FP515 Retirement Flashcards
Which of these is a type of defined contribution profit-sharing plan?
A) Cash balance pension plan
B) Employee stock ownership plan (ESOP)
C) Target benefit pension plan
D) Money purchase pension plan
B) Explanation
A cash balance pension plan is a type of defined benefit pension plan. An ESOP is a defined contribution profit-sharing plan.
LO 1.2.1
The maximum service requirement that a thrift plan may impose as a condition of participation is
A) two years.
B) one-and-a-half years.
C) six months.
D) one year.
A) Explanation
By law, the maximum service requirement that a thrift plan may impose is two years of service. An employee must become a participant in a thrift plan on the next plan entry date following the later of attainment of age 21 or the completion of two years of service. Of course, a more liberal participation requirement may be imposed. The maximum for a 401(k) is one year.
LO 1.3.1
Which of these is false regarding defined contribution plans?
A) The employer contribution limit is 25% of the participating employees’ payroll.
B) The retirement benefit is not certain; investment risk is borne by the participant.
C) Includible compensation is limited to the lesser of 100% of compensation or $230,000 in 2021.
D) The maximum allowable employee deferral amount for workers is $19,500 in 2021, not counting any catch ups.
C) Explanation
The maximum amount of includible compensation is $290,000, not $230,000. $230,00 is a maximum defined benefit test number in 2021.
LO 1.3.2
Question 4 of 20
Question ID: 1340519
Which of these statements regarding a top-heavy retirement plan is false?
A) Top-heavy plans favor key employees by providing more than 60% of the plan benefits to these employees.
B) Close scrutiny of the top-heavy rules is desirable from a planning standpoint because an understanding of these rules coupled with effective personnel decisions and plan design may enable the plan to escape top-heavy status.
C) Small-business owners are prone to shaping the organization’s retirement plan primarily to shelter taxes for themselves and key employees, thereby creating top-heavy plans.
D) Defined benefit pension plans can be top heavy; defined contribution plans cannot.
D) Explanation
Both defined benefit pension and defined contribution plans can be top heavy, but both must satisfy rules that apply to top-heavy plans.
LO 1.3.1
Benjamin Scott, age 42, earns $110,000 a year and wants to establish a profit-sharing plan. He employs four people whose combined salaries are $58,000 and who range in age from 24 to 30. The average employment period for all employees is three-and-a-half years. Which vesting schedule is best suited for Benjamin’s plan?
A) Three-to seven-year graded vesting
B) Five-year cliff vesting
C) Two-to-six-year graded vesting
D) Three-year cliff vesting
C) Explanation
The choices for vesting in a defined contribution plan are: (1) 100% full and immediate, (2) three-year cliff, or (3) two-to-six graded. Because of the average length of employment, the most suitable vesting schedule from Benjamin’s point of view (cash flow if termination occurs and reallocated forfeitures to Benjamin) is graded vesting. Five-year cliff vesting and three-to-seven-year graded vesting are not available to Benjamin’s company for a profit-sharing plan.
LO 1.3.1
Which of the following is CORRECT regarding IRS Form 5500?
A) A simplified version, Form 5500-EZ, is available for certain small employers.
B) The IRS 5500 is known as the employer’s annual return/report to the IRS of an employee benefit plan.
C) All of these statements are correct.
D) Filing an IRS 5500 is an ERISA requirement.
C) Explanation
All of these statements are correct regarding IRS Form 5500.
LO 1.4.1
If a qualified defined contribution retirement plan is found to meet the requirements under the Employee Retirement Income Security Act of 1974 (ERISA) and Internal Revenue Service (IRS) regulations, which of these statements is CORRECT?
A) The PBGC will provide coverage to the plan.
B) The participating employees must petition the IRS for acceptance of the plan.
C) The employer is permitted to require three years of service eligibility as long as employer contributions are immediately 100% vested to participants.
D) Employees are not taxed on plan contributions or earnings attributed to plan contributions as long as a plan distribution does not occur.
D) Explanation
Employees are not taxed on plan contributions or earnings attributed to plan contributions as long as a plan distribution does not occur. A two years of service eligibility requirement is permitted if 100% immediate vesting is also used. Employees do not petition the IRS for acceptance of the plan. No defined contribution plans are eligible for PBGC coverage.
LO 1.1.1
Which of the following describe differences between tax-advantaged retirement plans and qualified plans?
I. IRA-funded employer-sponsored tax-advantaged plans may not incorporate loan provisions.
II. Employer stock distributions from a tax-advantaged plan do not benefit from NUA tax treatment.
A) Both I and II
B) I only
C) II only
D) Neither I nor II
A) Explanation
Both statements are correct. IRA-funded employer-sponsored tax-advantaged plans are SEPs, SARSEPs, and SIMPLE IRAs.
LO 1.2.1
Which of the following are minimum coverage tests for qualified retirement plans?
I. Minimum allowed discrimination
II. Average benefits percentage test
III. Ratio test
IV. Maximum compensation test
A) II and III
B) II, III, and IV
C) I, II, and III
D) I and II
A) Explanation
The two minimum coverage tests for qualified retirement plans are the average benefits percentage test and the ratio test. To be qualified, a retirement plan must meet at least one of these tests if the plan does not meet the percentage (safe harbor) test.
LO 1.3.1
Which of the following are agencies that administer and ensure compliance with the federal laws that apply to qualified retirement plans?
I. Department of Labor (DOL)
II. Employee Retirement Income Security Agency (ERISA)
III. Internal Revenue Service (IRS)
IV. Pension Benefit Guaranty Corporation (PBGC)
A) I, II, and III
B) II and IV
C) I and III
D) I, III, and IV
D) Explanation
Under the reporting and disclosure requirements of the Employee Retirement Income Security Act of 1974 (ERISA), annual reports and summary plan descriptions are filed with the IRS (which provides copies to the DOL). An annual premium payment form is filed with the PBGC. If the defined benefit plan is not in compliance with funding requirements, the PBGC can terminate the plan. If the defined benefit plan is not in compliance with funding requirements, the PBGC can terminate the plan.
LO 1.1.1
Qualified retirement plans should do which of the following?
I. They must meet specific vesting requirements.
II. They have special tax advantages over nonqualified plans.
III. They must provide definitely determinable benefits.
IV. They require an annual profit to allow funding for the plan.
A) II and III
B) II, III, and IV
C) I, II, and III
D) I and II
C) Explanation
Qualified plans must meet specific vesting schedules. Qualified plans are preferred to nonqualified plans because of the special tax advantages enjoyed by qualified plans. Qualified retirement plans must offer definitely determinable benefits. An annual profit is not required for a qualified plan to be funded.
LO 1.2.1
Which of the following statements regarding nonqualified retirement plans is CORRECT?
A) Contributions are deductible by the employer when contributed to the plan.
B) Nonqualified plans do not have to meet the nondiscrimination requirements that apply to qualified plans.
C) Benefits are received by the employee income-tax-free.
D) Nonqualified plans are subject to the same Employee Retirement Income Security Act of 1974 (ERISA) requirements as qualified plans.
B) Explanation
Nonqualified plans do not have to meet the nondiscrimination requirements that apply to qualified plans. Nonqualified plans are not subject to all ERISA requirements applicable to qualified plans. Benefits are not deductible by the employer until paid and are includable in the employee’s taxable income at the time of receipt.
LO 1.2.1
Ryan, who is 50, is employed by Best Mutual Funds (BMF) and participates in its profit sharing Section 401(k) plan for 2021. The plan allocates contributions based on relative compensation and is not integrated with Social Security. Ryan’s current annual compensation is $80,000, and he has elected to defer 5% of compensation into the Section 401(k) plan. Including Ryan, 35 employees with a total covered payroll of $1.8 million participate in the plan and have elected to defer a total of $72,000 (4% of payroll). BMF’s matching contributions to the plan total $54,000 (3% of total covered payroll). What is the limit on annual additions to Ryan’s individual account?
A) $58,000
B) $13,500
C) $19,500
D) $26,000
A) Explanation
The limit on annual additions to Ryan’s account in 2021 is the lesser of 100% of compensation ($80,000) or $58,000.
LO 1.3.2
Which of the following statements regarding a top-heavy plan is CORRECT?
I. A top-heavy plan is one that provides more than 40% of its aggregate accrued benefits or account balances to key employees.
II. A top-heavy defined pension benefit plan must provide a minimum benefit accrual of 2% multiplied by the number of years of service (up to 20%).
III. For a top-heavy defined contribution plan, the employer must make a minimal contribution of 3% of annual covered compensation for each eligible non-key employee. If the contribution percentage for key employees is less than 3%, the contribution percentage to non-key employees can be equal to the key employees’ percentage.
IV. A top-heavy defined benefit pension plan must provide accelerated vesting.
A) I, II, and IV
B) II, III, and IV
C) I, II, III, and IV
D) I, II, and III
B) Explanation
Only Statement I is incorrect. A top-heavy plan is one that provides more than 60% of its aggregate accrued benefits or account balances to key employees.
LO 1.3.1
Velvet Lawns, Inc., employs 26 full-time workers and provides a money purchase pension plan for eligible employees. All 26 employees are plan participants this year. Jack, the owner of the company, has an account balance of $134,000. The total of the account balances of all plan participants amounts to $215,000.
Which of the following statements apply to this plan?
I. The plan would not pass the required coverage test and is therefore discriminatory.
II. The plan is top heavy.
III. ‘The plan may use either a five-year cliff or three- to seven-year graded vesting schedule.
IV. The plan must comply with requirements for minimum contributions to non-key employees.
A) I and III
B) II, III, and IV
C) I, II, and IV
D) II and IV
D) Explanation
If all 26 employees are participating in the plan, the coverage and nondiscrimination tests would be passed. The plan would, however, be top heavy (Jack’s $134,000 account balance is 62% of the $215,000 total of all account balances). Top-heavy plans must comply with minimum contribution requirements for non-key employees and use a top-heavy vesting schedule. All defined contribution plans are now required to vest no less rapidly than three-year cliff or two- to six-year graded.
LO 1.3.1
Which of the following are agencies that administer and ensure compliance with the federal laws that apply to qualified retirement plans?
I. Department of Labor (DOL)
II. Employee Retirement Income Security Agency (ERISA)
III. Internal Revenue Service (IRS)
IV. Pension Benefit Guaranty Corporation (PBGC)
A) I, II, and III
B) II and IV
C) I, III, and IV
D) I and III
C) Explanation
Under the reporting and disclosure requirements of the Employee Retirement Income Security Act of 1974 (ERISA), annual reports and summary plan descriptions are filed with the IRS (which provides copies to the DOL). An annual premium payment form is filed with the PBGC.
LO 1.1.1
In which situation(s) can the Pension Benefit Guaranty Corporation (PBGC) terminate a defined benefit pension plan?
I. The PBGC does not have the authority to terminate an employer’s defined benefit pension plan.
II. Joe’s Shoes Inc. has not met the minimum funding standards for the corporation’s defined benefit pension plan.
III. Ann has retired from her position and her former employer’s defined benefit pension plan cannot pay her retirement benefit because it lacks the funds.
IV. A professional service corporation with 15 active participants cannot meet the minimum funding standards of the defined benefit pension plan and has previously paid no PBGC premiums.
A) II, III, and IV
B) I only
C) II and III
D) III only
C) Explanation
Statements II and III are correct. The PBGC can terminate a defined benefit plan if:
minimum funding standards are not met;
benefits cannot be paid when due; and
the long-run liability of the company to the PBGC is expected to increase unreasonably.
A professional service corporation with 25 or fewer participants is not required to maintain PBGC coverage.
LO 1.1.1
Which of the following plans allow the excess method of permitted disparity?
I Money purchase pension plans
II. Defined benefit pension plans
III. Employee stock ownership plan (ESOP)
IV. Simplified employee pension (SEP)
A) I, II, and IV
B) II, III, and IV
C) I, III, and IV
D) I, II, and III
A) Explanation
All plans are allowed to integrate with Social Security except ESOPs, SIMPLEs, and SARSEPs. The excess method is allowed for all plans allowing integration, whereas the offset method is only allowed for defined benefit pension plans.
LO 1.3.3
Which of the following are included in the annual additions limit for defined contribution plans?
I. Investment gain
II. Employee elective deferral contributions
III. Employer contributions
IV. Forfeitures reallocated to the remaining participants in the plan
A) I, II, III, and IV
B) I and IV
C) II, III, and IV
D) II and III
C) Explanation
Only Statement I is incorrect. Investment gain is not considered in the calculation of annual additions.
LO 1.3.2
Which of the following are included in the annual additions limit for defined contribution plans?
I. Investment gain
II. Employee elective deferral contributions
III. Employer contributions
IV. Forfeitures reallocated to the remaining participants in the plan
A) I, II, III, and IV
B) I and IV
C) II, III, and IV
D) II and III
C) Explanation
Only Statement I is incorrect. Investment gain is not considered in the calculation of annual additions.
LO 1.3.2
ERISA requires reporting and disclosure of plan information to all of the following except
A) the Department of Labor (DOL).
B) plan participants.
C) plan sponsors.
D) the Internal Revenue Service (IRS).
C) Explanation
ERISA requires reporting and disclosure of plan information by plan sponsors to the IRS, DOL, Pension Benefit Guaranty Corporation (PBGC), and plan participants.
LO 1.1.1
Scott is the fiduciary of the BSB retirement plan. The entity responsible for monitoring his actions as a fiduciary is
A) the PBGC.
B) the DOL.
C) the SPD.
D) the ERISA.
B) Explanation
The Department of Labor (DOL) governs the actions of plan fiduciaries and ensures compliance with the ERISA plan reporting and disclosure requirements.
LO 1.1.1
Max is the finance director for Bland Foods, Inc. He is trying to implement a new qualified retirement plan for the company. There are numerous federal guidelines with which the company must comply. Which of the following federal agencies is tasked with supervising the creation of new, qualified retirement plans?
A) DOL
B) IRS
C) ERISA
D) PBGC
B) Explanation
The Internal Revenue Service (IRS) carries out the task of supervising the creation of new, qualified retirement plans.
LO 1.1.1
ERISA requirements for qualified plans include
A) participation and fiduciary requirements.
B) reporting and disclosure.
C) coverage and vesting.
D) all of these.
D) Explanation
All of these are ERISA requirements for qualified plans.
LO 1.1.1
Qualified retirement plans should do which of the following?
I. They must meet specific vesting requirements.
II. They have special tax advantages over nonqualified plans.
III. They must provide definitely determinable benefits.
IV. They require an annual profit to allow funding for the plan.
A) II and III
B) I, II, and III
C) I and IV
D) II, III, and IV
B) Explanation
Qualified plans must meet specific vesting schedules. Qualified plans are preferred to nonqualified plans because of the special tax advantages enjoyed by qualified plans. Qualified retirement plans must offer definitely determinable benefits. An annual profit is not required for a qualified plan to be funded.
LO 1.2.1
Qualified retirement plans are which of these?
I. They are subject to ERISA requirements.
II. They offer tax-deferred earnings to employees.
III. They can discriminate in favor of highly compensated employees.
IV. They provide a deferred tax deduction for employer funding.
A) I and II
B) I, II, and III
C) I, II, III, and IV
D) III and IV
A) Explanation
Statements I and II are correct. Qualified retirement plans are subject to ERISA requirements and provide tax deferral on investment earnings for employees. While qualified plans in general can provide different levels of benefits to different classes of employees, qualified plans cannot “discriminate in favor of highly compensated employees” in the sense that there is a legal limit to the amount of the difference. As long as the difference is inside the legal limits, the plan is not discriminatory (by definition). Qualified retirement plans provide an immediate tax deduction on employer contributions—not a deferred tax deduction, like a nonqualified deferred compensation plan.
LO 1.2.1
Which of the following describe differences between a tax-advantaged retirement plan and a qualified plan?
I. IRA-funded employer-sponsored tax-advantaged plans may not incorporate loan provisions.
II. Employer stock distributions from a tax-advantaged plan do not benefit from NUA tax treatment.
A) II only
B) Neither I nor II
C) I only
D) Both I and II
D) Explanation
Both statements are correct. IRA-funded employer-sponsored tax-advantaged plans are SEPs, SARSEPs, and SIMPLE IRAs.
LO 1.2.1
Jerry wants to establish a qualified plan for his business to provide employees of the company with the ability to save for retirement. Which of the following plans is a qualified plan?
I. Profit-sharing plan
II. Simplified employee pension (SEP) plan
III. SIMPLE IRA
IV. Section 457 plan
A) I, II, III, and IV
B) IV only
C) I only
D) II and III
C) Explanation
Of the plans listed, only the profit-sharing plan is a qualified plan. The SIMPLE IRA and the SEP plan are tax-advantaged plans, and the Section 457 plan is a nonqualified plan.
LO 1.2.1
Which of the following is an example of a qualified retirement plan?
A) Section 403(b) plan
B) Deferred compensation plan
C) Section 401(k) plan
D) SEP plan
C) Explanation
A Section 401(k) plan is a qualified plan. 403(b) plans and SEP plans are tax-advantaged plans, but are not ERISA-qualified retirement plans. A deferred compensation plan is a nonqualified plan. While tax-advantaged plans are very similar to qualified plans, there are some minor differences.
