Concepts Flashcards

Question 1

Q

Define Hedging Strategies - Straddles, Collar,

Protective Put

Answer

A

Straddle: Buying a put and buying a call - the buyer does NOT own the stock

Collar: Selling a call (out-of-the-money) at one strike price and buying a put at a lower strike price; investor OWNS the stock

Protective Put: Buying a stock (or already owning it) and a put for the stock serving as insurance against the decline in the underlying stock. (Hint: A good answer for the exam.)

Question 2

Q

Duration

(Principles to Remember)

Answer

A

First thing to do is to think if there were two bonds with similar varibales and then the variable below is different. How would the duration react.

Years to Maturity (Remember duration and maturity are positively related)

Annual Coupon (Remember duration is inversely related to coupon rate)

YTM, the current yield on comparative bonds (duration is inversely related)

How to Remember: Coupon and yield are interest rates - inversely related.

Ex: A bond’s coupon rate is a key factor in calculation duration. If we have two bonds that are identical with the exception on their coupon rates, the bond with the higher coupon rate will pay back its original costs faster than the bond with a lower yield. The higher the coupon rate, the lower the duration, and the lower the interest rate risk so it has an inverse relationship.

Question 3

Q

Zero Coupon Bonds

Answer

A

Duration equal to Maturity
No coupon interest, yet produces “phantom” income
No reinvestment rate risk
Sold at deep discounts to par
Fluctuate more than coupon bond with the same maturities

Question 4

Q

Rules for using Duration to Manage Bond Portfolios

Answer

A

If interest rates are expected to rise, shorten duration. (interest rates up, shorten duration. Remember: UPS - UP for up, and S for shorten.)
If interest rates are expected to fall, lengthen duration. Buy low coupon bonds with long maturities. Interest rates fall → lengthen duration. Remember: FALLEN - FAL for fall and LEN for Lengthen.

Question 5

Q

Conclusions to Fluctuations in Bond Prices

Answer

A

The smaller the coupon, the greater the relative price fluctuation
The longer the term to maturity, the greater the price fluctuation
The lower the market interest rate, the greater the relative price fluctuation

Question 6

Q

Define Convexity

Answer

A

The degree which duration changes as the yield-to-maturity (YTM) changes.
Largest for low coupon bonds, long-maturity bonds and low-YTM bonds
allows to improve the duration approximation for bond price changes.

Question 7

Q

What are the three Monetary Policy Tools by the Fed?

Answer

A

Open Market Operations
Discount Rate Changes
Reserve Requirement Changes

Question 8

Q

What are Expansionary Monetary Policy Tools?

Answer

A

Open Market Operations - Purchase Government Securities

Fed creates dollars to buy securities on the open market
Dollares transferred from the Fed to the Public and Banks

Discount Rate - Lower Discount Rate

Encourages banks to borrow from the Fed to lend to their customers

Reserve Requirements - Lower Reserve Requirements

Allows banks to expand lending

Question 9

Q

What are Contractionary Monetary Policies?

Answer

A

Open Market Operations - Sell Government Securities

Fed sells securities on the open market
Dollars transferred from the Public and Banks to the Fed

Discount Rate - Raise Discount Rate

Discourages banks to borrow from the Fed to lend to their customers

Reserve Requirements - Raise Reserve Requirements

Discourages banks from expand lending

Question 10

Q

Covariance and Correlation Coefficient

Answer

A

They communicate the same informaiton. They both measure the strength of the relationship between the returns of two securities.

The only reason Covariance may be needed is as an input into the formula for Standard Deviation of a portfolio.

You may be given the correlation coefficient and the standard deviation of two assets and then be asked to compute the covariance using the following formula COV_ij= ρ_ijσ_iσ_jand you would divide each side by σ_iσ_j to get COV_ij / σ_iσ_j= ρ_{ij or}R_ij

Question 11

Q

Similarities of Covariance and Correlation Coefficient?

Answer

A

Both measures only linear relationship between two variables, i.e. when the correlation coefficient is zero, covariance is also zero. Further, the two measures are unaffected by the change in location.

Question 12

Q

Differences of Covariance and Correlation Coefficient?

Answer

A

A measure used to indicate the extent to which two random variables change in tandem is known as covariance. A measure used to represent how strongly two random variables are related known as correlation.
Covariance is nothing but a measure of correlation. On the contrary, correlation refers to the scaled form of covariance.
The value of correlation takes place between -1 and +1. Conversely, the value of covariance lies between -∞ and +∞.
Covariance is affected by the change in scale, i.e. if all the value of one variable is multiplied by a constant and all the value of another variable are multiplied, by a similar or different constant, then the covariance is changed. As against this, correlation is not influenced by the change in scale.
Correlation is dimensionless, i.e. it is a unit-free measure of the relationship between variables. Unlike covariance, where the value is obtained by the product of the units of the two variables.

Question 13

Q

Shortcut to calculate Mean of portfolio?

Answer

A

First Enter Standard Deviation (SD or σ) asset and hit “INPUT”

Then enter Weighting of SD and hit “Σ+”

Then enter SD of next asset and hit “INPUT”

Then enter Weighting of SD and hit “Σ+”

Then keep going until all securities are entered

Then hit “shift” “6” key for answer

Question 14

Q

Testing Hierarchy of BATS

Answer

A

Beta - Make sure Beta is reliability (if R-squared is given, need 0.70 or higher)
Alpha - If Beta is reliable, then use alpha as first choice (since it is an absolute value)
Treynor - If Alpha is not available, then use Treynor
Sharpe - If these are not available or if beta is not reliable (R² below 70) use Sharpe.

Question 15

Q

What are the 5 categories of Fundamental Analsyis Ratio Analysis?

Answer

A

liquidity (current ratio which is current assets/current liabilities)
1. quick ratio is current assets minus inventory/current liabilities
activity (inventory turnover)
profitability (EBITDA, ROE, return on capital)
1. focus on these
leverage (debt to equity)
financial statement

Question 16

Q

Interest rates and duration are related?

