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Why this topic matters
Taxation and Regulation (REG) covers the rules for retirement accounts; Tax Compliance and Planning (TCP) asks how to use them — choosing a plan for a small business owner, deciding between traditional and Roth contributions, planning conversions and withdrawals, and handling employer stock and inherited accounts. Figures are for 2026 unless stated.
Choosing a plan for a small business or self-employed individual
| Plan | Who contributes | Features | Best for |
|---|---|---|---|
| Simplified employee pension (SEP) individual retirement account (IRA) | Employer only — up to 25% of compensation (about 20% of net self-employment earnings), subject to the annual dollar limit | Very simple; contributions can be made up to the return due date including extensions; must cover eligible employees at the same percentage | Sole proprietors and very small firms wanting flexibility and low cost |
| Savings Incentive Match Plan for Employees (SIMPLE) IRA | Employee deferrals (lower limit than a 401(k)) plus a required employer match (up to 3%) or 2% nonelective contribution | 100 or fewer employees; low administration | Small employers wanting employee deferrals cheaply |
| Solo 401(k) | Owner as employee ($24,500 deferral + catch-up) and as employer (profit-sharing up to 25%) | Only the owner (and spouse); Roth option; loans possible | Self-employed with no employees who want the highest contributions at moderate income |
| Traditional or safe harbor 401(k) | Employee deferrals + employer contributions | Nondiscrimination testing (avoided by safe harbor designs) | Growing businesses |
| Defined benefit or cash balance plan | Employer, actuarially determined | Very large deductible contributions possible for older, high-income owners; higher cost and required funding | High earners near retirement wanting to shelter large amounts |
Small employers may claim credits for plan start-up costs and automatic enrollment, which reduce the cost of adopting a plan.
Traditional or Roth?
| Choose traditional (pre-tax) when | Choose Roth when |
|---|---|
| Current marginal rate is higher than the expected rate in retirement | Current rate is lower than the expected future rate (early career, low-income years) |
| Lowering adjusted gross income (AGI) now preserves credits or deductions that phase out | The taxpayer values tax-free withdrawals and no required minimum distributions |
| Cash is needed now | Estate planning — heirs inherit tax-free Roth accounts (subject to the 10-year rule) |
From 2026, catch-up contributions for employees whose prior-year wages exceeded an indexed threshold (about $150,000) must be made as Roth contributions, under the Setting Every Community Up for Retirement Enhancement (SECURE) 2.0 Act.
Roth strategies
- Roth conversions: convert traditional balances in low-income years (between retirement and required distributions, or in a loss year) to fill up lower brackets. Pay the tax from non-retirement funds if possible. Conversions can't be undone (no recharacterization).
- Backdoor Roth IRA: high earners above the Roth contribution income limits make a nondeductible traditional IRA contribution and then convert it. The pro rata rule treats all traditional, SEP, and SIMPLE IRA balances as one — existing pre-tax balances make part of the conversion taxable (rolling them into an employer plan first avoids this).
- Mega-backdoor Roth: after-tax contributions to a 401(k) (if the plan allows) up to the overall annual additions limit, then in-plan Roth conversion.
- Each Roth conversion has its own 5-year period for the 10% penalty on converted amounts withdrawn before age 59½.
Distribution planning
- Required minimum distributions begin at age 73 (75 for those born in 1960 or later); the first may be delayed to April 1 of the next year (but that doubles up income). Roth IRAs and Roth 401(k)s have no lifetime distributions.
- Qualified charitable distributions (age 70½+): up to an indexed annual limit sent directly to charity — excluded from income and counted toward required distributions.
- Withdrawal sequencing: a common approach draws taxable accounts first, then tax-deferred, then Roth — but blending withdrawals to fill low brackets each year often lowers lifetime tax.
- Manage modified AGI to control taxation of Social Security benefits, Medicare premium surcharges, the net investment income tax, and the new senior deduction phase-out.
Employer stock — net unrealized appreciation
If a 401(k) holds appreciated employer stock, a lump-sum distribution of the stock in kind (after a triggering event such as separation or age 59½) lets the employee pay ordinary income tax only on the plan's cost basis. The net unrealized appreciation is taxed as long-term capital gain when the shares are sold, regardless of holding period — often better than rolling everything into an IRA, where all withdrawals are ordinary income.
EXAMPLE: A 401(k) holds employer stock with a cost basis of $50,000 and a value of $400,000. Distributed in kind in a lump sum, the employee reports $50,000 of ordinary income now; the $350,000 of appreciation is long-term capital gain when sold (taxed at up to 20% instead of up to 37%).
Inherited accounts
- A surviving spouse can treat an inherited IRA as their own (delaying distributions) or remain a beneficiary (allowing penalty-free withdrawals before 59½).
- Most other beneficiaries must empty the account within 10 years; if the owner had already started required distributions, annual distributions are also required during those 10 years.
- Eligible designated beneficiaries (minor children until majority, disabled or chronically ill persons, those not more than 10 years younger) may stretch distributions over life expectancy.
- Planning: spread withdrawals over the 10 years to avoid bunching income into high brackets.
Annuities
Nonqualified annuities grow tax-deferred; withdrawals are taxed on an earnings-first basis (a 10% penalty may apply before 59½), and annuity payments are part tax-free return of investment (the exclusion ratio). They provide longevity protection but often carry high fees.
How it is tested
- Choose the most suitable retirement plan for a business owner.
- Decide between traditional and Roth contributions or a conversion.
- Apply the pro rata rule to a backdoor Roth.
- Plan distributions, qualified charitable distributions, net unrealized appreciation, and inherited accounts.
EXAM TIP: A backdoor Roth is fully tax-free only if the taxpayer has no other pre-tax IRA balances at year-end. Otherwise the pro rata rule makes part of the conversion taxable.