LO 1.2.1
Which of the following is NOT an example of a qualified retirement plan?
A) New comparability plan
B) Section 403(b) plan
C) Employee stock ownership plan (ESOP)
D) Section 401(k) plan
B) Explanation
A Section 403(b) plan is a tax-advantaged plan but not an ERISA-qualified retirement plan. While tax-advantaged plans are very similar to qualified plans, there are some minor differences. For example, a tax-advantaged plan is not allowed to have NUA treatment. NUA is covered later in the course. They are also not allowed to offer 10-year forward averaging or special pre-1974 capital gains treatment. Tax-advantaged plans also have less restrictive nondiscrimination rules. Otherwise, they are very similar to qualified plans.
LO 1.2.1
Which of these statements regarding top-heavy plans is CORRECT?
I. An accelerated vesting schedule is used when a defined benefit pension plan is top heavy.
II. A qualified plan is considered top heavy if it provides more than 50% of its aggregate accrued benefits or account balances to key employees.
III. Top-heavy defined benefit plans must provide a minimum benefit accrual of 2% per year of service for up to 10 years (20%) for all non-key employees.
IV. For a top-heavy plan, a key employee is an employee who owns more than 3% of the employer with compensation greater than $130,000 (2021).
A) I and II
B) II and III
C) II and IV
D) I and III
D) Explanation
An accelerated vesting schedule is used when a defined pension benefit plan is top heavy. A defined contribution plan always requires an accelerated vesting schedule. A qualified plan is considered top heavy if it provides more than 60% of its aggregate accrued benefits or account balances to key employees. A key employee is an employee who, at any time during the plan year, is the following: greater than a 5% owner; a greater than 1% owner with compensation greater than $150,000 (not indexed); or an officer of the employer with compensation greater than $185,000 in 2021.
LO 1.3.1
Which of the following are minimum coverage tests for qualified retirement plans?
I. Nondiscrimination test
II. Average benefits percentage test
III. Ratio test
IV. Maximum compensation test
A) II, III, and IV
B) I, II, and III
C) I and II
D) II and III
D) Explanation
The two minimum coverage tests for qualified retirement plans are the average benefits percentage test and the ratio test. To be qualified, a retirement plan must meet at least one of these tests if the plan does not meet the percentage (safe harbor) test.
LO 1.3.1
Nigel’s employer, Alpha, Inc., maintains a qualified defined benefit pension plan. There are 100 eligible employees working for Alpha, Inc. What is the minimum number of employees the retirement plan must cover to satisfy the 50/40 test?
A) 100
B) 80
C) 40
D) 50
C) Explanation
Under the 50/40 test, a defined benefit plan must cover the lesser of 50 employees or 40% of all eligible employees. In this case, the lesser of 50 employees or 40% of all eligible employees (100) is 40 employees. One way to remember the 50/40 test is the phrase people before percentages (50 people or 40%). Also, note that there are no qualifiers to the types of people. It is not 50 non-highly compensated people. It is just 50 individuals who work for the employer.
LO 1.3.1
Brad has been the sole owner and operator of Woodmasters, Inc., for the past 15 years. Brad is age 45, and his salary from the business is $130,000. Brad and his spouse, Laura, want to retire when Brad is age 65. Relevant information regarding the business is summarized as follows:
Financial performance fluctuated over the first 10 years.
Cash flow and profits have stabilized during the past five years and are expected to show modest but consistent growth in the future. Excess cash flow of approximately $150,000 is expected to be available this year. Future years should be about the same. Brad has expressed some concern about the company’s outdated equipment and is considering renovating the plant and replacing the outdated equipment over the next five years. The total cost should be about $300,000.
Total compensation for all employees (including Brad) is $245,000.
The four full-time rank-and-file employees range from age 19 to age 38, and have been with Woodmasters for periods ranging from four months to six years. Age and service information is shown as follows:
Employee Age Completed Years of Service Compensation
Brad 45 15 years $130,000
Beth 38 6 years $40,000
Todd 27 6 months $25,000
Carol 30 2 years $28,000
Jim 19 4 months $22,000
Which of the following statements can be made regarding any qualified plan that Brad installs at Woodmasters? (Assume that the plan admits any employee who is eligible under the ERISA age and one-year service requirements and that all eligible employees are participating.)
The plan passes the ratio percentage test.
Three employees (in addition to Brad) will be eligible to participate.
The plan passes the participation (50/40) test, although it may not be required to do so.
Information is insufficient to perform coverage and participation tests.
A) II and III
B) I and III
C) I, II, and III
D) II and IV
B) Explanation
Since the plan admits all ERISA-eligible employees, relevant percentages for the coverage and participation tests will be 100%; the plan will pass the ratio percentage test. Since the lesser of 50 participants or 40% of the ERISA-eligible employees is two and because three (100%) actually participate, the plan passes the 50/40 test. The 50/40 test only applies to defined benefit plans.
LO 1.3.1
Which of the following statements regarding a top-heavy plan is CORRECT?
I. A top-heavy plan is one that provides more than 50% of its aggregate accrued benefits or account balances to key employees.
II. A top-heavy defined pension benefit plan must provide a minimum benefit accrual of 2% multiplied by the number of years of service (up to 20%).
III. For a top-heavy defined contribution plan, the employer must make a minimal contribution of 3% of annual covered compensation for each eligible non-key employee. If the contribution percentage for key employees is less than 3%, the contribution percentage to non-key employees can be equal to the key employees’ percentage.
IV. A top-heavy defined benefit pension plan must provide accelerated vesting.
A) I, II, III, and IV
B) II and IV
C) II, III, and IV
D) I and III
C) Explanation
Only Statement I is incorrect. A top-heavy plan is one that provides more than 60% of its aggregate accrued benefits or account balances to key employees.
LO 1.3.1
The Jones Corporation has a profit-sharing plan with a 401(k) provision. The company matches dollar-for-dollar up to 5%. Pedro makes $150,000 and defers 5% into the 401(k) for 2021. The Jones Corporation has had a banner year and is considering a large contribution to the profit-sharing plan. What is the most that could be contributed to Pedro’s profit-sharing account this year?
A) $58,000
B) $43,000
C) $49,500
D) $19,500
B) Explanation
The maximum allowed contribution for 2021 is $43,000. The section annual additions limit for 2021 is $58,000. However, Pedro has already contributed $7,500, and this amount has been matched. Thus, $15,000 has already gone toward the $58,000 annual additions limit for 2021.
LO 1.3.2
Susan makes $400,000 working for Great Grapes, Inc. She defers 4% into the 401(k) and receives the 4% match. How much will go into her account in 2021?
A) $16,000
B) $32,000
C) $23,200
D) $19,500
Explanation
Only the first $290,000 of compensation may be used to determine contributions to qualified retirement plans in 2021. Thus, she contributes 4% of $290,000 in 2021. This amount is matched, so $290,000 × 0.08 = $23,200.
LO 1.3.2
In a Section 401(k) plan, which of these must be considered in complying with the maximum annual additions limit?
I. Employee contributions
II. Catch-up contributions for an employee age 50 or older
III. Dividends paid on employer stock held in the Section 401(k) plan
IV. Employer contributions
A) I and II B) I and IV C) II and IV D) I, II, and V Explanation
B) Statement I is correct. Employee contributions are counted against the annual additions limit. Statement II is incorrect. Catch-up contributions for an employee age 50 or older are not counted against the annual additions limit. Statement III is incorrect. Earnings on plan investments are not taken into account when computing the maximum annual additions limit. Statement IV is correct. For 2021, the annual additions limit is the lesser of 100% of the employee’s compensation, or $58,000.
LO 1.3.2
If a defined benefit pension plan is determined to be top heavy, what is one practical significance of this determination?
A) Different eligibility requirements come into effect.
B) One of two maximum contribution and benefit formulas must be used.
C) Different coverage requirements and nondiscrimination tests apply.
D) One of two accelerated vesting schedules must be used.
D) Explanation
If a defined benefit pension plan is top heavy, one of two accelerated vesting schedules must be used: either 100% vesting after three years of service or graded two- to six-year vesting. The same eligibility and nondiscrimination tests apply as for qualified plans that are not top heavy.
LO 1.3.1
Mac, age 39, works for the SLH Company. He has a salary of $28,000 and a 401(k) there. Mac also has another job with AKH, Inc., making $65,000. SLH and AKH are not related. Mac is deferring $9,500 into the 401(k) at SLH. How much can he defer into the 401(k) at AKH?
A) $58,000
B) $47,500
C) $10,000
D) $19,500
C) Explanation
Mac can defer $10,000 into his 401(k) at AKH, Inc. The total he can contribute to employer retirement plans in 2021 is $19,500. Since he is already doing $9,500 at one employer, he is limited to $10,000 at the other. The fact that the two employers are unrelated does not matter for how much a worker can defer into the two plans. However, when it comes to unrelated organizations, each would have an independent annual additions limit. In other words, the law expects workers to know how much they are contributing to various employer retirement plans and to stay below the limit. The same would be true for related employers. However, unrelated employers are not held responsible for the employee or employer contributions to the other employers.
LO 1.3.2
Window Washers, Inc., is establishing a profit-sharing plan using Social Security integration. The base contribution percentage for the profit-sharing plan will be 5%, and the owners have come to you with some questions about Social Security integration. Which one of the following statements is CORRECT?
A) The permitted disparity for the plan is 3%.
B) The permitted disparity for the plan is 5.7%.
C) The excess contribution percentage for the plan could be as high as 10%.
D) The excess contribution percentage for the plan could be as high as 26.25%.
C) Explanation
The excess contribution percentage for the plan could be as high as 10%. The excess contribution percentage is the base contribution percentage plus the permitted disparity. The permitted disparity for the defined contribution plan is the lesser of the base benefit percentage and 5.7%. Thus, in this case, the permitted disparity is 5% and the maximum the excess benefit percentage could be would be 10%.
LO 1.3.3
Jim, the president of East Dover Construction Company, has requested your advice in setting up a defined benefit pension plan for eligible employees in the company. Jim founded the company 17 years ago and now has 200 employees, most of whom are under 35 years of age. Due to the nature of the work and ongoing management difficulties, tenure among the employees has averaged under two years. Jim has just fired the managers who were creating problems, but turnover is likely to remain high due to ongoing morale problems. Jim’s current salary is $300,000, and he wants the plan to provide him with annual retirement income of $100,000 per year. He expects to retire in 13 years, at age 64.
Which of the following statements describes information you need to convey to Jim about factors that could affect the amount of his retirement benefit?
A) If the plan investments outperform expectations, he will receive the largest allocation of the excess earnings.
B) One method of increasing the retirement benefit paid to him is by integrating the plan using the offset method.
C) Using a flat benefit formula will always provide Jim a larger benefit than would a unit benefit formula.
D) The excess integration method could be used to increase the amount of his plan benefit in retirement.
D) Explanation
The excess integration method increases the retirement benefit for compensation above the integration level. The offset integration method reduces the retirement benefit due to the receipt of Social Security benefits. With a defined benefit plan, excess investment performance reduces the subsequent employer contributions. A flat benefit formula versus a unit benefit formula would depend on the details of the flat benefit versus the unit benefit formula, so more information would be required to determine which would give a larger benefit.
LO 1.3.3
Able Company is considering various types of qualified plans and seeks your advice. You are asked how a plan participant’s benefits at retirement are determined in a defined benefit plan with a flat benefit formula that uses the offset method of integration.
Which of these statements would best answer the company’s question?
A) The percentage of pay benefit specified by the plan is reduced by a specific percentage of the retired employee’s Social Security benefit.
B) The benefit paid from the employer plan is based only on employee compensation above the Social Security wage base.
C) The employee’s Social Security benefit is reduced by a specific percentage of the retired employee’s retirement plan benefit.
D) The benefit paid from the employer plan is reduced by the amount the employer pays into Social Security on behalf of the employee.
A) Explanation
The percentage of pay benefit specified by the plan is reduced by a specific percentage of the retired employee’s Social Security benefit. Offset integration reduces the defined benefit received due to the retiree also getting Social Security benefits.
LO 1.3.3
What is the permitted disparity for a defined contribution plan with a current base contribution percentage of 6%?
A) 12.0%
B) 11.7%
C) 5.7%
D) 6.0%
C) Explanation
The permitted disparity is the extra amount reached above the integration level. For an integrated defined contribution plan, the permitted disparity is the lesser of 5.7% and the base contribution percentage. Since the base benefit percentage is 6%, the permitted disparity is limited to 5.7%. That would mean the excess benefit percentage is 11.7% (6% + 5.7%).
LO 1.3.3
With an integrated defined contribution plan, what is the maximum permitted disparity?
A) The maximum permitted disparity is 25%, so if the base benefit percentage is greater than 25% then the permitted disparity would be capped at 25%.
B) In an integrated defined contribution plan, if the base contribution percentage is 5% then the permitted disparity is 5.7%.
C) The permitted disparity is 0.75% per year for up to 35 years.
D) For an integrated defined contribution plan, the permitted disparity is the lower of the base amount, or 5.7%.
D) Explanation
The permitted disparity is the lower of the base amount, or 5.7%. Thus, the maximum permitted disparity is 5.7% for integrated defined contribution plans. The number 5.7% is the percentage of an employee’s compensation that goes toward his Social Security retirement benefit for compensation below the taxable wage base ($142,800 in 2021).
LO 1.3.3
Which of these statements regarding prohibited transactions is false?
A) One category of prohibited transactions involves the sale, lease, or exchange of any property between the plan and a party in interest.
B) One category of prohibited transactions involves the investment in the sponsoring employer’s stock or real property.
C) One category of prohibited transactions bars a fiduciary from causing the plan to engage in a transaction if the fiduciary knows or should know that such a transaction constitutes a direct or indirect involvement between the plan and the parties in interest.
D) The lending of money or other extension of credit between the plan and a party in interest is a prohibited transaction exemption.
D) Explanation
Loans between the plan and a party in interest are prohibited transactions.
LO 1.4.1
Which of the following penalties apply to prohibited transactions?
I. A tax equal to 15% of the amount involved applies unless it can be demonstrated that the transaction satisfies ERISA’s fiduciary standards.
II. The transaction must be corrected and the plan placed in a financial position no worse than if the transaction had never occurred.
III. Plan participants who engage in prohibited transactions are subject to income tax on a judicially determined amount.
IV. Transactions that continue uncorrected into subsequent years are subject to additional penalties.
A) I and II
B) I, II, and IV
C) I and III
D) II and IV
D) Explanation
The law requires correction (i.e., undoing) of a prohibited transaction and restoring a plan to the position it would have been in, had the transaction never occurred. Ongoing transactions (e.g., loans, leases) create additional prohibited transactions in subsequent years (and additional penalties) until corrected.
Options I and III are incorrect for the following reasons. Once the prohibited transaction has taken place, the 15% penalty cannot be waived for extenuating circumstances. Income tax consequences may or may not apply depending on the nature of the underlying prohibited transaction. Usually, the IRS (not the courts) determines the amount of tax involved.
LO 1.4.1
Prohibited transactions are those that are not in the best interest of plan participants and include which of these?
I. A loan between the plan and any party in interest
The acquisition of employer securities or real property in excess of legal limits
II. A transfer of plan assets to or use of plan assets for the benefit of a party in interest
III. The sale, exchange, or lease of any property between the plan and a party in interest
A) I and II
B) I, II, and III
C) I, II, III, and IV
D) III and IV
C) Explanation
All of the statements are prohibited transactions. Self-dealing is also a prohibited transaction.
LO 1.4.1
Which of the following is the easiest type of retirement plan for an employer to adopt?
A) An individually designed plan
B) A Pension Benefit Guaranty Corporation (PBGC) plan
C) A prototype plan
D) A custom plan
C) Explanation
Master plans and prototype plans are easier to use than individually designed plans or custom plans because they are standardized plans approved as qualified in concept by the IRS. The PBGC is the governmental body that insures pension benefits; it is not a type of plan.
LO 1.4.1
In the administration of a qualified retirement plan, which of the following individuals is considered to be a fiduciary?
A) The marketing director of the plan sponsor
B) A financial planner handling the investment of plan assets
C) A CPA who prepares the plan’s Form 5500
D) A highly compensated employee who participates in the plan
B) Explanation
A person or corporation is considered a fiduciary under ERISA if that person or entity renders investment advice or services to the plan for direct or indirect compensation. Clearly, the financial planner-investment manager is within this definition.
LO 1.4.1
Which of the following is a characteristic of a target benefit pension plan?
A) Allows higher contribution levels for older plan participants
B) Allows the employee to select the amount of monthly benefit at retirement
C) Requires greater employee contributions for older employees
D) Has no limit on employee contributions
A) Explanation
Under such a defined contribution plan, the employer selects the target benefit. The employer contributes more for older employees. The fixed contribution formula is based on an initial actuarial determination of contributions required to meet a specific targeted benefit level.
LO 2.3.2
Which of these statements regarding target benefit pension plans are CORRECT?