Answer

A

Invesely related

Question 17

Q

Bond Yield See-Saw and YMCA

Answer

A

Think of the Y M C A and drop the A.

C Y = Current Yield

YTM = Yield to Maturity

YTC = Yield to Call

Next - Think of a see-saw. Put Y M C on right side of Fulcrum

If we have a bond selling at a discount then we pull the see-saw down and the it goes Y< M

If we have a bond selling at a premium, then we push the see-saw up and the goes Y > M > C, but each one is lower than the next

Question 18

Q

Duration and Interest Rates & Coupons are ……… related?

Answer

A

Inversely related like with price.

Why?

Think of starting duration at it’s fulcrum and then raising and lowering interst rates. What does that do to duration?

What happens to the fulcrum point with higher coupons? The fulcrum point will then shift to the left (meaning lower duration).

What happens to the fulcrum point with lower coupons? The fulcrum point will then shift to the right (meaning higher duration).

Question 19

Q

What is Convexity and how does it work with Bonds?

Answer

A

For expected changes in rates of less than 1%, duration alone does a good job of explaining the expected change in bond price.
For changes in rates exceeding 1%, convexity must be considered.
The following graphic shows how convexity affects bond prices.
When rates fall, convexity causes the price increase to be greater than duration alone would indicate.

Question 20

Q

Duration and Maturity are ……… related?

Answer

A

Directly related.

Why?

Think of starting duration at it’s fulcrum and then shortening maturities and lengthening maturities. What does that do to duration?

The shorter the maturity, the lower the duration.

The longer the maturity, the higher the duration.

Question 21

Q

Bond Questions: Read this and be aware of question nuances.

Answer

A

Be prepared for bond questions to be presented in different ways. For example, the question may say that an investor purchased a 20-year bond five years ago. In this case, the number of years until maturity would be 15 (30 compounding periods with semi-annual compounding). Or a bond may be presented as having a call premium of 5%. So, you would take the $1,000 face amount; increase it by 5% to arrive at a call price of $1,050. Don’t let these nuances throw you.

Question 22

Q

What do we want our currency to do against other currencies to make money?

Answer

A

With currencies in order to make money you want your currency to weaken (devaluation) and the other currency to strengthen (revaluation).

Question 23

Q

When is a Put In The Money?

Answer

A

An investor who purchases a put option makes a profit only if the market price of the stock is lower than the exercise (strike) price of the option.

Until the market price drops below the strike price, the option is said to be out-of-the-money.

It is in-the-money when the market price drops below the strike price.

Question 24

Q

Boot / Gain Recognized / Basis

Answer

A

No boot received - recognized gain is zero
When boot is received, just answer the recognized gain is the boot received
Boot paid is added to the adjusted basis
Basis carries over from the prior property

Question 25

Q

Netting Capital Gains and Losses

Answer

A

Step 1:

ST capital gains and ST losses are netted
LT capital gains and LT losses are netted

Step 2:

If a gain and loss remain, they are again netted

Step 3:

If a loss remains after netting capital gains and losses, only $3000 of the net losses can be used to offset ordinary income

Question 26

Q

Section 179

Qualifying vs. Non-Qualifying Property

Answer

A

Qualifying:

Tangible personal property
1245 Property

Non-Qualifying:

Real Estate
1250 Property
Intangible (owning a franchise)

Question 27

Q

Historic Rehabilitation Programs

Answer

A

Historic Rehabilitation programs that are held as passive activity may generate a deduction - equivalent tax credit of up to $25,000. The benefit of this deduction - equivalent tax credit phases out between $200k- 250k of AGI.
How does the deduction - equivalent tax credit work? Calculate tax to determine the maximum marginal tax bracket. If it is 25%, for example, then you multiply $25,000 by 25% to get $6,250.

Question 28

Q

Low Income Housing Credit

Answer

A

Low-income housing programs that are held as passive activity may generate a deduction - equivalent tax credit up to $25,000. There is NO phase out.
The low income housing credit is allowed annually over a 10 year “credit period.” The depreciation is straight-line over 27.5 years.

How does the credit work?

For example, multiply 35% by $25,000 to get a credit of $8750.

NOTE: Because there is no phaseout, it produces a higher credit.

Question 29

Q

Types of Phantom Income

Answer

A

Insurance - Lapse of policy loan, Section 162 life/disability
Investments - Zero/Strip Income, TIPS, declared but not paid dividends.
Tax - K-1 Income from LP/FLP, recapture
Retirement - NUA, 20% withholding plan distributions, secular trust

Question 30

Q

Charitable Giving

Answer

A

Calculate the maximum deductible - 50% of AGI **Not rure here, but says you must use basis for this** pg 89 Live ITB but Q10 ITP Test.
Calculate the eligible amounts given to 50% organizations (public charities) such as all churches, schools, hospitals and organizations such as United Way, Red Cross, Humane Society, etc.
1. 50% for ordinary income property
2. 30% for LTCG property
Calculate the eligible amounts given to 30% AGI organizations (private charities) such as private non-operating foundations, war veteran groups, and fraternal orders.
1. 30% for ordinary income propety
2. 20% for LTCG property

Question 31

Q

Charitable Giving

(Types of property - 50% charities)

Answer

A

Long-term appreciated property - using FMV deduct up to 30% of AGI
Use-unrelated property, ST capital gain property - using basis deduct up to 50% of AGI

Question 32

Q

Schedule A

Itemized Deductions FROM AGI

Answer

A

Medical, dental and LTC (10% AGI)
Casualty and theft losses
Real estate taxes
Investment interest expense
Home mortgage interest
Personal Property tax
State and local income taxes (or sales taxes)
Charitable gifts or contributions
Miscellaneous Deductions
Tier II miscellaneous itemized deductions (exceeding 2% of AGI)

Question 33

Q

Schedule A

(subject to 2% of AGI - major ones)

Answer

A

Fees to investment counselors
Tax advice and preparation fees
Professional and business association dues
Unreimbursed employee business expense
Employee home office expense

Question 34

Q

Kiddie Tax

Answer

A

All net UNEARNED income of a child who has NOT attained the age 18 or turns 19-23 if a full-time student and who has at least one parent alive is taxed at the marginal rate of a child’s parents regardless of the source of the assets.

