Lesson 2 of Retirement Planning: Pension Plans and Profit Sharing Plans

Question 1

What amounts for Pension Plans PBGC amounts are not provided on the CFP Board Exam

Answer 1

PBGC Monthly Benefit at Age 65 = $6,750

PGBC Yearly Benefit at Age 65 = $81,000

Not provided on the CFP Exam

Question 2

Pensions Plans!

Answer 2

Background of Pension Plans?

Pension Plan Characteristics

Defined Benefit Pension Plans vs. Defined Contribution Pension Plans

Defined Benefit Pension Plans

Cash Balance Pension Plans

Money Purchase Pension Plans

Target Benefit Pension Plans

Question 3

Background of Pension Plans

Answer 3

Traditional Pension Plan

Legal Promise of a Pension Plan

Traditional Pension Plans Promise a Defined Benefit Amount

Question 4

Traditional Pension Plan

Answer 4

The traditional pension plan pays a formula-determined benefit beginning at retirement, usually in the form of an annuity, to a plan participant’s remaining life.

Question 5

Legal Promise of a Pension Plan?

Answer 5

Legal Promise = To Pay a Pension

Question 6

4 Types of Pension Plans

Answer 6

Defined Benefit Pension Plans:

• Defined Benefit Pension Plans
• Cash Balance Pension Plans

Defined Contribution Pension Plans:

• Money Purchase Pension Plans
• Target Benefit Pension Plans

Question 7

Traditional Pension Plans Promise a Defined Benefit Amount

Answer 7

Traditional pension plans promise a certain defined benefit amount available at the time of a participant’s retirement.

• This benefit, the present value of which can be calculated at any given time during the employee’s service, is most commonly based on a combination of the participant’s years of service with the company and the participant’s salary. An example of a common pension plan benefit formula is illustrated below (percent per year, years of service, and salary used can vary based on plan documents):

Question 8

Formula for “Annual Pension Benefit Amount”

Answer 8

An example of a common pension plan benefit formula is illustrated below (percent per year, years of service, and salary used can vary based on plan documents):

Question 9

Example of Annual Pension Benefit Amount

Assume that Jack works for XYZ company, which sponsors a a defined benefit plan with a ben-
efit formula of 1.5 percent times the years of service times the final salary. Assuming that Jack
worked for XYZ for 40 years and that his final salary is $100,000, he would be entitled to an
annual benefit of

Answer 9

$60,000 per year (1.5% × 40 x $100,000) during retirement. If Jack were to live for 30 years in retirement. XYZ would have to pay a total of $1.8 million in retirement benefts to Jack. (Note that pension benetits are not normally adjusted tor inflation)

Question 10

Exam Question

A company’s defined benefit pension plan utilizes a funding formula that considers years of service and average compensation to determine the pension benefit payable to the plan participants If Brenda is a participant in this defined benefit pension plan and she has 30 years of service with the company and average compensation of $75,000, what is the maximum pension benefit that can be payable to Brenda at her retirement?

a) $18,000
b) $54,000
c) $75,000
d) $265,000.

Answer 10

Answer: C

The maximum amount payable from a defined benefit pension plan is the lesser of $265,000
(2023) or 100 percent of the average of the employee’s three highest consecutive years compensation. Because the average of Brenda’s compensation is $75,000, she would be limited to
receiving a pension benefit at her retirement of $75,000

Question 11

Pension Plan Characteristics

Answer 11

Government Requirements + PGBC

Mandatory Funding:

• Defined Benefit Plans
• Defined Contribution Pension Plans

Disallowance of In-Service Withdrawals

Limited Investment in Employer Securities

Limited Investment in Life Insurance:

• 25 Percent Test
• 100-to-1 Ratio Test

Question 12

Government Requirements + PGBC

Answer 12

For qualified pension plans, the government requires:

• mandatory annual funding,
• disallows most in-service withdrawals,
• limits the investment of the plan assets in the employer’s securities, and
• limits the investment of the plan assets in life insurance.

In addition, the Pension Benefit Guaranty Corporation (PBGC) was established to
provide additional protection to lower-wage participants of defined benefit plans.

Question 13

Mandatory Funding - Defined Benefit Plan

Answer 13

The mandatory funding requirements help ensure that the future benefits promised by the defined benefit formula in the plan document are sufficiently funded and that the employer only deducts (shelters from tax) the amount necessary to fund the future promised benefit.

