Retirement Plans

Individual Retirement Accounts (IRAs)

Retirement planning is one of the most important aspects of financial advising, and it is heavily tested on the Series 7 exam. As a registered representative, you will need to understand the different types of retirement accounts, their contribution limits, tax advantages, distribution rules, and penalties. This chapter provides a comprehensive overview of every retirement plan type you are expected to know.

Individual Retirement Accounts, or IRAs, are personal retirement savings vehicles that offer tax advantages to encourage Americans to save for retirement. There are two primary types of IRAs: Traditional IRAs and Roth IRAs. Each has distinct rules regarding contributions, deductions, and distributions. Understanding the differences between them is essential for both the Series 7 exam and your career advising clients.

Traditional IRA

A Traditional IRA allows individuals to make contributions that may be tax-deductible, depending on their income and whether they (or their spouse) participate in an employer-sponsored retirement plan. Earnings within the account grow on a tax-deferred basis, meaning you pay no taxes on investment gains, dividends, or interest until you withdraw the money.

Contribution Rules

To contribute to a Traditional IRA, you must have earned income (wages, salaries, self-employment income, tips, bonuses, and commissions). Investment income, rental income, and pension income do not count as earned income for IRA purposes. The annual contribution limit for 2024 is $7,000 for individuals under age 50, with a $1,000 catch-up contribution for those aged 50 and older, bringing the total to $8,000. There is no age limit for making contributions, as long as you have earned income.

If your spouse has no earned income, you can contribute to a spousal IRA on their behalf, subject to the same annual limits. The couple must file a joint tax return, and the working spouse must have enough earned income to cover both contributions.

Tax Deductibility

Contributions to a Traditional IRA may be fully deductible, partially deductible, or non-deductible depending on two factors: (1) whether the contributor is covered by an employer-sponsored retirement plan, and (2) the contributor's modified adjusted gross income (MAGI). If neither you nor your spouse participates in an employer plan, your Traditional IRA contributions are fully deductible regardless of income. If you or your spouse is covered by an employer plan, the deduction phases out at certain income levels.

Distributions and Required Minimum Distributions (RMDs)

Distributions from a Traditional IRA are taxed as ordinary income in the year they are received. If you made non-deductible contributions, a portion of each distribution representing the return of after-tax contributions is not taxed (this is calculated using the pro-rata rule).

Required Minimum Distributions (RMDs) must begin by April 1 of the year following the year in which the account owner turns 73 (under the SECURE 2.0 Act). After the first RMD year, subsequent distributions must be taken by December 31 of each year. The RMD amount is calculated by dividing the account balance as of December 31 of the prior year by the applicable life expectancy factor from IRS tables. Failure to take an RMD results in a 25% excise tax on the amount that should have been withdrawn (reduced from the previous 50% penalty by SECURE 2.0). If corrected in a timely manner, this penalty may be further reduced to 10%.

Early Withdrawal Penalty

Distributions taken before age 59 1/2 are generally subject to a 10% early withdrawal penalty in addition to ordinary income tax. However, several exceptions exist where the penalty is waived (though income tax still applies):

• Death of the IRA owner (beneficiary receives distributions penalty-free)
• Disability (total and permanent disability as defined by the IRS)
• Substantially equal periodic payments (SEPP) under IRC Section 72(t) — also known as the "72(t) exception"
• First-time homebuyer expenses (up to $10,000 lifetime)
• Qualified higher education expenses
• Unreimbursed medical expenses exceeding 7.5% of adjusted gross income
• Health insurance premiums while unemployed
• IRS levy on the account
• Birth or adoption expenses (up to $5,000 per event, under SECURE Act)

Roth IRA

The Roth IRA is fundamentally different from the Traditional IRA in its tax treatment. Contributions to a Roth IRA are made with after-tax dollars — there is no tax deduction for contributions. However, the major benefit is that qualified distributions from a Roth IRA are completely tax-free, including all earnings. This makes the Roth IRA one of the most powerful retirement savings tools available.

Contribution Rules and Income Limits

The annual contribution limit for a Roth IRA is the same as for a Traditional IRA: $7,000 (under age 50) or $8,000 (age 50 and older) for 2024. However, the ability to contribute to a Roth IRA is subject to income limits. For single filers, the ability to contribute phases out between $146,000 and $161,000 MAGI. For married filing jointly, the phase-out range is $230,000 to $240,000. If your income exceeds these limits, you cannot contribute directly to a Roth IRA (though you may use a "backdoor Roth" conversion strategy).

