Retirement Planning

Qualified vs. Non-Qualified Plans

Retirement plans are broadly classified as either qualified or non-qualified. This distinction has enormous implications for tax treatment, regulatory requirements, and who can participate. Understanding this fundamental classification is essential for the Series 65 exam and for advising clients on retirement planning.

Qualified Plans

A qualified plan meets the requirements of the Internal Revenue Code (IRC) Section 401(a) and the Employee Retirement Income Security Act (ERISA). Qualified plans receive favorable tax treatment in exchange for meeting strict rules about participation, vesting, funding, and fiduciary responsibility.

Key tax advantages of qualified plans:

• Employer contributions are tax-deductible: The employer can deduct contributions as a business expense in the year they are made.
• Tax-deferred growth: Earnings within the plan grow tax-deferred—no income tax is due until funds are distributed.
• Employee contributions may be pre-tax: In plans like 401(k), employee contributions reduce current taxable income.
• Creditor protection: Qualified plan assets are generally protected from creditors under ERISA.

In exchange for these benefits, qualified plans must comply with strict rules:

• Non-discrimination: The plan cannot disproportionately benefit highly compensated employees (HCEs). Benefits must be available to rank-and-file employees.
• Vesting schedules: Must follow IRS-approved vesting schedules (cliff or graded vesting).
• Contribution and benefit limits: Annual contribution limits are capped by the IRS.
• Reporting requirements: Must file annual reports (Form 5500) with the Department of Labor.

Non-Qualified Plans

A non-qualified plan does not meet IRC Section 401(a) requirements. These plans do not receive the same favorable tax treatment but offer much greater flexibility in design. Non-qualified plans are typically used to provide supplemental retirement benefits to key executives and highly compensated employees.

Characteristics of non-qualified plans:

• No IRS contribution limits: The employer can contribute any amount.
• Can discriminate: Benefits can be limited to select employees (executives, key personnel).
• Employer contributions are NOT deductible when made: The employer deducts the contribution only when the employee recognizes it as income (at distribution).
• No ERISA protection: Assets are generally not protected from the employer's creditors—they remain part of the company's general assets.
• Fewer regulatory requirements: No need to file Form 5500 or meet non-discrimination testing.

Defined Benefit vs. Defined Contribution Plans

Qualified plans fall into two broad categories based on how benefits are determined: defined benefit (DB) plans and defined contribution (DC) plans. This classification determines who bears the investment risk, how benefits are calculated, and how the plan is funded.

Defined Benefit Plans

A defined benefit plan promises participants a specific monthly benefit at retirement, typically based on a formula incorporating factors like years of service and salary history. The employer bears all investment risk because the company must fund whatever is needed to pay the promised benefits. An actuary determines the required annual employer contributions based on assumptions about investment returns, employee turnover, life expectancy, and other factors.

Example formula: Annual pension = 1.5% x Years of Service x Final Average Salary. An employee with 30 years of service and a final average salary of $80,000 would receive: 1.5% x 30 x $80,000 = $36,000 per year.

Defined Contribution Plans

A defined contribution plan specifies the amount contributed to each participant's individual account, but makes no promises about the ultimate benefit. The employee bears the investment risk because the retirement benefit depends on how well the investments perform. Common defined contribution plans include 401(k), 403(b), profit-sharing, and money purchase plans.

Employer-Sponsored Retirement Plans

401(k) Plans

The 401(k) plan is the most common employer-sponsored defined contribution plan for private-sector employees. Employees make pre-tax contributions through salary deferrals, reducing their current taxable income. Many employers offer matching contributions (e.g., 50 cents for each dollar contributed, up to 6% of salary). The 2024 employee contribution limit is $23,000, with a $7,500 catch-up contribution for employees age 50 and older.

Withdrawals from a traditional 401(k) are taxed as ordinary income. Early withdrawals (before age 59 1/2) are subject to a 10% penalty in addition to ordinary income tax, with limited exceptions.

A Roth 401(k) option allows employees to make after-tax contributions. Qualified distributions from a Roth 401(k) are completely tax-free, including earnings. To qualify, the account must have been open for at least 5 years and the employee must be at least 59 1/2, disabled, or deceased.

403(b) Plans (Tax-Sheltered Annuities)

403(b) plans are available to employees of public schools, tax-exempt organizations (501(c)(3) nonprofits), and certain ministers. They function similarly to 401(k) plans with pre-tax salary deferrals and the same contribution limits. The key difference is the eligible employer type and the investment options, which traditionally were limited to annuity contracts and mutual funds (though many 403(b) plans now offer a broader range).

Employees with 15 or more years of service with certain qualifying organizations may be eligible for an additional $3,000 catch-up contribution beyond the standard age-50 catch-up.

457 Plans (Deferred Compensation for Government)

457(b) plans are deferred compensation plans available to employees of state and local governments and certain tax-exempt organizations. The contribution limit is the same as 401(k) ($23,000 in 2024), but 457 plans have a unique advantage: there is no 10% early withdrawal penalty. Withdrawals are taxed as ordinary income, but the penalty does not apply regardless of the employee's age at distribution.

