Chapter 10: Retirement Plans and Other Tax Advantaged Accounts

Question 1

Qualified plans

Answer 1

Qualified plans require IRS approval and the dollars invested are before-tax dollars (contributions are deductible), creating a zero cost basis for the investor. Therefore, when the investor takes the money out at retirement, the entire withdrawal is taxable. Additionally, qualified plans are not allowed to discriminate between employees, meaning that no one who meets the minimum requirements for inclusion in the plan can be left out.

Question 2

Nonqualified plans

Answer 2

Nonqualified plans may discriminate and do not need IRS approval. The dollars that are invested in nonqualified plans are generally after-tax dollars, which establish the investor’s cost basis. When money is withdrawn at retirement, the investor pays taxes on the amount of the withdrawal that exceeds the cost basis. All investments grow tax-deferred, so the investor is not taxed on any gains until money is withdrawn at retirement.

Question 3

Qualified vs. Nonqualified Plans

Answer 3

-A qualified retirement plan meets the guidelines set out by ERISA.
-Qualified plans qualify for certain tax benefits and government protection.
-Nonqualified plans do not meet all ERISA stipulations.
-Nonqualified plans are generally offered to executives and other key personnel whose needs cannot be met by an ERISA-qualified plan.

Question 4

Deferred compensation plans

Answer 4

Deferred compensation is a type of nonqualified plan in which the employer promises to pay compensation to the employee in the future. Compensation is effectively deferred until a specified future date or retirement. The plan is authorized under IRS Code 457.

A 457(b) plan is a nonqualified, tax-deferred account that is made available to employees of public institutions, such as state and local governments, and to private, or nongovernmental, tax-exempt organizations, such as hospitals. Currently, 457(b) plans are not available to churches.

Public governmental 457 plans are required to be funded and the funds are held in trust for the sole benefit of the plan participants or their beneficiaries. In contrast, private 457 plans generally only allow a select group of employees designated by the employer to participate in the plan and are funded by a trust or annuity.

In 457(b) plans, employees set aside current compensation into the account on a pretax basis through a salary deferral agreement with the employer. Contributions are not taxed because the employee has not received the income – it is deferred income. Monies in the plan grow tax deferred until they are withdrawn at retirement or when the employee terminates employment. In the case of termination of employment, the employee may transfer 457(b) account funds into another retirement account such as a new employer’s retirement plan if such plans accept transfers. Additionally, public 457(b) plan funds may be transferred into an IRA account.

As with other retirement plans, withdrawals from a 457(b) must begin by age 73. However, unlike the other plans, there is no 10% penalty on early withdrawals made before age 59½ or after terminating employment. This exemption is lost if 457(b) funds are transferred into a qualified plan, such as a 401(k), 403(b), or IRA.

Summary of features of a deferred compensation plan:
1) Contributions currently are not tax-deductible because the employee has not “received” the money.
2) Plan does not require IRS approval.
3) Employer may discriminate in plan offering (therefore, it is a nonqualified plan).
4) Funds in the plan grow on a tax-deferred basis.
5) Any excess over the cost basis is taxed when received.

Question 5

Employee stock options plans (ESOPs)

Answer 5

common form of employee noncash compensation. An ESOP allows the employee to purchase company stock in the future at a predetermined price. An employee stock option is similar to a stock warrant in that it is long term and at issue its exercise price is above the stock’s current market value. ESOPs are generally given to executives and firm management as an incentive toward the employer’s future growth. These may also be granted to nonemployees who are important to the company, such as nonemployee directors, attorneys, and key suppliers. Employee stock options are granted with a vesting schedule. Remember that vesting is the systematic ownership transfer to the employee.

For example, an employee may be granted 1,000 options with 100 vesting each year for 10 years. At the end of each year the employee may exercise 100 options.

Question 6

Incentive stock options - basics

Answer 6

An incentive stock option, also called a qualified stock option, is a tax-qualified employee stock purchase plan. The plan is similar to an ESOP, except there is no employee tax liability when the option is exercised.

To meet IRS guidelines, stock must be held for at least 1 year from exercise and at least 2 years from the date the option was granted.

Gains realized upon sale of the stock are treated as long-term capital gains. One note of caution is that incentive stock options may trigger alternative minimum tax (AMT).

Because incentive stock options are tax qualified, the plan must be approved by company shareholders 1 year prior to the plan taking effect.