I. The plans are covered by Pension Benefit Guaranty Corporation (PBGC) insurance.
II. Older participants who are new to the employer are favored in a target benefit pension plan.
III. Each employee has an individual account.
IV. Minimum funding standards apply.
A) I, II, III, and IV
B) I and III
C) II, III, and IV
D) II and IV
C) Explanation
Statements II, III, and IV are correct. Target benefit pension plans are a type of defined contribution plans and are not covered by PBGC insurance. Each plan participant has an individual account. Because target benefit plans are pension plans, minimum funding standards apply. Like defined benefit plans, the plans favor older participants in the sense that a new employee who is older than another employee and has the same compensation as the younger employee will get a larger target benefit contribution than the younger employee. This is true because both workers have the same target benefit, but the younger worker has more time for the balance to grow than an older worker.
LO 2.3.2
In a money purchase pension plan that utilizes plan forfeitures to reduce future employer plan contributions, which of the following components must be factored into the calculation of the maximum annual addition limit?
(CFP® Certification Examination, released 11/94)
I. Forfeitures that otherwise would have been reallocated
II. Annual earnings on all employer and employee contributions
III. Rollover contributions for the year
IV. Employer and employee contributions to all defined contribution plans
A) IV only
B) I, II, and III
C) I, II, III, and IV
D) I and III
A) Explanation
Because the forfeitures will be used to reduce future employer contributions, they will not count against the annual additions limit. Defined contribution plans do not consider earnings on investments when calculating contributions.
LO 2.3.1
Target benefit pension plans are defined contribution plans that do which of these?
I. They fund for a targeted benefit level.
II. They require a fixed contribution formula.
III. They provide a guaranteed retirement benefit.
IV. They adjust the contribution formula annually.
A) I and II
B) III and IV
C) II, III, and IV
D) I and III
A) Explanation
Statements I and II are correct. Target benefit pension plans have a fixed contribution formula that is based on an actuarial calculation and the participant’s age at plan inception or plan entrance. The plan allows higher contributions for older participants. Although the plan is technically a defined contribution plan, its intention is to fund for a targeted benefit at retirement, based on the participant’s age and number of years to retirement. The actual contributions may or may not achieve the targeted benefit; therefore, the retirement benefit is not guaranteed. The plan sponsor does not actuarially adjust the participant’s contribution percentage annually.
LO 2.3.2
Which of the following factors affect a target benefit plan participant’s retirement benefits?
I. The actuarial assumptions used to determine the contribution to the plan
II. The participant’s compensation for the plan year
III. The investment performance of the plan’s assets
IV. The age of the plan participant
A) I, II, III, and IV
B) II, III, and IV
C) I and III
D) I and II
A) Explanation
Options I, II, III, and IV are all correct. Actuarial assumptions about longevity and interest rates affect the amount contributed to a participant’s account. A participant’s compensation directly affects the size of her plan benefit. The value of a participant’s target benefit account balance (i.e., a separate account) depends, in part, on the investment performance (gains and losses) of the plan’s assets. Target benefit plans favor older employees who are closer to retirement.
LO 2.3.2
Which of the following is a basic provision of a money purchase pension plan?
A) Before-tax salary reductions or elective deferrals are subject to prescribed limitations on amounts.
B) Forfeitures from a nonvested participant’s account must be reallocated proportionately among remaining plan participants.
C) Forfeitures from a nonvested participant’s account must be applied to reduce the employer contribution to the plan.
D) In establishing such a plan, the employer typically agrees to make an annual contribution for each eligible employee as a fixed percentage of compensation.
D) Explanation
In establishing a money purchase pension plan, the employer agrees to make a fixed annual contribution, usually expressed as a percentage of compensation for each eligible employee.
LO 2.3.1
Which of the following statements regarding money purchase pension plans is CORRECT?
A) These plans typically favor younger employees.
B) They allow a maximum of 25% of employer stock.
C) The plan requires actuarial services.
D) Annual employer funding is optional.
A) Explanation
Money purchase plans favor younger employees. Money purchase pension plans have known funding costs, mandatory annual contributions, and limit the amount of company stock to a maximum of 10%.
LO 2.3.1
Which of the following are eligibility requirements that a defined benefit plan must satisfy to qualify for tax-favored status?
I. The plan must include employees who have attained 21 years of age.
II. The plan must include employees who have given one year of service to the employer during which they have worked a minimum of 1,000 hours.
III. If the employer uses the two-year 100% rule, participation requirements may be based on completion of two years of service.
IV. An employee’s service with a predecessor must count toward years of service in a successor’s plan.
A) I, II, and III
B) I, III, and IV
C) I, II, III, and IV
D) I, II, and IV
C) Explanation
All of these requirements must be met if the defined benefit plan is to qualify for tax-favored status.
LO 2.1.1
Which of the following statements regarding money purchase pension plans are CORRECT?
I. The employer makes annual mandatory contributions to each employee’s individual account.
II. The plan is relatively straightforward and easy to explain to participants.
III. Annual additions to each employee’s account are limited to the lesser of 100% of compensation, or $58,000 (for 2021).
IV. Generally, employer securities held by the plan cannot exceed 25% of the FMV of the plan assets at the times the securities are purchased.
A) I, II, III, and IV
B) I, II, and III
C) III and IV
D) I and II
B) Explanation
Only Statement IV is incorrect. Generally, employer securities held by the plan cannot exceed 10% of the FMV of the plan assets at the time the securities are purchased.
LO 2.3.1
Which of the following statements regarding fully insured Section 412(e)(3) plans is FALSE?
A) Section 412(e)(3) plans must meet minimum funding standards each plan year.
B) This type of plan is not required to be certified by an enrolled or licensed actuary.
C) A fully insured plan is inappropriate for an employer who cannot commit to regular premium payments.
D) A Section 412(e)(3) plan is a type of defined benefit pension plan.
A) Explanation Section 412(e)(3) plans must only meet minimum funding standards if there is a loan outstanding against the insurance policy funding the plan.
LO 2.2.2
All of the following are characteristics of traditional defined benefit pension plans except
A) the employer is required to make annual contributions.
B) employees assume the risk of poor investment results.
C) they are complex to design and operate.
D) limited benefits are guaranteed by the Pension Benefit Guaranty Corporation (PBGC).
B) Explanation
A traditional defined benefit pension plan guarantees a specific benefit at retirement, and limited benefits are guaranteed by the PBGC. The employer assumes the risk of poor investment results in the plan. If investment results are poor, the employer may have to supply additional funding to assure that the guaranteed benefits are available.
LO 2.1.1
Which of the following statements is CORRECT in describing an accrued benefit?
A) The total benefit the participant has earned to date (amount is usually determined by multiplying the result of the participant’s years of service divided by the total potential years of service times the benefit formula in a flat percentage benefit plan)
B) The benefit that each employee receives when they leave the company
C) The dollar amount set aside in the defined benefit plan for the employee
D) The dollar amount distributed to the employee at termination of employment
A) Explanation
An accrued benefit is usually determined by multiplying the result of the participant’s years of service divided by the total potential years of service, times the benefit formula. The dollar amount to be distributed on termination is the “present value of the vested accrued benefit times the assumed annuity factor.”
LO 2.1.2
Which of the following statements is CORRECT in describing an accrued benefit?
A) The total benefit the participant has earned to date (amount is usually determined by multiplying the result of the participant’s years of service divided by the total potential years of service times the benefit formula in a flat percentage benefit plan)
B) The benefit that each employee receives when they leave the company
C) The dollar amount set aside in the defined benefit plan for the employee
D) The dollar amount distributed to the employee at termination of employment
A) Explanation
An accrued benefit is usually determined by multiplying the result of the participant’s years of service divided by the total potential years of service, times the benefit formula. The dollar amount to be distributed on termination is the “present value of the vested accrued benefit times the assumed annuity factor.”
LO 2.1.2
Which of the following statements regarding employer contributions to money purchase pension plans are CORRECT?
I. Aggregate employer deductible contributions may not exceed 25% of covered compensation.
II. Money purchase pension plans are not subject to a minimum funding standard.
III. Plan investment earnings and losses do not affect employer contributions.
IV. Forfeitures may be reallocated to remaining participants.
A) II and IV
B) I, III, and IV
C) II, III, and IV
D) I, II, and III
LO 2.3.1
B) Explanation
Money purchase pension plans require mandatory annual funding. Investment earnings and losses do not affect employer contributions. Most pension plans (like money purchase pension plans) are subject to minimum funding standards.
Your client, the chief financial officer of a new company, wishes to install a retirement plan in the company in which the pension benefits to employees are guaranteed by the Pension Benefit Guaranty Corporation (PBGC). Identify the plan(s) which must meet this requirement.
I. Profit-sharing plan
II. Money purchase plan
III. Target benefit plan
IV. Defined benefit plan
A) III and IV
B) II and III
C) IV only
D) I and II
C) Explanation
Only two defined benefit pension plans (defined benefit and cash balance) have PBGC insurance.
LO 2.1.1
Joe, 46, has owned his company for 18 years and wishes to retire at age 70. All of Joe’s employees are older than he is and have an average length of service with the company of eight years. Joe would like to adopt a qualified retirement plan that would favor him and reward employees who have rendered long service. Joe has selected a traditional defined benefit pension plan with a unit benefit formula. Which of these statements regarding Joe’s traditional defined benefit pension plan is CORRECT?
I. Increased profitability would increase both Joe’s and his employees’ pension contributions.
II. A unit benefit plan formula allows for higher levels of integration than other defined benefit pension plans.
III. A unit benefit plan formula rewards older employees who were hired in their 50s or 60s.
IV. A traditional defined benefit pension plan will maximize Joe’s benefits and reward long-term employees based on length of service.
A) III and IV
B) IV only
C) I, II, and IV
D) II only
B) Explanation
Statement I is incorrect. Contributions to traditional defined benefit pension plans are not dependent on the profitability of a company. Statement II is incorrect because a unit benefit plan formula will not allow higher integration levels. Statement III is incorrect because a flat percentage formula favors workers without much longevity.
LO 2.1.2
Which of the following types of qualified retirement plans are subject to the minimum funding requirements?
I. Defined benefit pension plans
II. Money purchase pension plans
III. Profit sharing plans
IV. Target benefit plans
A) I and II
B) II, III, and IV
C) I, III, and IV
D) I, II, and IV
D)
Explanation
The only qualified plans exempt from the minimum funding standard are profit sharing plans and stock bonus plans. Section 401(k) provisions are only permitted with profit sharing plans and stock bonus plans.
LO 2.3.2
Your client has a retirement plan with separate participant accounts and 40% of salary as a projected retirement benefit. Which of the following type of plans does your client most likely have?
A) Target benefit pension plan
B) Money purchase pension plan
C) Cash balance pension plan
D) Traditional defined benefit pension plan
A) Explanation
This plan is most likely a target benefit pension plan because of the individual account (DC) and projected (targeted) retirement benefit.
LO 2.3.2
Baxter and Smith is a law firm with a defined benefit pension plan. When would the plan be required to be covered by the Pension Benefit Guaranty Corporation (PBGC)?
A) If the firm employs 26 or more employees
B) If the firm employs 25 or fewer employees
C) A professional service employer is not required to be covered by PBGC
D) If the firm employs 10 or more employees
A) Explanation
Defined benefit plans maintained by certain professional service employers with 26 or more employees must be covered by the PBGC.
LO 2.1.1
Bart’s employer has a defined benefit pension plan. He has worked for the company for 20 years. His highest salaries occurred in the final three years before retirement: $255,000, $260,000, and $290,000.
Without considering the formula used to arrive at his retirement benefit amount, what is Bart’s maximum possible benefit from the defined benefit plan if he retires in 2021?
A) $285,000
B) $266,667
C) $230,000
D) $268,333
C) Explanation
Under Section 415 of the Tax Code, there is a limit on the projected annual benefit the plan can provide to the employee-participant at age 65. For 2021, this maximum benefit is the lesser of:
$230,000 of annual compensation; or
100% of the participant’s compensation averaged over his highest three consecutive years of earnings.
Bart’s last three years also contained his highest salaries, and averaged $266,667 [($255,000 + $260,000 + $285,000 maximum) ÷ 3], which is greater than the $230,000 maximum benefit allowed under Section 415. Compensation considered in any qualified plan benefit formula is capped at $290,000 (2021).
LO 2.1.2
What is the minimum number of employees a defined benefit plan must benefit to conform to IRS and ERISA regulations?
A) 50 employees
B) The lesser of 50 employees, or 40% of all eligible employees
C) The lesser of 50 employees, or 50% of all eligible employees
D) The lesser of 40 employees, or 50% of all eligible employees
B) Explanation
A defined benefit plan must meet an additional test to retain its qualified plan status. The 50/40 test states that the plan must benefit the lesser of 50 employees, or 40% of all eligible employees.
LO 2.1.1
Your client, the chief financial officer of a new company, wishes to install a retirement plan in the company in which the pension benefits to employees are guaranteed by the Pension Benefit Guaranty Corporation (PBGC). Identify the plan(s) that must meet this requirement.
(CFP® Certification Examination, released 12/96)
I. Profit-sharing plan
II. Money purchase plan
III. Target benefit plan
IV. Defined benefit plan
A) I and III
B) III and IV
C) IV only
D) I and II
C) Explanation
Only two defined benefit pension plans (defined benefit and cash balance) are covered by PBGC insurance.
LO 2.1.1
Assume a company’s goal is to maximize retirement benefits to the highly compensated employees, who also happen to be the oldest employees. Which of the following best accomplishes this goal if the company is installing a new plan?
A) An age-weighted profit-sharing plan
B) A money purchase pension plan
C) A defined benefit pension plan
D) A target benefit pension plan
C) Explanation
The defined benefit pension plan favors older participants and generally allows larger contributions than other plans. Age-based profit-sharing plans and target benefit pension plans also favor older participants. However, age-based profit-sharing plans and target benefit pension plans are both defined contribution plans that are subject to the annual additions limit (for 2021 a maximum contribution of no more than the lesser of 100% of an employee’s compensation or $58,000).
LO 2.1.1
Which of the following statements is CORRECT in describing the effects of actuarial methods or assumptions on contributions to a defined benefit pension plan?
A) Using salary scales tends to reduce the cost for funding younger employees’ benefits.
B) The lower the projected investment earnings on plan assets over the life of the plan, the lower the required employer contribution for the year.
C) The higher the turnover rate assumed by the actuary, the lower the required employer contribution for the year.
D) The higher the interest rate assumed by the actuary, the higher the required employer contribution for the year.
C) Explanation
Because defined benefit plans must apply forfeitures to reduce the employer contribution, an actuarial assumption of high turnover in a plan year will result in a lower required employer contribution.
LO 2.1.1
This year, its pension actuary informed Gear-It-Up Bicycles, Inc., that its required annual contribution to the company defined benefit pension plan needs to be significantly higher than last year. Which of the following factors could be responsible for this increase in annual contributions?
A) Lower-than-expected earnings on plan investments
B) Lower-than-expected number of employees nearing normal retirement age
C) Higher-than-expected employee turnover
D) Higher-than-expected forfeitures
LO 2.1.1
A) Explanation
Earnings on investment plans, which were lower than anticipated, will result in an increase to the required annual employer contributions to a defined benefit pension plan. The other factors noted may result in a decrease in plan contributions.
An increase in which of the following factors will increase plan costs for a defined benefit pension plan?
A) Mortality
B) Life expectancies
C) Investment returns
D) Employee turnover
Explanation
An increase in employee life expectancies will increase the potential costs of the plan, so life expectancies have a direct impact on plan costs.
LO 2.1.1
ERISA requires reporting and disclosure of defined benefit plan information to
I. the PBGC.
II. plan participants.
III. the IRS.
IV. the DOL.
A) I, II, and III
B) I, II, III, and IV
C) III and IV
D) I and II
LO 2.1.1
B) Explanation
All of these statements are correct.
Great Benx Corporation provides both a defined benefit plan and a money purchase plan for its employees. The defined benefit plan is covered by the PBGC. All employees participate in each plan. If the Section 415 limits apply, how do they pertain to this plan?
A) The Section 415 limits are applied separately for each plan. The annual additions limit for the money purchase plan in 2021 is 100% of the participant’s compensation or $58,000, whichever is less. The participant’s benefit in the defined benefit plan is limited in 2021 to 100% of the participant’s compensation or $230,000, whichever is less.
B) Each participant could receive a maximum contribution of 25% of the participant’s compensation for the money purchase plan and a maximum contribution of 100% of the participant’s compensation for the defined benefit plan.
C) The Section 415 limits no longer apply. These limits were repealed by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) for qualified plan application.
D) Under the Section 415 limits, the total contributions to both accounts of a participant are limited to 25% of the participant’s compensation.
A) Explanation
The annual additions limit for the money purchase plan in 2021 is 100% of the participant’s compensation or $58,000, whichever is less. The participant’s benefit in the defined benefit plan is limited in 2021 to 100% of the participant’s compensation or $230,000, whichever is less. The Section 415 limits are applied separately for each plan.
LO 2.1.2
Joe, age 46, has owned his company for 18 years and wishes to retire at age 70. All of Joe’s employees are older than he is and have an average length of service with the company of eight years. Joe would like to adopt a qualified retirement plan that would favor him and reward employees who have rendered long service. Joe has selected a traditional defined benefit pension plan with a unit benefit formula. Which of the following statements regarding Joe’s traditional defined benefit pension plan is CORRECT?
