5. Retirement Planning - All Exam Tips and Practitioner's Advice Flashcards
Module 5. Retirement Planning
Lesson 2. Qualified Plans
Practitioner Advice:
Practitioner Advice:
* Although the 70% – 80% estimate is a common practice, studies have not been conclusive as to an effective wage replacement ratio and this should be considered a “rule of thumb” for projecting living expenses.
Practitioner Advice:
Practitioner Advice:
* A spouse may collect either their own benefit or 50% of their retired spouse’s benefit, whichever is greater.
* For example, if a spouse’s retirement Social Security estimate is less than 50% of their husband’s or wife’s, he or she can round up the amount to 50% of their husband’s or wife’s projected benefit.
* This is because a spouse will get an amount of retirement benefit that equals the greater of his or her benefit or 50% of the spouse’s.
Practitioner Advice:
Practitioner Advice:
* You cannot overestimate to your client the value of starting to save and invest early.
* For example, if Bob, age 25, saved $3,000 per year (at the beginning of each year) for 10 years and earned 10% after tax and then stopped but let the fund accumulate to age 65, he would have accumulated $917,725.
* If we compare this to Steve, age 25, waiting until age 35 to begin and saving $3,000 (also at the beginning of each year) for 30 years, he would have accumulated $542,830.
* Not only will Steve have less money, but also he put in three times as much. This example illustrates the importance of saving early for retirement and the effects of compound interest.
Practitioner Advice:
Practitioner Advice:
* Most seniors believe that Medicare will cover all their long-term care needs but this is false.
* Medicare does not pay for custodial nursing care if that is the only care needed.
* Also, Medicare will only pay up to 100 days in a skilled nursing facility per benefit period (only if hospitalized for at least 3 days).
Exam Tip:
Exam Tip:
* As of current legislation, a person is entitled to Medicare health benefits at age 65 even if their full retirement age is later.
Exam Tip:
Exam Tip:
* If a question asks you what the potential client should do but states the potential client has concealed important information, the correct response is that you should revise the scope of the engagement or you should not work with the potential client.
Practitioner Advice:
Defined contribution plans can be integrated only under the excess method. Generally, if the integration level is equal to the Social Security taxable wage base in effect at the beginning of the plan year, which is $160,200 (2023), the difference in the allocation percentages above and below the integration level can be no more than the lesser of:
* The percentage contribution below the integration level, or
* The greater of:
* 5.7%, or
* The old-age portion of the Social Security tax rate. The IRS will publish the percentage rate of the portion attributable to old-age insurance when it exceeds 5.7%.
Another way to state the rule is that the amount of permitted disparity is the lesser of twice the percentage contribution below the integration level or 5.7%.
For example, an integrated plan, for a plan year beginning in 2023, might have an integration level of $160,200. The plan allocates employer contributions plus forfeitures at the rate of 15.7% of compensation above the integration level. Then it would have to provide at least a 10% allocation for compensation below the integration level, making the difference 5.7%.
Percentage contribution below the integration level Maximum allowable percentage contribution above the integration level
1% 2%
2% 4%
3% 6%
4% 8%
5% 10%
6% 11.7%
7% 12.7%
8% 13.7%
9% 14.7%
10% 15.7%
11% 16.7%
12% 17.7%
Practitioner Advice:
* The integration level may be set to any salary level at or below the current social security wage base, as long as this does not create a discriminatory plan.
Exam Tip:
Actuarial cost methods depend on making assumptions about various cost factors, as actual results cannot be known in advance. The annual cost developed under an actuarial cost method depends significantly on these assumptions, and there is some flexibility in choosing assumptions. Under the Code, each assumption must be reasonable, within guidelines in the Code and regulations. Actuarial assumptions include:
* Investment return on the plan fund,
* Salary scale, which is an assumption about increases in future salaries and is particularly significant if the plan uses a final average type of formula,
* Mortality, or the extent to which some benefits will not be paid because of the death of employees before retirement,
* Annuity purchase rate, which determines the funds needed at retirement to provide annuities in the amount designated by the plan formula,
* Assumptions about future investment return and postretirement mortality that the annuity purchase rate depends on, and
* Turnover, or the extent to which employees will terminate employment before retirement and thereby receive limited or no benefit.
Exam Tip:
* The CFP Exam will test your knowledge as to the impact of these assumptions on the funding level of the plan for each year.
* For example, if the assumption of investment return is too low, the funding may have to be increased next year.
Practitioner Advice:
Practitioner Advice:
* Many planners discourage loans from qualified plans for two reasons.
* First, the outstanding balance loses the opportunity for growth.
* Second, many plans “call the note” when an employee terminates from service. If the employee cannot pay back the outstanding loan balance within the prescribed time period (usually 60-90 days), then the outstanding loan balance is deemed a distribution subject to taxes and possibly early withdrawal penalties.