Question 7

Defined benefit plan

Answer 7

Under a defined benefit plan, the employer specifies an amount of benefits promised to the employee at his or her normal retirement date. The payments are based on a specified formula that considers age, years of service and salary history, and is adjusted each year for inflation.

In defined benefit plans, the employer is responsible for maintaining adequate funds to provide the promised benefit, and an actuarial calculation is required to determine the annual deposit for each year. It helps to remember that defined benefit plans favor older employees nearing retirement age, and allow for higher benefits for high-salaried owners and key employees.

Question 8

Defined contribution plan

Answer 8

Ex: 401k, 403b.

Defined contribution plans have become much more popular than defined benefit plans because they are generally more flexible and less expensive for employers to administer. These plans are focused on contributions rather than on the benefits they will pay out. These plans favor young employees just starting out, with many years to retirement.

Annual contributions to a defined contribution plan are limited to the greater of 25% of the employee’s gross compensation, or the maximum dollar amount set by the IRS (currently $58,000). This annual limit includes employer and employee total contributions. Employer contributions are required without regard to the company’s profitability in a given year.

Question 9

IRA

Answer 9

An individual retirement account (IRA) is a type of tax-qualified retirement plan. Anyone who has earned income is allowed to contribute to a traditional IRA, regardless of age. The SECURE Act of 2019 removed the prior age limit for all contributions starting in tax year 2020 (The acronym SECURE stands for Setting Every Community Up for Retirement Enhancement.). The contribution may or may not be deductible, depending on whether the individual qualifies for a retirement program through an employer and the level of earned income. However, the earnings in an IRA always grow tax-deferred, whether or not the contribution is deductible, and taxes are not paid on the deferred earnings until the money is withdrawn from the account.

Contributions — The maximum amount an individual can contribute annually to an IRA is the lesser of the two following amounts:

$6,500* (younger than age 50) or $7,500 (catch-up provision for age 50 and older); or
100% of earned income.
* All dollar amounts are current for 2023.

Know This! Anyone who is working and has earned income can contribute to a traditional IRA, regardless of age.

IRA contributions must be made in cash (or cash equivalent) in order to be tax deductible. The term cash includes any form of money, such as cash, check, or money order. The money invested in the account can be used to buy stocks, bonds, mutual funds, or annuities. The money used for IRA contributions cannot be used to purchase life insurance policies or collectibles such as art, antiques, or stamps. Also, investors cannot trade on margin in an IRA account.

A traditional IRA is a top choice for immediate tax savings because contributions can be deducted from that year’s taxable income. Generally, taxes are not due until withdrawals are made, usually after retirement. At that time, unless nondeductible contributions were made to the account, the total amount withdrawn is included as income.

Question 10

Spousal IRA

Answer 10

In a marriage where only one spouse has earned income and has contributed to an IRA, the nonwage earning spouse may also contribute to a spousal IRA if the earned income from the wage-earning spouse is greater than the total contributions to both IRAs. Each spouse must maintain a separate account not exceeding the individual limit. By contributing to a spousal IRA, a married couple younger than age 50 may contribute up to a total of $13,000 ($6,500 to each IRA).

Question 11

IRA catch up provision

Answer 11

Taxpayers who are age 50 or older are entitled to make additional “catch-up” contributions. Currently, the taxpayers may contribute up to an additional $1,000 each year, making their total contribution $7,500.

For example, a married person with a nonworking spouse may currently contribute $6,500 annually to a spousal IRA, making the total contribution for the couple $13,000 (with catch-up provisions: $14,000 may be contributed if only one spouse is age 50 or older, and $15,000 may be contributed if both spouses are 50 or older).

Question 12

IRA Rollover and Transfer Rules

Answer 12

An individual may choose to move the monies in a qualified retirement plan to another qualified retirement plan. However, benefits that are withdrawn from any qualified retirement plan are taxable the year in which they are received if the money is not moved properly. There are two ways to move money from plan to plan:

A rollover; and
A custodian-to-custodian transfer.
A rollover describes a cash and or asset contribution to a new IRA by an individual within 60 days of receiving an eligible rollover distribution from an old plan. The individual may roll over all or any part of the actual amount received. The individual is subject to 20% federal withholding on the distribution from the old plan. However, the individual must then deposit the full rollover amount into the new plan (including 20% from outside sources to compensate for the withheld 20%) within 60 days. The individual then files for a refund of the 20% withholding in their next federal income tax return. A rollover can be done no more than once every 12 months, and if the rollover is not completed within 60 days, the withdrawal is considered a permanent distribution and subject to ordinary income tax and a 10% penalty. This applies to both IRA-to-IRA rollovers and employer plan-to-IRA rollovers.