I. Increased profitability would increase both Joe’s and his employees’ pension contributions.
II. A unit benefit formula allows for higher levels of integration than other defined benefit plans.
III. A unit benefit formula rewards older employees hired in their 50s or 60s.
IV. A traditional defined benefit pension plan will maximize Joe’s benefits and reward long-term employees based on length of service.
A) I, II, and IV
B) II and III
C) IV only
D) I and III
C) Explanation
Statement I is incorrect. Contributions to defined benefit pension plans are not dependent on the profitability of a company. Statement II is incorrect, because a unit benefit formula plan will not allow higher integration levels. Statement III is incorrect because a unit benefit formula favors workers with longevity. Employees hired in their 50s or 60s will not have significant years of service in the formula at retirement.
Fernando, age 45, participates in his employer’s defined benefit pension plan. This plan provides for a retirement benefit of 2% of earnings for each year of service with the company and, given Fernando’s projected service of 20 years, will provide him with a benefit of 40% of final average pay at age 65. What type of benefit formula is this plan using?
A) A flat benefit formula
B) A discretionary formula
C) A unit benefit formula
D) A flat percentage of earnings formula
C) Explanation
Because this formula considers both compensation and years of service, the defined benefit plan is using a unit benefit formula. This type of formula is frequently used to reward continued service with the same employer.
LO 2.1.2
Three common formulas for determining annual retirement benefits from a defined benefit plan include all of the following except
A) the flat percentage of earnings.
B) the percentage of earnings per year of service (unit benefit).
C) the flat dollar amount.
D) the dollar percentage matrix.
D) Explanation
The dollar percentage matrix formula does not exist.
LO 2.1.2
An employer must comply with restrictions on the use of more than one qualified retirement plan where employees participate in both plans. Which of the following are CORRECT about some of these limitations?
I. If a target benefit plan is a fully insured plan and covered under the PBGC, then the target benefit plan is not taken into account in applying the overall limit on deductions.
II. When an employer has more than one plan, the overall contribution limit will be the lesser of 25% of total participants’ compensations or the amount required to meet the minimum funding standard of the defined benefit plan. This limit applies only to the extent that the employer contribution to the defined contribution plan or plans is greater than 6%.
III. If an employer sponsors both a defined benefit plan and a defined contribution plan (and the defined benefit plan is exempt from the PBGC), the overall employer limit is the amount necessary to meet the minimum funding requirement of the defined benefit plan. A contribution of up to 6% of compensation is also allowed into the defined contribution plan.
IV. Under current law, if a defined benefit plan is covered under the PBGC, then the defined benefit plan is not taken into account in applying the overall limit on employer deductions.
A) II and IV
B) I and III
C) I and II
D) III and IV
D) Explanation
One exception to the overall deduction limit is for defined benefit plans that are covered by the PBGC. Under current law, if a defined benefit plan is covered under the PBGC, then the defined benefit plan is not taken into account in applying the overall limit on employer deductions.
LO 2.1.2
Which of the following is a defined benefit pension plan that promises a benefit based on a hypothetical account balance versus a traditional defined benefit pension plan, which promises a monthly retirement benefit for life?
A) Target benefit pension plan
B) Cross-tested plan
C) Cash balance pension plan
D) Age-weighted plan
C) Explanation
The plan described is a cash balance pension plan. Age-weighted plans allocate contributions to participants in such a way that when contributions are converted to equivalent benefit accruals (stated as a percentage of compensation), each participant receives the same rate of benefit accrual. Cross-tested plans are defined contribution plans that test whether the contribution formula discriminates in favor of the highly compensated employee by converting contributions made for each participant into equivalent benefit accruals. Target benefit pension plans are hybrid retirement plans that use a benefit formula like that of a defined benefit pension plan and the individual accounts like a defined contribution plan.
LO 2.2.1
Which of the following is CORRECT about contributions made to a cash balance pension plan?
A) Neither the employer nor the employee make contributions. Cash balance plans are funded entirely by payroll taxes.
B) Both the employer and the employee make contributions.
C) All contributions are made by the employee.
D) All contributions are made by the employer.
D) Explanation
All contributions to the account-based cash balance plan come from the employer and must reflect a uniform allocation formula based on compensation.
LO 2.2.1
Which of the following statements are disadvantages for the employer-sponsor of a cash balance pension plan?
I. A certain level of plan benefit is guaranteed by the PBGC.
II. The employer bears the investment risk in the plan.
III. Cash balance pension plans are less expensive for the employer than a traditional defined benefit pension plan.
IV. Retirement benefits may be inadequate for older plan entrants.
A) I and II
B) I and III
C) III and IV
D) II and IV
D) Explanation
Statements II and IV are disadvantages. Statements I and III are advantages of a cash balance pension plan.
LO 2.2.1
Tax implications of cash balance pension plans include which of these?
I. Employer contributions on behalf of employees grow tax deferred.
II. Employer contributions to the plan are deductible when made.
III. Annual retirement benefits are limited to $290,000 (2021).
IV. There are no penalties for distributions before age 59½.
A) I and II
B) III and IV
C) I, II, and III
D) I, II, III, and IV
A) Explanation
Statements I and II are correct. Section 415(b) limits the benefits provided under the plan to the lesser of $230,000 per year (2021) or 100% of the participant’s highest consecutive three-year average compensation. Distributions from the plan must follow the rules for qualified plan distributions and may be subject to penalty for early distribution.
LO 2.2.1
Which of the following statements are advantages for the employer-sponsor of a cash balance pension plan?
I. A certain level of plan benefit is guaranteed by the PBGC.
II. The employer bears the investment risk in the plan.
III. Cash balance pension plans are less expensive to administer for the employer than traditional defined benefit pension plans.
IV. Retirement benefits may be inadequate for older plan entrants.
A) I and III
B) I and II
C) III and IV
D) II and IV
A) Explanation
Statements I and III are advantages of a cash balance pension plan. Statements II and IV are disadvantages of a cash balance pension plan.
LO 2.2.1
Which of the following is a type of traditional defined benefit pension plan?
A) A money purchase pension plan
B) An employee stock ownership plan (ESOP)
C) A target benefit pension plan
D) A fully insured Section 412 (e)(3) pension plan
D) Explanation
A fully insured Section 412(e)(3) pension plan is a type of traditional defined benefit pension plan. The other types of plans noted are defined contribution plans, including the money purchase pension plan.
LO 2.2.2
Which of the following statements regarding fully insured Section 412(e)(3) plans is CORRECT?
I. A fully insured Section 412(e)(3) plan is a type of defined benefit plan.
II. All fully insured Section 412(e)(3) plans must meet minimum funding standards each plan year.
III. This type of plan is not required to be certified by an enrolled or licensed actuary.
IV. A fully insured plan is inappropriate for an employer who cannot commit to regular premium payments.
A) I, III, and IV
B) I and III
C) II and III
D) IV only
A) Explanation
Statements I, III, and IV are correct. Section 412(e)(3) plans are a type of defined benefit plan. This type of plan is not required to be certified by an enrolled or licensed actuary. A fully insured plan is inappropriate for an employer who cannot commit to regular premium payments. Statement II is incorrect. Fully insured Section 412(e)(3) plans must only meet minimum funding standards if there is a loan outstanding against the insurance policy funding the plan.
LO 2.2.2
Which of the following apply to money purchase pension plans?
I. The normal retirement benefit must be specified in the plan.
II. The formula is a specified percentage of each employee’s annual compensation.
III. While the amount of final benefit is not guaranteed or promised, there is an employer promise to contribute to the plan each year.
IV. A separate account must be maintained for each participant.
A) II, III, and IV
B) I and II
C) I, II, and III
D) I, II, and IV
A) Explanation
Statements II, III, and IV are correct. The first option states a requirement that applies to defined benefit pension plans but not to money purchase plans.
LO 2.3.1
Which of the following describe money purchase pension plans?
I. The participant’s final account balance determines the actual retirement benefit.
II. The maximum annual contribution is the lesser of 100% of eligible compensation or $58,000 (2021).
III. The employer bears the investment risk.
IV. The plan requires the services of an actuary.
A) I, II, and III
B) III and IV
C) II and IV
D) I and II
D) Explanation
Options I and II describe a money purchase pension plan, while options III and IV do not. The employee bears the investment risk and there is no actuary needed for this plan.
LO 2.3.1
Frank and his daughter, Joan, own and operate a gravel pit. Frank is age 55 and hopes to retire when he reaches age 65. Joan is age 33 and plans to continue operating the business after Frank retires. Currently, Frank owns 70% of the corporation and Joan owns the remaining 30%. Frank’s current income from the corporation is $72,000. They have established a target benefit plan; Frank’s account has been earning 8%, and the balance is currently $67,590. Based upon an analysis of Frank’s cash flow, you and he have determined that he will need annual retirement income of $54,000 in today’s dollars. With this information, which of the following best describes how the target benefit plan will provide for Frank’s and Joan’s retirement?
I. Considering Joan’s age, a money purchase plan would be more beneficial to her.
II. Frank can anticipate that the age-weighted nature of the target benefit plan will provide the bulk of his needed retirement income.
III. Based upon the present investment return, the target benefit plan may provide Frank with less than 40% of the income that he will need at retirement.
IV. For Frank, a target benefit plan will not provide adequate retirement income for him to meet his retirement income objective because of the 25% limit on deductions for employer contributions; additional methods of saving for retirement need to be explored.
A) II only
B) I and III
C) I and II
D) I, III, and IV
D) Explanation
Even if the company contribution is 25% of participant compensation, the current account balance and future contributions will not be adequate to meet his retirement income objective. Because of Joan’s age, the annual contributions into her account may be under 6%. Although she has time to accumulate savings, the level of the contribution will provide less retirement fund accumulation for her than a money purchase plan could.
LO 2.3.1
A money purchase pension plan is a defined contribution plan in which
A) the employer receives no tax deduction for the contribution.
B) the final retirement benefit amount is guaranteed.
C) the employer must contribute 25% of participant compensation each year.
D) the employer typically contributes a fixed percentage of participant compensation each year.
D) Explanation
In a money purchase pension plan, the employer typically contributes a fixed percentage of each participant’s compensation. The employer does receive a tax deduction for the amount of contribution to the plan. No guaranteed retirement benefit is provided in a defined contribution plan. The contribution is defined, not the benefit. Only defined benefit pension plans provide guaranteed retirement benefits.
LO 2.3.1
What is the maximum annual contribution by an employer to a plan participant’s money purchase pension plan account in 2021?
A) Lesser of 100% of employee compensation, or $58,000
B) $19,500
C) The amount required to pay the benefit promised without limit
D) 25% of the employee’s compensation
A) Explanation
The maximum annual contribution to the participant’s account under the plan is the lesser of 100% of the eligible employee’s compensation, or $58,000 (for 2021). The deduction for employer contributions to a defined contribution plan is limited to 25% of aggregate covered compensation.
LO 2.3.1
Ross, age 75, works for Financial Strategies, Inc. The company has a long-established retirement plan. The plan does not require an actuary or Pension Benefit Guaranty Corporation (PBGC) insurance, but the employer is required to make annual mandatory contributions to each employee’s account. What type of retirement plan was established by Financial Strategies?
A) Cash balance pension plan
B) Money purchase pension plan
C) Traditional defined benefit pension plan
D) Target benefit pension plan
B) Explanation
A money purchase pension plan requires annual mandatory employer contributions to each employee’s account, does not require an actuary, and does not require PBGC insurance.
The other choices are incorrect:
A cash balance pension plan requires an actuary and PBGC insurance.
A target benefit pension plan requires an actuary at the inception of the plan, but not on an annual basis.
A traditional defined benefit pension plan requires the services of an actuary annually as well as PBGC insurance.
LO 2.3.1
In which of the following ways are target benefit pension plans similar to money purchase pension plans?
I. Pension Benefit Guaranty Corporation (PBGC) insurance is required.
II. The actual dollar retirement benefit is guaranteed.
III. The employee bears the investment risk.
IV. Each employee has an individual account.
A) I, II, III, and IV
B) III and IV
C) I and II
D) I, II, and III
B) Explanation
Statements III and IV are correct. PBGC insurance is not available for target benefit or money purchase pension plans. Also, the actual dollar retirement benefit is not guaranteed in either of these plans.
LO 2.3.2
Under which of the following circumstances is a target benefit plan the most appropriate choice for small-business owners?
I. To simplify and reduce the cost of eliminating a defined benefit plan (without termination) by amending it into a target plan
II. Where the employer wants to provide larger retirement benefits for key employees who are significantly older than the other employees
III. To meet the employer’s goal of maximizing deductible contributions to provide benefits for older, highly compensated employees
IV. Where the employer is opposed to assuming the investment risk and prefers the simplicity of a separate account plan
A) I, II, and IV
B) I and III
C) II, III, and IV
D) II and IV
D) Explanation
Statements II and IV are correct for the following reasons. Target benefit plans have benefit formulas similar to those of defined benefit plans, which favor employees who are significantly older and higher paid than the average employee of the employee group. Because target benefit plans use separate accounts, the participants bear the risk of the plan’s investment performance. Statement I is incorrect because amending a defined benefit plan into a target plan will result in termination of the defined benefit plan. Statement III is not true since a DC plan is limited to 25%, and a DB plan is not limited by a set percentage. Therefore, the DB plan will usually provide a greater tax deduction if an age-weighted plan works best. The key word to Statement III is “maximizing.”
LO 2.3.2
In which of the following ways is a target benefit pension plan similar to a traditional defined benefit pension plan?
A) It benefits older employees
B) Investment returns have no bearing on benefit
C) Employer contribution is flexible
D) Employee assumes the investment risk
A) Explanation
A target benefit pension plan is similar to a traditional defined benefit plan in that they are both designed to benefit older employees. The employer bears the risk in the defined benefit plan only, and the employer contribution is not flexible in either plan. In a target benefit pension plan, the investment returns do affect the final benefit.
LO 2.3.2
Which of the following is a hybrid retirement plan that uses an actuarially designed benefit formula like that of a traditional defined benefit plan and individual accounts like that of a defined contribution plan?
A) Target benefit pension plan
B) Cash balance pension plan
C) Age-weighted profit-sharing plan
D) Money purchase pension plan
A) Explanation
The plan described is a target benefit pension plan. The contribution is derived from an actuarially designed benefit formula in a target benefit pension plan, but once determined, the plan resembles a money purchase pension plan in all other ways. Cash balance pension plans are defined benefit pension plans that promise a benefit based on a hypothetical account balance versus a traditional defined benefit plan, which promises a monthly retirement benefit for life. Age-weighted profit-sharing plans are defined contribution plans that allocate contributions to participants in such a way that when contributions are converted to equivalent benefit accruals (stated as a percentage of compensation), each participant receives the same rate of benefit accrual. A money purchase pension plan does not use an actuarially designed benefit formula.
LO 2.3.2
Which of the following is a retirement plan that requires the initial services of an actuary, the employee assumes the investment risk, and it favors older plan participants?
A) Target benefit pension plan
B) Money purchase pension plan
C) Traditional defined benefit plan
D) Traditional profit-sharing plan
A) Explanation
The question is describing a target benefit pension plan.
LO 2.3.2
Which of the following statements regarding target benefit pension plans is FALSE?
A) Each plan participant has an individual account in the plan.
B) Target benefit pension plans favor older participants.
C) The ultimate account balance for the employee’s account is guaranteed by the plan.
D) Target benefit pension plans are a type of defined contribution plan.
C) Explanation
A target benefit pension plan is a type of defined contribution plan and, as in all other defined contribution plans, there is no guaranteed ultimate account balance. The plan favors older participants by making a larger contribution for an older plan entrant than for a younger plan entrant with exactly the same salary.
LO 2.3.2
Netcyber, Inc., is a 10-year-old C corporation that has experienced dramatic growth during three of the past five years. There are currently 168 employees. The two owners, who are 35 and 31 years old, wish to establish a retirement plan. Which plan would probably be the best for them?
A) Profit-sharing plan
B)Target benefit pension plan
C) Age-weighted profit-sharing plan
D) Money purchase pension plan
A) Explanation
A profit-sharing plan would be most appropriate, as the owners could choose when to make contributions. Also, because the owners are young, they would have more time to receive contributions on their own behalf. A money purchase pension plan or target benefit pension plan would not be appropriate because this young company would not want to commit a large sum of money every year. The company probably would want the ability to reinvest the money in the firm if needed. The target benefit pension and age-weighted profit-sharing plans are also designed for older owner-employees.
LO 3.1.1
Under a profit-sharing plan
A) the company must make annual contributions.
B) up to 25% of the plan’s assets can be invested in the employer’s stock.
C) the company has flexibility regarding annual funding.
D) the employer bears investment risk.
C) Explanation
The company has funding flexibility. Pension plans can invest only up to 10% of plan assets in employer stock. Profit-sharing plans have no restrictions regarding investment in employer stock. The employer may deduct a contribution limited to only 25% of participating employees’ covered compensation. They must make substantial and recurring employer contributions, or the IRS will remove the plan’s qualified status. The employee bears investment risk.