Exam Tip: AUDIO: Highly Compensated Employees (HCEs) & Key Employees
Exam Tip:
* Distinguishing between Highly Compensated Employees (HCEs) and Key Employees is essential for navigating the retirement plan selection process and understanding certain employer-provided benefits.
* Highly Compensated: More than a 5% owner or received compensation in excess of $150,000 (2023) (indexed).
* Key Employee: Greater than a 5% owner or an officer of the employer having annual compensation greater than $215,000 or a greater than 1% owner whose salary exceeds $150,000.
Here, Mike serves up a breakdown of the two categories and points out the need-to-know elements of each category.
Need to keep these straight:
Highly Compensated Employees (HCEs) - Someone that is more than a 5% owner will ALWAYS be a Highly Compensated Employee.
* ADP
* ACP testing
* 401k
* Coverage Test, Safe Harbor Test
* Ratio Test
* Average Benefit Test
Key Employees
* Top Heavy Testing
* Qualified plans
* Group life insurance
Practitioner Advice:
Practitioner Advice:
* Many employers offer a 401(k) plan with matching contributions.
* Some employers even match dollar for dollar up to a certain limit.
* Believe it or not, many employees do not take advantage of the “free money” that their employers are making available.
* Employees should at least contribute up to the matching level that the employer provides.
* This is a financial planning recommendation that almost always makes sense.
Practitioner Advice: Roth 401(k) Distributions
There are some unique distribution rules for Roth 401(k) money that contrast sharply with Roth IRA rules.
Withdrawals of less than the full amount of the account are made pro-rata with a portion of each withdrawal being taxable and tax-free. This is markedly different than the Roth-IRA distribution FIFO rules.
Direct Transfers from a Roth 401(k) to another Roth 401(k) plan are permitted. However, if a distribution (rather than a direct transfer) of Roth 401(k) money is taken, only the un-taxed gains can then be rolled over to another Roth 401(k) plan within sixty days. The post-tax contributions cannot be rolled over. Naturally, the new plan must allow for the acceptance of Roth 401(k) contributions.
If loans from a Roth 401(k) should default, the outstanding balance will be treated as a non-qualified distribution and any earnings distributed are fully taxable and subject to a 10% excise tax. For this reason, every effort should be made to repay an outstanding loan from a Roth 401(k) plan rather than allowing it to default.
The Five-Year Rule - Frankie begins Roth 401(k) contributions in October, 2019. 2019 becomes year 1. As of December 31, 2023, Frankie will meet the five-year rule. He may now withdraw the gains on his Roth 401(k) account tax-free after 59 ½ or disability or his beneficiary will receive them tax-free following his death.
Practitioner Advice:
* It may be advisable to directly transfer Roth 401(k) assets to a Roth-IRA before taking withdrawals.
* Then the more favorable FIFO withdrawal rules will apply.
* This also helps avoid mandatory withdrawals at age 73.
* To avoid Required Minimum Distributions of Roth 401(k) accounts, the participant can directly transfer them to a Roth-IRA account prior to age 73.
* Roth IRA accounts are not subject to mandatory withdrawals at 73.
* However, there’s a “tax trap” here to be careful of.
* If the receiving Roth IRA is established at that point in time, a new five-year rule will have to be satisfied before untaxed gains can be withdrawn tax-free, even though the five-year rule was satisfied in the 401(k) plan.
* It would be wise for the participant to have anticipated this and started a Roth IRA at least five years prior to rolling the Roth 401(k) money in.
Practitioner Advice: Adding Safe Harbor 401k plan eliminate ADP/ACP
Adding Safe Harbor provisions to a 401(k) plan will eliminate the need for the ADP/ACP test thus allowing highly compensated employees to contribute the maximum elective deferral amount.
* Safe Harbor provisions can only be added to a plan at the beginning of a new plan year, after providing employees with advance written notice of the change.
* These provisions require the plan to provide either a minimum matching contribution or a non-elective contribution for all eligible employees.
* Additionally, the matching contributions or the non-elective contributions must be immediately vested.
The employer must provide one of these options plus immediate vesting under Safe Harbor 401(k) provisions:
* Matching Contributions must equal 100% of the first 3% of employee contributions and 50% of the next 2% of employee contributions, or
* Non-Elective Contributions for all eligible employees equal to 3% of their compensation.
Practitioner Advice:
* The employer must announce (in writing) which of the two options will be used for the year. This eliminates the employer’s ability to simply select the option that will cost less.
* If all employees contribute at least 5% to the plan, then the non-elective option would be cheaper for the employer.
* However, if most employees were not contributing to the plan, the matching formula would be less costly.