A transfer describes a movement of cash and/or assets that takes place directly between the trustee/custodian of an old plan and the trustee of a new plan. By directly transferring the distribution from one custodian to another (as opposed to personally receiving the funds and then depositing them into the new plan), the individual can avoid the 20% federal income tax withholding. Technically, a direct transfer takes place between trustees, and the investor never touches the money. There is no annual limit on the permissible number of direct transfers.

Question 13

IRA tax deductibility

Answer 13

Tax deductibility — In many cases, individual contributions to traditional IRAs are tax deductible for the year of the contribution. Any eligible person not participating in a qualified retirement plan can take a full deduction from taxable income up to the maximum limit. If an individual is a participant in an employer’s qualified retirement plan, there are income limitation tests to determine how much, if any, of the individual’s IRA contribution is tax deductible. Contributions into an IRA for the current tax year can be made up to April 15 of the following year. Anyone with earned income may contribute to an IRA, even if the contributions are not tax deductible.

Question 14

IRA excess contributions

Answer 14

If an individual’s IRA contribution exceeds the maximum allowable amount, a 6% penalty is assessed on the excess contributions every year until it is removed from the plan. The excess contribution is not deductible, and earnings on the excess portion do not accumulate tax deferred.

Question 15

IRA distributions

Answer 15

Distributions from IRAs are divided into pretax and after-tax contributions (if applicable) for tax purposes. All investment income and pretax contributions are taxed as ordinary income in the year received. After-tax contributions are not taxed when distributed.

If both tax deductible and nondeductible contributions were made to the IRA, each distribution is partially taxable and partially nontaxable. The IRS requires the IRA owner to complete a special tax form annually that figures the taxable and nontaxable distributions.

Question 16

Taxes/penalties - premature IRA distributions

Answer 16

If withdrawals from an IRA are made prior to age 59½, they are considered premature distributions, and a 10% early withdrawal penalty is assessed by the IRS. The amount of the premature withdrawal is also taxed as ordinary income to the recipient in the year received.

Question 17

Penalty-free premature IRA distributions

Answer 17

Early withdrawal without penalty is allowed under certain circumstances, although the amount received is still taxable as ordinary income to the recipient in the year received. The following circumstances determine how a penalty-free premature distribution can occur:
-Death of the account owner;
-Permanent disability or terminal illness of the owner;
-Unreimbursed medical expenses in excess of 10% of adjusted gross income (7.5% if over age 65);
-Distributions are made in equal periodic installments for a minimum of 5 years or until the recipient reaches age 59½, whichever period is greater;
-Education expenses for the owner or the owner’s immediate family;
-Down payment on a first-time home purchase of the primary residence of the owner, limited to a lifetime amount of $10,000; or
-Childbirth or adoption expenses up to $5,000.

Question 18

IRA Required minimum distributions (RMDs)

Answer 18

Normal distributions from a traditional IRA can occur at any point after the account holder reaches the age of 59½. An IRA owner must begin taking annual required minimum distributions (RMDs) no later than April 1 of the year following the year in which the participant turns 73.*

*Effective year 2023, the SECURE Act 2.0 raised the required minimum distribution age from 72 to 73, and reduced the penalty for failing to take an RMD from 50% to 25%.

The owner of an IRA is required to take their first RMD by April 1 of the year following the year that the individual turns 73. If the first RMD is taken by April 1, the individual will have to take a second RMD by December 31 of the same year, and every year thereafter. Failure to take an RMD results in a 25% tax penalty (50% prior to 2023) levied on the amount of the required distribution that was not taken, which drops to 10% if corrected in a timely manner. Distributions can be received in a lump sum or as periodic payments using a number of different methods. If periodic distributions do not begin until age 73, the amount received must pay out at least as fast as a schedule (IRS actuarial life expectancy table), which theoretically would reduce the account to zero by the time the retiree dies.

Question 19

IRA Distributions after Owner’s Death

Answer 19

At the IRA owner’s death, the beneficiary may cash in the IRA. Taxes will be due, but the early withdrawal 10% penalty will NOT apply.

For the year of the account owner’s death, the RMD is based on the RMD the account owner would have received. For the year following the owner’s death, the RMD will depend on the identity of the designated beneficiary. There is a distinction between an eligible designated beneficiary and other beneficiaries who inherit an IRA.