Children under 18 are entitled (2017) to a standard deduction amount ($1,050) and an additional $1,050 of unearned income will be taxed at the child’s rate (10%).

Question 35

Q

Self-Employment Income

Answer

A

Net schedule C income
General partnership income (K-1 income)
Board of Directors fees
Part-time earnings (1099)
NOT wages or K-1 distributions from an S corp

Question 36

Q

Self-Employment Tax Calculation

Answer

A

The taxable wage base will not exceed $127,200 (2017). If you added up the self-employed income, and you exceeded $127,200, you did something wrong.

Why? Social Security tax stops at $127,200 (2017).

Shortcut: Multiply self-employment income by 0.1413

Question 37

Q

Realized gain versus recognized gain…. What’s the difference

Answer

A

Realized gain is economic or inherent gain at the time of the transaction.
Recognized gain is the part of the realized gain that is immediately taxable.

Question 38

Q

Basis for Property

Answer

A

The basis of property acquired by purchase is equal to cost increased by acquisition (i.e., capitalized) costs, such as legal fees, commissions, sales taxes, freight, etc.
The basis of property acquired by inheritance is the fair market value on the date of the decedent’s death or the alternate valuation date if so elected. An asset acquired by inheritance is deemed to be held for the long-term holding period.
The basis of property acquired by gift
If the FMV on the date of the gift is greater than the donor’s adjusted basis, then use donor’s adjusted basis.
If the FMV on the date of the gift is less than the donor’s adjusted basis in the asset, then
if sold for less than FMV on date of gift, basis is FMV on the date of the gift
if sold for more than the donor’s basis, then basis is the donor’s basis
if the sale price of the asset is between the donor’s basis and the FMV on the date of the gift, no gain or loss is recognized—basis is tied to the sale price
if donor’s basis is used, the holding period is “tacked”; if FMV is used, there is no tacking of the holding period
basis further increased by improvements, but not repairs
improvement significantly increases the useful life of, or the value of, the asset involved
repair merely maintains the asset in normal working condition

Question 39

Q

What are the Cost Recovery Deductions (CRD) Rules under MACRS?

Answer

A

Cost recovery deductions (CRD) are an allowance for the exhaustion and wear and tear of property used in a trade or business, or held for the production of income. (Can Depreciate)
The modified accelerated cost recovery system (MACRS) applies to all recovery property (not land or intangibles) placed in service after 1986.

Question 40

Q

What are the benefits of 1231 Property?

Answer

A

1231 Gains are LTCG which is better rate than Ordinary Income.
1231 Losses are Ordinary Income and 100% deductible against income. Ordinarily this would be capital loss and only available to deduct $3,000 for the year with an outstanding Loss Carry Forward.
This law makes it so taxpayers and business owners get the best of both worlds.

Additional Explainations:

Broadly speaking, if gains on property fitting Section 1231’s definition are more than the adjusted basis and amount of depreciation, the income is counted as capital gains, and as result it is taxed at a lower rate than ordinary income.
When losses are recorded on section 1231 property, however, that loss is classified as an ordinary loss and is 100% deductible against their income.
Ordinarily, if income was qualified as capital gains, so would any losses which can only be deductible up to $3,000 for the tax year, and any losses in excess of that figure would be arrived at in the following year.
This law makes it so taxpayers and business owners get the best of both worlds.

Question 41

Q

What is 1231 Property?

Answer

A

1231 property, defined by section 1231 of the U.S. Internal Revenue Code, is real or depreciable business property held for over a year.

Section 1231 property includes buildings, machinery, land, timber and other natural resources, unharvested crops, cattle, livestock and leaseholds that are at least a year old, but does not include poultry, trademarks, or inventory

Question 42

Q

What is Section 1245 Property?

Answer

A

Section 1245 Property is any new or used tangible or intangible personal property that has been or could have been subject to depreciation or amortization. It is Personalty Property.
- Examples of tangible personal property are machinery, vehicles, equipment, grain storage bins and silos, blast furnaces, and brick kilns.
- Examples of intangible personal property are patents, copyrights and trademarks.
Section 1245 property is NOT land or land improvement, nor its buildings or inherently permanent structures, nor its structural components.
- Examples of property that is NOT personal property are land, buildings, walls, garages and HVAC.

Question 43

Q

Example of 1231 and 1245 (recapture)

Answer

A

Any sales price between the cost basis and the adjusted basis results in Section 1245 gain.

Example of 1231 and 1245 (recapture)

It is best not to consider something a 1231 or a 1245 asset, but rather thinking of the character of the gain/loss.

Say you have a $100 widget which is personal property that was subject to depreciation and now has an adjusted tax basis of $25 because you took $75 of depreciation.
- If you sell that widget for $125, you have a $100 gain. Of that $100, $75 is 1245 ordinary gain (recapture of the depreciation taken is 1245 gain), $25 is 1231 LTCG gain or capital gain.
- If you sell that widget for $10, you have a $15 loss. That loss is a 1231 ordinary loss

Summary:

1231 loss - the loss on personal property used in a trade or business. there are netting and lookback rules, but net 1231 losses are ordinary losses
1245 gain (never a loss) - recapture of depreciation to the extent there is gain. 1245 gain is an ordinary gain.
1231 gain - gain above after depreciation has been fully recaptured. subject to capital gain rates.

Question 44

Q

Unrecaptured Section 1250 Income - Real Estate

Answer

A

The gain attributable to straight-line depreciation on realty is treated as long-term capital gain income (Section 1231 income), subject to a maximum 25% long-term capital gain rate.

The gain created by actual appreciation of the realty is “regular” long-term capital gain, generally subject to a 15% or 20% maximum rate (also Section 1231).

Any sales price between the cost basis and the adjusted basis results in unrecaptured Section 1250 income. Any gain created by actual appreciation of the realty is “regular” LTCG.