* Thus the employer must declare first.
PRACTITIONER ADVICE Section 2 - Defined Contribution Plans Summary
PRACTITIONER ADVICE
* 401(k) plans are usually built on to a profit sharing plan. Adding 401(k) provisions to a profit sharing plan meets the “substantial and recurring” standard thus relieving the employer of ever having to make any profit sharing contributions to the plan.
Defined contribution plans are retirement plans in which the employer alone or both the employee and the employer together contribute directly to an individual account set-aside specifically for the employee. In effect, a defined contribution plan can be thought of as a savings account for retirement. However, eventual payments are not guaranteed to the employee. What he or she eventually receives depends on how well the plan investments perform. Many defined contribution plans allow the employee to choose how the account is invested. They involve no investment risk for the employer because their responsibility ends with their contribution.
In this lesson, we have covered the following:
* Money purchase plan is a defined contribution pension plan under which the employer must contribute a stated percentage of the participant’s compensation to each participant’s account annually. The money purchase plan is probably the simplest of all types of plans and until recently had been one of the most common. For the employer, such a plan offers less flexibility, because contributions are required regardless of how well the firm does. For the employee, these plans are preferable to profit sharing because of the guaranteed contribution.
* Profit sharing plan is a defined contribution plan under which the employer determines the amount of the contribution each year, rather than having a stated contribution obligation. The employer contributions can vary from year to year depending on the firm’s performance. The employer can decide not to contribute to the plan at all in certain cases. If a contribution is made, the total amount must be allocated to each participant’s account using a nondiscriminatory formula. Such formulas are usually based on the employee’s compensation level, but service can be taken into account.
- Savings Plan is a defined contribution plan under which the employer may match a percentage of the employee’s contributions to their retirement account. The employee’s contributions are usually after-tax. A compensation limit is also set. Above this amount, contributions aren’t matched, but employees can continue to contribute up to 15 percent of their salary.
- Section 401(k) Plan is a plan under which employees can make either tax deductible or after-tax Roth contributions by electing salary reductions. These can be set up as part of a profit sharing plan, with both the employer and the employee contributing to the plan, or with only the employee making a contribution. Employers often match employee salary reductions in order to encourage employee participation in these plans. Traditional employee’s contributions to the plan and the earnings on those contributions are tax-advantaged, with all taxes being deferred until retirement withdrawals are made. Roth 401(k) contributions are no tax advantaged when contributed but may be withdrawn along with gains tax free if certain conditions are met. Also, 401(k) plans usually offer a wide variety of investment options, with a minimum of three that must be offered.
- Target benefit pension plan is similar to a money purchase plan in that the employer must make annual contributions to each participant’s account under a formula based on compensation. In a target plan, however, the participant’s age at plan entry is also taken into account in determining the contribution percentage. This is done on an actuarial basis so that older entrants can build up retirement accounts faster. The target provides approximately the same benefit level as a percentage of compensation for each participant at retirement. The employer does not guarantee this level, however, and the employee bears the risk and also reaps the benefit of varying investment results.
- Age weighted profit sharing plan is a profit sharing plan with an age-weighted factor in the allocation formula. Like all profit sharing plans, the employer’s annual contribution can be discretionary, so the participants have no assurance of a specific annual funding level. However, since the plan allocations are age-weighted, older plan entrants are favored.
Module 5. Retirement Planning
Lesson 3. Non-Qualified Plans
Practitioner Advice: When Benefits in Nonqualified plans Forfeitable
When are Benefits in Nonqualified plans Forfeitable?
The qualified plan vesting rules apply only if the plan covers rank-and-file employees.
* If the plan covers only independent contractors or a select group of management or highly compensated employees, benefits must be forfeitable in full at all times or subject to current taxation to the employee.
Practitioner Advice:
* For that reason, these plans are often referred to as “Top Hat” plans.
Practitioner Advice: Nonqualified Deferred Comp Salary Reduction
A salary reduction formula involves an elective deferral of a specified amount of the compensation that the employee would have otherwise received. The employer contribution under this type of plan could be in the form of a bonus, without actual reduction of salary. The plan is somewhat similar to a defined contribution type of qualified plan, although the qualified plan restrictions do not apply.
The amount deferred each year under a salary reduction formula is generally credited to the employee’s account under the plan. When benefits are due, the amount accumulated in this account determines the amount of payments. Payment is generally in the form of a lump sum, but the account balance can also be paid in an equivalent stream of periodic payments.
The salary reduction formula generally provides a method by which earnings on the account are credited. These earnings credits may be based upon a specified interest rate, or an external standard, such as Moody’s Bond Index, the federal rate or other indexed rate, or the rate of earnings on specified assets.
