~55 min read
~8-10 exam questions (5-8%)

In December 1963, the Studebaker automobile company shut down its South Bend, Indiana factory and terminated its pension plan. More than 4,000 workers lost most or all of their promised retirement benefits overnight. Some had worked at the plant for decades. The scandal wasn't that Studebaker went bankrupt—companies fail all the time. The scandal was that nothing in existing law required the company to actually fund the pensions it had promised.

Congress spent the next eleven years debating what to do about it. The result was the Employee Retirement Income Security Act (ERISA) of 1974—the single most important piece of retirement legislation in American history. Everything in this chapter flows from that moment: the rules governing IRAs, the structure of employer-sponsored plans, and the regulatory framework that protects workers from another Studebaker.

Section 1: Individual Retirement Accounts (IRAs)

The Series 7 exam treats retirement plans as a product knowledge area. You need to know contribution limits, withdrawal penalties, tax treatment, and the critical distinctions between plan types. The questions aren't conceptually difficult, but they're detail-heavy—the kind where mixing up "59 1/2" with "73" costs you the point.

Contributing to an IRA

Under IRS rules, individuals can set up individual retirement accounts (IRAs) to save for retirement on a tax-deferred basis. Depending on income and the availability of a workplace retirement plan, specific individuals may be eligible to deduct their contributions. At withdrawal, all deductible (pre-tax) contributions and earnings are taxed at the individual's ordinary income tax rate. Nondeductible (after-tax) contributions can be withdrawn tax-free. To distinguish them from Roth IRAs, these accounts are commonly referred to as traditional IRAs.

The government puts limits on IRA contributions. All contributions must be made only from earned income, as opposed to passive income. Earned income typically means wages. Unearned income includes dividends, capital gains, interest on securities, Social Security benefits, unemployment benefits, child support, rental income, and inherited funds. All new contributions to an IRA must be made in cash only. Existing assets from a pre-existing IRA may be transferred to another IRA.

Test Tip: There is no such thing as a joint IRA. IRAs are for individuals and must be separate accounts.

Contribution Limits

Traditional IRA contributions are limited to earned income, up to $7,500 per year. Persons aged 50 or above may contribute an extra $1,000 annually as a catch-up contribution. In addition, a nonworking spouse can set up a separate IRA, and their working spouse can contribute up to the annual maximum with their earned income (with a catch-up contribution if qualified). Excess contributions are taxed at 6% per year as long as they remain in the account.

If an individual is participating in another qualified retirement plan, such as a 401(k), they can open an IRA and make contributions up to the limit, but their contributions may not be tax-deductible. The deduction amount will depend on the individual's income level.

Suitable Investments for an IRA

Only cash or cash equivalents can be deposited into an IRA. However, once the funds are in the account, they can be used to buy securities. IRAs can even be used to purchase real estate. Collectibles, such as works of art and stamps, and life insurance can never be purchased in an IRA. In addition, naked calls are also prohibited trades in an IRA. However, writing covered calls and buying protective puts are permitted. Although the purchase of municipal bonds is allowed, they are typically not suitable, given the tax-deferred nature of an IRA—you'd be wasting the muni's built-in tax advantage inside an account that's already tax-sheltered.

Withdrawing Funds from a Traditional IRA

Most individuals will make pre-tax contributions to their traditional IRA. Any after-tax contributions can be withdrawn tax-free, but the individual must show evidence that taxes were paid on those contributions. While individuals can withdraw funds at any time from their accounts, if they make withdrawals before the age of 59 1/2, they will be taxed on both their pre-tax contributions and their earnings and will face an additional 10% tax penalty. Individuals can avoid the 10% penalty if the withdrawal is for one of the following reasons:

Required Minimum Distributions (RMDs)

Why RMDs Exist

Congress created Required Minimum Distributions because IRAs were meant to fund retirement, not serve as perpetual tax shelters to pass wealth to heirs. Without RMDs, a wealthy individual could park money in an IRA indefinitely, deferring taxes for decades while the account compounds. The government wants its tax revenue eventually.

