All employer-sponsored retirement plans fall into one of two structural categories. Understanding this split is foundational for the Series 7.
Defined Benefit (DB) Plan — the pension: The employer promises a specific monthly benefit at retirement, typically calculated by a formula such as:
> Years of service × Final average salary × Benefit multiplier
Example: 2% multiplier, 30 years of service, $100,000 final salary → $60,000/year in retirement income.
The employer bears all investment risk. If the pension fund underperforms, the employer must make up the shortfall. Employees receive a guaranteed, predictable income stream regardless of market performance. Defined benefit plans are actuarially funded — an actuary determines the required annual contribution based on projected future obligations.
Defined Contribution (DC) Plan: The contribution amount is defined (by the employee, employer, or both), but the eventual retirement benefit is unknown — it depends entirely on investment performance and contribution history. The employee bears the investment risk. Examples include 401(k), 403(b), profit sharing plans, and money purchase pension plans.
The 40-year shift from DB to DC plans has transferred retirement investment risk from employers to employees — a major structural change in American retirement finance.
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A profit sharing plan is a defined contribution plan where the employer makes discretionary contributions based on company profitability. Unlike a pension or money purchase plan, the employer is not required to contribute every year — the amount can vary or be zero in a difficult year.
Key features:
Real-world example: A regional retailer earns strong profits one year and contributes 8% of each employee's salary to the profit sharing plan. The following year is poor — they contribute nothing. This flexibility makes profit sharing attractive for businesses with cyclical or unpredictable earnings.
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Unlike profit sharing, money purchase pension plans require the employer to make a fixed annual contribution — typically a set percentage of each employee's compensation — regardless of profitability. Once established, the contribution is mandatory, not discretionary.
Example: A money purchase plan specifies 10% of compensation. If the plan has 20 eligible employees averaging $60,000 each, the employer must contribute $120,000 every year regardless of how the business performs.
Money purchase plans have largely been replaced in practice by 401(k) + discretionary profit sharing combinations, which provide flexibility while maintaining an employee-directed savings component.
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A SEP-IRA is a retirement plan designed for self-employed individuals and small business owners. It combines the simplicity of an IRA with much higher contribution limits.
Key rules:
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A SIMPLE IRA is designed for businesses with 100 or fewer employees. Unlike a SEP-IRA, employees can make salary deferral contributions — making it more similar in concept to a 401(k).
Key rules:
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IRS rules prevent qualified plans from disproportionately favoring Highly Compensated Employees (HCEs) over Non-Highly Compensated Employees (NHCEs). Two annual tests enforce this:
ADP Test (Actual Deferral Percentage): Compares the average deferral rate of HCEs vs. NHCEs. The HCE group average cannot exceed the NHCE average by more than specified limits. If HCEs defer too much relative to NHCEs, the plan must either return excess contributions to HCEs ("excess refunds") or the employer must make additional contributions for NHCEs.
ACP Test (Actual Contribution Percentage): Similar test applied to employer matching contributions.
HCE definition (2024): An employee who owned more than 5% of the company at any time during the year or preceding year, OR earned more than $155,000 in the preceding year.
Safe harbor plans: Exempt from ADP/ACP testing if the employer provides either a matching formula of 100% on first 3% + 50% on next 2% (total 4% maximum match), or a 3% non-elective contribution to all eligible employees.
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A qualified plan is top-heavy when more than 60% of total plan account balances belong to "key employees" (officers earning over $220,000, or owners of more than 5%, or owners of more than 1% earning over $150,000, in 2024).
When a plan is top-heavy, the employer must make a minimum contribution of at least 3% of compensation for all non-key employee participants who are employed on the last day of the plan year — even those who made no contributions themselves. This ensures lower-paid employees receive some retirement benefit when the plan primarily accumulates value for owners and executives.
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Anti-alienation rule: Qualified plan benefits cannot be assigned, pledged as collateral, transferred, or seized by creditors. Your 401(k) is generally protected from bankruptcy proceedings.