Question 14

Mandatory Funding - Defined Contribution Pension Plan

Answer 14

The mandatory funding requirements for a defined contribution pension plan, either a money purchase pension plan or a target benefit pension plan:

• require that the plan sponsor fund the plan annually with an amount as defined in the plan document.

Question 15

Disallowance of In-Service Withdrawals

Answer 15

An in-service withdrawal is any withdrawal from the plan while the employee is a participant in the
plan other than a loan.

• Plan loans are not in-service withdrawals because they are required to be paid back. Although loans are allowed by the IRC, most pension plans do not permit plan loans because the contributions are primarily funded by the employer.

Under the Pension Protection Act of 2006, defined benefit pension plans can now provide for in-service distributions to participants who are age 59 1/2 (as amended) or older. This in-service distribution can take the form of a bona fide phased retirement benetit

Question 16

Limited Investment in Employer Securities

Answer 16

The assets of a pension plan may be invested in the securties of the employer/plan sponsor BUT the aggregate value of the employer securities cannot exceed 10 percent of the fair market value of the pension plan assets at the time the employer securties are purchased.

• Employer securities are any securities issued by the plan sponsor or an affiliate of the plan sponsor, including stocks, bonds, and publicly traded partnership interests.

In addition to the 10 percent limitation, the Pension Protection Act of 2006 requires defined
contribution plans holding publicly traded employer securities to allow plan participants to diversify their pretax deterrals after-tax contrbutions, and employer contributions. The employer must offer a choice of at least three investment options, other than employer securities.

Question 17

Limited Investment in Life Insurance

Answer 17

Any qualified plan may purchase life insurance. As long as life insurance is not the primary focus of the plan, the government allows this exception from the ultimate retirement benefit promise because the death benefit of the life insurance policy is payable to the employee’s spouse and other survivors at the employee’s death.

Premiums paid by the employer for the life insurance policy, however, are taxable to the employee at the time of payment, to the extent of the Table I cost of insurance.

To maintain its qualified plan status, a qualified plan that includes life insurance must pass either:

• (1) the 25 percent test or
• (2) the 100-to-I ratio test.

Question 18

25/50 Percent Test

Answer 18

The 25 percent test consists of two tests, a 25 percent test and a 50 percent test. The test used
depends upon the type of life insurance provided by the plan.

If a term insurance or universal life insurance policy is purchased within the qualified plan, the
aggregate premiums paid for the life insurance policy cannot exceed 25 percent of the employer’s aggregate contributions to the participant’s account.

If a whole life insurance policy is purchased within a qualified plan, the aggregate premiums paid for the whole life insurance policy cannot exceed 50 percent of the employer’s aggregate contributions to the participant’s account.

Universal or Term Life = 25%

Whole life = 50%

In either case, the entire value of the life insurance contract must be converted into cash or periodic income at or before retirement.

Question 19

Example of 25/50 Percent Test

Morris is a participant in a qualified plan sponsored by his employer. The employer has made aggregated contributions for Morris of $100,000. His plan holds a $90,000 term life insurance policy on his life. The total premiums that have been paid for the policy are $4,000.

Answer 19

Because this is a term life insurance policy, the premiums paid cannot exceed $25,000 ($100,000x25%) per the 25 percent test. Since the premiums for this policy have been $4,000, the plan meets the 25 percent test.

Question 20

Exam Question Limited Investment in Life Insurance

Which of the following statements concerning the use of life insurance as an incidental benefit
provided by a qualified retirement plan is (are) correct?

1. The premiums paid for the life insurance policy within the qualified plan are taxable to the
   participant at the time of payment.
2. Under the 25 percent test, if term insurance or universal life is involved, the aggregate premiums paid for the policy cannot exceed 25 percent of the employer’s aggregate contributions to the participant’s account. If a whole life policy other than universal life is used, however, the aggregate premiums paid for the whole life policy cannot exceed 50 percent of the employer’s aggregate contributions to the participant’s account. In either case, the entire value of the life insurance contract must be converted into cash or periodic income at or before retirement.

a) 1 only
b) 2 only
c) Both 1 and 2.
d) Neither 1 nor 2.

Answer 20

Answer: C

Statement 1 is correct. The premiums paid for the life insurance policy are taxable to the participant at the time of payment. Statement 2 is correct because the 25 percent test is actually a misnomer, for it is really two tests: a 25 percent test and a 50 percent test, depending on which type of life insurance protection is involved.