In a salary reduction arrangement, the employer has no obligation to actually set assets aside. The participant’s account can be purely an accounting concept existing only on paper. In that case, when payment becomes due, the employer pays it from its current assets. This points out the fact that all nonqualified deferred compensation plans are essentially based only on the employer’s contractual obligation to pay benefits.
Practitioner Advice:
* Since the financial stability of corporations is not bullet proof, a financial planner needs to explore all alternatives to a nonqualified deferred compensation plan, as well as the company’s financial strength, before recommending that his or her client defer current income into a non-qualified salary reduction agreement.
Exam Tip: Nonqualified Deferred Compensation Plan - Excess Benefit
Under ERISA Section 4(b)(5), an excess benefit plan is a plan that is unfunded and is not subject to Title I of ERISA, which contains the reporting and disclosure, participation, vesting, funding, and fiduciary responsibility provisions.
Excess benefit plans are designed to provide benefits only for executives whose annual projected qualified plan benefits are limited under the dollar limits of Code Section 415. An excess benefit plan makes up the difference between the qualified plan benefits top executives are allowed under Section 415 compared to the benefits provided to rank-and-file employees. In other words, highly compensated employees receive the difference between the amounts payable under their qualified plan and the amount they would have received if there were no benefit limitations under Code Section 415.
For some time, it was believed that an excess benefit plan could not restore benefits lost under the Code Section 401(a)(17) limitation on compensation of $330,000(2023) (as indexed), which would limit the usefulness of this type of plan.
Even if the excess benefit formula is not specifically based upon the Section 401(a)(17) compensation limitation, many nonqualified plan benefit formulas are related to qualified plan formulas and are designed to make the executive whole, that is, to provide an amount that makes up the difference between the benefit that the executive would have received under the employer’s qualified plans without the limitations of either Section 415 or Section 401(a)(17) and the amount actually received.
Exam Tip:
* The maximum annual benefit a company can provide in a qualified defined benefit plan is the lesser of $265,000 (2023) or 100% of the participant’s compensation averaged over his three highest-earning consecutive years.
* For an employee who makes significantly more than this limit, an excess benefit plan can provide a greater percentage of pre-retirement income during retirement.
Exam Tip: nonqualified deferred compensation plan funded by life ins
Life insurance policies on the employee’s life, owned by and payable to the employer corporation, can provide financing for the employer’s obligation under nonqualified deferred compensation plans.
* With life insurance financing, the plan can provide a substantial death benefit, even in the early years of the plan.
* This is of significant value to younger employees.
Exam Tip:
* Informally funding a nonqualified deferred compensation plan with life insurance is common because the cash value buildup is tax-deferred.
Practitioner Advice: Split Dollar Life Insurance
Split dollar life insurance is an arrangement, typically between an employer and an employee, in which there is a sharing of the costs and benefits of the life insurance policy.
* Split dollar plans can also be adopted for purposes other than providing an employee benefit, for example,
* between a parent corporation and a subsidiary, or
* between a parent and a child or in-law.
* Usually, split dollar plans involve a splitting of premiums, death benefits, and/or cash values.
In today’s environment, the split is usually based on the Endorsement Method with the employer being the owner of the policy. The cash value is rarely split anymore due to the tax implications. The most common form of Split Dollar, Endorsement, will have the employer own the policy and all of the cash value. The employer gets enough of the death benefit to pay back their costs with the balance going to the employee.
* The Equity Split Dollar Method is rarely viable or favorable anymore as any payments by the employee towards premiums will create a taxable event for the employee.
In general, the owner of the contract is deemed to be providing economic benefits to the non-owner of the contract (reduced by any consideration paid by the non-owner).
* The relationship between the owner and the non-owner will dictate whether the economic benefit is deemed to be compensation, dividend, or gift.
* The two parties must account for any benefit.
* In an employer/employee relationship the employee must report any benefit received as compensation on the employee’s federal income tax return.
* In a trust arrangement a federal gift tax return may be required.
* Generally speaking, the economic benefit, and therefore the gift or taxable income (depending upon the relationship between the owner and non-owner) will be determined by applying the rates from the 2001-10 table per thousand dollars of pure life insurance amount at risk that is to the benefit of the non-owner’s beneficiary. It may be possible to use the issuing insurance company’s least expensive term insurance rate under certain circumstances.
Under an equity split dollar arrangement the “loan regime” would apply.
* In an employer/employee relationship the employee would be the owner of the contract from inception and thus would enjoy the normal tax benefits associated with a life insurance contract.
* The employer is deemed, in effect, to be making a loan to the employee.
* In the future the loan must either be repaid or forgiven and treated as compensation or a dividend.
* This assumes that the life insurance policy is not a MEC, a modified endowment contract, whose loans are treated as ordinary income and subject to a 10% penalty if the employee is under age 59 ½.