LO 3.1.1
Which of these statements regarding profit-sharing plans is false?
A) The maximum tax-deductible employer contribution to a profit-sharing plan is 25% of total (aggregate) eligible employee covered compensation.
B) Profit-sharing plans are types of qualified defined contribution plans.
C) Profit-sharing plans are best suited for companies that have fluctuating cash flows.
D) A company that adopts a profit-sharing plan must make contributions each year.
D) Explanation
Profit-sharing plans are not required to make contributions each year.
LO 3.1.1
A client’s employer has recently implemented a traditional Section 401(k) plan as part of its profit-sharing plan. Which of these is CORRECT regarding the client’s participation in the plan?
A) The client will not pay current federal income taxes on amounts distributed from the plan.
B) The client is always immediately vested in all employer-matching contributions and their accrued benefits.
C) The client is immediately vested in all elective deferrals and their accrued earnings.
D) The client will not pay Social Security (FICA) taxes on amounts paid into the plan.
C) Explanation
Because a Section 401(k) plan is a qualified defined contribution plan, the employee is immediately vested (100%) in all elective deferrals and their accrued benefits. Such deferrals are, however, subject to FICA taxes. Vesting schedules may be used with employer-matching contributions.
LO 3.3.1
Valerie earns $320,000 annually from XYZ Corporation. The company profit-sharing plan provides for a contribution of 25% of participant compensation. What is the amount of the company’s contribution for Valerie for 2021?
A) $100,000
B) $58,000
C) $230,000
D) $71,250
B) Explanation
Valerie earns $320,000 annually in 2021. The plan provides for a contribution of 25% of participants’ compensation. However, the maximum compensation that can be taken into consideration is $290,000. Twenty-five percent of $290,000 is $72,500. Finally, the maximum annual additions limit is $58,000, making the maximum company contribution for Valerie $58,000.
LO 3.1.1
Which of the following statements regarding the characteristics or use of a profit-sharing plan is CORRECT?
A) The maximum tax-deductible employer contribution to a profit-sharing plan is 15% of covered payroll.
B) A company with a great number of older employees will find the implementation of a traditional profit-sharing plan to be the most beneficial for the older employee-participants.
C) Profit-sharing plans require a fixed, mandatory, annual contribution by the employer to the plan.
D) Profit-sharing plans are best suited for companies that experience fluctuating cash flow.
D) Explanation
A profit-sharing plan does not require a mandatory, annual employer contribution. Therefore, they are best suited for companies that experience fluctuating cash flow and would like the flexibility of a discretionary (though substantial and recurring) contribution. The maximum tax-deductible contribution is 25% of covered payroll. Because there is less time to accrue a retirement benefit by retirement age, a profit-sharing plan is not the best choice for a plan with a great number older employee-participants.
LO 3.1.1
In addition to meeting the financial needs and resources tests for hardship withdrawals, money may only be withdrawn from profit-sharing plan accounts for the following reasons:
I. Purchase of a primary residence
II. Payment of unreimbursed medical expenses
III. Payment necessary to prevent foreclosure on the participant’s primary residence
IV. Payment of higher education expenses for the participant, spouse, or dependent children
A) III and IV
B) I, II, and III
C) I, II, III, and IV
D) I and II
C) Explanation
All of the statements regarding hardship withdrawal requirements are correct.
LO 3.1.1
Jack, age 51, is the owner of an architectural firm with 23 employees, most of whom are younger than 40. The company’s cash flow varies from year to year, depending on their contracts. Jack wants to implement a qualified plan that is easy for employees to understand and that is administratively cost-effective. He also wants a plan with an incentive feature by which an employee’s account balance increases with company profits. Which of the following plans would be most appropriate for Jack’s firm?
A) Defined benefit pension plan
B) Money purchase pension plan
C) Section 403(b) plan
D) Traditional profit-sharing plan
D) Explanation
A traditional profit-sharing plan may be appropriate when an employer’s profits, or cash flow, fluctuate from year to year;
an employer wishes to implement a qualified plan with an incentive feature by which an employee’s account balance increases with employer profits; or
most employees are young (under age 50) and have substantial time to accumulate retirement savings, and the employees are, most likely, willing to accept a degree of investment risk in their individual accounts.
Jack’s company is not eligible to implement a Section 403(b) plan, as it is not a nonprofit organization. A defined benefit plan is not appropriate for the company’s employee demographics, requires stable cash flows, and can be expensive to administer. Money purchase plans also require a mandatory contribution each year and do not provide the incentive feature regarding company profits.
LO 3.1.1
The Acme Corporation has six owners, ranging in age from 30 to 60 years old, and 25 rank-and-file employees. The owners want to adopt a qualified retirement plan that will allow them to maximize the contributions to the owners’ accounts and minimize the contributions to the accounts of the rank-and-file employees. Which of the following plans would best meet the owners’ needs?
A) Section 401(k) plan
B) Self-employed Keogh plan
C) Age-based profit-sharing plan
D) New comparability plan
D) Explanation
A new comparability plan would allow the owners to divide the participants into two classes based on their compensation levels and allocate different contribution levels to the classes. An age-based profit-sharing plan wouldn’t meet their objectives because the owners’ ages are significantly different. Section 401(k) plans are subject to discrimination testing, and a self-employed Keogh plan is inappropriate because the owners aren’t self-employed.
LO 3.2.1
How is an age-weighted profit-sharing plan similar to a traditional defined benefit pension plan?
A) Contribution allocations to older participants may be maximized, while allocations to younger participants may be minimized.
B) Retirement benefits are determined by the participant’s final account balance.
C) Minimum vesting schedules are more liberal than in other types of plans.
D) Employer contributions are flexible from one year to another and, if resources are not available, the employer may choose not to contribute to the plan.
A) Explanation
Contribution formulas for both age-weighted profit-sharing plans and traditional defined benefit pension plans favor older employees. Retirement benefits are determined by the participant’s final account balance in defined contribution plans. Employer contributions can be flexible in an age-weighted profit-sharing plan, but not in a defined benefit pension plan. Vesting is not more liberal in these plans than in other types of plans.
LO LO 3.2.1
Which of the following plans is NOT a cross-tested plan?
I. New comparability plan
II. Employer stock ownership plan
III. Age-based profit-sharing plan
IV. Stock bonus plan
A) III and IV
B) II only
C) II and IV
D) I, II, III, and IV
C) Explanation
Of the plans listed, the employer stock ownership plan and the stock bonus plans are not cross-tested plans. Only the new comparability plan and the age-based profit-sharing plan are cross-tested plans.
LO 3.2.1
Which of the following plans is a cross-tested plan?
I. New comparability plan
II. Employee stock ownership plan (ESOP)
III. Age-based profit-sharing plan
IV. Stock bonus plan
A) I, II, III, and IV
B) III and IV
C) I only
D) I and III
D) Explanation
Of the plans listed, only the new comparability plan and the age-based profit-sharing plan are cross-tested plans. Cross-testing means a defined contribution plan is tested for nondiscrimination based on benefits rather than contributions.
LO LO 3.2.1
Bernie is a participant in his employer’s noncontributory employee stock ownership plan (ESOP). Two years ago, his employer contributed stock with a fair market value of $30,000 into Bernie’s account. Bernie retired one year later and took distribution of the stock when its fair market value was $40,000. Two years after his retirement, Bernie sold the stock for $50,000. What is the appropriate tax treatment available to Bernie upon sale of the stock?
A) $20,000 ordinary income
B) $20,000 long-term capital gain
C) $10,000 long-term capital gain
D) $50,000 ordinary income
B). Explanation
Employees are not taxed on stock in an ESOP until the stock is distributed. Upon distribution, the employee must pay ordinary income taxes on the fair market value of the stock when it was contributed to the plan on his behalf. Any net unrealized appreciation (NUA) at that time can be deferred until the stock’s subsequent sale. Upon the sale, the NUA portion will be treated as long-term capital gain. Additionally, the growth of the stock subsequent to the distribution will receive long-term capital gain treatment because Bernie held the stock longer than one year after distribution. Therefore, the appropriate tax treatment available to Bernie upon sale of the stock is a $20,000 long-term capital gain.
LO 3.2.2
ABC Corporation is a closely held company that wants to establish a qualified retirement plan for its employees. Also, the company wants to improve the marketability of its stock and give the employees an ownership stake in the company. Which of the following plans would help ABC meet all of these objectives?
A) SIMPLE 401(k)
B) Keogh (self-employed) plan
C) Target benefit pension plan
D) Employee stock ownership plan (ESOP)
D) Explanation
An ESOP could help ABC meet all of these objectives.
LO 3.2.2
An employee stock ownership plan (ESOP) is a defined contribution plan that may provide the employer with which of the following advantages?
I. Increased corporate cash flow
II. The ability to borrow money to purchase corporate stock
III. A market for employer stock
IV. Financial resources to expand the business
A) I, II, and III
B) I and II
C) III and IV
D) I, II, III, and IV
D) Explanation
All of these statements are ESOP advantages to the employer.
LO 3.2.2
Which of the following legal requirements apply to employee stock ownership plans (ESOPs)?
I. ESOPs must permit participants who have reached age 55 and have at least 10 years of service the opportunity to diversify their accounts.
II. ESOPs cannot be integrated with Social Security.
III. An employer’s deduction for ESOP contributions and amounts made to repay interest on an ESOP’s debt cannot exceed 25% of the participants’ payroll.
IV. The mandatory 20% income tax withholding requirement does not apply to distributions of employer stock from an ESOP.
A) II and III
B) I, II, and IV
C) I, II, and III
D) I and II
B) Explanation
Options I and II correctly state the diversification rule and the rule that prohibits integrated ESOPs. There is no limit on amounts used to pay interest on ESOP debt. ESOP distributions of employer stock only are not subject to the 20% income tax withholding requirement.
LO 3.2.2
An employer is permitted to make what level of contributions to an employee stock ownership plan (ESOP)?
A) An ESOP is a defined contribution plan that limits employer contributions to 25% of covered payroll.
B) An ESOP is a defined benefit plan. Thus the contribution limit is the amount required to fund the projected benefits.
C) An ESOP is a stock bonus plan that permits a maximum contribution to a non-leveraged ESOP of 35% (rather than the 25% that would otherwise apply).
D) An ESOP is a stock bonus plan that permits a maximum contribution to a leveraged ESOP of 27% (rather than the 25% that would otherwise apply).
A) Explanation
Defined contribution plans limit employer contributions to 25% of covered payroll. With a leveraged ESOP, the employer may deduct both the principal (up to 25% of compensation paid to covered employee-participants) and additional amounts paid as interest as the loan is paid off. An ESOP is not a defined benefit plan.
LO 3.2.2
Which of these are basic provisions of an IRC Section 401(k) plan?
I. Employee elective deferrals are exempt from income tax withholding and FICA and FUTA taxes.
II. An employer’s deduction for contributions to a Section 401(k) plan cannot exceed 25% of covered payroll, which is not reduced by the employees’ elective deferrals.
III. A Section 401(k) plan cannot require as a condition of participation that an employee complete a period of service longer than one year.
IV. Employee elective deferrals may be made from salary or bonuses.
A) II, III, and IV
B) I and IV
C) I and III
D) II and IV
A) Explanation
Options II, III, and IV correctly describe the 25% employer deduction limitation, eligibility requirement, and potential sources of employee elective deferrals for Section 401(k) plans. Option I is incorrect because employee elective deferrals (i.e., salary deferrals) are subject to FICA and FUTA taxes. Option III is correct. There can be a two-year period of service requirement if the participants are 100% immediately vested for some other employer retirement plans. However, this does not apply for 401(k) plans.
LO 3.3.1
Which of these statements regarding Section 401(k) plans is CORRECT?
I. Employer contributions and their accrued earnings are always immediately 100% vested in the plan.
II. A Section 401(k) plan is a qualified profit-sharing or stock bonus plan.
III. The maximum pretax elective deferral for a participant age 35 is $19,500 in 2021.
IV. Elective deferrals in a cash or deferred arrangement (CODA) are not subject to FICA and FUTA taxes.
A) II and III
B) I and IV
C) III only
D) I, II, III, and IV
A) Explanation
Statements II and III are correct. Statement I is incorrect. Employee contributions and investment earnings are always 100% vested, not the employer contributions. Statement IV is incorrect. Elective deferrals in a CODA are subject to FICA and FUTA taxes.
LO 3.3.1
What is the maximum elective deferral a participant can make to a Section 401(k) plan in 2021, assuming no catch-up provisions apply?
A) $13,500
B) $6,000
C) $57,000
D) $19,500
D) Explanation
The elective deferral limit for 2021 to a Section 401(k) is $19,500. The maximum annual additions limit is $58,000.
LO 3.3.1
A Section 401(k) plan allows plan participants the opportunity to defer taxation on a portion of regular salary or bonuses simply by electing to have such amounts contributed to the plan instead of receiving them in cash. Which of these is a rule that applies to Section 401(k) plan elective deferrals?
I. Section 401(k) plan elective deferrals are immediately 100% vested and cannot be forfeited.
II. In-service withdrawals are to be made only if an individual has attained age 62.
III. An extra nondiscrimination test called the actual deferral percentage test applies to elective deferral amounts.
A) III only
B) I and II
C) I only
D) I and III
D) Explanation
Statement II is incorrect. A Section 401(k) plan may allow in-service distributions before age 62.
LO 3.3.2
All of these statements regarding a traditional Section 401(k) plan are CORRECT except
A) a Section 401(k) plan is a qualified profit-sharing or stock bonus plan.
B) employer contributions and their accrued earnings are always immediately 100% vested in the plan.
C) the maximum pretax elective deferral for a participant age 35 is $19,500 in 2021.
D) elective deferrals in a cash or deferred arrangement (CODA) are subject to FICA and FUTA taxes.
B) Explanation
Employee contributions and investment earnings are always 100% vested, not the employer contributions. The vesting of employer contributions depends on the type of employer contribution to the plan.
LO 3.3.1
In 2021, what is the maximum amount an employee under the age of 50 may contribute to a traditional Section 401(k) plan as an elective deferral?
A) $19,500
B) The lesser of 100% of compensation or $57,000 annually
C) $26,000
D) $13,500
A) Explanation
The maximum amount of elective deferrals possible in 2021 to a traditional profit-sharing Section 401(k) plan for an individual under age 50 is $19,500 (it is $26,000 for an individual age 50 or older). The lesser amount of $13,500 applies to the SIMPLE 401(k) form.
LO 3.3.1
Hardship withdrawals are only allowed from Section 401(k) plans if specifically stated in the plan document and typically for expenses such as
I. vacation costs.
II. medical expenses.
III. college tuition costs.
IV. insurance premiums.
A) I and III
B) II, III, and IV
C) I and II
D) II and III
D) Explanation
Hardship withdrawals are typically allowed for unreimbursed medical expenses, college tuition and fees, to purchase a principal residence, burial expenses for spouse or dependents, and to prevent eviction from one’s principal residence or foreclosure on the mortgage of such residence.
LO 3.1.1
A Section 401(k) plan does not have to satisfy the ADP and ACP tests if it meets one of the safe harbor provisions. All of these about the safe harbor provisions are correct except
A) a plan that satisfies the safe harbor provisions is not subject to the top-heavy rules.
B) an employer may satisfy the safe harbor provisions by making non-elective contributions for all eligible employees.
C) an employer may satisfy the safe harbor provisions by making certain matching contributions for non-highly compensated employees who participate in the plan.
D) mandatory employer contributions under the safe harbor provisions may be subject to a three-year cliff vesting requirement.
D) Explanation
Employees must be immediately 100% vested in mandatory employer contributions that are made under the safe harbor provisions. The mandatory contributions can take the form of either a non-elective contribution to all eligible employees or matching contributions to participating non-highly compensated employees who participate in the plan.
LO 3.3.1
Which of these statements regarding the safe harbor rules for Section 401(k) plans is CORRECT?
I. The employer can avoid ACP and ADP testing if it matches 100% up to 4% of compensation for nonhighly compensated employees.
II. The employer can avoid ACP and ADP testing if it makes contributions of 3% or more of compensation for all employees who are eligible to participate in the plan, whether or not the employee chooses to participate.
III. To meet the safe harbor requirements, the matching and non-elective contributions must be immediately 100% vested.
IV. The employer must provide notice to each eligible employee about rights and obligations under the plan.
A) II and III
B) III and IV
C) IV only
D) I, II, III, and IV
D) Explanation
All of these statements regarding Section 401(k) plan safe harbor rules are correct.
LO 3.3.1
Northwest Instruments Corp. made matching contributions to its SIMPLE 401(k) in the last three years. Assume all eligible employees earn at least the maximum includible compensation limit and all defer the maximum amount allowed. Due to extensive capital expenses anticipated this year, the company is considering how to reduce expenses. It will not be able to continue to make the 3% matching contribution and has called you to discuss their options. Which of these could you recommend?
A) Because they have satisfied the 3% matching contribution for three years, Northwest Instruments Corp. could reduce the matching contribution to 1%.
B) By providing adequate notice, Northwest Instruments Corp. could move to the 2% non-elective contribution this year, although the savings would be minimal.