Question 21

100-to-1 Ratio Test

Answer 21

The 100-to-1 ratio test limits the amount of the death benefit of life insurance coverage purchased to 100 times the monthly-accrued retirement benefit provided under the same qualified plan’s defined benefit formula.

Question 22

Example of 100-to-1 Ratio Test

As a participant in her employer’s defined benefit plan, Jess has accrued a retirement benefit of
$4,000 per month.

Answer 22

Based on the 100-to-1 ratio test, the plan is limited to utilizing plan assets to purchase life insurance up to a face amount of $400,000 ($4,000 x100).

Question 23

Defined Benefit Pension Plans vs. Defined Contribution Pension Plans

Answer 23

Differences?

Actuary

Commingled v.s. Seperate Individual Investment Accounts

Investment Risk

Allocation of Forfeitures

Pension Benefit Guaranty Corporation Insurance

Benefits - Accrued Benefit/Account Balance

Credit for Prior Service

Integration with Social Secueity

Commingled Accounts

Younger/Older

Eligibility/Coverage/Vesting

Question 24

Differences of Defined Benefit Pension & Defined Contribution Pension

Answer 24

The defined benefit pension plan and the cash balance pension plan are both defined benefit pension plans, whereas the money purchase pension plan and the target benefit pension plan are both defined contribution pension plans. The primary differences between the two categorizations of the plans include the following:

• the use of an actuary (annually or at inception);
• assumption of the investment risk (to the employer or to the employee);
• the disposition of plan forfeitures (reduce plan costs or allocate to remaining employees);
• coverage under the Pension Benefit Guaranty Corporation (PBGC);
• the use of Social Security integration (offset or excess);
• the calculation of the accrued benefit or account balance;
• the ability to grant credit for prior service for funding; and
• the use of commingled funds versus separate, individual investment accounts

Question 25

Actuary

Answer 25

Defined benefit plans require the use of annual actuarial services to determine the proper funding of the plan.

• Use of an actuary allows for some limited discrimination in benefit.
• Actuarial costs can drive up the administrative costs of a plan.

The target benefit pension plan, a defined contribution plan, uses actuarial assumptions only at the inception of the plan and does not require annual actuarial work.

The money purchase pension plan has no need for actuarial services because the annual contribution is predefined in the plan documents.

Question 26

Commingled vs. Separate Individual Investment Accounts

Answer 26

Defined benefit pension plans use commingled investment accounts but send individual summaries to participants showing what benefits they have accrued to a certain date.

Most defined contribution plans, including target benefit and money purchase pension plans, use separate, individual accounts and require that the individual participant invest in his own retirement asset.

Question 27

Investment Risk

Answer 27

In a defined benefit plan, the plan sponsor bears the investment risk.

In a defined contribution plan, the individual plan participant generally maintains their own account and bears the risk of investment.

Question 28

Allocation of Forfeitures

Answer 28

For a defined benefit pension plan, the forfeited funds can only be used to reduce future plan costs for the employer.

The plan sponsor of a defined contribution pension plan, however, can choose to utilize plan forfeitures one of two ways, either to reduce future plan costs or the forfeitures can be allocated to other remaining participants in a nondiscriminatory manner.

Question 29

Example of Allocation of Forfeitures

Antoine has an accrued benefit from his employer’s defined benefit plan equal to $6,000 per month at retirement. Based on the plan’s vesting schedule, however. Antoine has a vested
accrued benefit equal to $4,800 per month at retirement.

Answer 29

If Antoine terminates employment today, the $1,200 of nonvested assets in the defined benefit plan will be used to offset future plan costs.

( $6,000 - $4,800 )= $1,200

Question 30

Pension Benefit Guaranty Corporation Insurance (PBGC)

Answer 30

The plan sponsors of defined benefit pensions plans pay premiums for insurance coverage designed to pay the “promised pension” in the event the plan is underfunded or unfunded.

The PBGC pays only a limited retirement benefit ($6,750 per month or $81,000 per year (2023)) in the event of a plan completely or partially terminating with an unfunded or underfunded liability.

The PBGC does NOT insure defined contribution pension or profit sharing plans, AND
it does not insure defined benefit pension plans of professional service corporations with 25 or fewer participants.