Question 45

Q

An Example of Section 1250 Applicability?

Answer

A

An Example of Section 1250 Applicability

Consider an investor who purchased real estate with a useful life of 40 years for a total purchase price of $800,000. After five years, the investor claimed $120,000 in accumulated depreciation expenses using the accelerated depreciation method, resulting in a cost basis of $680,000.

Suppose that the investor sells this property after five years for $750,000, for a total taxable gain of $70,000. Because the accumulated straight-line depreciation is $100,000 (initial price of $800,000 divided by 40 years times five years of use), $20,000 of the actual depreciation that exceeds straight-line depreciation must be taxed as ordinary income, while the remaining $50,000 of the total gain is taxed at applicable capital gains tax rates.

The recapture of gain as ordinary income under Section 1250 is limited to the extent of actual gain recorded on a sale of real property.

If the real property in the above example was sold for $690,000, producing a gain of $10,000, only $10,000 would be considered ordinary income, not the excess $20,000.

Question 46

Q

Section 1245 Property Steps:

Answer

A

This applies to the sale of personalty that is or has been subject to an allowance for depreciation.
Section 1245 also applies to nonresidential real property placed in service after 1980 and before 1987, and depreciated under the ACRS rules.
The amount of gain treated as ordinary income on the disposition of Section 1245 property generally is equal to the lesser of:
1. the cost recovery deductions taken, or
2. the gain realized on the sale.
If a loss is recognized on the disposition, there is no Section 1245 recapture; the entire loss is treated as a Section 1231 loss.
The gain not characterized as Section 1245 recapture is treated as a Section 1231 gain.
The gain attributable to the taking of cost recovery deductions is ordinary income; only gain caused by appreciation of the asset is potential long-term capital gain.

Question 47

Q

General Rules of Like-Kind Exchanges

Answer

A

Losses are never recognized by the taxpayer who qualifies for like-kind exchange treatment.
Gain realized is FMV of property received minus A/B of property given up.
The gain recognized is always the lesser of the gain realized or the boot received.
Basis of the like-kind property received is its fair market value reduced by any gain realized but not recognized. (OR old basis, minus boot received, plus boot paid and gain recognized).

Question 48

Q

Breaking down Section 1250

Answer

A

Section 1250 deals with taxing gains at an ordinary tax rate that arises from selling depreciable real property, such as commercial buildings, warehouses, barns, rental properties and their structural components.

Personal property, either tangible or intangible, and land do not fall under the scope of this tax regulation. Section 1250 is mainly applicable when a company depreciates its real estate using the accelerated depreciation method, which results in larger deductions in the early life of a real asset, in comparison to the straight-line method.

Section 1250 says that if a real property sells for a purchase price that produces a taxable gain, and that property is depreciated using the accelerated depreciation method, the difference between the actual depreciation and the straight-line depreciation is taxed as ordinary income.

Because all post-1986 real estate is required to be depreciated using the straight-line method, treatment of gains as ordinary income under Section 1250 is rare.

If the property is disposed of as a gift, transferred at death, sold as part of a like-kind exchange, or disposed of through other methods, no possible taxable gain exists.

Question 49

Q

What is Section 1250?

Answer

A

Section 1250 is a section of the United States Internal Revenue Service Code that states that a gain from selling real property that has been depreciated should be taxed as ordinary income, to the extent that the accumulated depreciation exceeds the depreciation calculated using the straight-line method.

Section 1250 bases the amount of tax due on the type of property, such as residential or nonresidential property, and on how many months the property was owned.

Question 50

Q

How do I qualify as a like-kind exchange?

Answer

A

The property to be received must be identified within 45 days after the date on which the old property is transferred.
The new property must be received within 180 days after the date on which the old property is transferred, but not later than the due date of the tax return (including extensions) for the year that the old property is transferred.
The like-kind provision is mandatory.

Question 51

Q

How to calculate S/E income deduction for AGI?

Answer

A

Step 1: Figure out the amount of your earnings that is actually taxable for the S/E taxable income

Step 2: Calculate the amount you owe for S/E Tax

Step 3: Report half of your S/E tas as an adjustment

Ex: S/E of $100K

Step 1: $100,000 x 0.9235 = $92,350 ($92,350 is the S/E Taxable Earnings/Income - we times it by 92.35% because 7.65% is the ER half of FICA tax

Step 2: $92,350 x 0.1530 = $14,129.55 (we times it by 15.30% becuase this is the OASDI HI or FICA amount)

Step 3: $14,129.55 x 0.50 = $7,064.78 (this is the 1/2 S/E amount you can deduct Above the Line for AGI)

Shortcut is to multiply $100,000 x .1413 = 14,130

Question 52

Q

Can a publicly traded limited partnership offset the income from a non-publicly traded partnership?

Answer

A

Income from a publicly traded limited partnership may not be offset by any other passive losses.

Question 53

Q

Section 179 Deduction when net income is lower than the equipment cost or the taxable (earned) income limitation.

Answer

A

Ex:

Equipment purchase is $620K

Net Income is $220K

The Section 179 deduction is subject to a taxable (earned) income limitation. However, for this purpose, wages received (even from a completely unrelated source) are considered to be from the active conduct of a trade or business. With only $220,000 of earned income, only $220,000 may be deducted under Section 179.

Question 54

Q

Is flow-through of income from an S corporation (or limited partnership income to a limited partner) is considered to be self-employment income?

Is Sole Proprietorship net income considered self employment income?

Answer

A

No, it is not considered to be SE employment income so we do not have to calculate the SE tax.