Eligible designated beneficiaries may take their distributions over the beneficiary’s life expectancy. An eligible designated beneficiary includes a(n):
-Surviving spouse;
-Disabled individual;
-Minor child; or
-Individual who is not more than 10 years younger than the deceased IRA owner.

However, minor children must still take the remaining distributions within 10 years of reaching age 18.

A surviving spouse beneficiary may delay the start of distributions until the later of, the end of the year that the IRA owner would have attained age 73 or the surviving spouse’s required beginning date.

Designated beneficiaries, who are not eligible designated beneficiaries, such as a non-spouse heir, must withdraw the entire account within 10 years of the IRA owner’s death.

Non-designated beneficiaries must withdraw the entire account within 5 years of the IRA owner’s death if distributions had not begun prior to death.

Question 20

Roth IRA

Answer 20

Roth IRAs differ from traditional IRAs in several ways. Roth IRA contributions and all earnings may be withdrawn tax free as long as the account is open for at least 5 years, and if certain requirements are met. Another important distinction between Traditional IRAs and Roth IRAs is that Roth IRAs must be funded with after-tax dollars.

Roth IRAs are an excellent choice for future tax savings. Distributions, including investment gains, are not taxed when withdrawn. Roth IRA conversions from traditional IRAs can also help save taxes on future earnings.

Question 21

Modified Adjusted Gross Income (MAGI) phase-out ranges for Roth IRA contributions

Answer 21

Single or Head of Household: $138,000 to $153,000

Married filing jointly $218,000 to $228,000

Married filing separately $0 to $10,000

Question 22

Roth IRA contributions and limits

Answer 22

Roth IRA contributions are not tax deductible and are made with after-tax dollars.

SAME AS IRA: An individual can contribute 100% of earned income up to a specified maximum which is indexed for inflation. Currently, as with traditional IRAs, these amounts are $6,500 if younger than age 50, and $7,500 for age 50 or older (catch-up provision).

Should a taxpayer make an excess contribution to a Roth IRA, there is a 6% tax penalty. A traditional IRA can be converted to a Roth IRA if a person’s adjusted gross income is less than the applicable limit. The converted funds are considered income, and therefore taxed at income tax rates applicable in the year that the traditional IRA is rolled into a Roth IRA.

Question 23

Roth IRA eligibility

Answer 23

Eligibility — Unlike a traditional IRA, Roth IRA eligibility is phased out based on the individual’s earned income level. These specified dollar limits are periodically increased to compensate for inflation.

Participation in an employer’s retirement plan does not affect a person’s eligibility for a Roth IRA. Total contributions to all traditional and Roth IRAs, other than employer contributions, cannot exceed a specified maximum.

Question 24

Roth IRA rollovers

Answer 24

Rollovers — Note that rollovers from an employer’s pre-tax qualified plan cannot be directed to Roth IRAs. Rollovers must be directed to traditional IRAs. That traditional IRA may subsequently be rolled into a Roth IRA.

Question 25

Penalty-free Roth IRA distributions

Answer 25

Like in a traditional IRA, penalty-free distributions (before age 59½) from a Roth IRA are allowed under the following circumstances:

-Owner’s death — payable to the estate or beneficiary;
-Owner’s disability or terminal illness;
-Unreimbursed medical expenses or health insurance if unemployed;
-Distribution in substantially equal payments for a minimum of 5 years or until the owner reaches age 59½, whichever period is greater;
-First-time homebuyer expenses (subject to a lifetime cap, currently $10,000); or
-Qualified higher education expenses for the owner, owner’s spouse, children, or grandchildren; or
-Childbirth/adoption expenses (up to $5,000).

Question 26

Qualified Roth IRA distributions

Answer 26

These include distributions made after the age of 59½ and are not subject to the 10% penalty for early withdrawals. Nonqualified distributions are subject to the same tax consequences as traditional IRAs.

Any Roth IRA distributions that are a return of regular contributions and any qualified distributions are not included in the individual’s gross income, meaning they are excluded from federal income tax. Distributions are considered qualified if they are made under the following circumstances:

-After a 5-year holding period beginning with the first taxable year for which a Roth IRA contribution was made;
-On or after the date the individual reaches age 59½;
-Because the individual becomes disabled or terminally ill;
-To cover certain unreimbursed medical expenses up to a specified limit;
-To a beneficiary or the estate after the individual’s death;
-To cover education expenses;
-As a down payment on a first home up to $10,000; or
-For childbirth/adoption expenses (up to $5,000).