The first distribution from the plan must be taken no later than April 1 of the year following the year in which the participant turns 73. All subsequent distributions must occur by December 31 each year. The amount of the withdrawal is calculated by the IRS. Failure to take an RMD on time results in a tax equal to 25% of the undistributed RMD.

MEMORIZE THIS

RMD penalty = 25% of the amount that should have been withdrawn but wasn't. This is one of the harshest penalties in the tax code—memorize the number.

Retirement Plan Transfer vs. Rollover

A person can transfer their IRA directly into another IRA at a different bank or broker-dealer. If the individual is leaving a company, retirement plan assets can also be directly transferred into a conduit IRA. When assets are transferred directly from one account to another, there is no tax liability. The number of transfers that can be made is unlimited. Transfers may also be referred to as direct rollovers.

Another method of transferring retirement assets is a rollover. In this case, a check is sent directly to the participant, and 20% of the rollover will be withheld. The money must be redeposited within 60 days of the distribution date, or the entire amount will be taxable and possibly subject to early withdrawal penalties. Rollovers can only occur once per year.

Test Tip: Know the difference between a transfer (direct, unlimited, no withholding) and a rollover (indirect, 20% withheld, 60-day deadline, once per year). The exam loves to test this distinction.

Traditional IRA: Death of IRA Owner

What happens if an IRA holder dies? As a general rule, the recipient of the IRA must deplete the assets over 10 years or less and pay taxes due, but no penalty tax applies if the recipient is under age 59 1/2. However, spouses have more tax-friendly options available to them.

Spousal beneficiary — The spouse has 3 choices based on age and need:

  1. A younger spouse may roll over the account into their existing IRA. Therefore, if the spouse is 53 years old, RMDs are not required to begin until 20 years later.
  2. An older spouse with sufficient income may open an inherited IRA, which is depleted over a 10-year period. So, if the spouse is 80 years old with a 2-year life expectancy, this choice “stretches” the payout window by 8 years, reducing annual tax liability.
  3. Wealthy persons may refuse to accept (disclaim) the IRA.

Non-spousal beneficiary — The non-spouse has 3 choices:

  1. Transfer the IRA into an inherited IRA and deplete the assets within 10 years.
  2. Cash out the IRA and pay taxes due.
  3. Wealthy persons may refuse to accept (disclaim) the IRA.

Roth IRAs

Unlike traditional IRAs, Roth IRA contributions are never tax-deductible. In other words, contributions to a Roth IRA are made with after-tax dollars. However, if the account has been held for 5 years or more and the individual is at least age 59 1/2, earnings may be withdrawn tax-free and penalty-free. The following rules apply to Roth IRAs:

Individuals may contribute to both a traditional and a Roth IRA, but they cannot contribute more than the annual maximum combined across both accounts.

MEMORIZE THIS
A Comparison of Traditional and Roth IRAs
Traditional IRA Roth IRA
Contributions May be tax-deductible; Must be earned income Not tax-deductible; Must be earned income
Withdrawals 10% penalty if made before age 59 1/2, subject to exceptions 10% penalty on earnings if made before age 59 1/2, subject to exceptions
Taxation Pre-tax contributions and earnings taxed at ordinary rates; after-tax contributions withdrawn tax-free Contributions and earnings can be withdrawn tax-free (subject to age and holding period)
Contribution limits $7,500 + $1,000 catch-up (age 50+) $7,500 + $1,000 catch-up (age 50+)
Earnings Tax-deferred until withdrawn May grow tax-deferred; generally tax-free

Section 2: Employer-Sponsored Retirement Plans

Historical Context

Before ERISA, employers could promise pensions and simply never fund them. The law changed that by establishing minimum standards for retirement plans in private industry—covering participation, vesting, benefit accrual, and fiduciary responsibility. It also created the Pension Benefit Guaranty Corporation (PBGC) to insure defined benefit plans. Essentially, Congress said: if you're going to promise workers a retirement, you have to actually put money aside for it.