Yes, S/P net income is considered employment income so you do have to calculate the SE tax and you can take the short cut by multiplying by 0.1413

Question 55

Q

Types of Qualified Plans/ERISA

(vesting/admin costs/exempt from creditors/integrate with Social Security)

Answer

A

Defined Benefit
Cash Balance
Money Purchase
Target Benefit
Profit Sharing
Profit Sharing 401(k)
Stock Bonus
ESOP (NOT integrated with Social Security or cross-tested)

http://www.pensioncon.com/plantypes.php

Question 56

Q

Types of Retirement Plans

(no vesting/limited admin costs)

Answer

A

SEP
SIMPLE
SAR-SEP
Thrift or Savings Plans (TSP - Federal EE’s and Military)
403(b) (Public Schools and some Non-Profits)

Question 57

Q

Money Purchase Pension Plan -

Qualified Plan = ERISA

Pension Plan = Subject to Minimum Funding Standards and the Qualified Joint and Survivor Annuity requirement

Defined Contribution Plan = Provide Uncertain Retirement Benefit due to annual contributions and the investment returns of the EE account.

Answer

A

Mandatory contributopm of up to 25% employer payroll and can deduct same 25%.
Fixed contributions - need stable cash flow
Maximum annual contribution lesser of 100% or salary of $54k (2017)
No acutuarial determination in this plan

In money purchase plans, the employer is obligated to contribute even if the company didn’t make a profit. The contributions are determined by a specific percentage of each employee’s compensation and must be made annually.

Although a younger and an older employee with the same level of compensation will receive the same allocation, the long-term accumulation of tax-sheltered funds will benefit younger employees more than older employees.

A money-purchase pension plan is a pension plan to which employers and employees make contributions based on a percentage of annual earnings, in accordance with the terms of the plan. Upon retirement, the total pool of capital in the member’s account can be used to purchase a lifetime annuity. The amount in each money-purchase plan member’s account differs from one member to the next, depending on the level of contributions and the investment return earned on such contributions.

Question 58

Q

Target Benefit Pension Plan?

Qualified Plan = ERISA

Pension Plan = Subject to Minimum Funding Standards and the Qualified Joint and Survivor Annuity requirement & Needs stable cash flow

Defined Contribution Plan = Provide Uncertain Retirement Benefit

Answer

A

Up to 25% employer deduction
Fixed contributions - need stable cash flow
Maximum annual contribution less of 100% of salary or $54k (2017)
Favors older workers - How?

The Target Benefit Plan, which is an age-weighted pension plan. Under this plan, each employee is targeted to receive the same formula of benefit at retirement (age sixty-five), but the benefits are not guaranteed. Because older employees have less time to accumulate the funds for retirement, they receive a larger contribution as a percentage of compensation than the younger employees do. The target plan is a hybrid of defined benefits and defined contribution plans, but it is a defined contribution pension plan with the same limits and requirements as defined contribution plans.

One such defined contribution plan is the target plan, which is an age-weighted pension plan. Under this plan, each employee is targeted to receive the same formula of benefit at retirement (age sixty-five), but the benefits are not guaranteed. Because older employees have less time to accumulate the funds for retirement, they receive a larger contribution as a percentage of compensation than the younger employees do. The target plan is a hybrid of defined benefits and defined contribution plans, but it is a defined contribution pension plan with the same limits and requirements as defined contribution plans.

Question 59

Q

Safe Harbor

Nondiscrimination

Answer

A

A safe harbor 401(k) plan automatically satisfies the nondiscrimination tests involving highly compensated employees (HCEs) with either an employer matching contribution or a nonelective contribution.

Question 60

Q

Safe Harbor

Match/Vesting

Answer

A

The statutory contribution using a match is $1/$1 on the first 3% employee deferral and $0.50/$1 on the next 2% employee deferral. If the employer chooses to use the nonelective deferral method, the employer must contribute 3% of all eligible employees’ compensation regardless of whether the employee is deferring or not.

Employer contributions must be immediately vested.

Question 61

Q

SIMPLE Plan

Answer

A

Fewer than 100 employees
Employer cannot maintain any other plan
Participants fully vested
Easy to administer and funded by employee salary reductions and an employer match

Question 62

Q

Vesting - Fast / Slow

Answer

A

Fast: DB Top-heavy Plans / All DC Plans

3 - year cliff or 2-6 year graded or 100% vested after 2 years

Slow: Non-top-heavy DB Plans only

5 - year cliff or 3-7 year graded or 100% vested after 2 years

Question 63

Q

IRA

Exceptions to 10% Penalty for

Early Distributions before age 59½

Answer

A

Death
Disability
Substantially equal periodic payments
Medical expenses in excess of 10% of AGI or health insurance costs while unemployed
First home expense up to $10,000
Qualified education expense
Distribution used to pay insurance premium after separation from employment (must have received unemployment compensation for 12 weeks)

Question 64

Q

Roth IRA

Ordering rules for distribution

Answer

A

Any contributions (not conversions) are withdrawn first
Conversions are withdrawn second
Earnings are withdrawn last

Answer 65

A

RMDs for Roth IRAs only required after Death of original owner

Distributed within 5 years of owner’s death or
Distributed over the life expectancy of the designated beneficiary with distributions commencing prior to the end of the calendar year following death (stretch)
Where the sole beneficiary is the owner’s surviving spouse, the spouse may delay distributions until the Roth owner would have reached 70½, or may treat the Roth as his or her own (roll it to her/her Roth)

Answer 66

A

Key Words - merger, acquisition or change of ownership
Assets in rabbi trust available for company’s creditors
Fear that ownership / management may change before deferred compensation is paid
Irrevocable Trust set aside for the benefit of the EE
Contributions to trust are not currently taxable to EE if the Trust does not contain financial triggers and is not located “offshore”.

The assets of a rabbi trust must be available to the employer’s creditors, and cannot have “insolvency triggers” that would accelerate payment to the participants in the event that the employer’s net worth fell below a certain point. In the event that the employer faced bankruptcy or a financial hardship, the trustee must be notified. The trust’s assets are then frozen so that the assets will be available to the employer’s creditors. Due to Section 409A, an offshore rabbi trust will result in immediate taxation of the benefits, interest at the underpayment rate plus 1%, and a 20% penalty tax.

Answer 67

A

Younger employees,
short-service employees,
employees in lower-pay brackets,
employees who quit after medium lengths of service are those who will benefit most from profit-sharing plans.