Question 27

Simplified Employee Pension (SEP) plans

Answer 27

Simplified Employee Pension (SEP) plans are qualified plans that allow self-employed individuals (or small self-employed groups) to contribute to their retirement in amounts greater than are available with traditional IRAs.

SEP plans are written plans that allow the individual to make contributions toward their own (if self-employed) and employees’ retirement without getting involved in a more complex qualified plan. Under a SEP, an employer contributes directly to traditional individual retirement accounts (SEP-IRAs) for all eligible employees, including the employer.

Question 28

SEP IRA eligibility

Answer 28

AEP IRA eligible employee meets all the following requirements:
-Has reached age 21;
-Has worked for the same employer in at least 3 of the last 5 years; and
-Has received at least an IRS-specified amount in compensation from the employer.

The employer may use less restrictive participation requirements than those listed, but not more restrictive requirements.

The following employees can be excluded from coverage under a SEP:
1) Employees covered by a union agreement and whose retirement benefits were bargained for in good faith by the employees’ union and the employer; and
2) Nonresident alien employees who have received no U.S. source wages, salaries, or other personal services compensation from the employer.

Question 29

SEP IRA contributions

Answer 29

Summary:
1) contributions are tax deductible, grow tax deferred
2) YoY employer contributions do not have to be the same, but must be same for all employees within a year.
3) cannot exceed the lesser of 25% of their gross earnings or the maximum annual contribution limit ($66,000 for 2023
4) No catch-up provision
5) No employee contribution
6) Subject to RMD after 73

Contributions to SEP-IRAs are fully tax deductible and all earnings grow on a tax-deferred basis until withdrawn. SEP plans allow flexibility of contributions. That is, employers do not need to contribute the same percentage each year. However, for any given year, contributions for all employees must be based on the same percentage.

Employer’s contributions to each employee’s SEP IRA, or contributions for self-employed individuals). If a self-employed person has any full-time employees as defined by IRS standards, contributions must be made in an individual account for each employee at the same percentage of earnings as the employer’s contributions. There is no catch-up provision for SEP IRAs.

All contributions made under a SEP are employer contributions. An employee cannot defer a portion of their salary and contribute it to a SEP IRA.

Note that SEP IRAs are subject to the same distribution requirements that apply to traditional IRAs with required minimum distributions (RMDs) to begin at age 73.

Question 30

Advantages of SEP IRAs

Answer 30

SEP plans have several advantages for small employers:

1) Contributions are tax-deductible, and the business does not pay any taxes on the earnings on the investments;
2) Employers are not locked into making annual contributions; they can decide each year whether, and how much to contribute to the employees’ plans;
3) Sole proprietors and partnerships can set up a SEP; and
4) Low administrative costs.

Question 31

SIMPLE (Savings Incentive Match Plan for Employees) IRA plan

Answer 31

Summary:
1) </= 100 employees
2) No concurrent qualified plan
3) Voluntary employee deferral
4) Max currently $15,500/yr
5) mandatory employer dollar-for-dollar match of up to 3% of the employee’s salary (only for employees who voluntarily elect to participate).
6) The employer may lower the percentage to 1% for any 2 years out of every 5-year period.
7) As an alternative contribution method, the employer can choose to contribute 2% of salary for all eligible employees, whether they voluntarily participate or not.
8) Participants are immediately 100% vested in employer contributions.
9) No loans permitted, there is a 2-year waiting period before assets can be rolled into an IRA.

A SIMPLE IRA plan is available to small businesses that employ not more than 100 employees. To establish a SIMPLE plan, the employer must not have a qualified plan in place. Plan funding comes from voluntary employee salary deferral with no salary percentage limit, but with a maximum annual deferral up to a specified amount, which periodically increases for inflation (currently $15,500). In addition, there is a mandatory employer dollar-for-dollar match of up to 3% of the employee’s salary (only for employees who voluntarily elect to participate). The employer may lower the percentage to 1% for any 2 years out of every 5-year period. As an alternative contribution method, the employer can choose to contribute 2% of salary for all eligible employees, whether they voluntarily participate or not.

Participants are immediately 100% vested in employer contributions. No loans are permitted and there is a 2-year waiting period before assets can be rolled into an IRA.

