105-3 Profit-Sharing and Other Defined Contribution Plans Flashcards
Traditional profit-sharing plan
- defined contribution plan
- flexible, discretionary employer contribution provision
- to remain qualified, plan must be made on a substantial and recurring basis
- annual contributions limited to lesser of 100% of employee compensation or $56,000 (2019) w/ only the first $280k (2019) of employee compensation taken into account
Appropriate when:
- employer’s profits/cash flow fluctuate from year to year
- employer wishes to implement a qualified plan w/ an incentive feature
- majority of employees are young (under 50)
- employees are willing to accept a degree of investment risk in their individual accounts
In-service distributions
ability of the participant to access the individual account balance prior to retirement
Major advantage of profit-sharing plans
Hardship withdrawal
Qualifying distribution from profit-sharing plan. Must meet following tests:
- Financial needs test: hardship must be due to an immediate and heavy financial need of the participant-employee
- Resources test: participant may not have other financial sources sufficient to satisfy the need
Age-based profit-sharing plan
Profit-sharing plan in which allocations to participants are made in proportion to the participant’s age-adjusted compensation
Each participant’s compensation is weighted by an age factor
this is a cross-tested plan: may be tested for nondiscrimination on the basis of benefits
Most appropriate when the biz owner is significantly older than most employees, wishes to show annual contribution on his behalf without violating nondiscrimination rules
New Compatibility Plan
Cross-tested profit-sharing retirement plan in which the employee-participants are divided into groups or classes
(e.g. job category, age, or years of service)
Each group or class typically receives a different level of employer contribution as a % of compensation
It may also be tested for nondiscrimination on the basis of benefits rather than contributions
Stock Bonus Plan
Type of profit-sharing plan w/ 1 major difference: the employer contributions and benefits distributed from the plan are generally made in the form of employer stock, not in cash
Appropriate for employer w/ unstable cash flow who does not wish to deplete needed cash and, instead, wishes to make contributions in the form of listed or closely held stock
Option for net unrealized appreciation (NUA)
Net Unrealized Appreciation (NUA)
Participant retirees are not taxed on the full FMV of employer stock when it is distributed
Instead, the NUA is taxed as long-term capital gain when the participant or beneficiary subsequently sells the stock
At time of distribution, participant recognizes as ordinary income an amount equal to the value of the stock at the time of contribution
Employee Stock Ownership Plan (ESOP)
A type of stock bonus plan in which individual participant accounts are invested primarily in employer stock
The ESOP may borrow money in the name of the plan without violating the prohibited transaction rules
If ESOP does borrow money in the plan’s name, it is commonly referred to as the leveraged ESOP (LESOP)
Complex retirement plan
Most appropriate when:
-employer wishes to make the employees owners of the biz through a tax advantaged means and at a relatively low cost
4 types of Section 401(k) Plans
- Traditional Section 401(k) plans
- Safe harbor Section 401(k) plans
- SIMPLE 401(k)
- ROTH 401(k)
Traditional Section 401(k) plan
aka qualified cash or deferred arrangement (CODA)
Plan participants have an option to contribute money to the plan on a pretax basis, known as an elective deferral, or receive taxable cash compensation
Appropriate plan type when: A) employee wants to provide qualified retirement plan but employees can afford only minimal expense beyond existing salary costs, B) employees are relatively young and have substantial time to accumulate retirement savings, C) employers want to encourage employees to save for own retirement
Elective deferrals are not subject to income taxation, they are subject to FICA and FUTA taxes
Max elective deferral is $19k (2019)
Participants at least age 50 by the end of the taxable year can make additional catch-up contributions of $6k (2019)
401k plan must satisfy general nondiscrimination test and 2 special nondiscrimination tests:
1) Actual Deferral % (ADP) test
2) Actual Contribution % (ACP) test
Because of these tests, a 401k plan can be complex and costly to administer
Qualified matching contributions and qualified nonelective contributions
Do count in the application of the annual additions limit ($56k in 2019) for 401k plans
Pension Protection Act of 2006 (PPA) Automatic Enrollment in Traditional Section 401(k) Plans
Automatic enrollment aka negative election
Allows an employer to enroll employees in the Section 401(k) plan without the employees’ consent, as long as the employees have the right to opt out of contributing
Safe Harbor Section 401(k) Plan
Permits a high level of elective deferrals by employees without annual discrimination testing
Not subject to top-heavy plan provisions
Mandatory minimum employer contribution is required in which the employee must be 100% vested immediately
Many small businesses like this plan because it is less expensive to operate and does not need to be tested annually
SIMPLE 401(k)
100 or fewer employees earning $5k (or more) during the preceding year
Maximum deferral limits are less than those permitted under a traditional Section 401(k) plan
2019: employee elective deferrals –> limited to $12k w/ catch-up contribution for those age 50+ of $3k
Employee is always 100% vested int he contributions made to a SIMPLE 401(k)
ROTH 401(k)
Type of Section 401(k) plan in which elective deferral contributions are permitted on an after-tax basis
Separate account created for the ROTH
Same contribution limits as for traditional Section 401(k)
Unlike the ROTH IRA, the ability to make contributions to a ROTH 401(k) is not phased out bases on the taxpayer’s AGI
Only the employer matching contributions (if any) and the related earnings w/ a ROTH 401(k) are taxable
Distribution is tax free if both tests met:
A) after 5-yr period from the date of the 1st contribution
B) occurs after age 59.5, becomes disabled or made to beneficiary of a deceased participant