The PBGC does insure that all other defined benefit plans and covered plans are required to pay a flat-rate, per participant premium.

Question 31

Benefits - Accrued Benefit/Account Balance

Exam Tip: This is a Key to understanding DB vs DC plans.

Answer 31

A participant in a defined benefit plan has an accrued benefit roughly equal to the present value of the expected future payments at retirement discussed further below).

Accrued Benefit
Account Balance

Question 32

Accrued Benefit

Answer 32

A defined benefit plan is subject to the mandatory funding requirement as calculated by an actuary.

An employee who terminates participation in the plan, usually through termination of employment
before full retirement age, will be entitled to a benefit payable from the plan equal to the retirement benefit earned to date. This benefit is the actuarial equivalent of the benefit that would have been provided to the participant had the participant waited until retirement to receive the payments.

In contrast, a participant in a defined contribution plan has an accrued benefit equal to the account balance of the qualified plan consisting of any combination of employer and employee contributions plus the earnings on the respective contributions reduced by any nonvested amounts.

Question 33

Account Balance

Answer 33

The benefit in a defined contribution plan is simply the participant’s account balance reduced by any non-vested amounts.

The participants account balance is the sum of the employer contributions to the plan and the employee contributions to the plan plus or minus any investment earnings or losses.

Question 34

Credit for Prior Service

Answer 34

An employer who establishes a defined benefit plan may elect to give employees credit for their service prior to the establishment of the plan. This means that an employee will receive “accrued benefits” in a DB plan based on his service prior to the start of the DB plan.

Granting credit for prior service must be nondiscrminatory, but may benefit an older owner-employer who does not have many long-term employees.

A defined contribution plan cannot grant credit tor prior service

Question 35

Example of Credit for Prior Service

Answer 35

Seth started Snazzy Stereos 12 vears ago. His company is finally profitable, and he would like to
establish a defined benefit plan to benefit himself and his employees.

The plan will provide the employees with a benefit equal to 1.5 percent x years of service x final salary. If Seth elects when he establishes the plan to give credit for prior service, immediately Seth ‘s benefit would be based on 12 years of service; however, the plan must then count prior years of service for all employees.

Alternatively, Seth could choose not to count prior years of service in the calculatior
of the benefit, but then his benefit would only be calculated on years of service after the estab-
lishment of the defined benefit plan

Question 36

Integration with Social Security - Permitted Disparity for Defined Benefit Plans

Answer 36

Permitted disparity (often referred to as Social Security Integration) allows a higher contribution or allocation of benefits to employees whose compensation exceeds the Social Security wage base for the plan year- a sort of “reverse discrimination.”

All qualified pension plans may utilize permitted disparity (Social Security integration) as a method of allocating benefits to plan participants. Permitted disparity allows the qualified plan to consider the Social Security benefits that will be provided to plan participants in the calculation of the participant accrual of benefit or contribution amount. Integration was designed to resolve this conflict.

There are two methods of permitted disparity:

• 1) the excess method and
• 2) the offset method.
• Defined benefit plans can use either method. Defined contribution plans are only permitted to utilize the excess method.

Question 37

Excess Method - Defined Benefit Pension Plans and Defined Contribution Plans

Answer 37

The excess method provides an increased percentage benefit, referred to as the excess benefit, to those plan participants whose earnings are in excess of an average of the Social Security bases over the 35-year period pror to the individual’s Social Security Retirement Age. This wage average is called the covered compensation limit.

The increased percentage benefit only applies to income that exceeds the covered compensation
limit and is limited to the lesser of:

• (1) 0.75 percent per year of service or
• (2) the benefit percentage
  for earnings below the covered compensation limit per year of service.

This additional benefit only applies up to 35 years. Therefore, the maximum increase In benefits for compensation over the covered compensation limit is 26.25 percent, which is found by multiplying 0.75 percent by 35
years

The 2nd or for less than, meaning?

Question 38

Example of Excess Method

Answer 38

Maggie is a participant of Dress Depot’s defined benefit pension plan, earns $150,000 per year,
and has been employed with Dress Depot for 30 years. The base funding formula for Dress
Depot’s defined benefit plan is one percent per year of service multiplied by final salary. Under
this formula, Maggie would have a benefit equal to $45,000 (1% x30 x$150,000).