Answer 68

A

qualified defined benefit plan that provides specified employer contributions and a guaranteed return into a hypothetical account.
Favors Younger Employees. Uses Career Average Pay ONLY.
The cash-balance plan credits your account with a set percentage of your salary each year.
Another key difference: If you leave the company before retirement age, you may take the contents of your cash-balance plan as a lump sum and roll it into an IRA. A traditional pension isn’t portable.

Answer 69

A

guaranteed benefit
quasi money purchase plan with guaranteed return
Defined benefit plan can be AMENDED into a cash balance plan to simplify and reduce costs. (When this is done, the company can keep the same vesting schedule and amounts in the new plan. In other words, all participants in the defined benefit plan would not be automatically 100% vested because of the defined benefit pension plan termination.)

Answer 70

A

Similar to a pension plan and a 401(k) combined. You have ER guaranteed returns (5% + 3%) in a hypothetical account for each EE. Account builds and at retirement can take an annuity on the account balance. The account is Portable.

Cash balance pension plans are defined benefit plans that appear similar to defined contribution plans.
Instead of guaranteeing Retirement Benefit
Cash balance plans are defined benefit (DB) plans
- Maximum annual benefit is limited to the amount that will fund a benefit of $215,000 a year in retirement in 2017, or if compensation is less, 100% of compensation.
- Only up to $270,000 in compensation can be used when calculating this benefit.
- Actuarial services are required annually.
- The employer guarantees the specified investment result. Usually fixed percentage (5%) + interest credit (3%).
- The cash balance plan does NOT provide an amount of benefit that will be available for the employee at retirement. Rather….
  - Instead, the cash balance plan sets up a “hypothetical individual account” for each employee, and credits each participant annually with a plan contribution (usually a percentage of compensation).
  - The employer also guarantees a minimum interest credit on the account balance. For example, an employer might contribute 10 percent of an employee’s salary to the employee’s plan each year and guarantee a minimum rate of return of 4 percent on the fund.

In a typical cash balance plan, a participant’s account is credited each year with a “pay credit” (such as 5 percent of compensation from his or her employer) and an “interest credit” (either a fixed rate or a variable rate that is linked to an index such as the one-year treasury bill rate). Increases and decreases in the value of the plan’s investments do not directly affect the benefit amounts promised to participants. Thus, the investment risks are borne solely by the employer.

When a participant becomes entitled to receive benefits under a cash balance plan, the benefits that are received are defined in terms of an account balance. For example, assume that a participant has an account balance of $100,000 when he or she reaches age 65. If the participant decides to retire at that time, he or she would have the right to an annuity based on that account balance. Such an annuity might be approximately $8500 per year for life. In many cash balance plans, however, the participant could instead choose (with consent from his or her spouse) to take a lump sum benefit equal to the $100,000 account balance.

If a participant receives a lump sum distribution, that distribution generally can be rolled over into an IRA or to another employer’s plan if that plan accepts rollovers.

The benefits in most cash balance plans, as in most traditional defined benefit plans, are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation.

Answer 71

A

Employer contributions are limited to up to 25% of covered payroll up to $54,000 per participant.
Forfeitures may be reallocated to remaining participants’ accounts or applied to reduce employer contributions.
Subject to minimum funding standards
**Allocation of employer (ER) contributions is based on age-weighted formula.
**Actuary is used for the first year of the plan only.

Answer 72

A

An age-weighted profit sharing plan provides the same potential benefit as the target benefit plan; however, the age-weighted profit sharing plan is not subject to mandatory funding.

Answer 73

A

401(k) provision allows for pre-tax EE deferrals.
Prior to the enactment of 401(k) provisions in 1981, employees could only make after-tax contributions—this was called a Thrift Plan.
The IRS issued proposed regulations on 401(k) plans that sanctioned the use of employee salary reductions as a source of retirement plan contributions. Many employers replaced older, after-tax thrift plans with 401(k)s and added 401(k) options to profit-sharing and stock bonus plans.

Answer 74

A

Relatively simple to explain and install
Annual contributions generally in favor of older, highly paid participants.

Answer 75

A

Mandatory annual contributions
Limits employer’s tax deduction

Answer 76

A

25% employer deduction limit
Employer contributions usually are discretionary, but must be “substantial and recurring”
Forfeitures usually are reallocated to remaining participants’ accounts

Answer 77

A

DB Plans Provide specified retirement benefit

Defined Benefit Pension Plan

Cash Balance Pension Plan

Answer 78

A

DC Plans Provide an uncertain retirement benefit

PSP (PSP)

Money Purchase (PP)

Target Benefit (PP)

Answer 79

A

They are subject to Minimum Funding Standards

DBPP

CBPP

MPPP

TBPP

Answer 80

A

A money purchase plan or money purchase pension is a type of defined contribution retirement plan offered by some employers. Money purchase plans are like other defined contribution plans, such as 401(k) and 403(b) plans, in that both the employer and employee make contributions to the plan. EE makes after-tax contributions into plan. What makes money purchase plans different is that they require fixed employer contributions. That means that employers must contribute a fixed percentage of each eligible employee’s salary annually to their separate retirement accounts.

Money purchase plans are similar to profit-sharing plans, but with a profit-sharing plan, the employer can determine each year how much will be distributed to employees. Instead of a fixed percentage of salary, a profit-sharing employer could decide to share a fixed amount of profit, and distribute it to employees each year as a percentage of salary. For employers, money purchase plans make budgeting and planning for contributions easier, while profit-sharing plans offer more flexibility in less profitable years.

A money purchase pension plan is a type of qualified defined contribution plan in which you, the ER, make annual required contributions to the accounts of participating EE’s. The amount of your employer contributions is generally determined based on a preset formula that cannot be changed without amending the plan, even if your business profits are low or nonexistent.

A money purchase pension plan is very similar to a profit-sharing plan. In fact, the two plans are so similar that each type of plan is specifically required to identify itself as either a “money purchase pension plan” or a “profit-sharing plan” in the plan document. The most significant distinction between the two types of plans is the MPPP mandatory fixed contribution formula (in contrast, contributions to a profit-sharing plan are generally discretionary).