ERISA Requirements

ERISA (Employee Retirement Income Security Act) establishes minimum standards for retirement plans in private industry. Not all plans are subject to ERISA—notably, 457 plans for state and local government employees are exempt. Plans subject to ERISA must meet requirements including fiduciary responsibilities and minimum vesting standards.

A person who is vested has worked for the company long enough for the employer's contributions to become fully theirs. The employee's own contributions always vest immediately.

Test Tip: Remember: 457 plans are NOT subject to ERISA. This is a favorite exam question. The 401(k), 403(b), SEP, SIMPLE, ESOP, and profit-sharing plans ARE subject to ERISA.

Defined Benefit vs. Defined Contribution Plans

In a defined benefit plan, the employer promises a specific retirement benefit—typically a percentage of salary multiplied by years of service. The employer bears the investment risk because they must deliver on the promised benefit regardless of how the underlying investments perform. Think traditional pensions—the kind your grandparents might have had.

In a defined contribution plan, the employer and/or the employee contribute specific amounts to an individual account. The retirement benefit depends entirely on investment performance. The employee bears the investment risk. Common types include:

Qualified withdrawals from a defined contribution plan are taxed as ordinary income. Early withdrawals before age 59 1/2 are generally subject to a 10% penalty in addition to regular taxes.

MEMORIZE THIS

Who bears the investment risk?
Defined benefit plan = employer bears the risk (they promised a specific benefit)
Defined contribution plan = employee bears the risk (they own the account, for better or worse)

Other Plan Types

Profit sharing plans: Employer contributions are discretionary, typically based on company profits. Subject to ERISA.

SEP IRA (Simplified Employee Pension): Designed for small businesses and self-employed individuals. Only the employer makes contributions. Subject to ERISA.

SIMPLE IRA (Savings Incentive Match Plan for Employees): For businesses with 100 or fewer employees. Both employer and employee can contribute. Subject to ERISA.

ESOP (Employee Stock Ownership Plan): The company contributes its own stock to employee accounts, giving employees an ownership stake. Subject to ERISA.

Nonqualified retirement plans: NOT subject to ERISA. Employer contributions are not tax-deductible until the employee actually receives the benefit. Deferred compensation plans—where an employer promises to pay an employee at a later date—are the most common type. These plans are typically used for highly compensated executives, which is probably why nobody rushed to regulate them.

Section 3: Variable Annuities

In 1952, the Teachers Insurance and Annuity Association (TIAA) launched the College Retirement Equities Fund (CREF)—the world's first variable annuity. The idea was radical at the time: instead of promising retirees a fixed monthly check that inflation would slowly erode, why not tie the payments to the stock market? If equities grew over time (and historically they had), retirees could maintain their purchasing power. The insurance industry had just built a bridge to Wall Street—and regulators have been trying to figure out who's in charge ever since.

Annuity Basics

An annuity is an investment contract between an individual and an insurance company. The owner invests money with the insurance company, either as a lump sum or in periodic payments. When the owner reaches retirement age, the insurance company distributes payments. There are two types: fixed annuities and variable annuities.

In a fixed annuity, the insurer guarantees a specific rate of return. The insurance company invests the customer's annuity premiums into the company's general account, assumes the investment risk, and a fixed annuity is not considered a security—it is an insurance product regulated by insurance laws only. Indexed annuities track an index and are also considered fixed annuities, not subject to securities laws.

In a variable annuity, there is no guarantee of a specific rate of return. Customers choose from a menu of mutual fund-like investments. Since the investor selects the investment vehicles, variable annuities are considered securities and must be sold under a prospectus. Sellers must be state registered to sell insurance products AND registered to sell securities (Series 6 or Series 7).