In a non-employment trust situation the same “loan regime” would apply but ultimately the loan would have to be repaid, or forgiven and treated as a gift. Under either scenario the most common approach would be for the non-owner to pay part or all of the premium and treat such payment as an interest free loan. Under the interest free loan rules (Section 7872 of the IRC) an economic benefit would be determined by imputing interest on the outstanding loan balance in any given year. The most common approach for determining the appropriate interest rate would be to use the short term Applicable Federal Rate (AFR) on a blended basis for the current tax year. In an employment situation the imputed income would be taxable income to the employee. The employer would be in a wash position with no tax consequence. In a non-employment or trust situation the imputed interest would most usually be treated as a gift.
There are an almost infinite number of variations on the splitting of dollars theme, limited only by the needs and premium-paying abilities of the parties and the creativity of the planner.
To ensure that you have a solid understanding of Split Dollar Life Insurance, the following topics will be covered in this lesson:
* When Is It Used?
* Advantages
* Disadvantages
* ERISA Requirements
Upon completion of this lesson, you should be able to:
* Identify the uses of split dollar insurance,
* Define the advantages of this type of plan,
* Describe the disadvantages of this plan, and
* Describe the ERISA requirements for split dollar insurance.
Practitioner Advice:
* After a series of interim notices, including Notice 2001-10, Notice 2002-8 and Notice 2002-59, the IRS issued final regulations regarding split dollar on September 11, 2003 for all transactions entered into after September 17, 2003.
* Notice 2002-8 will be the main source of guidance for split dollar arrangements entered into prior to September 17, 2003.
* It should be noted that under transition rules prior arrangements for so called “equity split dollar” could be converted to a “loan regime” approach for periods after January 1, 2004 and expect to receive safe harbor treatment.
* Existing arrangements before September 17th may also continue to consider themselves treated under the old rules but if they choose that approach there is no assurance that the IRS will agree upon audit.
- The final regulations, officially known as Split Dollar Life Insurance Arrangements, TD 9092, significantly revise the traditional treatment of split dollar.
- Under the new rules there are two mutually exclusive regimes. They are an “economic benefit regime” where the only benefit being bestowed and therefore measured is a pure death benefit, and a “loan regime” where equity or cash value benefits are being enjoyed in addition to a pure death benefit. The IRS says that the split dollar participants can, in effect, select which regime will apply by determining who is the owner of the life insurance contract.
Exam Tip Split dollar plan. Employer reliquinsh, taxable to employee
What are the Disadvantages of the split dollar plan?
The employer receives no current tax deduction for its share of premium payments under the split dollar plan.
The employee must pay income taxes each year on the current cost of life insurance protection under the plan, less any premiums paid by the employee.
* This cost can be determined by using either one-year term rates provided by the federal government to measure the taxable economic benefit received by employees from the pure insurance protection provided by split dollar plans when the employer owns the policy or imputed income to the employee under the “loan regime” when the employee owns the policy.
The plan must remain in effect for a reasonably long time, that is 10 to 20 years, in order for policy cash values to rise to a level sufficient to maximize plan benefits.
Plans that provide for an employee share in the policy’s cash value-equity-type split dollar plans have been attractive in the past because they provide a savings or investment benefit for the employee.
* Under new regulations the employee tax cost of these plans is directly linked to the level of interest rates.
* The tax consequences under the new regulations make this form of split dollar unattractive.
Exam Tip:
* If the employer relinquishes the rights to the policy, there will be a taxable event at that time to the employee.
Practitioner Advice:
What are the Penalties for Non-compliance with Section 409A?
There are significant penalties that apply for noncompliance with Section 409A. If a deferral amount is required to be included in income under Section 409A, the amount is subject to both income tax and interest.
The interest imposed is equal to the interest at the underpayment rate plus one percentage point.
The additional tax is equal to 20 percent of the compensation required to be included in gross income.
In addition, in calendar years beginning after December 31, 2004, there are new reporting rules that apply requiring the deferred amounts to be submitted to the IRS using Form W-2 (for employees) or Form 1099 (for non-employees).
Practitioner Advice:
* As long as the non-discounted grant is greater than or equal to the fair market value at all times, the rules and penalties associated with Section 409A will not apply.
* However, if the non-discounted grant is LESS than the fair market value you should review all of the specific rules that relate to 409A and outstanding stock rights. For more information about these rules, see Notice 2005-1 and Notice 2006-4 at www.irs.gov
Practitioner Advice: Incentive Stock Option (ISO) - triggering AMT
What are Incentive Stock Option (ISO)?
An incentive stock option (ISO) plan is a tax-favored plan for compensating executives by granting options to buy company stock at specific exercise prices.
