8.4 Qualified Plans, IRAs, and Retirement (TEFRA/SEP/401k)
Key Takeaways
- Qualified plans give pre-tax (deductible) contributions, tax-deferred growth, and fully taxable distributions.
- Early distributions before 59 1/2 incur a 10% penalty; RMDs begin at age 73.
- TEFRA created the top-heavy test: a plan is top-heavy when over 60% of benefits go to key employees.
- SEP-IRAs are employer-funded and 100% vested; SIMPLE plans (<=100 employees) allow deferrals plus employer match.
- Direct (trustee-to-trustee) rollovers avoid the mandatory 20% withholding triggered by 60-day indirect rollovers.
Qualified Plans, IRAs, and Retirement
A qualified plan meets IRS and ERISA requirements and earns three tax advantages: deductible (pre-tax) contributions, tax-deferred growth, and taxation only at distribution. Because contributions go in pre-tax, qualified-plan distributions are fully taxable as ordinary income (the basis is zero).
Qualified Plan Basics
To be qualified, a plan must generally satisfy:
- Nondiscrimination — cannot favor highly compensated employees or owners.
- Coverage and eligibility — must cover a broad cross-section of employees.
- Vesting — employee contributions are always 100% vested; employer contributions vest on an IRS schedule.
- Funding and fiduciary standards under ERISA.
Distributions before age 59 1/2 trigger a 10% penalty plus ordinary income tax (exceptions: death, disability, IRS Rule 72(t) equal payments, certain medical/first-home rules for IRAs). Required Minimum Distributions (RMDs) must begin by age 73 (SECURE 2.0); failure incurs an excise tax.
Types of Qualified Plans
| Plan | Type | Key trait |
|---|---|---|
| Defined benefit (pension) | Employer-funded | Guarantees a formula benefit; employer bears investment risk |
| 401(k) | Defined contribution | Employee salary deferral, often with employer match |
| 403(b) / TSA | Defined contribution | For schools and 501(c)(3) nonprofits |
| Profit-sharing | Defined contribution | Discretionary employer contributions |
| Keogh (HR-10) | Self-employed | For unincorporated businesses |
TEFRA and Top-Heavy Rules
TEFRA (Tax Equity and Fiscal Responsibility Act of 1982) tightened qualified-plan rules to curb plans that disproportionately benefited owners. It introduced top-heavy testing: a plan is top-heavy when more than 60% of plan assets/benefits belong to key employees (owners and highly paid officers). A top-heavy plan must provide minimum contributions and accelerated vesting for non-key employees. TEFRA also reduced contribution/benefit limits and tightened loan rules. On the exam, link TEFRA with the 60% top-heavy threshold.
SEP and SIMPLE Plans
- SEP-IRA (Simplified Employee Pension). The employer contributes to each eligible employee's own IRA. Contributions are employer-only, are immediately 100% vested, and allow much higher limits than a regular IRA. Ideal for small businesses and the self-employed because of minimal paperwork.
- SIMPLE plan. For employers with 100 or fewer employees; allows employee salary deferrals plus a required employer match (or non-elective contribution).
Individual Retirement Accounts (IRAs)
| Traditional IRA | Roth IRA | |
|---|---|---|
| Contributions | May be tax-deductible | After-tax (never deductible) |
| Growth | Tax-deferred | Tax-free |
| Qualified withdrawals | Fully taxable | Tax-free (5-year rule + age 59 1/2) |
| RMDs | Required at 73 | None during owner's life |
| Income limits | Deduction phases out if covered by a plan | Contribution phases out at high income |
Worked 401(k) / Distribution Example
Tom, age 50, takes a $40,000 distribution from his traditional 401(k) before retirement. Because all contributions and growth are pre-tax (zero basis), the entire $40,000 is ordinary income, and because he is under 59 1/2, a 10% penalty ($4,000) applies — total federal hit is income tax on $40,000 plus the $4,000 penalty. A direct rollover to an IRA would have avoided both.
Rollover Trap
A 60-day (indirect) rollover triggers mandatory 20% withholding on the distribution; the participant must replace that 20% from other funds to roll the full amount, or the shortfall is taxed and penalized. A trustee-to-trustee (direct) rollover avoids withholding entirely — the preferred method. Only one indirect IRA-to-IRA rollover is permitted per 12-month period; direct transfers are unlimited.
Funding Qualified Plans with Annuities and Life
Insurance products are common qualified-plan funding vehicles. A 403(b) Tax-Sheltered Annuity (TSA) funds retirement for public-school and nonprofit employees through annuity or mutual-fund contracts. When life insurance is held inside a qualified plan, the participant must report the annual cost of the pure insurance protection (the P.S. 58 / Table 2001 cost) as current taxable income — life insurance in a plan must be incidental to the retirement purpose.
Non-Qualified Plans Contrast
A non-qualified plan (such as deferred compensation or an executive bonus / Section 162 plan) does not meet IRS qualification rules, so it can discriminate in favor of select executives. Trade-off: employer contributions are generally not deductible until the employee is taxed, and there is no up-front deduction. The exam loves the contrast — qualified = nondiscriminatory + immediately deductible; non-qualified = selective + deferred deduction.
Distribution Triggers Recap
| Event | Tax treatment |
|---|---|
| Distribution before 59 1/2 | Ordinary income + 10% penalty |
| Distribution after 59 1/2 | Ordinary income, no penalty |
| RMD not taken by 73 | Excise tax on the shortfall |
| Direct rollover | No tax, no withholding |
| 60-day indirect rollover | 20% mandatory withholding |
Defined Benefit vs Defined Contribution
The exam repeatedly contrasts the two plan structures. In a defined benefit (pension) plan, the benefit is fixed by a formula (such as years of service times final-average salary), and the employer bears the investment risk of funding that promise. In a defined contribution plan (401(k), profit-sharing, SEP, SIMPLE), only the contribution is defined; the eventual benefit depends on investment performance, so the employee bears the investment risk. Defined contribution plans dominate today because they shift risk off employer balance sheets.
Worked SEP Contribution Example
Dana is self-employed and uses a SEP-IRA. Because SEP contributions are employer (business) contributions to her own IRA, they are immediately 100% vested and deductible by the business, and the percentage applied must be uniform across eligible employees. If she also employs two staff, she must contribute the same percentage of compensation to their SEP-IRAs that she contributes for herself — a key nondiscrimination feature that distinguishes a SEP from a personal IRA.
Quick Reference: Plan Selection
| Situation | Typical fit |
|---|---|
| Self-employed, minimal admin | SEP-IRA or Keogh |
| Small employer (<=100), wants deferrals | SIMPLE plan |
| Mid/large employer, salary deferral + match | 401(k) |
| School/nonprofit employee | 403(b) TSA |
| Wants employer-guaranteed pension | Defined benefit |
| Select executives only, can discriminate | Non-qualified deferred comp |
A plan is considered top-heavy under TEFRA when what portion of plan benefits is attributable to key employees?
Which statement correctly distinguishes a Roth IRA from a traditional IRA?