Test Tip: Fixed annuity = insurance product only (general account, NOT a security). Variable annuity = both insurance product AND security (separate account, requires prospectus). This distinction drives dozens of exam questions.

Variable Annuity Phases

Funds from variable annuities are kept in separate accounts, distinct from the insurance company's general account. Within a separate account, the investor chooses from subaccounts that operate similarly to mutual funds. The investor bears the investment risk.

Accumulation Phase

The customer contributes money and purchases accumulation units. These units grow or shrink based on subaccount performance. The contract grows tax-deferred. Riders are optional benefits like a guaranteed minimum income benefit (GMIB), which guarantees a minimum level of payments once annuitized, regardless of market conditions.

Distribution Phase

When the customer annuitizes the contract, they become an annuitant. Accumulation units convert into annuity units based on life expectancy. Monthly payments depend on investment performance, age and sex of the annuitant, and the chosen payout option.

Contributions are typically made with after-tax dollars. Taxes on earnings are deferred until withdrawal. There is a 10% penalty on the earnings portion of withdrawals made before age 59 1/2. Withdrawn earnings are taxed at the customer's ordinary income tax rate.

MEMORIZE THIS

Fixed annuity → General account. Insurance company bears the risk. Fixed payments. NOT a security.
Variable annuity → Separate account. Investor bears the risk. Variable payments. IS a security. Requires a prospectus.

Characteristics of Variable Annuities

Death Benefit

If the annuitant dies during the accumulation period, the beneficiary receives a death benefit equal to the total investments plus any earnings (or the total invested amount if the annuity has lost money). The beneficiary pays income taxes on any earnings. Annuitization payments are not considered a death benefit.

Purchase Options

Types of Purchase Options
Type of Annuity How Purchased Payout
Single premium deferred annuity Lump sum Delayed to a later date
Periodic payment deferred annuity Weekly, monthly, or annually Delayed to a later date
Immediate annuity Lump sum Begins in 30 days

Test Tip: There is no periodic payment on an immediate annuity. If you see this as an answer choice, it's wrong.

Surrender Periods and Free-Look

The surrender period is the time the investor must wait before withdrawing without penalty (up to 10 years). Withdrawing early means paying a surrender fee. Variable annuities also have a free-look period (typically 10+ days) to cancel at no charge.

Test Tip: Customers who need income in the near future, such as the elderly, should not consider deferred annuities.

Payout Options (Settlement Options)

When the owner annuitizes, they choose a payout method:

Assumed Interest Rate (AIR)

The assumed interest rate (AIR) is used to calculate the initial annuity payment after annuitization. The AIR is fixed once set and represents a projected rate of growth. It applies to annuity units only (not accumulation units).

MEMORIZE THIS

AIR vs. Actual Performance:

  • Perform in line with AIR → next payment stays the same
  • Outperform AIR → next payment increases
  • Underperform AIR → next payment decreases

AIR is not a guarantee. It is a conservative estimate, not a guaranteed minimum rate of return.

Section 4: Variable Annuity Rules and Taxation

Federal Regulations

Under the Securities Act of 1933, variable annuities must be registered with the SEC and sold with a prospectus. Under the Securities Exchange Act of 1934 and the Investment Company Act of 1940, they may only be sold by a registered broker-dealer (member of FINRA) and their registered representatives. The invested premiums must be kept in a separate account from the insurance company's other accounts.

Suitability

When recommending annuities, representatives must consider:

Voting Rights

Owners of variable annuity contracts can vote based on their ownership interest in the separate account—voting for the sub-account's board of directors, investment adviser, and independent auditor, and on changes in investment policies. However, annuity holders do not vote on distributions of dividends and capital gains.

Taxation

In a nonqualified annuity (after-tax contributions), earnings are taxed as ordinary income when withdrawn. In a qualified annuity (e.g., 403(b) plan, pre-tax contributions), all withdrawals are fully taxable as ordinary income.