SIMPLE IRAs are subject to the same distribution requirements that apply to traditional IRAs with required minimum distributions (RMDs) to begin at age 73, (no later than April 1 of the year following the year in which the participant turns 73).

Question 32

401k plan

Answer 32

One of the most popular qualified retirement plans is the 401(k) plan, named after the IRS Code that established the guidelines. There are many options as to how employers can establish these plans. 401(k) allows employees to take a reduction in their current salaries by deferring amounts into a retirement plan. The company can also match the employee’s contribution, whether it is dollar-for-dollar or on a percentage basis.

Under a 401(k) plan, contributions into the plan are excluded from the individual employee’s gross income through a payroll deduction up to a specified maximum ($22,500 in tax year 2023). The ceiling amount is adjusted periodically for inflation. 401(k) plans also allow a larger contribution, known as a catch-up contribution, for participants who are 50 years of age or older. This catch-up limit is also indexed for inflation.

Plans permit early withdrawal for specified hardship reasons, such as death, disability, or terminal illness. Loans are also permitted in certain instances, up to 50% of the participant’s vested accumulated balance or a specified maximum

Question 33

401k distributions and taxation

Answer 33

All distributions made from a 401(k) plan are considered ordinary income to the employee and taxable at their applicable tax bracket. In the event distributions are taken prior to age 59½ and have not met one of the plan’s hardship provisions (similar to those of the IRA), a 10% premature distribution penalty would also apply.

RMD on April 1 year after person turns 73.

Question 34

Profit-sharing plans

Answer 34

With this type of defined contribution plan, employers are allowing their employees to share in the profitability of the company. The company, however, does not need profits in order to make contributions to a profit-sharing plan. Employer contributions to the plan must be allocated in a nondiscriminatory manner based on a prearranged method. The most common method of determining each participant’s allocation is the “comp-to-comp” method: the employer first calculates the sum of all employees’ compensation (total “comp”), then divides the individual employee’s compensation (employee “comp”) by the total comp, and finally multiplies each employee’s fraction by the amount of the employer contribution.

Companies that establish a profit-sharing plan can be of any size, can have other retirement plans, and need to file a Form 5500 annually.

Employers are allowed full discretion with regard to making contributions into a profit-sharing plan. They are limited, however, to a maximum annual contribution of 25% of total employee compensation or a maximum amount specified by the IRS (currently $53,000).

Question 35

Vesting of profit-sharing plans

Answer 35

Vesting refers to the systematic transfer of ownership between the employer and the employee of the employer’s matching funds in a qualified retirement plan. Employees are always 100% vested in their own contributions; however, they usually have to wait a number of years until they are entitled to 100% of the employer’s contributions. A vesting schedule is part of the plan.

Question 36

Taxation of profit sharing plans

Answer 36

Qualified plans allow the employer to take a current deduction for all plan contributions made on the employee’s behalf. The amount of employer contribution is not included in the employee’s gross income. Employees realize these contributions as ordinary income at distribution. All investment earnings in the account accumulate tax-deferred until withdrawn by the employee.

Question 37

Rollover and transfer rules - profit sharing plan

Answer 37

Often, an employee receives a lump-sum distribution from a retirement plan prior to retirement, usually by changing employment or in an early retirement package. The employee may choose to receive the proceeds directly, or have the current custodian make a direct transfer to either another qualified plan or to a rollover IRA account.

Same as IRA:
Under current law, if the employee chooses to receive the proceeds directly, the employer is required to withhold 20% of the taxable sum due as a prepayment of income taxes (i.e., the employee receives 80%). However, in order to recover the taxes withheld, the employee must roll an amount equal to 100% of the total distribution over to another plan or a rollover IRA account within 60 days.

A direct transfer is not a taxable event because the proceeds are made payable to the successor custodian. Therefore, there is no withholding and the entire amount is transferred directly to the new qualified account.

Question 38

403(b) eligibility

Answer 38

A 403(b) plan, also referred to as a tax-deferred annuity (TDA) or tax-sheltered annuity (TSA), is a qualified plan available to employees of certain nonprofit organizations under Section 501(c)(3) of the Internal Revenue Code, and to employees of public-school systems. Therefore, these plans are not governed by ERISA. ERISA governs only corporate plans and union plans.