According to the Internal Revenue Service, a money purchase retirement plan is a defined contribution plan into which the employer is required to contribute money. The plan prescribes the contribution percentage that the employer is required to make and the employer makes the contribution, typically annually, to a separate account for each eligible employee based on the employee’s pay.

Like a defined benefit pension plan, a money purchase plan is subject to the minimum funding requirements and the qualified joint and survivor annuity requirements. Like a defined contribution plan, a money purchase plan is subject to the annual limit on contributions to the plan and the annual valuation of plan assets. This duality of requirements significantly affects the design of money purchase plans.

Although a younger and an older employee with the same level of compensation will receive the same allocation, the long-term accumulation of tax-sheltered funds will benefit younger employees more than older employees.

Answer 81

A

A Keogh plan is a tax-deferred pension plan available to self-employed individuals or unincorporated businesses for retirement purposes. It can be set up by small businesses that are structured as LLCs, sole proprietorships or partnerships.
A Keogh plan can be set up as either a defined-benefit or defined-contribution plan, although most plans are defined as contributions.
A Keogh is similar to a 401(k) for very small businesses, but the annual contribution limits are higher than 401(k) limits. $54K for 2017.

Answer 82

A

Integrated with Social Security aka ‘premitted disparity’

A company retirement plan may take into consideration Social Security when allocating an employer contribution to eligible employees.
Because Social Security is only paid on compensation up to a certain dollar amount, any employee with compensation over the Social Security Taxable Wage Base (TWB) will receive a large allocation of the employer contribution allocated in the company retirement plan to account for this.
The TWB for 2017 is $127,200.

Answer 83

A

In addition to that broad discretion, IRS rules also allow a variety of methods to determine what portion of the total contribution goes to each plan participant. Each of these allocation methods can be combined with 401(k) features, matching contributions, etc. to achieve an overall design customized for each company’s needs.

Salary Proportional Method aka Pro-Rata
Permitted Disparity Method aka Social Security Integration
New Comparability Method aka Cross-Tested
Age Weighted Method (TBPP)
Service Based Method

Answer 84

A

The Permitted Disparity Method, aka as Social Security Integration, recognizes that Social Security benefits are only provided on an individual’s compensation up to the Social Security Wage Base ($127,200 for 2017) and allows additional plan contributions on pay exceeding that level (referred to as Excess Compensation).

The contribution is calculated in two steps:

Step 1. A uniform percentage of total base pay is allocated to all eligible participants. This is referred to as the base percentage.

Step 2. A uniform percentage of Excess Compensation is allocated to all eligible participants who have such pay. The excess percentage cannot exceed the lesser of the base percentage or 5.7%.

It is possible to integrate the allocation at a level below the Social Security Wage Base; however, doing so often results in a reduction of the maximum excess contribution percentage.

Answer 85

A

Under the Age-Weighted method, the employer’s profit sharing contribution is allocated in a manner that considers both the participant’s age and compensation.

Using one of the mandated mortality tables and interest rates, points are allocated to each participant based on age.

The ratio of a participant’s points to the total points of all participants determines the participant’s percent of the overall profit sharing contribution.

Answer 86

A

A profit sharing contribution must demonstrate non-discrimination in either the form of allocations or benefits.

Giving all participants the same percentage of pay as an allocation is clearly non-discriminatory.

However, giving each participant the same theoretical retirement benefit is also non-discriminatory and the present-day allocations required to generate these benefits may not be equal.

This is because older participants have less time to retirement, and thus require larger allocations to reach the same benefit level.

Certain design-based safe harbor allocation methods like the Salary Ratio and Social Security Integration (permitted disparity) methods are deemed to be non-discriminatory.

Non-safe harbor allocation methods like the Age-Weighted and New Comparability (Cross Tested) methods must demonstrate non-discrimination by passing the General Test on either an allocations basis or on a benefits basis.

When an allocation method passes the General Test on a benefits basis, this is known as Cross-Testing.

Answer 87

A

Hardship W/D for QP and NQP

How to set up the Problem for how much of an IRA we can deduct when we are investing in a QP?

Answer 88

A

Yes, you are taxed at your income tax rate and there is a 10% penatly but you can only access your deferrals.

Answer 89

A

The participant must exhaust other “reasonably available” resources.

Examples of the required “immediate and heavy financial need” include:

college tuition expenses
medical expenses
purchase of a primary residence
prevention of eviction from a primary residence

Hardship withdrawals may consist of the participant’s elective deferrals only, not earnings associated with these deferrals.

If the participant is under age 59 1/2, the withdrawal is subject to the 10% early withdrawal penalty.

Answer 90

A

Qualified employee discounts and health and accident insurance are the only listed employee benefits that are nontaxable to the employee.

Answer 91

A

Yes, Withdrawals can be taken from an IRA penalty free if used for qualified education expenses but you will have to pay regular taxes on the distribution.

Answer 92

A

Yes, Withdrawals can be taken from a Roth IRA penalty free if used for qualified education expenses and the distribution is tax free as long as you take less than the amount contributed.

Answer 93

A

Yes, but it would have to be in the form of a loan. You can not take a distribution or you will be taxed.

Answer 94

A

Integration with Social Security and permitted disparity. The purpose of integration is to equalize the employer’s contributions (to a qualified plan and Social Security) regarding retirement benefits for higher- and lower-paid employees. Without integration, the disparity is that the employer contributes a higher percentage of compensation for lower-paid employees. The net result is to lower the cost for rank-and-file employees while maintaining the same level of contribution (cost) for more highly paid employees (typically owners).

Permitted disparity is the lesser of the base contribution percentage or 5.7%.

Answer 95

A

The NHCE benefiting from the plan must be at least 70% of the HCE’s.

Ex. 1,000 EE’s

100 HCE

900 NHCE

If 90% of the highly compensated employees benefit from the plan (90/100 = 90%). Therefore, at least 63% of nonhighly compensated employees must benefit from the plan (90% × 70% = 63%). With 900 eligible nonhighly compensated employees, 567 must participate (900 × 63% = 567).