* Unlike regular stock options, ISOs generally do not result in taxable income to executives either at the time of the grant or the time of the exercise of the option.
* If the ISO meets the requirements of Internal Revenue Code Section 422, the executive is taxed only when stock purchased under the ISO is sold, except for the potential of Alternative Minimum Tax.
For example, in 2019, through an ISO Plan at Sally’s work, she is given the right to buy 100 shares of stock at $15 per share for 10 years. After five years, in 2023, the stock is priced at $24, and Sally can buy the $24 stock for $15. Sally pays no tax when she exercises her options, and the company gets no tax deduction. Subsequently, she sells the shares for $30 per share (the fair market value (FMV)) in 2026. Sally has met the minimum holding requirements of waiting two years after the options were granted and one year after exercising the options.
In this scenario, Sally pays capital gains tax on $6, the difference between the market value when exercised ($24) and the sale price ($30) and the capital gains tax on $9, which was the difference between the exercise price ($15) and the market value ($24) at the time of exercise.
* If the holding period is not met, the gain will be ordinary income and taxed as such.
* If the ISO rules are not met, then the options are taxed like a non-qualified option.
Practitioner Advice:
* Regarding the above example, Sally could have a tax liability because of AMT.
* The difference between the market price and the exercise price is a tax preference item and gets added back for the AMT calculation in the year the ISOs are exercised.
Practitioner Advice: Incentive Stock Option: AMT, stock dec in value
What are the Disadvantages of Incentive Stock Options?
There are certain drawbacks to the ISO plan. These are detailed below:
* The corporation granting an ISO does not ordinarily receive a tax deduction for it at any time.
* The plan must meet complex technical requirements of Code Section 422 and related provisions.
* The exercise price of an ISO must be at least equal to the fair market value of the stock when the option is granted. There is no similar restriction on nonstatutory options.
* As with all stock option plans, the executive gets no benefit unless he is able to come up with enough cash to exercise the option.
* An executive may incur an alternative minimum tax (AMT) liability when an ISO option is exercised, thus increasing the executive’s cash requirements in the year of exercise.
Practitioner Advice:
* Many people during the tech boom exercised their incentive stock options, which caused them to pay AMT.
* Unfortunately, in many circumstances, stock prices have been drastically reduced.
* In addition to paying AMT at exercise, these employees own stock that is worth much less than they paid for it.
Practitioner Advice: Section 457 $22,500 limit, $7,500 catch up 50yo
What is the Limit on Amount Deferred in Eligible Section 457 plans?
For an eligible plan, the amount deferred annually by an employee cannot exceed the lesser of 100% of the employee’s compensation or $22,500 in 2023.
The applicable dollar amount is adjusted for cost-of-living increases, in increments of $500. Salary reductions under a Section 457 plan do not have to be coordinated with elective deferrals to other plans such as Section 401(k) plans (qualified profit-sharing or stock bonus plans under which participants have the option to put money in the plan or receive the same amount as taxable cash compensation) and Section 403(b) plans (a tax-deferred employee retirement plan that can be adopted only by certain tax-exempt organizations and certain public school systems.
* This means that any elective deferral under a 457 plan will not decrease the amount that an employee can defer under other tax-advantaged plans.
* A participant with sufficient compensation at two employers, one that sponsors a Section 457 plan, can contribute the maximum to each employer’s plan.
Suppose Michael Orentlich, whose annual salary is $150,000, participates in his employer 457 plan. Michael has another job that has a 401(K) plan. Even though Michael contributes the maximum to his 457 plan, he would still be able to contribute and deduct up to an additional $22,500 into his 401(k) plan in 2023.
Practitioner Advice:
* Participants in a plan of a governmental employer or a non-church-controlled tax-exempt organization who are age 50 and over are eligible for an additional salary reduction catch-up contribution of $7,500 (2023).
The $7,500 catch-up limit will be indexed for inflation in future years.
Exam Tip: elective deferrals must be aggregated, EXCEPT into a 457
Describe Catch-up Contributions in 457 Plans
The old catch-up provision, which still applies to each of the last three years before normal retirement age, enables participants to make up for contributions not deferred in previous years. They may “catch up” for any year(s) since January 1, 1979, if they were eligible to contribute to a deferred compensation plan but did not contribute the maximum amount allowed under the Internal Revenue Code.
Catch-up contributions can be defined as elective contributions which:
* Exceed the applicable limitation as determined at year-end,
* Are treated by the eligible plan as catch-up contributions, and
* Do not exceed the annual catch-up contribution limit.
Special rules apply to the new catch-up contributions under a Section 457 plan:
* The additional over-50 elective deferral amounts are not available in any year in which the participant makes additional deferrals under the old three-year catch-up provision described below.