In addition, Dress Depot also provides an additional benefit of 0.75 percent per year of service for income that exceeds the covered compensation limit. Assuming that the covered compensation limit is $100,000, Maggie would be entitled to an additional benefit of $11,250 (0.75% x30* 550,000). (150,000 - 100,000)

Therefore, by integrating the plan with Social Security, Maggie receives $11,250 more during retirement than she would have received if the plan had not been integrated.

Note: the $100,000 in this problem is an assumed covered compensation limit, which represents the annual covered compensation limit over a 35-year period.

Question 39

Defined Benefit Pension Plans (only for DB plans)

Answer 39

To provide an increased benefit to those individuals whose earnings are in excess of the covered compensation limit, the offset method applies a benefit formula to all earnings and then reduces the benefit on earnings below the covered compensation limit.

The reduction of the benefit is limited to the lesser of:
- (1) 0.75 percent per year of service up to 35
years or
- (2) 50 percent of the overall benefit funding percentage per year of service.

As with the excess method, the total reduction is limited to 26.25 percent of the earnings below the 35 year covered compensation limit.

The 2nd or for less than?

Question 40

Example of Offset Method

Consider the same facts as before except that Dress Depot’s defined benefit funding formula is
1.75 percent per year of service multiplied by final salary and includes an offset reduction that
reduces the benefit for earnings below the covered compensation limit by 0.75 percent.

Answer 40

In this case, Maggie would receive a benefit equal to $56,250 [(1.75% x 30 x $150,000) - (0.75% x 30
× $100,000)].

The above examples were designed to illustrate that the same outcome could be reached whether you followed the excess benefit method or the offset method. The important concept, however, is that defined benefit plans can be structured in such a way as to provide higher benefits to those employees who have compensation above the 35 year covered compensation limit.

Question 41

Commingled Accounts

Answer 41

A defined benefit plan does not maintain separate accounts for each participant, although each participant is entitled to a calculated accrued benefit.

The assets of a defined benefit plan are managed as a group, and it is impossible to segregate any individual participant’s funds. Benefits are paid from the pool of assets.

Question 42

Younger / Older

Answer 42

A defined benefit plan is generally considered to benefit older participants because at the creation of the plan, the largest percentage of the overall contribution to the plan will be attributable to the older participant(s).

In addition, defined benefit plans can consider prior service.

Question 43

Eligibility/Coverage/Vesting

Answer 43

Defined benefit plans follow the eligibility, coverage (including the extra 50/40 test), and vesting rules as described in the previous section.

Question 44

Chart of Defined Benefit Plans vs Defined Contribution Plans

• Actuary (Annually)
• Investment Risk Borne by
• Treatment of Forfeitures
• PGBC Insurance
• Credit for Prior Service
• Social Security Integration
• Seperate Investment Accounts
• Favors Younger/Older

Answer 44

Question 45

Defined Benefit Pension Plans

Answer 45

Establishing the Formulas for Benefits:

• To determine the retirement benefit provided under a defined benefit plan, the plan’s funding and allocation formula must be established. The most common benefit formulas are:
• (1) the flat amount formula,
• (2) the flat percentage formula, and
• (3) the unit credit formula

Question 46

Flat Amount Formula

Answer 46

The flat amount formula provides an amount that each plan participant will receive at retirement,
such as $250 per month. The formula is not based on years participant’s salary.

From the highest paid participant to the lowest paid plan participant, each participant will receive the same amount at retirement.

Question 47

Flat Percentage Formula

Answer 47

The flat percentage formula provides all plan participants with a benefit equal to a specific percentage of the participant’s salary,

• usually the final salary or an average of the participant’s
  highest salaries.

The percentage remains the same throughout participation in the plan and does not increase based on additional years of service or age.

Question 48

Unit Credit Formula

Answer 48

The unit credit formula utilizes both a participant’s years of service and salary to determine the participants accrued benefit.

Unit credit formulas provide a fixed percentage of a participant’s salary multiplied by the number
of years (the unit) the participant has been employed by the employer. **The salary may be average of the final three years, highest average three years or some iteration of that the employer chooses. **

The multiplier is chosen by the plan sponsor and is typically between 1 and 2 percent

Question 49

Defined Benefit Pension Plan Formula Charts

Answer 49

Question 50

Exam Question

Which of the following is (are) a defined benefit plan formula(s)?

a) Unit benefit (a.k.a, percentage-of-earnings-per-year-of-service) formula
b) Flat-percentage formula.
c) Flat-amount formula
d) All of the above:

Answer 50

Answer? D

All of the above are benefit formulas used by defined benefit plans.