Answer 96

A

HCE:

A greater than 5% owner
- OR
An employee earning in excess of $120,000 during the preceding year (2016)

Key Employee:

An individual is a key employee if at any time during the current year he/she has been one of the following

A greater than 5% owner or
An officer and compensation > $170,000 (2017) or
Greater than 1% ownership and compensation > $150,000 (2017)

Answer 97

A

Property subject to a general power will be included in a donee decedent’s estate (or considered a taxable gift” only to the extent that the property exceeds the greater of:

$5,000 or
5% of the total value of the fund subject to the power as measured at the time of lapse

Answer 98

A

Simple trusts (2503(b), Marital, QTIP) are considered merely a “conduit” for forwarding income to the beneficiaries (pass-through)
Complex trusts (2503(c)), are separate tax entities and taxed as such if it meets two requirements:

It is irrevocable, and the grantor has not retained any control
Income is accumulated

Answer 99

A

Property transferred to the trust at the time of the decedent’s death
Can be structured to provide a stream of income to surviving spouse or other individuals
Decedent has postmortem control

Answer 100

A

Provides surviving spouse with a stream of income for life, but decedent has postmortem control of trust property
Property qualifies for marital deduction
Mainly used for second marriages
Key word for QTIP - LAME
- Lifetime income for the spouse
- Annual payments to spouse
- Mandatory payments to spouse
- Exclusively for spouse

Answer 101

A

No unlimited marital deduction
However, no estate tax due
Jointly held property between spouses is not considered one-half owned
Limited gift between spouses of only 100K (indexed) per year

Answer 102

A

Remember: PIGS need income

Private annuity
Installment Sale
Grantor Annuity Trusts (GRAT/GRUT)
Self canceling installment note (SCIN)

Answer 103

A

Partnership / S-corp
Family Limited Partnership (FLP)
Gift Leaseback
Qualified Personal Residence Trust (QPRT)

Answer 104

A

Stock Redemption (Section 303):

Business must be incorporated (closely held)
Value of business must exceed 35% of the decedent’s adjusted gross estate
Redemption cannot exceed the sum of the estate taxes plus administrative expenses

Installment payment of estate taxes (Section 6166):

Value of business must exceed 35% of decedent’s adjusted gross estate
During the first 4 years (of 14 years) can pay interest only on taxes due

Answer 105

A

Special Use Valuation (Section 2032A):

25% of the gross estate consists of real property
Must be in qualified use: 5-out-of-8 year rule before death and 10 years after death.

Answer 106

A

Transfer sections:

a. Property gifted by decedent is included in the gross estate if the decedent retained rights with respect to the property, including:
1. (1) the right to use or receive income from the property (§2036)
2. (2) the right to designate the persons who shall possess or enjoy the property or the income therefrom (§2036)
3. (3) the right to vote stock in a controlled corporation (§2036)
4. (4) a right of reversion in the property (§2037)
5. (5) the right to alter, amend, terminate, or revoke disposition of the property (§2038)
6. (6) the right to affect the time or manner of enjoyment of the property or its income by others (§2038)

Answer 107

A

1. Three-year inclusionary rule (§2035)
1. a. There are only three situations in which property must be included in the gross estate of a decedent because of an action taken within three years of death:
  1. (1) paid gift taxes out of pocket on gifts made within three years of death (the “gross up” rule)
  2. (2) transferred incidents of ownership on a life insurance policy on his or her own life
  3. (3) released a retained right mentioned in the transfer sections of the Code (§§2036–2038)

Answer 108

A

Used for large block of publicly traded stock that cannot be marketed without adversely affecting the price

Answer 109

A

Inability of closely held business interest to control business decisions

Answer 110

A

Real estate that has impaired marketability because estate cannot sell its partial interest or purchase co-owner’s partial interest

Answer 111

A

Loss of person who is vital to business operations

Answer 112

A

Restrictions on marketability and costs of taking public a closely held business

Answer 113

A

Tax on transfer of wealth (during life or at death) to persons who are deemed to be two or more generations younger than the transferor
GSTT in addition to any gift or estate tax due on the transfer
Taxed at top regular estate tax rate for year of transfer

Answer 114

A

Lineal Relatives - The Transferee is two or more generations younger than the Transferor. Grandchild or great grandchild.
Non Lineal Relatives - Someone who is 37.5 years younger than the Transferor.

Answer 115

A

Transferee who is deemed to be less than two generations younger than the transferor or the transferor’s spouse. Like a child or nephew of the Transferor.
Transferor’s spouse or former spouse is always considered a non-skip person regardess of age difference with the transferor.

Answer 116

A

Spouses
Ex-Spouses
Charities
Transfers that qualify for the annual exclusion
Direct Payments to Medical and Educaitonal providers

Answer 117

A

Let’s say son dies and the grandfather transfers assets to the grandson, then the grandson would move into the son’s slot and there would be no GSTT due to the deceased ancenstor rule.

Answer 118

A

GSTT is in addition to any estate of gift tax due.
Annual exclusion available for present interest gifts.
GSTT exemption is $5,490,000 in 2017.
Gift Splitting allowed for spouses.
Direct payment to educational and medical providers are exempt.
Flat tax rate of 40% at Gift and Estate Level and a 40% at the GSTT level.

Answer 119

A

Provides surviving spouse with a stream of income for life, but decedent has postmortem control of trust property
Property qualifies for marital deduction
Mainly used for second marriages
Key word for QTIP - LAME
- Lifetime income for the spouse
- Annual payments to spouse
- Mandatory payments to spouse
- Exclusively for spouse

Answer 120

A

(1) Substantial risk of forfeiture is necessary to prevent constructive receipt in certain plans.
(2) Substantial risk of forfeiture generally requires the employee’s actual performance of services.
(3) Substantial risk of forfeiture is not necessary in an unfunded plan that is executed prior to the performance of services.
(4) Substantial risk of forfeiture provisions are generally necessary only in funded plans to prevent constructive receipt.

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