Government employees can contribute to both a 457(b) and a 401(k) or 403(b) plan simultaneously, effectively doubling their deferral capacity. This is a significant planning opportunity.

Profit-Sharing Plans

A profit-sharing plan is a defined contribution plan where the employer makes discretionary contributions based on company profits. There is no obligation to contribute in any given year, providing the employer with maximum flexibility. Contributions can be up to 25% of total eligible compensation, with individual account limits of $69,000 (2024).

Keogh (HR-10) Plans

Keogh plans are qualified retirement plans for self-employed individuals and unincorporated businesses (sole proprietors and partnerships). They can be structured as either defined benefit or defined contribution plans. Keogh plans follow the same contribution limits and rules as corporate qualified plans, but the calculation of maximum contributions for self-employed individuals is more complex because self-employment tax must be considered.

Individual Retirement Accounts (IRAs)

Traditional IRA

A Traditional IRA allows individuals with earned income to contribute up to $7,000 per year (2024), with an additional $1,000 catch-up contribution for those age 50 and older. Contributions may be tax-deductible depending on whether the individual (or their spouse) is covered by an employer-sponsored plan and their modified adjusted gross income (MAGI).

Key rules for Traditional IRAs:

• Contributions: Must have earned income. No age limit for contributions (as of SECURE Act 2019).
• Deductibility: If neither the taxpayer nor spouse is covered by an employer plan, the full contribution is deductible regardless of income. If covered by an employer plan, deductibility phases out based on MAGI.
• Growth: Tax-deferred. No tax is due on earnings until distribution.
• Distributions: Taxed as ordinary income. Deductible contributions and all earnings are taxed. Non-deductible contributions are returned tax-free (basis).
• Early withdrawal penalty: 10% penalty on distributions before age 59 1/2 (with exceptions).
• Required Minimum Distributions (RMDs): Must begin by April 1 of the year following the year the owner turns 73.

Roth IRA

A Roth IRA is funded with after-tax contributions. The contribution limit is the same as the Traditional IRA ($7,000 in 2024, $8,000 for age 50+). However, Roth IRA contributions are subject to income limits: single filers with MAGI above $161,000 (2024) and married filing jointly above $240,000 cannot contribute directly.

Key rules for Roth IRAs:

• Contributions: Not tax-deductible. Made with after-tax dollars.
• Growth: Tax-free if qualified distribution.
• Qualified distributions: Completely tax-free and penalty-free. Must meet two conditions: (1) the account has been open for at least 5 years, and (2) the owner is age 59 1/2, disabled, deceased, or using up to $10,000 for a first-time home purchase.
• No RMDs for the original owner: Unlike Traditional IRAs, Roth IRAs do NOT require minimum distributions during the owner's lifetime. This makes Roth IRAs excellent estate planning vehicles.
• Contribution withdrawals: Roth IRA contributions (not earnings) can be withdrawn at any time, tax-free and penalty-free, because they were made with after-tax money.

SEP IRA (Simplified Employee Pension)

A SEP IRA is designed for self-employed individuals and small business owners. Only the employer contributes (employees cannot make salary deferrals). The employer can contribute up to 25% of each eligible employee's compensation, with a maximum of $69,000 (2024). SEP IRAs are simple to establish and administer, with minimal paperwork compared to 401(k) plans.

Key feature: If the employer contributes to a SEP IRA for themselves, they must contribute the same percentage for all eligible employees. An employee is eligible if they are age 21+, have worked for the employer in at least 3 of the last 5 years, and have received at least $750 in compensation.

SIMPLE IRA (Savings Incentive Match Plan for Employees)

A SIMPLE IRA is available to employers with 100 or fewer employees. Unlike a SEP, employees CAN make salary deferral contributions up to $16,000 (2024), with a $3,500 catch-up for employees age 50+. The employer must either match employee contributions dollar-for-dollar up to 3% of compensation OR make a 2% non-elective contribution for all eligible employees.

Important: SIMPLE IRA early withdrawal penalty is 25% (instead of the usual 10%) if taken within the first 2 years of participation. After 2 years, the standard 10% early withdrawal penalty applies.

ERISA Requirements

The Employee Retirement Income Security Act of 1974 (ERISA) is a federal law that establishes minimum standards for most voluntarily established retirement and health plans in private industry. ERISA does NOT require employers to offer retirement plans, but if they do, the plans must comply with ERISA's standards. ERISA is enforced by the Department of Labor (DOL) and the IRS.

