Chapter 16 Part 4 Flashcards
Nonqualified Plans Deferred Compensation Plans
a contract between the employer and the employee intended to defer some of the employee’s income for distribution and taxation at a future date. Deferred compensation plans can be split into two types—funded and unfunded. When created by a for-profit entity, these plans are most commonly unfunded and, therefore, the employee is at financial risk. Since this is a contract where the employer agrees to pay the employee compensation at a later date, if the corporation is bought by another entity or goes bankrupt, the employee becomes a general creditor. The money is not considered to be wages owed, so there will often be forfeiture provisions wtitten into the contract for the protection of the employer. Since deferred compensation plans are nonqualified, the employer may be selective in choosing the employees that may participate.
Nonqualified Plans
These plans are a type ofnonqualilied retirement plan that may be established only by government entities and certain nonprofit organizations. For the most patt, these plans operate the same way as 40l(k) and 403(b) plans. The individual employee sets aside a certain percentage of her income before taxes, which is invested and continues to grow on a tax-deferred basis until withdrawn. The maximum contribution limits are the same as those for 401(k) and 403(b) plans.
governmental 457 plans, which are typically offered by state and local governments or public school systems, have two major advantages for employees
First, if their employer also offers another retirement plan, such as a 403(b) or 401(k) plan, the employee may contribute the maximum amount to both plans. For example, a municipal employee could contribute $17,000 to a 403(b) plan and $17,000 to a 457 plan during the same year for a total of $34,000 pretax. Second, there is no 10% tax penalty if a participant in a governmental 457 plan withdraws the money before the age of 59.5. Of course, the employee will need to pay ordinary income taxes on the amount withdrawn, but no penalty
will be assessed.
Nongovernmental 457 plans, which may be offered by
nonprofit organizations such as private colleges, are less advantageous for employees. Only highly compensated employees may participate in these types of 457 plans, and participants who withdraw money before the age of 59.5 will be subject to a 10% tax penalty.
withdrawals from nongovernmental 457 plans may not be
rolled over into a qualified plan such as a 401(k). However, withdrawals from government-sponsored 457 plans maybe rolled over into a qualified retirement plan.
Coverdell Education Savings Accounts
These accounts are not retirement plans, but a means to save money for a child’s educational expenses. The money may be used for elementary, secondary, and postsecondary school expenses. A parent, grandparent, or complete stranger, whose adjusted gross income is within certain limits, may contribute a maximum of$2,000 per year to an account established for the benefit of a child under the age of 18. The total of all contributions from various individuals to one child’s account may not exceed $2,000 during any given year.
Contributions to ESAs are made with
after-tax dollars–in other words, they are not tax-deductible. Money in the plan accumulates on a tax-deferred basis and withdrawals are tax-free if they are used to pay for the child’s expenses at an educational institution (primary, secondary, or college). lf the withdrawals are not used to pay for the child’s educational expenses, the earnings portion of the withdrawal is subject to ordinary income taxes plus a 10% tax penalty.
if the original beneficiary does not need the money for educational purposes, funds may be transferred to
an account maintained for one of the original beneficiary’s relatives without penalty. If the money is not used by the beneficiaiy’s 30th birthday or transferred to another beneficiary, it must be distributed and is subject to ordinary income taxes in addition to a 10% penalty.
529 plans are not retirement accounts. They are
savings vehicles designed to meet future college expenses. Under federal law, contributions are made with after-tax dollars, and any earnings are tax-deferred. However, qualified withdrawals used for educational purposes are tax-free. States that offer 529 plans determine the specific plan rules such as maximum allowable contributions, investment options (e.g., mutual funds), and deductibility of contributions for state tax purposes. Individuals may choose to use either their own state’s 529 plan or that of any other state. Once an individual chooses the plan, the plan’s investment adviser determines the specific investments.
An individual investor may contribute up to
$14,000 per year to a person’s 529 plan without incurring federal gift taxes. Therefore, a married couple may conllibute $28,000 per individual per year. 529 plans allow individuals to aggregate five years’ wmih of annual gifts and contribute $70,000 (5 x $I4,000) at one time. For a married couple, the amount contributed is $140,000 (5 x $28,000) per child. Unlike the
Coverdell ESA, there is no income limitation imposed on contributors to 529 plans.
Individuals may contribute these same amounts to 529 plans maintained for
more than one beneficiary. ln other words, if an individual has five grandchildren, she could conttibute $70,000 to each grandchild’s 529 plan without incurring federal gift taxes. These amounts would double for a married couple funding multiple 529 plans. The money is also removed from the contributor’s estate.