* Notwithstanding the amount in the table, the additional deferral cannot exceed the excess, if any, of the participant’s compensation overall regular elective deferrals.
* For example, consider a participant over age 50 who has compensation of $23,000 in 2023 and regular salary deferrals of $22,500. In such a case, only an additional $500 can be deferred under this 50-or-over provision (ignoring that FICA contributions may need to be made from the compensation).
* The Section 415 limitation (limitation applied to qualified deferral plans that place a cap on the amount of money that plan participants and employers can contribute to a plan on a tax-deferred basis) does not prevent the use of this 50-or-over provision, even if the total deferred thereby exceeds the Section 415 limitation.
* For example, suppose a participant over age 50 has annual compensation of $100,000. He or she has regular annual additions of $66,000(2023) to the employer’s defined contribution plans for the year, which is the full Section 415 limitation. In this case, the 50-or-over excess deferrals would still be available.
* All eligible participants must have the same right to make this election.
The dollar limit is applied per individual, not a per-plan, basis. For example, consider the case of Lydia, who is employed by two different governmental employers. Her total annual deferral from both employers cannot exceed the $22,500 limit in 2023. The 100% of compensation limit applies on a per-plan basis. Thus, Lydia may not defer more than 100% of her includable compensation under any one plan.
The new catch-up rule does not apply during a participant’s last three years before retirement. During those years, the old catch-up rule of Section 457(b)(3) applies. The contribution ceiling can be increased in each of the last three years before the normal retirement age to the lesser of:
* Twice the dollar limit for the year, or
* The regular limit of the lesser of the dollar limit for the year or 100% of taxable compensation, plus the total amount of deferral not used in prior years.
Exam Tip:
* Remember that all elective deferrals must be aggregated in applying the applicable limit EXCEPT deferrals into a Section 457 plan.
Exam Tip: 457 plans not tax deductible to company (don’t pay taxes)
Are 457 plans Deductible?
An employer sponsoring a Section 457 plan does not pay federal income taxes, therefore deductibility is not an issue.
Exam Tip:
* Be careful on the Certification Examination.
* For example, if an answer to a question states that the employer sponsoring a 457 plan enjoys a tax deduction, it is not correct. The employer does not pay taxes and thus does not get a tax deduction.
Exam Tip: Guaranteed benefit retirement = Defined benefit plan
Exam Tip:
* On any exam, if asked what retirement plan is most appropriate for someone who wants a GUARANTEED BENEFIT at retirement, the answer is always a defined benefit plan, either the traditional or cash balance plan.
Under the final average method, earnings are averaged over a number of years, usually the three to five years immediately prior to retirement.
* The final average method usually produces a retirement benefit that is better matched to the employee’s income just prior to retirement.
In either a career average or final average formula, a maximum of $330,000 (2023) of each employee’s compensation is taken into account.
* In other words, an employee earning $400,000 in 2023 is treated as if their compensation were $330,000.
* Also, the defined benefit amount that is paid to the employee cannot exceed the Section 415 limit which will be discussed later.
In many plans, these formulas are further modified by integrating them with Social Security benefits.
* Integrating the formula gives the employer some credit for paying the cost of employee Social Security benefits.
* It helps to provide a reasonable level of retirement income for all employees by taking Social Security benefits into account.
Course 5. Retirement Planning & Employee Benefits.
Lesson 5. Other Tax-Advantaged Retirement Plans
Exam Tip & Advice: need income to contribute Trad IRA, inc cont amounts
What are the Advantages with a traditional IRA?
Eligible individuals may contribute up to the maximum annual contribution amount to a traditional IRA, as shown in the table below, and up to the maximum annual contribution amount for a spouse if a traditional spousal IRA is available. This amount may also be deductible from the individual’s current taxable income.
Note: The Tax Cuts and Jobs Act changed the tax treatment of alimony paid pursuant a divorce decree finalized after December 31, 2018. In such cases, alimony is no longer taxable to the recipient or deductible by the payor. Alimony payments pursuant divorces finalized prior to January 1, 2019 are grandfathered in the previous law and payments continue to be taxable to the recipient and deductible by the payor.
Investment income earned on the assets held in a traditional IRA is not taxed until it is withdrawn from the account. This deferral applies no matter what the nature of the investment income. It may be in the form of interest, dividends, rents, capital gain or any other form of income. Such income is taxed only when it is withdrawn from the account and received as ordinary income.
The maximum annual contribution amount for an IRA is $6,500 (2023).
For individuals who have attained age 50 before the close of the tax year, an additional contribution of $1,000 amount is allowable. The resulting total maximum contribution amount is $7,500 (2023).
The SECURE Act of 2019 eliminated the age limit for making IRA contributions.
