8.4 Qualified Plans, IRAs, and Retirement (TEFRA/SEP/401k)
Key Takeaways
- Qualified plans must meet ERISA/IRS rules and offer tax-deductible contributions, tax-deferred growth, and fully taxable distributions.
- Traditional IRA contributions may be deductible with pre-tax growth; Roth IRA uses after-tax dollars with tax-free qualified distributions.
- Early distributions before age 59 1/2 generally incur a 10% penalty; Required Minimum Distributions begin at age 73 (SECURE 2.0).
- A 401(k) allows pre-tax salary deferrals with employer matching; SEP and SIMPLE plans serve small employers and the self-employed.
- TEFRA/TRA tightened nondiscrimination and integration rules so qualified plans cannot favor highly compensated employees.
Qualified Plans, IRAs, and Retirement
Retirement funding is a core insurance-producer topic because annuities and life insurance are common funding vehicles. The exam tests the difference between qualified plans (which meet IRS/ERISA requirements for tax favoritism) and nonqualified plans, plus the contribution, distribution, and penalty rules.
Qualified vs. Nonqualified Plans
A qualified plan meets IRS requirements and earns three tax breaks: (1) employer/employee contributions are tax-deductible, (2) earnings grow tax-deferred, and (3) distributions are fully taxable as ordinary income (because the money went in pre-tax).
| Feature | Qualified Plan | Nonqualified Plan |
|---|---|---|
| Contributions | Tax-deductible (pre-tax) | After-tax (not deductible) |
| IRS approval | Required | Not required |
| Coverage | Must be nondiscriminatory | Can favor select employees |
| Growth | Tax-deferred | Tax-deferred (annuity) |
| Distributions | Fully taxable | Only gain is taxable |
TEFRA and the Nondiscrimination Framework
The Tax Equity and Fiscal Responsibility Act (TEFRA, 1982) and the Tax Reform Act tightened the rules so qualified plans cannot disproportionately benefit highly compensated employees. Plans must satisfy nondiscrimination, coverage, and Social Security integration limits, and contribution/benefit ceilings apply. This is why a true qualified plan must cover rank-and-file workers, not just owners.
Qualified plans are also governed by the Employee Retirement Income Security Act (ERISA), which imposes vesting schedules, fiduciary duties, reporting and disclosure (the summary plan description), and minimum participation standards. A plan that fails these tests can lose its qualified status, making contributions immediately taxable to participants — a costly result that underscores why employers rely on tested prototype documents.
Individual Retirement Arrangements (IRAs)
Traditional IRA: Contributions may be tax-deductible (subject to income and active-participant limits); growth is tax-deferred; distributions are fully taxable as ordinary income.
Roth IRA: Contributions are after-tax (not deductible), but qualified distributions are entirely tax-free (account open 5+ years AND age 59 1/2, death, disability, or first-home). Roth contributions phase out at higher incomes.
| Rule | Traditional IRA | Roth IRA |
|---|---|---|
| Deductible contribution | Maybe (income limits) | Never |
| Qualified distribution | Fully taxable | Tax-free |
| Required Minimum Distributions | Yes, at age 73 | None during owner's life |
| Early-withdrawal penalty | 10% before 59 1/2 | 10% on earnings before 59 1/2 |
Penalties and Required Minimum Distributions
- Premature distribution penalty: A 10% additional tax applies to taxable amounts withdrawn before age 59 1/2, with exceptions (death, disability, qualified education, first-home up to $10,000, substantially equal periodic payments).
- Required Minimum Distributions (RMDs): Traditional IRAs and most qualified plans must begin RMDs at age 73 (raised by SECURE 2.0). Failure to take the RMD triggers a steep excise tax on the shortfall.
Exam trap: Roth IRAs have no lifetime RMDs for the original owner, and the contribution (basis) can be withdrawn anytime tax- and penalty-free — only the earnings face the 10% penalty before 59 1/2.
Under current rules, when must an owner of a Traditional IRA begin taking Required Minimum Distributions (RMDs)?
Employer Plans: 401(k), SEP, and SIMPLE
401(k) plan: A cash-or-deferred arrangement letting employees defer pre-tax salary (or Roth after-tax), with growth tax-deferred. Employers may add a matching contribution (e.g., 50% of the first 6% deferred). Deferrals reduce current taxable wages; distributions are taxed as ordinary income.
SEP (Simplified Employee Pension): The employer contributes to each employee's own IRA. Easy to administer, no annual filings, contributions are employer-funded only and discretionary — popular with self-employed people and small firms.
SIMPLE plan: For employers with 100 or fewer employees; allows employee salary deferrals plus a required employer match or nonelective contribution. Lower limits and less administration than a 401(k).
| Plan | Who Contributes | Best Fit |
|---|---|---|
| 401(k) | Employee deferrals + optional employer match | Mid/large employers |
| SEP-IRA | Employer only | Self-employed, small firms |
| SIMPLE IRA | Employee + required employer match | Small employers (≤100) |
Other Vehicles
- 403(b) / TSA: Tax-Sheltered Annuity for public-school and 501(c)(3) nonprofit employees; pre-tax deferrals.
- 457 plan: deferred-comp plan for government and certain nonprofit employees.
- Keogh (HR-10): a qualified plan for self-employed individuals and unincorporated businesses.
Defined benefit plans promise a specific retirement benefit (often a salary/service formula) and the employer bears the investment and funding risk. Defined contribution plans fix the contribution but leave the ending benefit dependent on investment results, so the employee bears the investment risk.
Annuities are a natural funding vehicle inside these plans because they offer guaranteed lifetime income — though placing a tax-deferred annuity inside an already tax-deferred qualified plan provides no additional tax deferral, a point regulators stress in suitability review.
Exam trap: In a SEP, the employer funds the employee's IRA — not the employee. In a SIMPLE, both contribute and the employer match is mandatory, not optional. A 401(k) is funded primarily by employee salary deferrals, with employer matching optional.
Which retirement plan is funded solely by the employer, who contributes directly to each eligible employee's own IRA, and is popular with small businesses and the self-employed?