Question 51

Cash Balance Pensions Funds

Answer 51

What Are They, Cateogirzed as, More Info?

Contributions and Earnings

Quasi-Seperate Accounts

Younger/Older

Eligibility/Coverage/Vesting

Conversions to a Cash Balance Plan

Question 52

What Are They, Cateogirzed as, More Info?

Answer 52

A cash balance plan is a defined benefit pension plan that shares many of the characteristics of defined contribution plans BUT provides specific defined retirement benefits.

From the participant’s perspective, a cash balance plan is a qualified plan that consists of an individual account with guaranteed earnings attributable to the account balance. HOWEVER, the account that the employee sees is merely a hypothetical account displaying hypothetical allocations and hypothetical earnings.

Because the cash balance pension plan is a defined benefit pension plan, it is subject to all of the requirements of defined benefit plans and pension plans.

Question 53

Contributions and Earnings

Answer 53

When a cash balance pension plan is established, the plan sponsor develops a formula to fund the cash balance hypothetical allocation. This formula consists of a Pay Credit and an Interest Credit.

The pay credit may be integrated with Social Security to produce a higher benefit percentage to those participants who earn a salary above the Social Security wage base or may be based on a combination of age and years of service - thus rewarding participants for longer service.

The plan sponsor is responsible for the investment performance of the plan’s assets and earnings. The benefit, which is a guaranteed return and is determined under the plan document, will be payable to the participant at retirement regardless of the plan’s true
earnings, whether greater than or less than the
benefit provided by the plan formula.

Therefore a cash balance formula might be structured as follows:
- 5% pay credit with a guaranteed
interest credit of 2%.
- Each year, a hypothetical contribution of 5% of salary is contributed to the plan and the balance earns a guaranteed 2% rate of return.

Question 54

Quasi-Seperate Accounts

Answer 54

A cash balance pension plan does not have separate accounts for each participant even though the plan participant receives a statement detailing a separate account in his name.

A cash balance pension plan consists of a commingled account that has a value equal to the actuarial equivalent of the present value
of the expected future benefits that will be paid from the cash balance pension plan to the participants (the promised contribution and earnings).

Question 55

Younger/Older

Answer 55

A cash balance pension plan is generally more beneficial for younger participants because the formula is generally based on the number of years the participant is employed by the plan sponsor with a guaranteed rate of return.

Younger participants have more years of contributions and earnings than older
participants.

Question 56

Eligibility/Coverage/Vesting

Answer 56

The cash balance pension plan follows the rules and requirements for eligibility, coverage, and vesting previously described.

Remember that a Cash Balance Plan uses 3 year cliff vesting.

Question 57

Conversions to a Cash Balance Plan

Answer 57

A cash balance “conversion” occurs when an employer changes from a traditional defined benefit pension plan into a cash balance plan.

Under the PPA 2006, a hybrid plan must meet three main requirements.

• The first requirement is that a participant’s accrued benefit, as determined as of any date under the terms of the plan, would be equal to or greater than that of any similarly situated, younger participant. For this purpose, an individual is similarly situated to a participant if the individual and the participant are (and always have been) identical in every respect (including period of service, compensation, position,
  date of hire, work history, and any other respect) except for age.
• The second requirement is that the interest rate used to determine the interest credit on the account balance in the hybrid plan must NOT be greater than a market rate of return, to be determined under regulations to be issued.
• The third requirement is that for plan years beginning after 2007, the hybrid plan must provide 100 percent vesting after three years of service.

The PA 2006 also addresses the “whipsaw effect” by providing that the distribution of a participant’s hypothetical cash balance account is sufficient to satisfy his or her benefit entitlement from distributions after the date of enactment.

Thus, employers are no longer penalized for using a higher interest credit.

Question 58

Exam Tip:

Answer 58

Cash Balance plans are a popular choice to get rid of old expensive DB plans.

Question 59

Exam Question Cash Balance Pension Plans

All of the following statements concerning cash balance pension plans are correct EXCEPT:

a) The cash balance plan is generally motivated by two factors: selecting a benefit design that employees can more easily understand, and as a cost-saving measure.

b) The cash balance plan is a defined benefit plan.

c) The cash balance plan has no guaranteed annual investment return to participants.

d) The cash balance plan is subject to minimum funding requirements.