Exam Tip:
* A person needs earned income or taxable alimony to contribute to an IRA.
Practitioner Advice:
* The changes to the IRA contribution levels are significant and can play an important role in planning for retirement.
Exam Tip: Alimony divorce before 1-1-19 is compensation for IRA purposes
What are the Deduction Limits for a traditional IRA?
The maximum annual deductible IRA contribution for an individual is the lesser of the maximum annual contribution amount or 100% of the individual’s earned income.
* This covers income from employment or self-employment.
* It does not include investment income.
A provision for traditional spousal IRAs permits additional contributions up to an additional maximum annual contribution amount for the spouse in some cases.
Assuming the active participant restrictions do not apply, the maximum allowable deductible contribution in the year 2023 is the lesser of:
$6,500, or
100% of includable compensation plus 100% of includable compensation of a spouse minus the amount of the deduction taken by the spouse for IRA contributions for the year.
* In order to contribute to a traditional spousal IRA, the couple must file a joint return.
If both spouses have earned income, each can have a traditional IRA. The maximum deduction limit for each spouse with earned income is the maximum annual contribution amount/100% limit.
* However, traditional IRA contribution limits are combined with those for Roth IRAs.
* The maximum annual contribution amount is reduced for each dollar contributed by the same taxpayer to a Roth IRA. For example, if John, age 30, earned $20,000 and wants to contribute to both a traditional IRA and a Roth IRA, he can do it, but the total IRA contributions cannot exceed $6,500.
Exam Tip:
* Alimony received pursuant to a divorce finalized prior to January 1, 2019, is considered compensation for IRA contribution purposes.
Exam Tip, Advice: 457 plan no affect deduct of IRA. Active Participant
Current law imposes income limitations on the deductibility of traditional IRA contributions for those persons who are active participants in an employer-sponsored retirement plan. This includes all qualified retirement plans, simplified employee pensions (SEPs), Section 403(bs) tax-deferred annuity plans, or SIMPLE IRAs.
Describe the Active-Participant Restrictions on the deductibility of traditional IRA
Current law imposes income limitations on the deductibility of traditional IRA contributions for those persons who are active participants in an employer-sponsored retirement plan.
* This includes all qualified retirement plans, simplified employee pensions (SEPs), Section 403(bs) tax-deferred annuity plans, or SIMPLE IRAs.
If an otherwise eligible person actively participates in the employer plan, the available traditional IRA deduction is reduced below the maximum annual contribution amount if the AGI of the taxpayer is within the phaseout ranges indicated below, with the deduction eliminated entirely if the AGI is above the upper limit of the phaseout range.
IRA ACTIVE PARTICIPANT AGI PHASE-OUT RANGES
The reduction in the maximum annual deductible contribution amount in the phase-out AGI region is proportional to the amount by which the AGI exceeds the lower limit.
* For example, suppose that in 2023 a single taxpayer’s AGI is $76,000, and he is an active participant under age 50. The taxpayer is $3,000 into the phase-out range of $73,000 - $83,000, so his annual traditional IRA deduction is reduced by $3,000/$10,000, or 30%.
* This is a reduction of $1,950 (30% of $6,500), so the maximum IRA deduction is $4,550 ($6,500 less $1,950).
* For MFJ taxpayers, both active participants in an employer-sponsored plan, the deduction phase-out is $116,000 - $136,000 (2023).
An individual is not subject to the active participant restrictions just because his or her spouse is an active participant in an employer-sponsored retirement plan. However, this provision phases out for joint adjusted gross incomes from $218,000 to $228,000 (2023) for the non-active participant spouse. The active participant spouse is subject to the MFJ phase-out threshold of $116,000 and $136,000.
Chris and Pat are MFJ taxpayers. Chris, but not Pat, actively participates in an employer-sponsored qualified plan. Chris and Pat earn $120,000 and 70,000, respectively. Pat may contribute and deduct up to $6,500 to an IRA because their AGI is less than $218,000. Chris may contribute (but not deduct) up to $6,500 to an IRA because their AGI is greater than $136,000. However, if Chris and Pat’s MAGI was greater than $228,000 in 2023, each may contribute, but neither one could claim a deduction.
Single - $73,000 - $83,000
Married filing joint $116,000 - $136,000
Married filing separately $0 - $10,000
Exam Tip:
* Participation in a 457 plan will not affect the deductibility of an IRA contribution. A participant in a Section 457 plan is not considered an active participant for IRA contribution deduction purposes.
Practitioner Advice:
* The definition of an Active Participant is that the taxpayer either received any annual additions within a defined contribution plan during the year or was eligible for any benefits in a defined benefit plan during the year.
* Annual additions consist of employer contributions, employee contributions, or reallocated forfeitures.