The combined total of your Traditional and Roth IRA contributions cannot exceed the annual limit. You can split contributions between accounts, but the total across all IRAs must stay within the limit.

Qualified Distributions (Tax-Free)

For a Roth IRA distribution to be qualified (and therefore entirely tax-free), two conditions must be met:

1. The 5-year rule: The Roth IRA must have been open for at least 5 tax years from the year of the first contribution.
2. A qualifying event: The distribution must be made after the account owner reaches age 59 1/2, becomes disabled, dies (distribution to beneficiary), or is used for first-time homebuyer expenses (up to $10,000).

If both conditions are met, the entire distribution — contributions and earnings — is tax-free. If a distribution is not qualified, earnings may be subject to income tax and the 10% early withdrawal penalty. However, contributions can always be withdrawn tax-free and penalty-free at any time, because they were made with after-tax dollars. The ordering rules dictate that contributions are deemed withdrawn first, then conversions, then earnings.

The 5-Year Rule — In Detail

The 5-year clock starts on January 1 of the tax year for which the first Roth IRA contribution is made. For example, if you make your first Roth contribution for tax year 2024 (even if you make it in early 2025 before the filing deadline), the 5-year period begins January 1, 2024, and ends December 31, 2028. After that date, distributions of earnings can be qualified if a qualifying event also occurs.

For Roth conversions, each conversion has its own 5-year clock for purposes of the 10% early withdrawal penalty on the converted amount (not for determining whether earnings are tax-free). This is an important distinction that the exam may test.

No Required Minimum Distributions

One of the most significant advantages of the Roth IRA is that there are no required minimum distributions (RMDs) during the account owner's lifetime. This allows the account to grow tax-free for as long as the owner lives, making it an excellent estate planning tool. However, beneficiaries who inherit a Roth IRA are subject to distribution rules (generally the 10-year rule under the SECURE Act for non-spouse beneficiaries).

Roth Conversions

Anyone can convert a Traditional IRA (or other pre-tax retirement account) to a Roth IRA, regardless of income level. The converted amount is treated as ordinary income in the year of conversion and is fully taxable. However, the 10% early withdrawal penalty does not apply to conversions. After conversion, the funds grow tax-free and can be distributed tax-free once the 5-year rule and a qualifying event are satisfied.

Converting to a Roth can be a smart strategy when you expect to be in a higher tax bracket in retirement, when tax rates are temporarily low, or when you want to avoid RMDs. The decision should consider the tax bill in the conversion year versus the long-term benefit of tax-free growth.

Comparing IRA Types

Employer-Sponsored Retirement Plans

Employer-sponsored retirement plans are a cornerstone of retirement savings in the United States. These plans allow employees to save for retirement with significant tax advantages, and many employers match a portion of employee contributions. The Series 7 exam tests your knowledge of the major types of employer plans, including their contribution limits, vesting schedules, and distribution rules.

401(k) Plans

The 401(k) plan is the most common employer-sponsored defined contribution retirement plan for private-sector employees. Named after Section 401(k) of the Internal Revenue Code, it allows employees to defer a portion of their salary into a retirement account on a pre-tax basis (or after-tax for Roth 401(k) contributions).

Employee Deferrals

For 2024, employees can defer up to $23,000 of their salary into a 401(k) plan. Employees aged 50 and older can make an additional $7,500 catch-up contribution, for a total of $30,500. Pre-tax deferrals reduce the employee's taxable income in the year of contribution. For example, an employee earning $80,000 who defers $23,000 is only taxed on $57,000 of income for that year.

Employer Matching Contributions

Many employers offer a matching contribution — a percentage of the employee's deferral that the employer contributes to the plan. Common match formulas include 50% of the first 6% of salary deferred (meaning if you contribute 6%, the employer adds 3%) or dollar-for-dollar up to 3%. Employer matching contributions are always pre-tax and are subject to the overall contribution limit of $69,000 (employee + employer combined, for 2024) or $76,500 for those 50+.

Vesting Schedules

Vesting determines how much of the employer's contributions (including matching contributions) the employee owns if they leave the company before retirement. Employee deferrals are always 100% vested immediately. Employer contributions may be subject to a vesting schedule:

• Cliff vesting: The employee becomes 100% vested after a specific period (up to 3 years). Before that period, they own 0% of employer contributions.
• Graded vesting: The employee gradually becomes vested over a period (up to 6 years). For example, 20% per year starting in year 2.

