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

What Makes a Plan 'Qualified'

A qualified retirement plan meets IRS and ERISA requirements and therefore earns favorable tax treatment. The defining features tested on the exam are:

• Pre-tax contributions: Employer and employee contributions are made with before-tax dollars (or are deductible), reducing current taxable income.
• Tax-deferred growth: Earnings accumulate without current taxation.
• Fully taxable distributions: Because contributions were never taxed, 100% of distributions are taxed as ordinary income — there is no basis.
• Non-discrimination: The plan must not favor highly compensated employees and must follow approved vesting schedules.

Contrast this with a non-qualified plan, which uses after-tax dollars, can discriminate (e.g., a deferred-comp plan for executives), and is not subject to the same ERISA rules.

IRAs — Traditional vs. Roth

Individual Retirement Arrangements let individuals save independently of an employer:

Key numbers: distributions before age 59½ generally incur a 10% penalty plus ordinary income tax (Traditional). Excess contributions are subject to a 6% excise tax per year until corrected. A Roth requires the account to be held 5 years and the owner to be 59½ for fully tax-free earnings.

TEFRA and the Early/Late Distribution Rules

The Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982 tightened retirement-plan rules and is the source of several exam facts, including reduced contribution limits for certain plans and parity between corporate and self-employed (Keogh/HR-10) plans.

Distribution timing rules to memorize:

• Pre-59½: 10% early-distribution penalty on the taxable amount (exceptions: death, disability, qualifying first-home up to $10,000 for IRAs, certain medical expenses).
• Age 73: Required Minimum Distributions (RMDs) must begin (the SECURE Act 2.0 raised the start age to 73). Failure to take an RMD triggers an excise tax on the shortfall.
• Keogh (HR-10): A qualified plan for self-employed individuals and unincorporated businesses.

Employer-Sponsored Plans: SEP, SIMPLE, and 401(k)

The exam expects you to distinguish the common employer plan types:

• SEP IRA (Simplified Employee Pension): The employer contributes to each eligible employee's IRA. Easy to administer for small businesses; contribution limits are far higher than a regular IRA. Employees are immediately 100% vested.
• SIMPLE IRA: For small employers (generally ≤100 employees); allows employee salary deferrals plus a mandatory employer match or contribution.
• 401(k): A cash-or-deferred arrangement (CODA) letting employees defer salary pre-tax (or Roth after-tax), often with an employer match. Subject to annual deferral limits and non-discrimination testing.
• 403(b) / TSA: A tax-sheltered annuity for public schools and 501(c)(3) nonprofit employees, functionally similar to a 401(k).

Defined Benefit vs. Defined Contribution

A final classification candidates must know:

In a defined benefit plan the employer promises a specific retirement income and bears the investment risk. In a defined contribution plan only the input is defined; the eventual benefit depends on investment performance, so the employee bears the investment risk. A common trap is reversing who carries the risk.

Rollovers and Vesting

When an employee leaves a job, qualified-plan assets can be moved without current tax through a rollover. A direct (trustee-to-trustee) rollover moves funds straight to the new plan or IRA with no withholding. An indirect rollover pays the participant, who must redeposit the full amount within 60 days — and the plan withholds 20% that the participant must replace from other funds to avoid taxation on the shortfall.

Vesting determines how much of the employer's contributions the employee keeps on departure. Employee deferrals are always 100% vested immediately. Employer contributions may follow a cliff schedule (fully vested after a set number of years) or graded schedule (vesting in increasing percentages). SEP and SIMPLE contributions are always immediately and fully vested — a frequently tested distinction.

Required Minimum Distributions and Contribution Caps

Qualified plans and traditional IRAs require required minimum distributions (RMDs) beginning at the statutory age (currently 73); failing to take an RMD triggers a steep excise penalty on the shortfall. Roth IRAs have no RMDs during the owner's lifetime because contributions were already taxed — a frequent exam contrast.

ERISA and Top-Heavy Protections

Employer qualified plans are governed by ERISA, which imposes fiduciary duties, reporting and disclosure (the summary plan description), and non-discrimination testing so plans do not favor highly compensated employees. Contributions are made with pre-tax dollars, grow tax-deferred, and are taxed as ordinary income on distribution. The exam contrasts this with a non-qualified plan, which uses after-tax dollars, can legally discriminate in favor of key executives, and does not require IRS approval.

403(b), 457, and the Catch-Up Rules

Two specialized salary-reduction plans appear on the exam alongside the 401(k). A 403(b) (TSA/tax-sheltered annuity) is available to employees of public schools and 501(c)(3) nonprofits and historically funded only with annuities or mutual funds.

A 457(b) plan serves state and local government and certain nonprofit employees and is unique in that early distributions on separation from service are not subject to the 10% pre-59 1/2 penalty. Participants age 50 and older may make additional catch-up contributions above the normal elective-deferral limit. The exam tests who is eligible for a 403(b) (educators/nonprofits) versus a 457 (government).

Keogh (HR-10) and the Self-Employed

A Keogh (HR-10) plan is a qualified retirement plan for the self-employed and unincorporated businesses, allowing larger deductible contributions than an IRA. Like other qualified plans, Keogh contributions are pre-tax, grow tax-deferred, and are taxed as ordinary income on distribution, with the same 59 1/2 and RMD rules. Recognizing the Keogh as the self-employed counterpart to a corporate qualified plan is a recurring exam point.