In 1875, the American Express Company created the first private pension plan in the United States. The idea was revolutionary: instead of working until you dropped, employees could actually stop working someday and still have income. It took another century before Congress passed ERISA in 1974, finally protecting workers from employers who promised pensions but never funded them.
Today, retirement planning has shifted dramatically. The old promise of "work here for 40 years and we'll take care of you" has largely given way to "here's a 401(k)—good luck." Understanding how these plans work isn't just exam material; it's the difference between retiring comfortably and greeting customers at big-box stores well into your seventies.
Introduction to Retirement Plans
Most of us would like to stop working at some point in our lives, preferably as soon as possible. In order to do this, we need to have saved a sufficient amount of money to live. To achieve this goal, many people rely on a formal financial retirement plan. A financial retirement plan is a formal way for working people to systematically save and invest money for retirement.
At the heart of most retirement plans are two goals:
- To provide enough income to live on in retirement, including funds to meet other goals, such as travel, as well as emergency expenses.
- To defer taxes until after retirement; the conventional wisdom is that the participant will then be in a lower tax bracket.
Employer-Sponsored Retirement Plans
A qualified retirement plan is one that satisfies the requirements of the Employee Retirement Income Security Act (ERISA). ERISA covers retirement plans offered by for-profit employers. Qualified employer-sponsored retirement plans come in two types: defined benefit plans and defined contribution plans. Nonqualified plans would include Individual Retirement Accounts (IRAs) and deferred compensation plans.
Before ERISA, employees had almost no protection. Companies could promise pensions, underfund them for decades, then declare bankruptcy—leaving retirees with nothing. The Studebaker Corporation collapse in 1963, which left 4,000 workers without promised pensions, became the catalyst for reform. ERISA created minimum funding standards, fiduciary duties, and the Pension Benefit Guaranty Corporation (PBGC) to insure defined benefit plans.
ERISA Requirements
Nondiscrimination: All employees must be treated equally under the Act. These plans must be available to all eligible employees and not just highly paid executives.
Eligibility: Employers must offer their established plan to any employee who works more than 1,000 hours per year and has been with the company for more than 12 months.
Vesting: Employees must earn their employer contributions over a reasonable time period. Two vesting schedules exist:
- Cliff vesting: 100% vested after three years
- Graded vesting: 20% per year after year one, 100% after six years
Fiduciary responsibility: The plan trustee must manage assets in the best interests of all participants. Plan assets must be segregated from other company assets.
Test-Taking Tip: Employees are always 100% vested in their own contributions. Only employer contributions are subject to vesting schedules.
ERISA covers plans offered by for-profit companies. It does not cover public retirement plans for not-for-profit entities or U.S. government employees or state employees. These plans are exempt from ERISA requirements.
Defined Benefit vs. Defined Contribution Plans
Defined Benefit Plans
A defined benefit plan is a qualified plan where the employer promises to pay each eligible employee a specific periodic (usually monthly) benefit for life, starting at retirement. Also called a pension plan, it is typically funded and managed by the employer. The investment decisions are made by the employer, and it is the employer's responsibility to ensure enough money is set aside.
Defined Contribution Plans
A defined contribution plan is a retirement plan in which the employee determines the level of their contribution. Participants have their own individual accounts and choose from several different investment options. Benefits depend on total contributions and investment returns.
In defined contribution plans, investment risk and rewards are assumed by the participant rather than the employer. Contributions and earnings grow tax-deferred until withdrawn, at which time they are taxed as ordinary income. Some plans allow participants aged 50 and above to make additional catch-up contributions.
| Plan Type | Who It's For | Key Features |
|---|---|---|
| 401(k) | Corporate employees | Employee contributions; employer may match |
| 403(b) | Nonprofit employees (schools, charities) | Similar to 401(k); exempt from ERISA |
| Profit-Sharing | Corporate employees | Employer contributes based on profits; not guaranteed |
| 457 | State/local government employees | Nonqualified; exempt from ERISA |
Early Withdrawal Penalties
While individuals can withdraw funds at any time from their defined contribution account, they will be taxed and receive an additional 10% tax penalty on any withdrawals made before the age of 59½.
The early withdrawal penalty can be avoided for:
- Medical expenses exceeding 7.5% of gross income
- Death or permanent disability
- Substantially equal periodic payments
- Separation from service at age 55 or older
- Birth or adoption of a child (up to $5,000 per parent)
Test-Taking Tip: Trades within retirement accounts are not taxed. Income is only taxed when funds are withdrawn—and always as ordinary income, never capital gains.
| Feature | Defined Benefit | Defined Contribution |
|---|---|---|
| Investment risk | Employer | Employee |
| Investment decisions | Employer | Employee |
| Payout | Defined and guaranteed | Not defined or guaranteed |
Individual Retirement Accounts (IRAs)
Under IRS rules, individuals can set up individual retirement accounts (IRAs) to save for retirement on a tax-deferred basis. Depending on income and workplace plan availability, contributions may be deductible. At withdrawal, pre-tax contributions and earnings are taxed at ordinary tax rates.