Loan Provisions

Many 401(k) plans allow participants to borrow from their account balance. The maximum loan is the lesser of $50,000 or 50% of the vested balance. Loans must be repaid within 5 years (unless the loan is used to purchase a primary residence, which may have a longer repayment period). Loan repayments are made with after-tax dollars through payroll deduction. If the participant fails to repay the loan (including upon separation from service), the outstanding balance is treated as a taxable distribution and may be subject to the 10% early withdrawal penalty.

Hardship Withdrawals

A hardship withdrawal may be permitted if the employee demonstrates an immediate and heavy financial need. Qualifying hardship reasons include:

• Medical expenses for the employee, spouse, or dependents
• Purchase of a principal residence
• Tuition and educational fees for the next 12 months
• Prevention of eviction or mortgage foreclosure
• Funeral expenses
• Certain home repair expenses from casualty loss

Hardship withdrawals are subject to ordinary income tax and the 10% early withdrawal penalty (if under 59 1/2). Unlike loans, they do not have to be repaid.

403(b) Plans

A 403(b) plan, also known as a Tax-Sheltered Annuity (TSA), is the equivalent of a 401(k) for employees of public schools, tax-exempt organizations (501(c)(3) nonprofits), and certain ministers. The contribution limits mirror those of a 401(k): $23,000 employee deferral ($30,500 with catch-up). Investment options in 403(b) plans are typically limited to annuity contracts and mutual funds.

An additional catch-up provision is available for 403(b) participants with 15 or more years of service at the same qualifying organization, allowing an extra $3,000 per year (up to a $15,000 lifetime maximum) on top of the regular catch-up contribution.

457 Plans

The 457(b) plan is available to employees of state and local governments and certain non-governmental tax-exempt organizations. The contribution limit is $23,000 ($30,500 with catch-up). A unique feature of 457(b) plans is that there is no 10% early withdrawal penalty for distributions taken before age 59 1/2, though ordinary income tax still applies. This makes them attractive for those planning early retirement. Employees can contribute to both a 457(b) and a 401(k) or 403(b) simultaneously, effectively doubling their tax-deferred savings.

SEP IRAs

A Simplified Employee Pension (SEP) IRA is a retirement plan designed primarily for self-employed individuals and small business owners. Only the employer (or self-employed individual) makes contributions — there are no employee deferrals. The employer can contribute up to 25% of each eligible employee's compensation, up to a maximum of $69,000 for 2024. Contributions are immediately 100% vested. SEP IRAs are simple to set up and administer, requiring minimal paperwork (IRS Form 5305-SEP).

All eligible employees must receive contributions at the same percentage rate as the owner. This means if the owner contributes 15% for themselves, they must contribute 15% for every eligible employee as well.

SIMPLE IRAs

The Savings Incentive Match Plan for Employees (SIMPLE) IRA is designed for small businesses with 100 or fewer employees. Both employees and employers contribute. Employees can defer up to $16,000 ($19,500 with catch-up for 50+). The employer must make either a matching contribution of up to 3% of each participating employee's compensation, or a non-elective 2% contribution for all eligible employees regardless of participation.

An important penalty rule applies to SIMPLE IRAs: withdrawals taken within the first 2 years of participation are subject to a 25% early withdrawal penalty (instead of the usual 10%). After 2 years, the standard 10% penalty applies to distributions before age 59 1/2.

Comparing Employer-Sponsored Plans

Pension Plans: Defined Benefit vs. Defined Contribution

Retirement plans are broadly categorized as either defined benefit or defined contribution plans. Understanding the distinction is essential for the Series 7 exam.

Defined Benefit Plans

A defined benefit (DB) plan — the traditional pension — promises the employee a specific, predetermined benefit at retirement. The benefit is typically calculated based on a formula that considers factors such as years of service, average salary, and a benefit percentage. For example, a plan might pay 1.5% of the average salary for the last 5 years of service multiplied by the number of years employed.

The employer bears the investment risk in a defined benefit plan. If the plan's investments underperform, the employer must make up the shortfall. The employer is responsible for making sufficient contributions to fund the promised benefits. DB plans are insured by the Pension Benefit Guaranty Corporation (PBGC), a federal agency that protects participants if the plan sponsor cannot meet its pension obligations.

Defined Contribution Plans

A defined contribution (DC) plan specifies the amount of contributions that will be made to the plan, but the retirement benefit depends on investment performance. Examples include 401(k) plans, 403(b) plans, and profit-sharing plans. The employee bears the investment risk — if investments perform well, the retirement fund grows; if they perform poorly, the employee receives less.