Question 39

403(b) contributions

Answer 39

Contributions can be made by the employer or by the employee through salary reduction. In both cases, the contributions are excluded from the employee’s current income. As with the 401(k), 403(b), and 457(b) plans have employee contribution limits that are regularly adjusted for inflation. The same “catch-up” provisions also apply. Currently, the employee contribution limit is $22,500, and the additional catch-up provision (for workers who are 50 years old or older) is $7,500.

Question 40

403(b) characteristics

Answer 40

Permissible Investments:
Contributions to these plans may be used to purchase fixed and variable annuities, CDs, mutual funds, and other securities.

Taxation:
As with 401(k) plans, the employee’s cost basis is zero; every dollar withdrawn is taxable at ordinary income tax rates. This includes employer matching dollars as well as employee contributions.

Transfers:
Individuals with one of these plans who terminate employment can transfer the proceeds into another qualified plan in the same manner as previously described for rollover elections.

Portability:
Individuals holding a 403(b) plan who terminate with one employer and gain employment with another employer covered by a 403(b) plan may participate in a direct rollover to that plan. This distribution is not considered taxable to the employee (similar to an IRA rollover).

Question 41

ERISA

Answer 41

In order to protect employees in the private sector (i.e., corporate, not government employees) against abuse and discrimination in pension and retirement plans, the Employee Retirement Income Security Act (ERISA) of 1974 was passed. This is the law that established the guidelines for the following:
-Eligibility rules for plan participation;
-Proper accounting and administration of plan funds;
-Vesting schedules for employer contributions;
-Nondiscrimination;
-Naming of beneficiaries; and
-Communication of plan rules and benefits to employees.

Both defined-benefit and defined-contribution plans are subject to the provisions of ERISA.

ERISA states that all eligible employees must be allowed participation in the plan. Eligible employees include employees age 21 and older, full-time or the equivalent (defined as 1,000 hours per year) and 1 year or longer of service. ERISA also regulates vesting, which is the systematic transfer of account ownership from the employer to the employee. ERISA plans may not discriminate among different classes of employees. Also, the plan must allow participants to name their own beneficiaries. Finally, the plan must communicate financial information to the participants as well as file reports annually with the Department of Labor.

Additionally, the plan administrator of a qualified plan has fiduciary responsibilities, and there are restrictions on the type of investments that may be purchased. For example, the purchase of options, or sale of short uncovered options is generally not allowed. However, covered call writing is permitted (this is writing calls against stock that is owned in the plan and may be delivered in the case of exercise). Pension fund managers may not purchase gold and silver, unless the gold or silver purchased is coins that were minted by the U.S. government. Pension fund managers must abide by fiduciaries standards when investing retirement monies on behalf of others. These standards are determined by the state in which the fiduciary is operating in, under “prudent investor” rules.

Question 42

Coverdell education plans

Answer 42

A trust or a custodial account created to pay the qualified education expenses of the designated beneficiary. Contributions are generally made after tax, thus contributions to Coverdells are not tax deductible. Also, above certain income limits, contributions are not allowed.

Taxpayers may deposit up to $2,000 per year into a Coverdell for a child younger than 18 years old. Parents, grandparents, and other family members may contribute to the child’s Education IRA, provided that the total contributions for the child during the taxable year do not exceed the $2,000 limit.

Any individual whose modified adjusted gross income (MAGI) is under the limit set for a given tax year can make contributions.

Contributions are made with after-tax dollars. However, amounts deposited in the account grow tax-deferred until distributed, and the child will not owe tax on any withdrawal from the account if the child’s qualified education expenses at an eligible educational institution for the year equal or exceed the amount of the withdrawal.

Note that the individual is required to use the money by age 30 or the funds must be rolled over to another qualified family member. Any money left in the account when the student turns 30 must be withdrawn within 30 days. A qualified family member must be under 18 years of age, and related by blood, marriage, or adoption. If the funds are not used by another family member for qualified education expenses, the earnings in the account become taxable and are subject to a 10% penalty.

Account holders may take tax-free Coverdell distributions to cover K-12 education, as well as college costs.

Amounts withdrawn from a Coverdell that exceed the child’s qualified education expenses in a tax year are generally subject to income tax and to an additional penalty of 10%.

Question 43

Incentive stock option - eligibility

Answer 43

Additional details of an incentive stock plan include
-Only employees are eligible; independent contractors and board members may not participate; and
-Options are exercisable up to 10 years after they are granted.

If an employee is a 10% or greater owner in the company, the strike price must be at least 110% of the stock’s market value at the time of the grant, and the exercise term is limited to 5 years rather than 10.