11.3 Employer Plans: 401(k), 403(b), SEP, SIMPLE, Pension/Profit-Sharing
Key Takeaways
- 401(k) plans serve for-profit employers; employee deferrals are always vested while employer matches may use vesting schedules and must pass ADP/ACP nondiscrimination tests.
- 403(b) tax-sheltered annuities are the salary-reduction plan for public schools and 501(c)(3) nonprofits, frequently funded with annuity contracts.
- SEP plans are employer-funded only (into employees' IRAs); SIMPLE plans (100 or fewer employees) combine employee deferrals with a mandatory employer match and immediate vesting.
- Pension plans require predictable funding (DB pensions are PBGC-insured), while profit-sharing plans allow discretionary, variable contributions.
- Tax-qualified annuity payouts are fully taxable (zero exclusion ratio); direct rollovers avoid the 20% withholding that hits indirect rollovers, which must be redeposited within 60 days.
Mapping the employer-plan landscape
Employer-sponsored qualified plans differ by who sponsors them, who may participate, and how money goes in. The exam tests your ability to match a fact pattern (a public school, a small business, a large corporation) to the correct plan. Almost all of these are defined contribution plans, meaning the contribution is fixed and the employee bears investment risk.
401(k) plans
A 401(k) is a cash-or-deferred arrangement (CODA) inside a profit-sharing plan offered by for-profit employers:
- Employees make elective salary deferrals (pre-tax, or after-tax in a Roth 401(k)).
- Employers may match contributions, often subject to vesting.
- Deferrals are always 100% vested; the match may use cliff/graded vesting.
- Subject to annual deferral limits plus a catch-up for age 50+.
- Plans must pass nondiscrimination (ADP/ACP) tests so HCEs don't disproportionately benefit, unless a safe-harbor design is used.
403(b) tax-sheltered annuities
A 403(b), also called a Tax-Sheltered Annuity (TSA), is the 401(k) equivalent for public schools and 501(c)(3) tax-exempt organizations (hospitals, churches, charities). Key points:
- Funded by employee salary reduction, often into annuity contracts or mutual funds.
- Contributions are pre-tax; growth is tax-deferred; distributions are ordinary income.
- A special 15-year service catch-up may apply for long-tenured employees of qualifying employers.
Trap: a 403(b) is for nonprofit/educational employers; a for-profit company would use a 401(k).
SEP and SIMPLE plans for small employers
| Plan | Who uses it | How funded | Notable trait |
|---|---|---|---|
| SEP (Simplified Employee Pension) | Small businesses, self-employed | Employer-only contributions into employees' IRAs | High contribution ceiling; easy admin |
| SIMPLE (Savings Incentive Match Plan for Employees) | Employers with 100 or fewer employees | Employee deferrals + mandatory employer match | Lower limits than 401(k); 100% immediate vesting |
In a SEP, only the employer contributes; in a SIMPLE, employees defer and the employer must either match (typically up to 3%) or make a flat nonelective contribution.
Pension vs. profit-sharing plans
- A pension plan is designed to provide definitely determinable retirement benefits and requires consistent funding. A defined benefit pension promises a fixed benefit and is PBGC-insured; a money-purchase pension fixes the contribution percentage.
- A profit-sharing plan lets the employer make discretionary contributions that may vary year to year (and need not depend on actual profits). 401(k) plans are a type of profit-sharing plan.
Key contrast: pension funding is mandatory and predictable; profit-sharing funding is flexible and discretionary.
Annuities as funding vehicles and rollovers
Many qualified plans and IRAs are funded with annuities, which makes this a Life & Health topic. Note the tax-qualified annuity twist: because the entire premium was pre-tax, the exclusion ratio is effectively zero and the whole annuity payout is taxable — unlike a nonqualified annuity, where the exclusion ratio shelters the recovered cost basis.
Rollovers move funds between plans without immediate tax. A direct (trustee-to-trustee) rollover avoids withholding; an indirect rollover is paid to the participant, subject to 20% mandatory withholding, and must be redeposited within 60 days or it becomes taxable.
Scenario: matching the employer to the plan
- A public high school science teacher wanting salary-reduction savings → 403(b) TSA.
- A dentist with 4 staff who wants to contribute generously without employee deferrals → SEP (employer-funded IRAs).
- A 30-employee landscaping company wanting employees to defer with a small mandatory match → SIMPLE IRA.
- A large corporation offering elective deferrals plus an employer match → 401(k).
- A firm guaranteeing a fixed pension to retirees → defined benefit pension (PBGC-insured).
Learn these mappings; the exam phrases questions exactly this way.
A 501(c)(3) nonprofit hospital wants to let employees make pre-tax salary-reduction contributions, often into annuity contracts. Which plan fits?
A participant requests an indirect rollover of a $50,000 qualified plan distribution paid directly to her. What happens?
Eligibility, vesting, and the ERISA top-heavy rules
Qualified employer plans must satisfy ERISA participation and vesting standards so that rank-and-file employees, not just owners and executives, actually benefit. The exam expects you to recognize the standard eligibility gate and the two permitted vesting schedules.
- Eligibility: an employer may require an employee to be at least age 21 and to complete up to one year of service (1,000 hours) before joining the plan.
- Cliff vesting: the employee is 0% vested until a set point, then 100% vested all at once (employer matching contributions commonly use a 3-year cliff).
- Graded vesting: vesting phases in over several years (for example, 20% per year reaching 100% after 6 years).
- Employee deferrals and all IRA-based plan contributions (SEP, SIMPLE) are always 100% immediately vested; only employer contributions to 401(k)/pension/profit-sharing plans may be subject to a vesting schedule.
A plan is top-heavy when more than 60% of plan assets belong to key employees; top-heavy plans must provide minimum contributions and accelerated vesting for non-key employees. This anti-discrimination structure is the reason qualified plans receive favorable tax treatment in the first place.
An employer's 401(k) uses a vesting schedule under which a worker is 0% vested for the first three years and then 100% vested in year four. What type of vesting is this, and does it apply to the worker's own salary deferrals?
SIMPLE plan two-year rule and matching choices
A SIMPLE IRA carries a tested trap: a withdrawal taken within the first two years of participation is hit with a 25% early-distribution penalty (rather than the usual 10%) if taken before age 59 1/2. The employer must either match employee deferrals dollar-for-dollar up to 3% of compensation or make a 2% nonelective contribution for all eligible employees regardless of whether they defer.
Profit-sharing flexibility and integration with Social Security
A profit-sharing plan lets the employer skip contributions in lean years, but contributions must be recurring and substantial over time to keep qualified status. Some plans use permitted disparity (Social Security integration), allocating a larger contribution percentage on pay above the Social Security wage base to offset the employer's Social Security contributions on lower pay. The exam expects you to recognize that profit-sharing funding is discretionary while pension funding is mandatory, and to match each small-business or nonprofit fact pattern to the correct plan type.