C) Employer contributions under a SIMPLE plan are discretionary, and Northwest Instruments Corp. could provide notice that they will not provide any contribution this year.
D) With SIMPLE 401(k) plans, employers who begin using the 3% matching contribution do not have any option available to modify the company’s contribution.
B) Explanation
Under a SIMPLE 401(k), an employer does not have the option to change the percentage used for the matching contribution. A SIMPLE IRA would be able to move the match down to 1% for two out of five years. However, in this case the employer can use the 2% non-elective contribution instead of the 3% matching contribution. Under the scenario described, however, the savings would be minimal.
LO 3.3.3
Grant, age 51, made an initial contribution of $10,000 to a Roth 401(k) in 2013. He made subsequent contributions of $6,000 annually for the next four years. In 2021, Grant separated from service and took a $50,000 distribution from his Roth 401(k) to purchase a boat. Which of these statements regarding this distribution is CORRECT?
A) It is income tax free because it was made after five taxable years from the date of initial contribution.
B) It is taxable because it was within 10 taxable years from the date of initial contribution.
C) It is income tax free because it was made after five taxable years, and Grant is over age 50.
D) It is partially taxable because Grant was not age 59½ or older, disabled, or deceased.
D) Explanation
Although Grant took the distribution after five taxable years from the date of initial contribution, he did not meet one of the other requirements for a qualified distribution (it must be made after the individual attained age 59½, the individual must be disabled, or the distribution must be made to a beneficiary or estate of an individual on or after the individual’s death). In this case, the first $34,000 is counted against his contributions. Thus, there is no tax or penalty on $34,000. There are no conversions, so the rest of the distribution is earnings and thus subject to income tax and the 10% early distribution rules.
LO 3.3.3
Ryan wants to take a distribution from his SIMPLE 401(k) account balance from his previous employer and deposit it in an IRA. Which of these statements regarding his transfer is CORRECT?
I. The distribution from the SIMPLE 401(k) plan is not subject to the mandatory 20% income tax withholding requirement.
II. A direct transfer from Ryan’s SIMPLE 401(k) to an IRA is not subject to the mandatory 20% income tax withholding requirement.
A) I only
B) II only
C) Neither I nor II
D) Both I and II
B) Explanation
Statement I is incorrect. SIMPLE 401(k) plans are qualified plans and are subject to mandatory 20% income tax withholding for a distribution that is not a direct trustee-to-trustee transfer. When there is a direct transfer of a distribution from a qualified plan to an IRA, the mandatory 20% withholding rule does not apply.
LO 3.3.3
Ellen participates in a SIMPLE 401(k) maintained by her employer. If she has completed two years of service, to what extent is she vested in the employer contributions to her account?
A) 100% B) 40% C) 0% D) 20% Explanation
A) Vesting schedules are not permitted in SIMPLE 401(k)s. Employees are always 100% vested in employer contributions.
LO 3.3.3
The actual deferral percentage (ADP) test is generally applicable to which of these?
I. Traditional Section 401(k) plans
II. Money purchase pension plans
III. SIMPLE 401(k)s
A) III only
B) I and II
C) II only
D) I only
D) Explanation
The ADP test applies only to traditional Section 401(k) plans. The test does not apply to SIMPLE 401(k)s or money purchase pension plans. The ADP deals with worker deferrals. A money purchase plan is essentially an employer contribution only plan.
LO 3.3.3
Which one of the following would NOT be an acceptable course of action for a 401(k) plan that has failed the actual deferral percentage (ADP) test?
A) A qualified nonelective contribution for all eligible nonhighly compensated employees
B) A qualified matching contribution for all eligible nonhighly compensation employees
C) A corrective distribution of a portion of the eligible nonhighly compensated employees’ deferrals
D) A corrective distribution to the eligible highly compensated employees
C) Explanation
The ADP test fails when too much is being saved or contributed on behalf of highly compensated employees. In order to bring the plan into compliance it would be necessary to make a corrective distribution to a portion of the highly compensated employee deferrals, not the nonhighly compensated employee deferrals. The other three options are stated correctly.
LO 3.3.2
Which plan is appropriate for a business with a fluctuating cash flow and an owner who is significantly older than the rank-and-file employees?
A) Cash balance
B) Target benefit
C) Defined benefit
D) Age-weighted profit sharing
D) Explanation
An age-weighted formula can be used by a profit-sharing plan. This arrangement will work best for a business with a fluctuating cash flow and key employees who are older than the other employees. Pension plans (i.e., cash balance plans and target plans) are subject to minimum funding requirements and may create a problem for a business with a fluctuating cash flow, even though they will maximize contributions for older employees. A service-based formula will favor employees who have many years of service with the business.
LO LO 3.2.1
George Cobb owns Cobb Construction Inc., which is worth $3 million with an annual payroll of $1.3 million. George receives a salary of $300,000. The company initiated a profit-sharing plan last year and makes contributions at year-end. The plan has about $120,000 in assets. George’s account has a balance of $28,000. He is 60 and wants to retire this year and sell his company. His problem is that the construction industry is very slow this year, and the major companies are retrenching, not expanding. George’s company is very profitable from year to year, earning a profit of $550,000 to $650,000 each year. George has an excellent management team in place that he has carefully built and trained over the years. His bank approached him recently, offering to loan him almost any amount, up to the value of his company, at 8%. Typically such loans are amortized over no more than 10 years.
How can George use a qualified plan to accomplish his goal?
A) George should have the company profit-sharing plan borrow $3 million and buy his stock.
B) George should borrow $3 million from the bank and retire.
C) George should amend the company profit-sharing plan and make it a leveraged employee stock ownership plan (LESOP), then have the plan borrow $3 million and buy his stock.
D) George should amend the company profit-sharing plan and make it an employee stock ownership plan (ESOP) and have the ESOP buy his stock.
C) Explanation
George should amend the profit-sharing plan, making it a LESOP. Then, as the LESOP trustee, he can borrow $3 million in the name of the LESOP from a bank familiar with LESOP loans. The LESOP will receive $3 million from the loan and it will use the proceeds to buy George’s $3 million worth of stock and become the owner of the company. George will receive the $3 million in cash and retire. Only a LESOP can borrow money. Borrowing $3 million doesn’t extract the value of his company for his benefit; it only creates debt and a nondeductible interest cost.
LO 3.2.2
Total annual contributions to an individual participant in a traditional Section 401(k) plan are limited in 2021 to
A) $19,500.
B) the lesser of 100% of compensation, or $58,000.
C) $290,000.
D) $13,500.
B) Explanation
Total annual contributions to a participant’s account are limited in 2021 to the lesser of 100% of employee compensation, or $58,000, with only the first $290,000 of employee compensation considered in the contribution formula. The total contribution is made up of the worker contribution, the employer contribution, and reallocated forfeitures. The worker contribution alone is limited to $19,500 in 2021 for those 49 and younger.
LO 3.3.1
Which statements describe one or more characteristics of hardship withdrawals from Section 401(k) plans?
I. Hardship withdrawals may be taken from elective deferral amounts and the investment income from such deferrals.
II. The participant must demonstrate “immediate and heavy financial need” and not have any other resources that are “reasonably available.”
III. A hardship withdrawal is exempt from the 10% early withdrawal penalty if the participant has not reached age 59½.
IV. Hardship conditions must be established for hardship withdrawals from profit sharing or stock bonus 401(k) plans.
A) I and II
B) II, III, and IV
C) I and III
D) II and IV
D) Explanation
Hardship withdrawals from profit sharing or stock bonus Section 401(k) plans require that hardship conditions (“immediate and heavy financial need” and other resources not “reasonably available”) be demonstrated. Only elective deferral amounts—not the associated earnings—are available for hardship withdrawals.
LO 3.3.1
Tina is a participant in her company’s employee stock ownership plan (ESOP). The company transfers 1,000 shares of employer stock at $5 per share to her account. Several years later, when the stock is $11 per share, Tina retires at age 61. If she elects to receive the stock in a lump sum at retirement and later sells the stock for $12,000, what are the tax consequences to Tina?
A) Tina will be taxed on $11,000 of ordinary income when she receives the stock at retirement.
B) Tina will have ordinary income of $12,000 when she sells the stock.
C) Tina will have a capital gain of $7,000.
D) Tina will have a capital gain of $1,000.
C) Explanation
Because of the net unrealized appreciation rule, at distribution, Tina will be taxed only on $5,000, the original cost of the stock when it was contributed to the plan. Tina was taxed on the $5,000 basis in the stock when she received her distribution. Therefore, her capital gain will be $7,000 if she sells the stock for $12,000.
LO 3.2.2
The Acme Corporation has six owners, ranging in age from 30 to 60 years old, and 25 rank-and-file employees. The owners want to adopt a qualified retirement plan that will allow them to maximize the contributions to the owners’ accounts and to minimize the contributions to the accounts of the rank-and- file employees. Which of the following plans would best meet the owners’ needs?
A) New comparability plan
B) Keogh plan
C) Section 401(k) plan
D) Age-based profit-sharing plan
A) Explanation
A new comparability plan would allow the owners to divide the participants into two classes based on their compensation levels, and to allocate different contribution levels to the classes. An age-based profit-sharing plan wouldn’t meet their objectives because the owners’ ages are significantly different. Section 401(k) plans are subject to discrimination testing, and a Keogh plan is inappropriate because the owners are not self-employed.
LO LO 3.2.1
The actual deferral percentage (ADP) test looks at the
A) employee deferrals (ADP).
B) age 50 and over catch-up contribution amounts.
C) amount of employer contributions.
Failed
D) amount of employee after-tax contributions.
A) Failed
Explanation
The ADP test looks at employee deferrals (ADP).
LO 3.3.2
Which of the following is a test that must be met before a hardship withdrawal from a profit-sharing plan?
I. The financial needs test requires the hardship be due to an immediate significant financial need of the participant-employee.
II. The resources test requires that the participant must not have other financial resources sufficient to satisfy the need.
A) II only
B) Neither I nor II
C) Both I and II
D) I only
Explanation
Both statements describe the tests that must be met to qualify for a hardship withdrawal.
LO 3.1.1
Jason, a CFP® professional, has a corporate client whose only two shareholders, ages 57 and 61, have asked for assistance with selecting a corporate retirement plan. His clients have annual compensation from the corporation of $145,000 each. They have nine employees, ages 21–40, with annual compensation of $18,000–$55,000. The clients want a qualified plan that offers maximum benefits for themselves, minimum benefits for the employees, contribution flexibility, and low administrative costs. Which of the following retirement plans should Jason recommend?
A) Defined benefit pension plan
B) Traditional profit-sharing plan
C) Simplified employee pension (SEP) plan
D) Age-weighted profit sharing
D) Explanation
An age-weighted profit-sharing plan is a qualified plan that would offer maximum benefits for the shareholders, who are older. An age-weighted profit-sharing plan would also offer flexible contributions and low administrative costs. A defined benefit pension plan would not have contribution flexibility or low administrative costs. Although a profit-sharing plan would offer contribution flexibility and low administrative costs, it would not allow maximum benefits for the principals. A SEP is not a qualified plan.
LO LO 3.2.1
If the actual deferral percentage (ADP) for nonhighly compensated employees is 9%, what is the maximum deferral percentage for highly compensated employees?
A) 11.00%
B) 18.00%
C) 11.25%
D) 12.50%
C) Explanation
For amounts higher than 8%, the allowable spread between NHCEs and HCEs is 1.25 (125%). So for this question, 9% × 1.25 = 11.25%. Besides the 1.25 times test, the other test is the 200% rule with a maximum difference of 2%. In this case, 200% is 18%, but the maximum difference of 2% brings this test down to 11%. Since 11.25% is higher, that test decides how much highly compensated employees could contribute.
LO 3.3.2
Which one of the following types of plan formulas should be considered by a relatively new business with a fluctuating cash flow and key employees who are significantly older than the rank-and-file employees?
A) Target benefit
B) Age weighted
C) Service based
D) Cash balance
B) Explanation
An age-weighted formula can be used by a profit-sharing plan. This arrangement will work best for a business with a fluctuating cash flow and key employees who are older than the other employees. Pension plans (i.e., cash balance plans and target plans) are subject to minimum funding requirements and may create a problem for a business with a fluctuating cash flow, even though they will maximize contributions for older employees. A service-based formula will favor employees who have many years of service with the business.
LO 3.2.1
If a tax-sheltered annuity (TSA) plan provides for employer-matching contributions, which of the following tests apply?
A) Actual deferral percentage (ADP) test
B) Neither test applies
C) Both the ACP and ADP tests
D) Actual contribution percentage (ACP) test
D) Explanation
While the ACP test applies to TSA plans, both the ACP and the ADP tests apply to 401(k) plans.
LO 3.3.2
Albert, 52, is the sole proprietor of a consulting business that will have Schedule C net income of $80,000 this year. The business maintains a profit-sharing Keogh plan and Albert is the only plan participant. What is the maximum that can be contributed to the plan this year on Albert’s behalf? The self-employment tax for Albert is $11, 304.
A) $20,000
B) $16,680
C) $23,500
D) $14,870
D) Explanation Schedule C net income $ 80,000 Less 7.65% (6,120) Self-employment income subject to self-employment taxes $ 73,880 Times 15.3% Self-employment tax $ 11,304
One-half of the self-employment tax is deductible as an adjustment to income. In this example, the deductible portion is $5,652 ($11,304 ÷ 2).
Determine the adjusted contribution percentage for the Albert, the business owner.
Maximum percentage contribution for participants
(employee %)
.25
Divided by (1 + employee %) 1.25
Equals adjusted contribution percentage for owner = .20
Schedule C net profit (business profit) $80,000
Less income tax deduction allowed (1/2 self-employment tax) ($5,652)
Net earnings from self-employment $74,348
Multiply by .20 =
Owner’s contribution $14,870
Note that $14,870 is 25% of $59,478 and $59,478 is the amount you get from taking the net earnings of $74,348 and subtracting $14,870. Thus, the IRS would argue that the self-employed owner is getting the same 25% contribution as the worker after all the accounting is factored in.
LO 3.3.3
The ABC Company’s 401(k) has just been changed to allow Roth elective deferrals. Which of the following does a Roth 401(k) plan have in common with a Roth IRA?
They both are phased out for higher income earners.
Withdrawals after age 59½ are tax free if the account is at least five years old.
Contributions are not deductible.
They are both subject to required minimum distributions (RMDs) for retirees starting after attaining age 72.
A) II and IV
B) I and IV
C) II and III
D) I and II
C) Explanation
Although Roth IRAs have an additional reason for qualified distributions (up to $10,000 of first-time homebuyer expenses), a distribution from either type of Roth account after five years and over age 59½ would be a qualified distribution. No type of Roth contribution is deductible. Roth IRAs are not subject to RMDs while the original owner is alive, but employer Roth accounts for retirees are subject to the normal RMD rules. Roth IRAs are phased out for higher earners, but not for employer Roth accounts.
LO 3.3.3
Which of the following are provisions of qualified stock bonus plans?
I. Taxation of the capital gain on employer stock held in the plan may be deferred beyond the distribution date.
II. Like profit-sharing plans, stock bonus plans allow for flexible employer contributions.
III. Social Security integration is not allowed in stock bonus plans.
IV. Participants must be allowed to receive their distributions in shares of employer stock that is publicly traded.
V. If the employer’s securities are not readily tradable on an established market, a participant who separates from service must be provided a put option that will be available for at least 60 days after distribution of the stock.
A) I, II, IV, and V
B) I, II, and III
C) II and IV
D) I, III, and V
A) Explanation
Assuming the participant elects NUA treatment, the unrealized gain in the value of the stock is not taxed until the stock is sold. Stock bonus and profit-sharing plans both have the flexible employer contribution characteristics. Participants have the option to take the employer’s stock under either. When the employer’s securities are not readily tradable on an established market, a participant who separates from service must be provided the right to have the employer—not the plan—repurchase the employer securities under a fair valuation formula (i.e., a put option). Although Social Security integration is allowed in stock bonus plans, it is not permitted in employee stock ownership plans (ESOPs).
LO 3.2.2
Which of the following statements regarding stock bonus plans and employee stock ownership plans (ESOPs) are CORRECT?
I. They allow employees to defer all income taxes on distributed stock until the stock is sold.
II. They can be costly and administratively cumbersome.
III. They always decrease corporate cash flows.
IV. They create a market for employer stock.
A) II and III
B) I and II
C) I, II, III, and IV
D) II and IV
D) Explanation
Statements II and IV are correct. Both ESOPs and stock bonus plans give employees a stake in the company through stock ownership. They may increase company cash flow because employers make cashless contributions to the retirement plan and create a market for employer stock. In addition, they both limit the availability of retirement funds to employees if an employer’s stock falls drastically in value and create an administrative and cash-flow problem for employers by requiring them to offer a repurchase option (put option) if their stock is not readily tradable on an established market. Employees must pay income tax on the value of the stock contributed to the plan at the time of distribution. Gain on the stock before a lump-sum distribution is net unrealized appreciation and is not taxed until the employee-participant sells the stock.
LO 3.2.2
Which of the following is a type of defined contribution profit-sharing plan?