Test Tip: Withdrawals from any retirement plan or variable insurance product are never subject to capital gains taxes; they are only treated as ordinary income.

MEMORIZE THIS

Three Distribution Tax Events in an Annuity:

Distribution Event Tax Effect
Annuitization Monthly blended payment of tax-free principal and taxable earnings
Lump sum withdrawal Single blended payment of tax-free principal and taxable earnings
Random withdrawal Taxable earnings distributed first, then tax-free principal (LIFO treatment)

Section 5: Variable Life Insurance Contracts

Another insurance product considered a security is variable life insurance. Premiums are deposited into a separate account, and the death benefit varies with the separate account's performance. The SEC views variable life as a security because the purchaser bears the investment risk—a prospectus is required.

Variable life insurance, also known as permanent insurance, remains in force as long as premiums are paid. The premium amount is fixed; what varies is the death benefit and the policy's cash value—the amount that can be borrowed against or withdrawn if the policy is surrendered.

Costs deducted from premiums include:

Section 6: Municipal Fund Securities & Education Savings

In 1996, New Hampshire launched the first state-sponsored 529 college savings plan. The idea was brilliantly simple: let parents invest after-tax dollars in a state-managed account, let the earnings grow tax-free, and make withdrawals tax-free as long as the money goes toward education expenses. It was essentially a Roth IRA for college. Within a decade, every state had one. Today, 529 plans hold over $450 billion in assets—proof that when you give Americans a tax break and tell them it's for their kids, the money shows up.

529 College Savings Plans

529 college savings plans are designed to encourage savings for college and other educational costs. Contributions are made with after-tax dollars. Earnings grow tax-deferred, and withdrawals for qualified education expenses are completely tax-free. Any adult can establish a 529 account in any state. The account owner (not the beneficiary) controls the account and can change the beneficiary at any time.

Qualified Education Expenses:

Test Tip: Funds withdrawn from a 529 plan for non-qualified expenses are subject to ordinary income tax on the earnings portion PLUS a 10% penalty. Know what counts as “qualified” and what doesn't.

Alternatives to 529 Plans

Coverdell ESAs are tax-favored savings for qualified education expenses (K-12 and higher education). Annual contribution limit: $2,000 per beneficiary. Account must be opened before the beneficiary turns 18, and funds must be used by age 30. Income limits apply—high earners cannot contribute.

529 Plans vs. Coverdell ESAs
Feature 529 Plan Coverdell ESA
Annual contribution limit $300K+ (varies by state) $2,000
Income limits None Yes — high earners excluded
Age limit to open None Before beneficiary turns 18
Age limit to use None By age 30

529 prepaid tuition plans allow tuition to be pre-purchased at today's rates. Typically limited to in-state residents. Guaranteed by the state government. These are considered municipal securities and are not registered securities.

Other Municipal Fund Securities

Local government investment pools (LGIPs) are trusts that offer municipal entities a place to invest surplus cash. Only municipal governments and their agencies may invest—LGIPs are not open to the public. Benefits include economies of scale, diversification, and professional management.

Achieving a Better Life Experience (ABLE) accounts allow people with disabilities to save on a tax-deferred basis. An ABLE account can hold up to $100,000 without affecting SSI eligibility. Disability must have begun before age 46. Unlike 529 plans, the beneficiary is also the account owner. A beneficiary can only have one ABLE account, but anyone may contribute.

Test Tip: Key ABLE account numbers: $100,000 SSI threshold, disability must begin before age 46, one account per beneficiary. Compare this to 529 plans where the account owner (not the beneficiary) controls the account.

Chapter 13 covers the three pillars of savings beyond the brokerage account: retirement plans (IRAs and employer-sponsored), variable annuities (the insurance-securities hybrid), and education savings (529 plans and their alternatives). Next up: how companies bring new securities to market in the primary market.