DC plans are NOT insured by the PBGC. The account balance at retirement depends entirely on contributions made and investment returns earned.

ERISA (Employee Retirement Income Security Act of 1974)

The Employee Retirement Income Security Act (ERISA) is federal legislation that sets minimum standards for most private-sector retirement plans. ERISA was enacted to protect participants and beneficiaries of employee benefit plans. Key ERISA provisions include:

• Fiduciary responsibility: Plan fiduciaries must act solely in the interest of plan participants and beneficiaries, with the care, skill, prudence, and diligence of a prudent person.
• Reporting and disclosure: Plans must provide participants with information about the plan's features, funding, and management, including a Summary Plan Description (SPD).
• Vesting: ERISA establishes minimum vesting schedules (cliff or graded) for employer contributions.
• Funding: Defined benefit plans must be adequately funded.
• Plan termination insurance: The PBGC insures defined benefit plans.

ERISA covers most private-sector employer-sponsored plans. It does NOT cover government plans (federal, state, or local), church plans, or plans maintained outside the United States for non-resident aliens. IRAs are also not subject to ERISA.

Rollover Rules and Transfers

When an employee leaves a job or wants to move retirement funds between accounts, understanding the rules for rollovers and transfers is critical. The Series 7 exam tests your knowledge of these rules in detail.

Direct Transfer (Trustee-to-Trustee)

A direct transfer (also called a trustee-to-trustee transfer) moves funds directly from one retirement plan or IRA to another without the account owner ever taking possession of the money. There is no mandatory tax withholding, no taxable event, and no limit on the number of direct transfers per year. This is the preferred method for moving retirement assets.

60-Day Rollover (Indirect Rollover)

In an indirect rollover, the account owner receives a distribution check and must deposit the funds into another qualified plan or IRA within 60 days. If the funds are not deposited within 60 days, the distribution is treated as a taxable event, subject to income tax and potentially the 10% early withdrawal penalty.

Critical rules for indirect rollovers:

• 20% mandatory withholding: When funds are distributed from an employer-sponsored plan (like a 401(k)) for an indirect rollover, the plan is required to withhold 20% for federal income tax. The account owner must come up with the withheld amount from other sources to roll over the full amount. If they only roll over what they received (80%), the 20% that was withheld is treated as a taxable distribution.
• Once-per-year rule: You can only do one indirect rollover between IRAs in a 12-month period. This applies in aggregate to all your Traditional and Roth IRAs. Direct transfers are not subject to this rule.
• Same property rule: The same property distributed must be rolled over (you cannot sell securities, roll over cash, and rebuy).

Permissible Rollovers

Generally, you can roll over funds between the following types of accounts:

• Traditional IRA to Traditional IRA
• 401(k) to Traditional IRA (most common upon job change)
• 401(k) to new employer's 401(k) (if the new plan accepts rollovers)
• Traditional IRA to Roth IRA (conversion — taxable event)
• 403(b) to IRA or 401(k)
• 457(b) to IRA or 401(k)

You cannot roll a Roth IRA into a Traditional IRA, nor can you roll a Roth IRA into a pre-tax employer plan. Pre-tax money can be converted to Roth (taxable), but the reverse is not possible.

Qualified vs. Non-Qualified Plans

Retirement plans are classified as either qualified or non-qualified, which determines their tax treatment and regulatory requirements.

Qualified Plans

A qualified plan meets the requirements of IRC Section 401(a) and receives favorable tax treatment. Benefits include:

• Employer contributions are tax-deductible to the employer
• Contributions grow tax-deferred for the employee
• Must meet non-discrimination requirements — cannot disproportionately favor highly compensated employees
• Must comply with ERISA requirements (vesting, funding, reporting)
• Must be established for the exclusive benefit of employees

Examples of qualified plans: 401(k), defined benefit pension, profit-sharing plans, money purchase plans, Keogh plans (for self-employed individuals).

Non-Qualified Plans

A non-qualified plan does not meet IRC Section 401(a) requirements and does not receive the same tax benefits. However, non-qualified plans offer employers more flexibility. Key characteristics:

• Employer contributions are not immediately tax-deductible — deductible only when the employee receives the benefit
• May discriminate — can be offered only to select executives or key employees
• Not subject to most ERISA requirements (though some reporting requirements still apply)
• Typically used as supplemental retirement benefits for executives

Examples of non-qualified plans: Deferred compensation plans (409A plans), executive bonus plans (Section 162 plans), and split-dollar life insurance arrangements.