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

Qualified Plans, IRAs, and Retirement

A qualified plan is a retirement plan that meets IRS and ERISA requirements and therefore receives favorable tax treatment. The defining features tested on the exam are: contributions are tax-deductible (pre-tax) to the employer/participant, earnings grow tax-deferred, and distributions are fully taxable as ordinary income (because no after-tax basis was created).

Qualified plans must be in writing, permanent, communicated to employees, for the exclusive benefit of employees, and must satisfy non-discrimination rules so they do not unduly favor highly compensated employees. Contrast a non-qualified plan, which uses after-tax dollars, is not subject to ERISA non-discrimination rules, and can selectively benefit executives.

Types of Qualified Plans

• Defined Benefit plan: promises a specific benefit at retirement (e.g., 60% of final salary). The employer bears the investment risk and funding obligation.
• Defined Contribution plan: defines the contribution going in (e.g., a percentage of pay); the eventual benefit depends on investment performance. The employee bears the investment risk. Examples include profit-sharing, money-purchase, and 401(k) plans.
• 401(k): a salary-deferral defined-contribution plan; employees defer pre-tax pay, often with an employer match.
• 403(b) / TSA: tax-sheltered annuity for non-profit and public-school employees.
• SEP (Simplified Employee Pension): an employer funds IRAs for employees; simple to administer, popular with small businesses and the self-employed.
• SIMPLE plan: salary-reduction plan for employers with 100 or fewer employees.

IRAs — Traditional vs. Roth

Both IRAs share an annual contribution limit and require earned income to contribute. A Roth has income (MAGI) eligibility limits; a traditional IRA has no income cap to contribute but income affects deductibility if the person is an active participant in an employer plan.

TEFRA, Penalties, and Required Distributions

TEFRA (1982) tightened qualified-plan and life-insurance-in-plan rules and is often cited as a milestone in retirement-plan regulation; it standardized many contribution and top-heavy concepts that later evolved into modern plan rules.

Key distribution rules to memorize:

• Premature distributions before age 59½ trigger a 10% IRS penalty on the taxable amount (on top of ordinary income tax).
• Penalty exceptions include death, total disability, qualified first-home purchase (IRA, up to $10,000), higher-education expenses (IRA), and substantially equal periodic payments (72(t)).
• Required Minimum Distributions (RMDs) from traditional IRAs and most qualified plans must begin by age 73. Failing to take an RMD historically triggered a steep excise tax on the shortfall.
• Excess contributions to an IRA are subject to a 6% excise tax per year until corrected.

Worked Distribution Example

A 50-year-old takes a $20,000 distribution from a traditional IRA funded entirely with pre-tax dollars (zero basis).

• Because the IRA holds only pre-tax money, the entire $20,000 is taxable as ordinary income.
• The owner is under 59½ and no exception applies, so a 10% penalty = $2,000 is added.
• If the owner is in a 22% bracket, income tax is $4,400, for a total tax cost of $6,400 on the $20,000 withdrawal.

Contrast a Roth IRA distribution after 59½ that meets the 5-year rule: it is entirely tax-free and penalty-free, including all earnings. This is why Roth distributions are so valuable late in retirement — and why Roths have no lifetime RMDs, letting the balance keep growing tax-free.

A final set of plan distinctions appears on the exam. A rollover moves funds between qualified plans/IRAs; a direct trustee-to-trustee transfer avoids withholding, while a 60-day indirect rollover is subject to a 20% mandatory withholding on plan distributions. Keogh (HR-10) plans serve the self-employed, and a 403(b)/TSA is limited to annuities and mutual funds for non-profit and public-school workers.

Remember the producer's duty of suitability: recommending or replacing a client's qualified plan or annuity requires documenting that the recommendation fits the client's age, time horizon, liquidity needs, and tax situation.

Qualified vs. Non-Qualified — The Core Distinction

A qualified plan meets IRS/ERISA rules, so contributions are pre-tax (or deductible), growth is tax-deferred, and all distributions are taxable as ordinary income. A non-qualified plan uses after-tax dollars, so only the gain is taxed later.

Key IRA and Plan Numbers

The IRS sets an annual IRA contribution limit with an extra catch-up for those age 50+. Distributions before 59½ generally incur a 10% penalty; Required Minimum Distributions begin at the statutory age (now 73). A SEP lets employers contribute to employee IRAs; a 401(k) allows employee deferrals with possible employer match; a 403(b)/TSA serves nonprofit and school employees.

Worked Example: A 45-year-old withdraws $20,000 of gain from a traditional IRA. The $20,000 is taxed as ordinary income plus a $2,000 (10%) early-distribution penalty — total tax hit depends on bracket. Exceptions to the penalty include death, disability, first-home purchase (IRA, up to a limit), and qualified higher-education costs.

Exam Tip: Roth withdrawals are tax-free only if the account is 5 years old and the owner is 59½, disabled, or deceased — "qualified" has both an age and a holding-period test.