QDRO (Qualified Domestic Relations Order): The primary exception to anti-alienation. A QDRO is a legal court order that assigns a portion of one spouse's qualified plan benefits to the other spouse as part of a divorce settlement. Without a properly drafted QDRO, an ex-spouse has no claim to the other's retirement plan benefits.
PBGC (Pension Benefit Guaranty Corporation): A federal agency that insures defined benefit pension plans. If a company terminates an underfunded DB pension, the PBGC takes over and continues paying benefits up to statutory limits. Critical point: the PBGC covers only defined benefit plans — it does not cover defined contribution plans (401(k), 403(b), profit sharing). DC plan assets are individually owned and protected from employer creditors by ERISA's asset segregation rules.
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Quiz Questions:
Q1. A self-employed graphic designer earned $160,000 in net self-employment income in 2024. What is the MAXIMUM she can contribute to a SEP-IRA?
A) $7,000 B) $23,000 C) $40,000 D) $69,000
Answer: C — SEP-IRA contributions are limited to 25% of compensation, maximum $69,000. 25% × $160,000 = $40,000. This is below the $69,000 cap, so $40,000 is the maximum. (Note: for self-employed individuals the IRS uses a slightly reduced effective rate of approximately 20% of gross self-employment income due to the self-employment tax deduction, but the Series 7 exam typically uses the straightforward 25% calculation.)
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Q2. A SIMPLE IRA participant enrolled in the plan 16 months ago withdraws $8,000 from her account. She is 40 years old. What early withdrawal penalty applies?
A) 10% B) 15% C) 20% D) 25%
Answer: D — SIMPLE IRA distributions within the first 2 years of plan participation are subject to a 25% early withdrawal penalty rather than the standard 10%. At 16 months she is still within the 2-year window. After 2 years of participation, the standard 10% penalty applies. This elevated penalty is one of the most tested SIMPLE IRA details on the Series 7.
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Q3. Which retirement plan structure provides the MOST protection for participants if the plan sponsor (employer) goes bankrupt?
A) 401(k) profit sharing plan B) 403(b) plan at a nonprofit hospital C) Defined benefit pension plan insured by the PBGC D) SEP-IRA established by a small business
Answer: C — The PBGC insures defined benefit pension plans. If a company terminates an underfunded DB pension in bankruptcy, the PBGC takes over and continues benefit payments up to statutory limits. DC plans (401k, 403b, SEP-IRA) are not covered by the PBGC — but participants' accounts are still protected from employer creditors because ERISA requires plan assets to be held separately from company assets.
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Q4. A company's 401(k) is determined to be top-heavy because 65% of total plan assets belong to key employees. What corrective action is required?
A) Return the excess contributions to key employees until the plan is no longer top-heavy B) Freeze all key employee contributions until non-key employees catch up C) Make a minimum contribution of at least 3% of compensation for all non-key employee participants D) Convert the plan from defined contribution to defined benefit structure
Answer: C — When a plan is top-heavy (more than 60% of assets belong to key employees), ERISA requires the employer to make a minimum contribution of at least 3% of compensation for each non-key employee participant employed on the last day of the plan year. This ensures lower-paid workers receive some retirement benefit even if the plan disproportionately accumulates value for owners and executives.
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Q5. Under ERISA's anti-alienation rule, which of the following transactions involving a participant's 401(k) account is PERMITTED?
A) Pledging the account balance as collateral for a personal bank loan B) Voluntarily transferring the account balance to a creditor to satisfy a debt C) Assigning a portion of the account to an ex-spouse pursuant to a Qualified Domestic Relations Order D) Garnishment of the account by a judgment creditor following a civil lawsuit
Answer: C — ERISA's anti-alienation provision prohibits assignment, pledge, and garnishment of qualified plan benefits. The primary exception is a Qualified Domestic Relations Order (QDRO), which allows a court to direct a portion of retirement benefits to an ex-spouse in a divorce proceeding. This is the only way to divide a 401(k) without triggering taxes and penalties on the participant. Choices A, B, and D all violate the anti-alienation rule.