A) Money purchase pension plan
B) Traditional Section 401(k) plan
C) Cash balance pension plan
D) Target benefit pension plan
B) Explanation
Of the choices offered, only a Section 401(k) is a defined contribution profit-sharing plan. The other choices are pension plans.
LO 3.1.1
Which of the following types of defined contribution plans may borrow money in the name of the plan?
A) A tandem profit-sharing plan and a traditional profit-sharing plan
B) A profit-sharing plan with Section 401(k) provisions
C) An age-weighted profit-sharing plan
D) A leveraged employee stock ownership plan (ESOP)
D) Explanation
For qualified plans, an ESOP or LESOP is unique in its ability to borrow money in the plan’s name without violating prohibited transaction rules.
LO 3.2.2
George, age 55, earns $250,000 and participates in his employer’s SIMPLE IRA. The employer match is on a dollar-for-dollar basis, up to 3% of each participating employee’s compensation for the year. What is the maximum amount of employee and employer contributions that can be contributed to George’s account in 2021?
A) $16,500
B) $19,500
C) $13,500
D) $24,000
D) Explanation
The total of the employee and employer contributions that may be made to George’s account in 2021 is $24,000.
$13,500 employee contribution
+ $7,500 employer contribution ($250,000 × 0.03)
+ $3,000 employee age-50-and-over catch-up contribution
$24,000
LO 4.2.1
A simplified employee pension plan (SEP)
A) is a very complex retirement plan for employees.
B) provides for mandatory funding.
C) allows employers to make contributions to one general account.
D) can be established by any type of employer.
D) Explanation
A SEP plan is a very simple retirement plan that provides for flexible funding and allows employers to make contributions directly to participants’ individual IRAs and can be established by any type of employer. The percentage contributed by the employer can fluctuate each year as long as it is the same for every employee. Up to 25% of an employee’s covered compensation is allowable for the tax benefit, up to a maximum of $58,000 (2021).
LO 4.2.2
PREV
Are the investment options available to 401(k) and 403(b) plans different in any way?
A) No, because both a 401(k) and a 403(b) are qualified plans.
B) No, because both a 401(k) and a 403(b) have unlimited access to all the same investment products.
C) Yes, because 403(b) plans are limited to investing in annuity contracts and/or mutual funds.
D)
Yes, because 401(k) plans can only be invested in mutual funds and/or annuity contracts.
C) Explanation A 403(b) plan is limited to investing in mutual funds and/or annuity contracts. Conversely, the Internal Revenue Code does not specify which instruments 401(k) funds can be invested in. A 403(b) plan is technically not a qualified plan under the Employee Retirement Income Security Act of 1974 (ERISA).
LO 4.3.1
PREV
Which of the following statements is CORRECT in describing requirements that must be met for a plan to be considered a Section 457 plan?
I. To avoid adverse income tax effects, the agreement must be executed during the same month as the participant’s services are provided.
II. Eligible participants include employees of agencies, instrumentalities, and subdivisions of a state as well as Section 501 tax-exempt organizations.
III. The deferral limit for employees younger than age 50 is the lesser of $19,500 in 2021, or 100% of compensation.
A) II only
B) I and II
C) I and III
D) II and III
D) Explanation
All of these organizations may establish a Section 457 plan. Deferrals are limited to the lesser of $19,500 in 2021, or 100% of compensation. Statement I is incorrect because the agreement must be executed before the first day of the month in which the services will be performed. The result will be a loss of the tax deferral for that month if the agreement is made during the month.
LO 4.3.2
PREV
Dorothy is a 36-year-old jewelry designer who owns her own small gallery. For most of the year, she works alone, handling the designing and sales herself. However, during the busy holiday season, she hires Yvonne and Mirabelle, two part-time sales clerks to help her. Each of these employees works approximately 300 hours, earning an average salary of $4,000. Dorothy would like to establish a retirement plan that would allow her to save for her own retirement, but not require her to cover the part-time employees. She also doesn’t want to pay expensive administrative costs. Which one of the following plans would be most appropriate for Dorothy?
A) SIMPLE IRA
B) Traditional Section 401(k) plan
C) SEP plan
D) Section 457 plan
A)Explanation
A SEP plan would not be appropriate because it would require coverage of Dorothy’s part-time employees. A traditional Section 401(k) is not appropriate because it would involve special nondiscrimination testing and annual filing of the Form 5500 series. A Section 457 plan is not appropriate because it is available only for certain, private tax-exempt organizations. A SIMPLE IRA would be the most appropriate plan because it involves little administrative costs and would meet Dorothy’s retirement planning goals.
LO 4.2.1
PREV
Shock Limited just established a simplified employee pension (SEP) plan for the benefit of its employees. The company has more than 500 employees, 60% of whom are highly compensated. This year, Shock contributed 6% of each eligible employee’s salary to the SEP plan. Several of the employees of the company are unfamiliar with the provisions of SEP plans and have come to you requesting information. Which of the following statements regarding the basic provisions of SEP plans is CORRECT?
I. Employees can roll money that is distributed from a SEP plan into a different IRA within 60 days without withholding or penalty as long as it is not a required minimum distribution.
II. Contributions must be made for any employee, age 21 or over, who has performed services for the company in three of the past five years and has earned at least $650 during 2021.
III. Employer contributions are 100% vested immediately.
IV. A SEP plan may exclude members of unions if the unions have their own retirement plan.
A) I, II, and III
B) I, III, and IV
C) II, III, and IV
D) I, II, III, and IV
PREV
D) Explanation
All of the statements are correct.
LO 4.2.2
Which of the following statements regarding the disadvantages for employees participating in SEP plans is NOT correct?
A) If an employer maintains a SEP plan and a qualified plan, contributions to the SEP plan reduce the amount that may be deducted for contributions to the qualified plan.
B) The special rule for calculating deductible contributions on behalf of an owner-employee also applies to a SEP plan.
C) Employees cannot rely on a SEP plan alone to provide an adequate retirement benefit.
D) The employer bears the investment risk under the plan.
D) Explanation
The employee bears the investment risk under the plan, which is a disadvantage to the employee. All of the other choices are disadvantages of a SEP plan.
LO 4.2.2
PREV
Paul, age 64, is retiring next year. He participates in an eligible Section 457 plan through his governmental employer. His employer’s plan has a normal retirement age of 65. Which of the following statements regarding Paul’s governmental Section 457 plan is false?
A) Section 457 plan distributions are not eligible for net unrealized appreciation treatment.
B) A lump-sum distribution from a governmental Section 457 plan may be rolled over to a qualified plan.
C) Because he is over age 50 and within the last three years of employment before retirement, Paul can defer the maximum amount under a special catch-up provision and an additional amount under the over-age-50 catch-up provision this year.
D) During the last three years of employment before the plan’s normal retirement age, Paul’s elective deferral may be increased up to $39,000 (2021).
C)Explanation
A participant in a governmental Section 457 plan may not use both the special catch-up allowance and the over-age-50 catch-up allowance in the same tax year.
LO 4.3.2
PREV
Paul, age 64, is retiring next year. He participates in an eligible Section 457 plan through his governmental employer. His employer’s plan has a normal retirement age of 65. Which of the following statements regarding Paul’s governmental Section 457 plan is false?
A) Section 457 plan distributions are not eligible for net unrealized appreciation treatment.
B) A lump-sum distribution from a governmental Section 457 plan may be rolled over to a qualified plan.
C) Because he is over age 50 and within the last three years of employment before retirement, Paul can defer the maximum amount under a special catch-up provision and an additional amount under the over-
D) During the last three years of employment before the plan’s normal retirement age, Paul’s elective deferral may be increased up to $39,000 (2021).
Failed
C) Explanation
A participant in a governmental Section 457 plan may not use both the special catch-up allowance and the over-age-50 catch-up allowance in the same tax year.
LO 4.3.2
PREV
Tom, a sole proprietor, is interested in implementing a retirement plan. He may have employees in the future. He also wants a plan that is easily understood, where the employees bear the investment risk, does not favor older participants, and allows elective deferrals. Which of the following plans is best suited to Tom’s goals?
A) Target benefit pension plan
B) SIMPLE IRA
C) Age-weighted profit-sharing plan
D) SEP plan
B) Explanation
Tom’s goals describe attributes of a SIMPLE IRA. The SEP plan and the target benefit plan do not allow worker contributions. The age-weighted profit-sharing plan is not as easily understood. Also, the target benefit plan and the age-weighted profit-sharing plan favor older employees.
LO 4.2.1
PREV
A government employer would choose to establish a Section 457 plan for all of the following reasons except
A) income tax credit for certain taxpayers regarding elective contributions.
B) tax deductibility of contributions.
C) no early withdrawal penalty on distributions.
D) tax-deferred growth.
B) Explanation
Because Section 457 plans are sponsored by tax-exempt entities, deductibility of plan contributions is not an issue.
LO 4.3.2
PREV
Which of the following statements regarding SIMPLE IRA employer contributions is CORRECT?
I. A 2% (of employee compensation) nonelective employer contribution can be made for all eligible employees.
II. A dollar-for-dollar matching contribution up to 3% of compensation can be contributed solely for participating employees who have elected to make contributions.
III. The employer’s contribution must remain the same for each year the plan is maintained.
IV. The employer must annually communicate its contribution level to employees before the beginning of the employees’ 90-day election period.
A) III and IV
B) I and II
C) I, II, and III
D) I, II, III, and IV
B) Explanation
Statements I and II are correct. An employer can make a 2% nonelective employer contribution in a SIMPLE IRA, where employees eligible to participate receive an employer contribution equal to 2% of their covered compensation (limited to $290,000 in 2021 and subject to cost-of-living adjustments for later years), regardless of whether they make their own contributions. Alternatively, an employer may make a dollar-for-dollar match up to 3% of compensation, where only the participating employees who have elected to make contributions will receive an employer-matching contribution. Each year, the employer can choose which contribution level it will use for the following year’s contributions. The company is required to communicate this information to employees before the beginning of the 60-day election period.
LO 4.2.1
PREV
George has been participating in his employer’s SIMPLE IRA for one year. He is 45 years old. If he withdraws $1,000 from this plan this year and the withdrawal is not covered by an exception to the penalty tax on premature withdrawals, he will owe a penalty tax of
A) $0.
B) $500.
C) $250.
D) $100.
C) Explanation
George will incur a $250 penalty tax on the $1,000 withdrawal. Premature withdrawals made from a SIMPLE IRA within two years of initial participation are subject to a penalty tax of 25%.
LO 4.2.1
PREV
Bonnet Company has 50 employees, of which 40 earned at least $5,000 in the prior year and are expected to earn at least that much in the current year. Bonnet Company does not currently maintain a retirement plan. If Bonnet implements a SIMPLE IRA, which of the following statements is NOT correct?
A) Employees may make elective deferrals into the SIMPLE IRA as a percentage of compensation of up to at least $13,500 in 2021.
B) The effective covered compensation limit for workers younger than age 50 for SIMPLE IRAs is $450,000 for 2021 when the employer elects the 3% match.
C) The covered compensation limit is $290,000 if Bonnet Company decides on the 2% nonelective employer contribution.
D) All of the employees of Bonnet Company are eligible to participate in the plan.
PREV
D) D) Explanation
Only the employees of Bonnet Company who earned at least $5,000 in the prior year and expect to earn at least that amount in the current year are eligible to participate in the plan (40 employees). Employees may make an elective deferral into the SIMPLE IRA as a percentage of compensation of up to at least $13,500 in 2021. Those age 50 and above can add an additional $3,000. The unofficial, but mathematically set, effective covered compensation limit for SIMPLE IRAs for employees under age 50 is $450,000 in 2021 when the employer elects the 3% match ($13,500 divided by 0.03). The covered compensation limit is $290,000 if Bonnet Company decides on the 2% nonelective employer contribution.
LO 4.2.1
Sharon Bender, age 52, has been a teacher in the Lammer County School District for 18 years. Recently, she inherited a large sum of money and wants to minimize her income tax. What is her maximum 403(b) deferral in 2021?
A) $26,000
B) $29,000
C) $19,500
D) $58000
B) Explanation
Sharon can defer the basic $19,500 allowed in 2021, plus $6,500 for the age 50 catch-up and $3,000 for the long service catch-up (15 years of service or more).
LO 4.3.1
PREV
Which of the following statements is CORRECT in describing a Section 457 catch-up provision?
A) During the final three years before retirement, a participant in a Section 457 plan could contribute up to the lesser of 100% of compensation, or $58,000. The other catch-up is for those who have attained age 50. They can increase their deferrals by $6,500 (in 2021) in all but the last three years before retirement.
B) During the final three years before the plan document normal retirement date, an employee can double the usual age 50 catch-up of $6,500 in 2021.
C) The final three-year catch-up provision allows participants to make contributions up to twice the maximum deferral allowed for a 457 plan. The additional deferral amount is available only from prior unused deferrals, and is to make up for those years when deferrals were less than the maximum allowed. The other catch-up is for those who have attained age 50. They can increase their deferrals by $6,500 (in 2021) in all but the last three years before retirement if they use the final three-year catch-up.
D) The final three-year catch-up provision allows all participants of a Section 457 plan to contribute an additional $19,500 during the three years preceding retirement, regardless of previous contributions. The other catch-up is for those who have attained age 50. They can increase their deferrals by $6,500 (in 2021) in all but the last three years before retirement.
C) Explanation
The additional deferral amount is available only from prior unused deferrals and is to make up for those years when deferrals were less than the maximum allowed. The other catch-up is for those who have attained age 50. They can increase their deferrals by $6,500 (in 2021) in all but the last three years before retirement if they are using the final three-year catch-up.
LO 4.3.2
PREV
All of the following statements regarding the basic provisions of a Section 457 plan are correct except
A) the contribution limit is doubled in the 3 years before an individual’s retirement.
B) in 2020, an individual who has attained age 50 may make additional catch-up contributions of up to $6,500.
C) distributions from a Section 457 plan are not subject to an early withdrawal penalty.
D) a Section 457 plan is a qualified plan of governmental units or agencies, and non-church-controlled, tax-exempt organizations.
D) Explanation
A Section 457 plan is not a qualified plan. This plan is a deferred compensation plan that may be established by governmental units or agencies and non-church-controlled, tax-exempt organizations. Section 457 plans have special catch-up rules.
LO 6.3.1
PREV
Bland Foods, Inc., wants to establish a retirement benefit for the company’s executives that is separate from its qualified plan. The plan will be unfunded and pay benefits only as needed from the company’s assets. Bland Foods wants to provide the benefits without requiring the executives to reduce their current salary. Which of these types of plans was most likely chosen by Bland Foods, Inc.?
A) Stock bonus plan
B) Defined benefit pension plan
C) Top-hat plan/nonqualified plan
D) Section 401(k) plan
C) Explanation
A top-hat plan would meet all of the company’s objectives. The other choices are all qualified plans and would be subject to the limitations on funding, contributions, and benefits.
LO 4.1.1
PREV
Which of the following are characteristics that simplified employee pensions (SEPs) share with qualified profit sharing plans?
I. Limitation on employer contributions
II. Application of controlled group rules
III. Nondiscrimination requirements
IV. Statutory eligibility requirements (age 21, one year of service)
A) I, II, and III
B) II, III, and IV
C) I and II
D) II and IV
A) Explanation
SEPs and profit sharing plans are both subject to the 25% limit on deductible employer contributions, the controlled group rules, and nondiscrimination requirements. Eligibility requirements are different for a SEP.
LO 4.2.2
PREV
Christopher works for the Ex-March Company, a small business with 75 employees. Ex-March has decided to establish a SIMPLE IRA plan for all of its employees and will make a 2% nonelective contribution for each of its eligible employees. Christopher’s annual salary is $40,000, and he has determined that he cannot afford to make an elective deferral to his SIMPLE IRA. Which of the following statements regarding Christopher’s SIMPLE IRA contribution is CORRECT?
A) Ex-March Company must make a nonelective contribution of $800 for Christopher.
B) Ex-March is not required to make a contribution for Christopher.
C) Christopher must make a 2% minimum contribution this year.
D) Ex-March must make a nonelective contribution of $1,200 for Christopher.
A) Explanation
Ex-March must make a nonelective contribution of $800 for Christopher. Though Christopher does not make a contribution this year, Ex-March must make a nonelective contribution of $800 (2% × $40,000) on his behalf. Under the employer contribution election Ex-March has selected, even if an eligible employee does not contribute to the SIMPLE IRA, that employee would still receive an employer nonelective contribution to his SIMPLE IRA equal to 2% of compensation.
LO 4.2.1
PREV
Which of the following are reasons a small business might choose the SIMPLE over a Section 401(k) plan?
A) Because a SIMPLE is less costly to operate, it is generally the better choice if the employer is not concerned about the design constraints of the plan.
B) A Section 401(k) plan would be top heavy (benefits for key employees will exceed 60% of total benefits), and the employer wants to minimize employer contributions.
C) The employer expects that it could not satisfy the Section 401(k) nondiscrimination test.
D) All of these are reasons.
D) Explanation
All of these statements are reasons a small business might choose the SIMPLE over a Section 401(k) plan.
LO 4.2.1
Which of the following describes a basic provision of a SIMPLE IRA?
