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

Qualified Plans, IRAs, and Retirement

A qualified plan meets IRS and ERISA requirements and earns favorable tax treatment: pre-tax (deductible) contributions, tax-deferred growth, and taxable distributions in retirement. The exam contrasts qualified versus non-qualified plans and tests the mechanics of IRAs, 401(k)s, SEPs, and the penalty rules.

Qualified vs Non-Qualified — The Core Difference

Key trap: Because qualified-plan dollars went in pre-tax and have zero basis, the entire distribution is taxable ordinary income. Non-qualified plans tax only the gain.

Penalties and Required Distributions

• 10% early-distribution penalty applies to taxable amounts withdrawn before age 59½ (exceptions: death, disability, qualifying first-home/$10,000 IRA, higher-education, substantially equal payments).
• Required Minimum Distributions (RMDs) must begin by age 73 for traditional plans (SECURE Act 2.0). Failure triggers an excise penalty on the shortfall.
• Roth IRAs have no lifetime RMDs for the original owner.

ERISA and Plan Qualification Requirements

To be "qualified," an employer plan must satisfy ERISA and IRS rules designed to protect rank-and-file workers:

• Nondiscrimination: the plan cannot favor highly compensated employees.
• Eligibility: generally cover employees age 21 with one year of service.
• Vesting: employer contributions must vest on an approved schedule (e.g., 3-year cliff or 2-to-6-year graded).
• Funding & fiduciary duty: the plan must be funded and administered solely in participants' interest.

Meeting these tests earns the plan its tax advantages; failing them can disqualify the plan and accelerate taxation.

IRAs: Traditional vs Roth

Traditional IRA: Contributions may be tax-deductible (subject to income/active-participant limits); growth is tax-deferred; distributions are taxable; RMDs apply at 73.

Roth IRA: Contributions are after-tax (never deductible); qualified distributions are tax-free; no lifetime RMDs. A qualified Roth distribution requires the account be held 5 years AND the owner be 59½+ (or death, disability, first home).

Employer Qualified Plans — 401(k), SEP, and TEFRA

• 401(k): A cash-or-deferred plan; employees elect salary deferrals (pre-tax or Roth), often with an employer match. Subject to nondiscrimination testing.
• SEP (Simplified Employee Pension): The employer contributes to each eligible employee's SEP-IRA. Easy to administer; only the employer contributes; high contribution limits make it popular with small businesses and the self-employed.
• SIMPLE IRA: For employers with ≤100 employees; both employee deferrals and a required employer contribution.
• TEFRA (Tax Equity and Fiscal Responsibility Act of 1982): Tightened top-heavy and contribution rules and introduced the LIFO/annuity penalty framework — exam relevance is recognizing TEFRA as the law that curbed plan abuses and set top-heavy/contribution limits.

Worked example: An employee defers $10,000 pre-tax into a 401(k) and the employer matches 50% up to 6% of a $80,000 salary. The match = 50% × (6% × $80,000) = 50% × $4,800 = $2,400, deposited pre-tax and growing tax-deferred.

Rollovers and Distribution Triggers

Money can move between qualified plans and IRAs without tax if done correctly:

• Direct (trustee-to-trustee) rollover: funds move directly between custodians — no withholding, no tax.
• Indirect (60-day) rollover: the participant receives a check, has 60 days to redeposit, and the plan must withhold 20% for taxes — a classic trap, because the participant must replace that 20% from other funds to avoid taxation on it.

Qualified-plan distributions are normally allowed only on separation from service, death, disability, age 59½, or plan termination. A 403(b) (TSA) is the parallel plan for public-school and nonprofit employees, funded by salary reduction much like a 401(k).

Trap: An indirect rollover of $50,000 nets only $40,000 after 20% withholding; to complete a full tax-free rollover, the participant must deposit the full $50,000 within 60 days, fronting the missing $10,000 until it is refunded at tax time.

Worked Example: Early-Distribution Penalty

A 45-year-old withdraws $20,000 from a traditional IRA for a non-exempt reason. The entire $20,000 is ordinary income, plus a 10% penalty = $2,000, unless an exception applies (first home up to $10,000, qualified education, disability, substantially equal periodic payments).

Trap: Roth accounts have no lifetime RMDs for the original owner and qualified withdrawals are tax-free; traditional accounts require RMDs and tax every dollar out.

Contribution Limits and the Saver Logic

Qualified plans and IRAs cap annual contributions, with catch-up contributions allowed at age 50+. The core trade is timing of tax: traditional contributions reduce taxable income now and tax withdrawals later; Roth contributions are after-tax now for tax-free qualified withdrawals later.

Trap: distributions before 59 1/2 trigger the 10% penalty unless an exception applies; RMDs force taxable withdrawals from traditional accounts starting at the statutory age, while Roth IRAs have no RMD for the original owner.