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

Qualified Retirement Plans

A qualified plan meets IRS and ERISA requirements and earns favorable tax treatment: employer contributions are tax-deductible, earnings grow tax-deferred, and employees defer tax until distribution. The trade-off is strict rules on coverage, vesting, nondiscrimination, and contribution limits.

Qualified vs. Nonqualified

Key takeaway: in a qualified plan the contributions are pre-tax (no basis), so distributions are fully taxable as ordinary income, the same principle as a qualified annuity. Nonqualified plans (such as deferred compensation) let an employer reward select executives without the coverage and nondiscrimination rules, but the employer loses the immediate deduction.

ERISA Protections and Vesting

Qualified plans are governed by ERISA, which protects participants through reporting and disclosure (the summary plan description), fiduciary standards, and vesting schedules. Vesting is the participant's nonforfeitable right to employer contributions; employee deferrals are always 100% vested immediately. Common schedules are 3-year cliff vesting (0% until year three, then 100%) and 2-to-6-year graded vesting. Eligibility rules generally let an employer require an employee to be age 21 and complete one year of service before participating, preventing both discrimination against rank-and-file workers and abuse by short-tenured hires.

Individual Retirement Arrangements (IRAs)

Traditional IRA. Contributions may be tax-deductible (subject to income limits if covered by an employer plan). Earnings grow tax-deferred; distributions are taxed as ordinary income. Required minimum distributions (RMDs) must begin at age 73. Withdrawals before 59½ trigger a 10% penalty (with exceptions: death, disability, first home up to $10,000, qualified higher education, certain medical expenses).

Roth IRA. Contributions are after-tax (never deductible), but qualified distributions are entirely tax-free (account open 5 years and owner over 59½). A Roth has no lifetime RMDs for the original owner, a common exam contrast with the Traditional IRA.

Penalty summary. Contributing more than the annual limit triggers a 6% excise tax each year the excess remains. The premature distribution penalty is 10%; failure to take an RMD historically triggered a 50% excise tax on the shortfall (reduced to 25%, or 10% if corrected promptly, under SECURE 2.0, though exams may still test the 50% legacy figure).

Employer Plans: TEFRA, SEP, and 401(k)

TEFRA (1982) tightened qualified-plan rules, most notably requiring top-heavy plans (where key employees hold more than 60% of benefits) to provide minimum benefits and accelerated vesting for rank-and-file employees, curbing plans skewed toward owners.

SEP (Simplified Employee Pension). The employer contributes to each eligible employee's own IRA. Contributions are employer-funded, flexible year to year, and the limits are much higher than a regular IRA. SEPs are popular with small businesses and the self-employed because of minimal administration.

SIMPLE plan. For employers with 100 or fewer employees, allowing employee salary deferrals with a required employer match or nonelective contribution; simpler than a 401(k).

401(k). A cash-or-deferred arrangement letting employees defer salary pre-tax (or as Roth 401(k), after-tax); employers often match. Earnings grow tax-deferred; distributions are ordinary income; the 10% pre-59½ penalty applies. A 403(b) (TSA) is the parallel plan for public-school and 501(c)(3) nonprofit employees.

Distributions, Rollovers, and Worked Numbers

Rollovers. A direct (trustee-to-trustee) rollover moves funds between plans or IRAs with no tax and no withholding. An indirect rollover pays the participant, who has 60 days to redeposit; the plan must withhold 20% for federal tax, and the participant must replace that 20% from other funds to avoid taxation on it. Only one indirect IRA rollover per 12 months is allowed.

Worked example. Priya, age 45, takes a $50,000 indirect rollover. The plan withholds 20% ($10,000), so she receives $40,000. To complete a full tax-free rollover within 60 days she must deposit the entire $50,000, adding $10,000 from other funds. If she only deposits the $40,000, the missing $10,000 is taxable income plus a $1,000 (10%) early-distribution penalty.

Exam Traps

• Qualified-plan and Traditional-IRA distributions are 100% ordinary income (pre-tax dollars, no basis).
• Roth IRA: after-tax in, tax-free out, no lifetime RMD for the owner; Traditional RMDs start at 73.
• Indirect rollover = 20% mandatory withholding + 60-day window; direct rollover avoids both.

Defined Benefit vs. Defined Contribution

Qualified employer plans fall into two families. A defined benefit plan promises a specific retirement benefit (often a formula based on salary and years of service); the employer bears the investment risk and must fund the promise actuarially.

A defined contribution plan, such as a 401(k), SEP, or profit-sharing plan, defines only the contribution going in; the eventual benefit depends on investment performance, and the employee bears the market risk. The decades-long shift from defined benefit to defined contribution plans explains why salary-deferral arrangements like the 401(k) now dominate the workplace, and why portability through rollovers matters so much.

72(t) Substantially Equal Periodic Payments

A taxpayer who needs income before 59½ can avoid the 10% penalty by taking substantially equal periodic payments under IRC Section 72(t). The payments must continue for at least five years or until age 59½, whichever is longer, and must be calculated under an IRS-approved method. Modifying the schedule early retroactively triggers the penalty on all prior payments, so this exception is used carefully and is a favorite exam detail when a question describes early but penalty-free retirement income.