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

Qualified retirement plans receive favorable tax treatment in exchange for meeting ERISA and Internal Revenue Code requirements. The exam expects you to distinguish qualified from non-qualified plans, know contribution and distribution rules, and identify the major plan types (401(k), SEP, SIMPLE) and IRA rules.

Qualified vs Non-Qualified Plans

The defining trait: qualified plan contributions are tax-deductible and pre-tax, so there is no cost basis, and the entire distribution is taxed as ordinary income.

Qualified Plan Requirements

• Nondiscrimination — cannot favor highly compensated employees.
• Vesting — employees gain non-forfeitable rights on a schedule (e.g., 3-year cliff or 2-to-6-year graded).
• Eligibility — generally age 21 and 1 year of service.
• Funding & fiduciary standards under ERISA.

TEFRA and the Distribution Rules

The Tax Equity and Fiscal Responsibility Act (TEFRA) and later acts shaped distribution timing:

• 10% early-withdrawal penalty on taxable distributions before age 59½ (exceptions: death, disability, certain medical, qualified first-home for IRAs, etc.).
• Required Minimum Distributions (RMDs) must begin by April 1 following the year the owner reaches the current RMD age (raised to 73 under SECURE 2.0). Failure to take an RMD triggers an excise penalty (reduced to 25%, or 10% if corrected timely).

Major Employer Plan Types

Individual Retirement Accounts (IRAs)

Worked numeric — Traditional IRA distribution. A retiree contributed $60,000 (all deducted) and the account grew to $90,000. Because all contributions were pre-tax (no basis), the entire $90,000 is taxable as ordinary income as it is withdrawn. Contrast a Roth: after the 5-year/age-59½ test, the full $90,000 comes out completely tax-free.

Exam traps:

• Roth has no lifetime RMDs; Traditional IRAs do.
• Qualified plan distributions are 100% ordinary income (no capital gains treatment, no basis) because contributions were pre-tax.
• The 10% penalty applies to the taxable portion only and is in addition to ordinary income tax.
• SEP and SIMPLE plans are employer-established but funded into IRAs, blending employer and individual mechanics.

Vesting Schedules in Detail

Vesting determines how much of the employer's contributions an employee keeps if they leave. Employee deferrals are always 100% vested immediately. The two common employer schedules:

Worked numeric — graded vesting. An employee with $20,000 of employer contributions leaves after 4 years under a 2-to-6 graded schedule. Year 4 vesting = 60%, so the employee keeps $20,000 x 60% = $12,000; the remaining $8,000 is forfeited.

SEP and SIMPLE for Small Employers

The SEP IRA is funded entirely by the employer, with relatively high contribution limits, making it popular with self-employed people and very small businesses — there is little administrative overhead. The SIMPLE IRA suits employers with 100 or fewer employees: employees defer salary and the employer must either match contributions up to a set percentage or make a flat nonelective contribution.

403(b) Tax-Sheltered Annuities

A 403(b), also called a tax-sheltered annuity (TSA), is the nonprofit and public-school analogue of the 401(k). Contributions are pre-tax salary deferrals, growth is tax-deferred, and distributions are fully taxable as ordinary income — the same tax skeleton as other qualified plans.

Roth Conversions and the 5-Year Rule

A key planning move is converting a Traditional IRA to a Roth: the converted amount is taxable now, but future qualified withdrawals are tax-free and escape lifetime RMDs. Each conversion starts its own 5-year clock, and the account owner must also be at least 59½ for earnings to come out tax-free and penalty-free. Confusing the conversion 5-year rule with the contribution 5-year rule is a frequent exam trap.