A) Only employers that average fewer than 20 employees can establish a SIMPLE IRA.
B) A SIMPLE IRA must satisfy both the ADP and ACP nondiscrimination tests.
C) An employer may add a SIMPLE IRA plan to an existing defined benefit plan to allow employees to make elective deferrals.
D) SIMPLE IRA plans can be arranged to allow for in-service loans for up to 50% of the account balance, but not to exceed $50,000.
E) One contribution formula an employer can use under a SIMPLE IRA is to make a 2% nonelective contribution on behalf of each eligible employee with at least $5,000 in current compensation.
E) Explanation
SIMPLE IRA plans are available to employers with 100 or fewer employees and with no other qualified retirement plan. The employer contribution requirement may be satisfied by either a 3% matching contribution formula or a 2% nonelective contribution for each employee with current-year compensation of $5,000 or more. IRA-funded employer-sponsored tax-advantaged plans may not incorporate loan provisions. These plans do not require ADP or ACP nondiscrimination tests.
LO 4.2.1
Tom, age 54, is the sole proprietor of a small business. He is interested in adopting a retirement plan for the business. His primary goals are to make large contributions to his own retirement account and to minimize the expense and paperwork associated with the plan. Which of the following retirement plans would you recommend for Tom’s business? (He makes $50,000 of self-employment income and has three part-time employees who earn $15,000 each.)
A) Section 401(k) plan funded by employee elective deferrals
B) SIMPLE IRA
C) SEP plan
D) Traditional defined benefit pension plan
B) Explanation
Qualified plans require a significant amount of expense and paperwork. Because Tom’s business is small, a SEP or SIMPLE IRA is preferred. Tom can, however, defer more in a SIMPLE than in a SEP. Based on 2021 plan contribution limits, in the SIMPLE, he can defer $16,500 ($13,500 salary deferral, plus $3,000 as a catch-up contribution) plus receive a 3% match. In a SEP, he would be limited to $9,293 as follows:
$50,000 Schedule C income
− 3,533 deductible half of self-employment tax (SECA)
$46,467 net Schedule C SE income
× 20% (the 20% is calculated by 0.25 ÷ 1.25 = 20%)
$9,293
LO 4.2.1
For which of the following plans does the employee bear the investment risk in the plan?
I. SIMPLE 401(k)
II. Traditional profit-sharing plan
III. SEP IRA
IV. SIMPLE IRA
A) I, II, III, and IV
B) II only
C) I, III, and IV
D) I and II
A) Explanation
The employee bears the investment risk for all of these plans.
LO 4.2.1
Gary was just hired by an employer that maintains a SIMPLE IRA for its employees. Which of these statements regarding Gary’s participation in the SIMPLE IRA is CORRECT?
A) Gary may only defer $6,000 into the SIMPLE IRA if he is younger than age 50.
B) Covered compensation is limited to $290,000 for a SIMPLE IRA in 2021 if the employer elects a 3% match.
C) When Gary participates in the plan, he will be 100% vested in his employer’s contributions.
D) The annual employer match may be limited to 1% of employee compensation each year.
C) Explanation
Gary will be 100% vested in his employer contributions to his account. He may defer up to $13,500 (2021) into the SIMPLE IRA if he is younger than age 50. An employer may only limit the matching contribution to 1% of employee compensation in no more than two out of every five years. Effective covered compensation for employees under age 50 is limited to $450,000 ($13,500 ÷ 0.03) for a SIMPLE IRA (2021) in which the employer elects to make 3% matching contributions. The covered compensation limit of $290,000 (2021) does not apply in this instance because there is a special rule for SIMPLE IRAs.
LO 4.2.1
Max, age 47, has been participating in his employer’s SIMPLE IRA for one year. If he withdraws $1,000 from this plan this year and the withdrawal is not covered by an exception to the penalty tax on premature withdrawals, he will owe a penalty tax of
A) $400.
B) $250.
C) $0.
D) $100.
B) Explanation
Premature withdrawals made from a SIMPLE IRA within two years of initial participation are subject to a penalty tax of 25%. Max’s penalty would be $250.
LO 4.2.1
Which of the following regarding a SIMPLE is CORRECT?
I. A SIMPLE requires ADP testing of employee elective deferral contributions.
II. SIMPLE IRAs are subject to top-heavy rules.
III. A 25% early withdrawal penalty may apply to distributions taken within the first two years of participation in the SIMPLE IRA plan.
IV. The maximum annual elective deferral contribution to a SIMPLE is $19,500 (2021) for an employee who has not attained age 50.
A) I, II, and IV
B) III only
C) I, II, III, and IV
D) II and III
B) Explanation
Neither a SIMPLE IRA nor a SIMPLE 401(k) requires ADP testing. A SIMPLE is not subject to top-heavy rules. Statement III is correct. The early withdrawal penalty is 25% for distributions taken within the first two years of participation in a SIMPLE IRA. The maximum elective deferral to a SIMPLE is $13,500 (2021). Employees who have attained age 50 by the end of the tax year will also be eligible for a catch-up contribution of $3,000.
LO 4.2.1
A savings incentive match plan for employees (SIMPLE) can be which of these?
I. It can be established as an IRA.
II. It can be established as a Section 401(k) plan.
III. It can be established as a Section 403(b) plan.
IV. It can be offered by employers who have 100 or fewer employees.
A) I and II
B) I, II, and IV
C) II and IV
D) I, II, and III
B) Explanation
Employers with more than 100 employees (who earn more than $5,000) may not offer a SIMPLE. In addition, the employer may not usually offer any other type of qualified retirement plan in conjunction with a SIMPLE. Union plans and governmental 457 plans are the exceptions to the employer having a second active plan. However, this is not to be applied to a test question unless specifically mentioned in the question. Basically, can a SIMPLE have a second active plan for its workers? No, because that is as far as the test is going. What about a union plan or a 457 for qualified state and local government employers? Well, okay, for those rare exceptions, but the question would have to bring up one of these rare exceptions. The point is that SIMPLEs were intended to be the only active plan for the small employer. Congress was afraid the employer would try to be discriminatory with the other retirement plan, so the rules was made that there could not be another retirement plan. Then governmental 457 plans and union plans snuck in, but these rare exceptions are not a part of the question unless specifically mentioned.
LO 4.2.1
Margaret is a 29-year-old attorney with her own law practice. She has hired four part-time employees over the past five years to assist her. Each of these employees works approximately 200 hours per year, earning an average annual salary of $4,000. Margaret would like to establish a retirement plan that would allow her to begin saving for her own retirement, with little administrative costs. Which one of the following plans would be most appropriate for Margaret in 2021?
A) SIMPLE IRA
B) Traditional Section 401(k) plan
C) SEP plan
D) Section 457 plan
A) Explanation
A SIMPLE IRA would be the most appropriate plan because it involves little administrative costs and would meet Margaret’s retirement plan goals. Notice the workers are making more than $650 and less than $5,000. If a SEP would be chosen, she would have to contribute for employees who made more than $650; are at least age 21; and who have worked for her for three of the preceding five years.
LO 4.2.1
Which of the following statements describes a basic provision or use of a savings incentive match plan for a SIMPLE IRA?
A) A SIMPLE IRA must satisfy special nondiscrimination tests in addition to general rules.
B) A SIMPLE IRA is primarily suitable for large, corporate-type employers.
C) Only employers that average fewer than 200 employees can establish a SIMPLE IRA.
D) One contribution formula an employer can use in a SIMPLE IRA is to make a 2% nonelective contribution on behalf of eligible employees.
D) Explanation
A 2% nonelective contribution formula on behalf of eligible employees is one of two formulas an employer may use in making contributions to a SIMPLE IRA. A 3% match is the other. For a SIMPLE IRA only, the 3% match can be lowered to 1% for two out of five years.
LO 4.2.1
Which one of the following requirements is a possible disadvantage of a simplified employee pension (SEP) for an employer?
A) The vesting requirements for a SEP prohibit forfeitures.
B) Employer contributions to a SEP are subject to payroll taxes.
C) The SEP’s trustee is subject to ERISA’s prohibited transaction excise tax penalties.
D) A SEP must have a fixed contribution formula that is nondiscriminatory.
A) Explanation
SEP contributions must be 100% vested (i.e., nonforfeitable). SEPs consist of individual IRAs; there is no trustee for a SEP plan. The contribution formula of a SEP is not required to be fixed. Employer contributions to a SEP are not subject to payroll taxes.
LO 4.2.2
Which of the following statements regarding the disadvantages to the employer of SEP plans is CORRECT?
I. Employees cannot rely on a SEP plan alone to provide an adequate retirement benefit, which may hinder appreciation of the plan by employees.
II. The employer bears the investment risk under the plan.
III. If an employer maintains a SEP plan and a qualified plan, contributions to the SEP plan reduce the amount that may be deducted for contributions to the qualified plan.
IV. The special rule for calculating deductible contributions on behalf of an owner-participant in a qualified plan also applies to a SEP plan.
A) III only
B) II only
C) I, III, and IV
D) I, II, III, and IV
C) Explanation
Statements I, III, and IV are disadvantages of a SEP plan to an employer. Statement II is false. The employee bears the investment risk under the plan.
LO 4.2.2
How does simplified employee pension (SEP) plan participation affect an employee’s IRA contributions?
I. The deductibility of an active participant’s IRA contribution depends upon his MAGI.
II. SEP plan participation does not reduce or eliminate an employee’s ability to fund an IRA.
III. Employees who participate in a SEP plan are considered active participants in an employer-sponsored retirement plan for the tax year in which an employer contribution is made.
IV. Employees who participate in a SEP plan are not considered active participants in an employer retirement plan for the tax year in which an employer contribution is made.
A) I, II, and III
B) I and II
C) II and III
D) I, II, and IV
A) Explanation
Statements I, II, and III are correct. Employees who participate in a SEP plan are considered active participants in an employer retirement plan for the tax year in which an employer contribution is made. The deductibility of an active participant’s IRA contribution depends upon his MAGI and can be phased out or eliminated at certain income levels. SEP plan participation does not reduce or eliminate an employee’s ability to fund an IRA. The IRA can be funded, but not necessarily deducted from gross income.
LO 4.2.2
Which of the following statements with respect to simplified employee pension (SEP) contributions made by an employer is CORRECT?
A) Contributions are currently excludible from the employee’s gross income.
B) Contributions are capped at $19,500 for 2021.
C) Contributions are subject to income tax withholding.
D) Contributions are subject to FICA and FUTA.
A) Explanation
Contributions are currently excludible from the employee’s gross income. Employer contributions to a SEP are not subject to FICA, FUTA, or income tax withholding. The SEP contribution limit for 2021 is the lesser of 25% of covered compensation or $58,000.
LO 4.2.2
George is a plumbing contractor and has implemented a retirement plan for his employees. The plan must cover all employees who are at least age 21 and have worked for George for three of the last five years (including part-time employees). Contributions must be made for employees who earned at least $600 in the prior year. The plan can exclude union members if they have their own retirement plan. Which type of plan has George selected?
A) Section 403(b) plan
B) Simplified employee pension (SEP) plan
C) SARSEP plan
D) SIMPLE IRA
B) Explanation
The requirement that contributions must be made for employees who earned at least $600 in the prior years identifies the plan as a SEP plan.
LO 4.2.2
All of the following statements regarding simplified employee pension (SEP) plans are correct except
A) all part-time employees can be excluded.
B) SEP plans can be established by any form of business entity.
C) the major advantage is the simplicity of the plan.
D) employer contributions are discretionary.
A) Explanation
A SEP plan must cover any employee who is at least 21 years old and who worked for the employer, even on a part-time basis, for three of the preceding five years. In addition, contributions must be made on behalf of any eligible employee whose compensation for the year is at least $650 (2021). These provisions make most part-time employees eligible to participate.
LO 4.2.2
Which of the following types of plans is typically used by religious, charitable, educational, and other Section 501(c)(3) entities or public school systems?
A) SIMPLE
B) Section 403(b) plan/TSA
C) Section 457 plan
D) SEP plan
B) Explanation
A Section 403(b) plan/TSA (tax-sheltered annuity) is a tax-deferred employee retirement plan that is adopted only by certain tax-exempt organizations and certain public schools and colleges. Employees have individual accounts to which employers contribute (or employees contribute through salary reductions).
LO 4.3.1
Which of the following statements regarding Section 403(b) plans is CORRECT?
I. Section 403(b) plans must comply with many of the same reporting and auditing requirements that apply to Section 401(k) plans.
II. Certain eligible participants in a Section 403(b) plan may defer as much as much as $29,000 into the plan in 2021.
III. Section 403(b) plans may provide for plan loans to participants.
IV. Funding for Section 403(b) plans is limited to mutual funds and annuities.
A) I and II
B) III and IV
C) I, II, and III
D) I, II, III, and IV
D) Explanation
All of the statements are correct. The $29,000 maximum elective deferral for 2021 includes the $19,500 basic limit; the extra $3,000 per year for up to $15,000 lifetime for employees of not-for-profit health care, education, and church employers; and the $6,500 catch-up for those age 50 and older.
LO 4.3.1
Which of the following statements regarding the basic provisions of tax-sheltered annuities (TSAs)/Section 403(b) plans is NOT correct?
A) An eligible employee may be able to use both a special catch-up provision and an over-age-50 catch-up provision in the same year.
B) TSAs are available to all eligible employees of Section 501(c)(3) organizations who adopt such a plan.
C) If an employee has at least 15 years of service with an eligible employer, an additional catch-up contribution may be permitted.
D) The special catch-up provision for eligible Section 403(b) participants allows up to a $39,000 (2 × $19,500 in 2021) elective deferral in the last 3 years of employment before retirement.
D) Explanation
The special catch-up provision for eligible Section 403(b) participants allows a maximum additional $3,000 per year elective deferral until a lifetime maximum catch-up is reached. The ability to double the worker contribution in the last three years before the retirement plan document’s normal retirement age applies to governmental 457 plans.
LO 4.3.1
Which of the following statements regarding TSAs/Section 403(b) plans is CORRECT?
I. The sponsor must be a tax-exempt organization that meets the requirements of Section 501(c)(3), a governmental organization, or public educational organization.
II. Lump-sum distributions may be eligible for special long-term capital gain treatment.
III. In-service withdrawals may be permitted.
IV. The plan can invest in individual stocks and bonds, but not options or futures.
A) I and III
B) I, II, and III
C) II, III, and IV
D) I, III, and IV
A) Explanation
Statement II is incorrect because distributions from a TSA are treated as ordinary income. Statement IV is incorrect. Only annuities and mutual funds are permitted investments in a TSA.
LO 4.3.1
For tax-exempt employers that do not want to implement a Section 457 plan and desire a plan funded strictly by employee elective deferrals, a good alternative would be
A) a SEP plan.
B) a Section 403(b) plan.
C) a profit-sharing plan.
D) a SARSEP plan.
B) Explanation
The Section 403(b) plan, like the Section 457 plan, can be used as an employee-deferred contribution plan. Certain tax-exempt employers can implement Section 403(b) plans. With a SEP plan or a profit-sharing plan, there are also employer contribution considerations. New SARSEP plans can no longer be established.
LO 4.3.1
Which of the following statements regarding the basic provisions of Section 403(b) plans is CORRECT?
I. A special catch-up provision is available to employees of Section 501(c)(3) organization employers who have at least 1 year of service.
II. An eligible employee may be able to use both a special catch-up provision and an over-age-50 catch-up provision in the same year.
III. TSAs are available to all eligible employees of Section 501(c)(3) organizations who adopt such a plan.
IV. If an employee has at least 15 years of service with an eligible employer, an additional catch-up contribution may be permitted.
A) I and II
B) II only
C) II, III, and IV
D) I, II, and III
C) Explanation
Statement I is incorrect. The special or additional catch-up provision requires at least 15 service years.
LO 4.3.1
Which of the following are permitted investments in tax-sheltered annuity (TSA) plans?
I. Individual stocks
II. Group or individual annuity contracts
III. Custodial accounts invested in mutual funds
A) I and II
B) I only
C) II and III
D) I, II, and III
C) Explanation
Investments in TSAs are limited to annuity contracts, either group or individual, and custodial accounts invested in mutual funds. Individual stocks and bonds are not permitted.
LO 4.3.1
Ronald, age 44, works for two private tax-exempt employers. One has a Section 403(b) plan and one maintains a nongovernmental Section 457 plan. If Ronald defers $10,000 into the Section 403(b) plan in 2021, what is the maximum amount he may defer into the Section 457 plan?
A) $19,500
B) $13,500
C) $9,000
D) $48,000
A) Explanation
Ronald can separately defer the maximum of $19,500 (2021) into the Section 457 plan because Section 457 plan limits are not aggregated with the Section 403(b) plan limits.
LO 4.3.2
Which of the following retirement plans, maintained by an employer, would also permit an eligible employer to establish a SIMPLE?
A) Section 401(k) plan
B) Section 457 plan
C) Section 403(b) plan
D) SEP plan
B) Explanation
To establish a SIMPLE, an employer cannot maintain another plan. However, a Section 457 plan is a nonqualified deferred compensation plan; therefore, it does not constitute a plan for purposes of establishing a SIMPLE.
LO 4.2.1