Answer 59

Answer: C

A basic component of a cash balance plan is the guaranteed minimum investment return.

Question 60

Money Purchase Pension Plans

Answer 60

Why are they, defined as, more information?

Contribution Limit

Seperate Accounts

Younger/Older

Impact on the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA 2001)

Eligibility/Coverage/Vesting

Question 61

Why are they, defined as, more information?

Answer 61

A money purchase pension plan is a defined contribution pension plan that provides for a contribution to the plan each year of a fixed percentage of the employees’ compensation..

Specifically, the employer promises to make a specified contribution to the plan for each plan year, but the employer is not required to guarantee a specific retirement benefit.

Question 62

Contribution Limit

Answer 62

An employer cannot deduct contributions to the plan in excess of 25 percent of the employer’s total covered compensation paid.

Defined contribution plans are limited to contributing, on behalf of each participant, the lesser of 100 percent of the participant’s compensation or $66,000 for 2023 to the plan.

Question 63

Separate Accounts

Answer 63

Contribution to a money purchase plan are made to a separate account on behalf of each participant.

Question 64

Younger/Older

Answer 64

A money purchase pension plan, like all defined contribution plans, benefits younger participants more than older participants because of the increased number of contributions and compounding periods.

Question 65

Impact of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA 2001)

Answer 65

EGTRRA 2001 increased the contribution limit for profit sharing plans to 25 percent (from 15 percent) putting defined contribution pension and profit sharing plans on “equal contribution levels”

• Since profit sharing plans do not require mandatory funding (more flexible), this law virtually ends the creation of new money purchase pension plans.

Question 66

Eligibility/Coverage/Vesting

Answer 66

The money purchase pension plan is subject to all of the eligibility, coverage, and vesting rules
applicable to defined contribution pension plans described previously.

As defined contribution plans, they are subject to the shorter vesting requirements established under PA 2006 (2-to-6 year graduated or 3-year cliff vesting schedule).

Question 67

Exam Question noncontributory Plans

Generally, which of the following
are noncontriutory plans?

1. 401(k) and money purchase pension plans.
2. 401(k) and thrift plans.
3. Thrift plans and ESOPs.
4. Money purchase pension plans and profit sharing plans.

a) 4 only
b) 1 and 2.
c) 3 and 4
d 1, 2, 3, and 4

Answer 67

Answer: A

Employers generally contribute to money purchase pension plans, ESOPs, and profit sharing plans. Employees contribute (thus contributory plans) to 401(k)s and thrift plans.

Question 68

Target Benefit Pension Plan

Answer 68

A special type of money purchase pension plan, known as a target benefit pension plan, determines the contribution to the participant’s account based on the benefit that will be paid from the plan at the participant’s retirement.

The plan formula may be written to provide a contribution to each participant during the plan year that is actuarially equivalent to the present value of the benefit at the participant’s retirement. This will provide a greater contribution for older participants.

An actuary is required at the establishment of the target benefit pension plan, but unlike a defined benefit plan or a cash balance pension plan, an actuary is not required on an annual basis.

This plan does not fund the plan with the amount necessary to attain the target at retirement rather the employer promises a contribution to the participant’s individual account based on the original actuarial assumptions. Once the contribution has been made, the participant is responsible for choosing investments. Like any defined contribution plan, the participant, at retirement, is entitled to the plan balance regardless of its value, be it greater
than or less than the intended target benefit.

The target benefit pension plan is a form of money purchase pension plan; consequently, the target benefit pension plan is subject to all of the same contribution, eligibility, coverage, vesting, and distribution limitations as the money purchase pension plan.

Like the money purchase pension plans, EGTRRA2001 has generally eliminated their usefulness. Instead, employers are establishing age-weighted profit sharing plans so that the contributions to the plan each year are discretionary rather than mandatory but still favor older employees.

Question 69

Profit Sharing Plans!

Answer 69

A profit sharing plan is a plan established and maintained by an employer to provide the participation in profits by employees or their beneficiaries.

Question 70

What are the types of Profit Sharing Plans:

Answer 70

• Profit Sharing Plans
• Stock Bonus Plans
• Employee Stock Ownership Plans
• 401(k) Plans aka CODA
• Thrift Plans
• Age-Based Profit Sharing Plans
• New Comparability Plans

Question 71

Chart Outlining the Differences of Pension Plans and Profit Sharing Plans

Answer 71

Question 72

Funding

Answer 72

There is no mandatory funding of a profit sharing plan.