Key ERISA Provisions

• Fiduciary duty: Plan fiduciaries (those who manage plan assets or exercise discretionary authority) must act solely in the interest of plan participants and beneficiaries. They must act with the "prudent expert" standard—the care, skill, and diligence that a prudent person familiar with such matters would use. This is stricter than the common "prudent person" standard.
• Vesting requirements: ERISA mandates minimum vesting schedules. Employees must become fully vested in employer contributions according to one of two schedules: cliff vesting (0% vested for the first 2 years, then 100% vested after 3 years) or graded vesting (20% per year starting after year 2, reaching 100% after year 6). Employee's own contributions are always 100% immediately vested.
• Reporting and disclosure: Plans must provide a Summary Plan Description (SPD) to participants, file Form 5500 annually with the DOL, and provide annual benefit statements.
• Participation rules: Employees generally must be eligible to participate after completing one year of service (1,000 hours) and reaching age 21.
• Plan termination insurance: The Pension Benefit Guaranty Corporation (PBGC) insures defined benefit plans (not defined contribution plans). If a defined benefit plan is terminated with insufficient assets, the PBGC pays benefits up to certain limits.

Required Minimum Distributions and Early Withdrawal Penalties

Required Minimum Distributions (RMDs)

The IRS requires that retirement plan participants begin taking Required Minimum Distributions (RMDs) by a certain age to prevent indefinite tax deferral. Under the SECURE 2.0 Act, the RMD starting age is 73 for individuals who reach age 72 after December 31, 2022 (and will increase to 75 starting in 2033).

Key RMD rules:

• First RMD deadline: April 1 of the year following the year the owner turns 73. However, taking the first RMD in this extended window means two RMDs in the same calendar year (the delayed first-year RMD plus the regular second-year RMD), which could push the taxpayer into a higher bracket.
• Subsequent RMDs: Must be taken by December 31 of each year.
• Calculation: RMD = Account balance as of December 31 of the prior year divided by the IRS Uniform Lifetime Table factor.
• Penalty for missing RMDs: A 25% excise tax on the amount that should have been distributed but was not (reduced from the previous 50% by SECURE 2.0). This can be further reduced to 10% if corrected within the correction window.
• Roth IRA exception: Original Roth IRA owners are NOT subject to RMDs during their lifetime.
• Still-working exception: Participants in employer plans (not IRAs) who are still working and do not own 5% or more of the company can delay RMDs until they actually retire.

Early Withdrawal Penalties and Exceptions

Distributions from retirement accounts before age 59 1/2 are generally subject to a 10% early withdrawal penalty in addition to ordinary income tax. However, there are several important exceptions:

• Death or disability: Distributions to beneficiaries after the participant's death or to participants who are permanently disabled.
• Substantially equal periodic payments (72(t)): Payments calculated using IRS-approved methods over the participant's life expectancy. Once begun, they must continue for 5 years or until age 59 1/2, whichever is later.
• Medical expenses exceeding 7.5% of AGI: To the extent unreimbursed medical expenses exceed the threshold.
• Qualified first-time homebuyer (IRA only): Up to $10,000 lifetime for purchase of a first home.
• Higher education expenses (IRA only): For qualified education expenses for the taxpayer, spouse, children, or grandchildren.
• Separation from service after age 55 (employer plan only): If the employee leaves the employer during or after the year they turn 55, penalty-free withdrawals from that employer's plan are permitted. This does NOT apply to IRAs.
• IRS levy: Distributions required by an IRS levy on the account.
• Qualified reservist distributions: For military reservists called to active duty for 180+ days.

Social Security and Retirement Income Planning

Social Security Basics

Social Security is a federal program that provides retirement income, disability benefits, and survivor benefits. Workers become eligible for retirement benefits by earning at least 40 credits (approximately 10 years of covered employment). Benefits are based on the worker's highest 35 years of earnings.

Key Social Security retirement ages:

• Age 62: Earliest age to claim retirement benefits, but benefits are permanently reduced (approximately 25-30% less than the full retirement benefit).
• Full Retirement Age (FRA): Between ages 66 and 67, depending on birth year. At FRA, the worker receives 100% of their primary insurance amount (PIA).
• Age 70: Maximum delayed retirement credits end. For each year past FRA that benefits are delayed (up to age 70), the benefit increases by approximately 8% per year. There is no benefit to delaying past age 70.

Social Security benefits may be subject to federal income tax. Up to 85% of benefits can be taxable depending on the recipient's "provisional income" (adjusted gross income + tax-exempt interest + 50% of Social Security benefits).

Retirement Distribution Options

When clients retire and begin accessing their accumulated retirement savings, they have several distribution options:

• Lump-sum distribution: Taking the entire account balance at once. This provides maximum control and flexibility but may create a large tax liability in a single year. A lump sum from a qualified plan may be eligible for rollover to an IRA to continue tax deferral.
• Annuitization: Converting the account balance into a stream of periodic payments (usually monthly) for life or a specified period. This provides income certainty but sacrifices liquidity. Options include life-only, joint and survivor, and period certain annuities.
• Systematic withdrawal: Taking regular withdrawals of a fixed dollar amount or a fixed percentage of the account balance. This provides flexibility to adjust withdrawals but carries the risk of outliving the assets (longevity risk).

Beneficiary Designations

Retirement account beneficiary designations are critically important and override the will. If a client's beneficiary designation names their ex-spouse but their will leaves everything to their current spouse, the ex-spouse receives the retirement account assets. Advisers should regularly review and update beneficiary designations, especially after major life events (marriage, divorce, birth of children, death of a beneficiary).