income later, so the choice turns on whether the client expects a higher or lower tax bracket in retirement.

Know the plan landscape the exam samples. Qualified employer plans divide into defined-benefit plans, which promise a formula-based pension and place investment risk on the employer, and defined-contribution plans such as the 401(k), where the account balance and thus the risk belong to the employee. A SEP IRA lets a small employer contribute to employee IRAs with high limits; a SIMPLE IRA suits employers with 100 or fewer employees and allows employee deferrals plus a mandatory employer match. A 403(b) or TSA serves nonprofit and public-school employees, and a 457 plan serves government workers.

Qualified plans must satisfy ERISA nondiscrimination, vesting, and reporting rules, and all of them share the 10% early-distribution penalty before 59 1/2 with the familiar exceptions for death, disability, and substantially equal periodic payments.