Contribution Rules
All IRA contributions must be made from earned income (typically wages). Unearned income—dividends, capital gains, social security, rental income, inheritances—cannot be contributed to an IRA.
Test-Taking Tip: There is no such thing as a joint IRA. IRAs are for individuals and must be separate accounts. A nonworking spouse can have their own IRA funded by the working spouse's earned income.
IRA Investment Restrictions
| Prohibited | Permitted |
|---|---|
| Collectibles (art, stamps) | Stocks, bonds, mutual funds |
| Life insurance | Real estate |
| Naked (uncovered) calls | Covered calls, protective puts |
Early Withdrawal Penalty Exceptions
The 10% penalty for withdrawals before age 59½ is waived for:
- Qualified education expenses (tuition, books, supplies)
- Medical expenses exceeding 7.5% of adjusted gross income
- Permanent disability
- First-time home purchase ($10,000 lifetime max)
- Health insurance premiums while unemployed
- Substantially equal periodic payments (Rule 72(t))
- Birth or adoption (up to $5,000 per parent)
Required Minimum Distributions (RMDs)
The first distribution must be taken by April 1 of the year following the year in which the participant turns 73. After that, distributions must occur by December 31 each year.
If distributions fall short of RMDs, a penalty tax of 25% is applied to the amount not distributed. There are no RMD requirements for Roth IRAs.
Transfers vs. Rollovers
| Feature | Transfer (Direct Rollover) | Rollover |
|---|---|---|
| How it works | Direct institution-to-institution | Check sent to participant |
| Withholding | None | 20% withheld |
| Time limit | None | 60 days to redeposit |
| Frequency | Unlimited | Once per year |
Traditional vs. Roth IRAs
Unlike traditional IRAs, Roth IRA contributions are never tax deductible—they're made with after-tax dollars. However, if the account has been held for five years or more and the individual is at least age 59½, earnings may be withdrawn tax-free and penalty-free.
- Contributions are never tax deductible
- Contributions must be from earned income
- Contribution limits same as traditional IRAs
- Contributions can be withdrawn tax-free at any time
- High earners are not eligible to contribute
- No required minimum distributions
| Feature | Traditional IRA | Roth IRA |
|---|---|---|
| Contributions | May be tax deductible | Never tax deductible |
| Early withdrawal penalty | 10% on all pre-tax amounts | 10% on earnings only |
| Tax on withdrawals | Ordinary income | Tax-free (if qualified) |
| RMDs | Required at age 73 | None |
| Plan Type | 2024 | 2025 | 2026 |
|---|---|---|---|
| 401(k), 403(b), 457 | $23,000 | $23,500 | $24,500 |
| Catch-up (50+) | $7,500 | $7,500 | $8,000 |
| IRA | $7,000 | $7,000 | $7,500 |
| IRA Catch-up (50+) | $1,000 | $1,000 | $1,100 |
Summary & Key Points
Retirement planning in America has evolved from company-guaranteed pensions to employee-directed savings accounts. Understanding the rules—contribution limits, tax treatment, early withdrawal penalties, and required minimum distributions—is essential both for the exam and for helping clients navigate one of the most important financial decisions of their lives.
Plan Types
- Qualified plans: Meet ERISA requirements; include 401(k) and pension plans
- Nonqualified plans: Exempt from ERISA; include 457 plans and deferred compensation
- Defined benefit: Employer bears investment risk; guaranteed payout
- Defined contribution: Employee bears investment risk; payout depends on performance
IRA Rules
- Contribution source: Must be earned income only
- Early withdrawal penalty: 10% before age 59½, with exceptions
- RMDs: Traditional IRAs at age 73; Roth IRAs have none
- Transfers: Unlimited; direct, no withholding
- Rollovers: Once per year; 20% withholding; 60-day rule
Key Terms
- ERISA: Employee Retirement Income Security Act—governs qualified plans
- Vesting: Process by which employer contributions become employee's property
- Catch-up contributions: Additional contributions for those 50 and older
- Traditional IRA: Pre-tax contributions; taxed at withdrawal
- Roth IRA: After-tax contributions; tax-free qualified withdrawals
- RMD: Required minimum distribution; mandatory withdrawals starting at 73