Contributions to profit sharing plans are generally discretionary but funding must be “substantial and recuring.”

There is no requirement that a company must contribute to the plan in a year in which it has profits nor is there a prohibition against contributions to the plan in years in which the company does not have profits.

Profit sharing plans generally have an employer plan contribution limit of 25 percent of covered
compensation.

Profit sharing plans can be established and funded as late as the federal income tax due date plus extensions.

• October 15th for sole proprietors or
• September 15th for all entities of the following year if all extension have been filed.

Question 73

Allocations/Formulas

Answer 73

A profit sharing plan must provide a definite predetermined formula for allocating plan
contributions to employee’s accounts.

Different Kinds are:

• Standard Method of Allocating
• Permitted Disparity (Social Security Integration)
• Age Based Profit Sharing Plans
• New Comparability Plans
• Other Allocation Methods
• Forfeitures

Question 74

Standard Method Profit Sharing Allocation

Answer 74

The standard method of allocating contributions to a profit sharing plan is to simply allocate the
contribution based on a percentage of each employee’s compensation.

Typically this type of formula benefits the highly compensated more than the nonhighly compensated in terms of absolute dollars but is nondiscriminatory with regard to percentages of the total contribution because the contributions are based on a straight percentage of total covered compensation.

Question 75

Example of Standard Method of Allocating

Answer 75

Question 76

Permitted Disparity (Social Security Integration)

Answer 76

Permitted disparity. as previously discussed in the Pension Plan section. is a technique or method of
allocating plan contributions to employees accounts so that a higher contribution will be made for those employees whose compensation is in excess or the social secunty wage base.

Profit sharing plans only allow the excess method to be used.

Basically two profit Sharing plan contribution rates are established. the base contubution
percentage rate and the excess contribution percentage rate.

• The base rate is applied on income earned up to the integration level (usually the Social
  Security wage base), while the excess rate is applied to income earned above the integration
  level BUT only up to the maximum covered compensation limit for the year, $330,000 for 2023
• The excess rate is limited to the LESSER of twice the base rate or a difference of 5.7 percent.
  As a result, the excess rate is generally 5.7 percent higher than the base rate.

EXAM TIP: Know the Basics Here

Question 77

Exam Tip

Answer 77

Know that the excess rate is generally 5.7% higher than the base rate.

Question 78

Chart of Various Base rates, Excess Rate and Permitted Disparity

Answer 78

Question 79

Exam Tip

Answer 79

Base Rate + Permitted Disparity = Excess Rate.
so “BP = Exxon” where

Permitted Disparity equals the lesser of the Base Rate or 5.7%

Question 80

Age-Based Profit Sharing Plans

Answer 80

Age-based profit sharing plans use both age and compensation as the basis for allocating contributions to an employee’s account.

An age-based plan is chosen when the employee census is such that the owner or key employee is older than most or all other employees and the company wants to tilt the contribution toward those older employees

Use of an actuary would allow for this “tilting” of contributions.

Question 81

New Comparability Plans

Answer 81

A new comparability plan is generally a profit sharing plan in which contributions are made to an employee’s account based on their respective classification in the company as defined by the plan sponsor (employer).

To meet the nondiscrimination rules, new comparability plans, like age-based profit sharing plans, must comply with the cross-testing rules.

• Cross-testing rules dictate testing of defined contribution plans on the expected benefits to be
  received by employees at retirement.

These plans are more expensive to administer.

Question 82

Other Allocation Methods

Answer 82

A highly compensated owner can fund his plan with the annual additions limit, $66,000 for 2023, using profit sharing plans with or without a cash or deferred arrangement.

In many cases, the use of a Cash Or Deferred Arrangement (CODA) may enable an owner to
reach the maximum contribution limit of $66,000 (2023) with a lower total employer
contribution.

Question 83

Forfeitures

Answer 83

Forfeitures for a profit sharing plan may either be used to reduce plan contributions or be reallocated to the remaining participants accounts. An such reallocation of the forfeiture amounts, however, must not be discriminatory in favor of highly compensated employees, owners, or officers.

Forfeitures can be allocated based on current year compensation - the same as normal contributions to the plan.

• Forfeitures cannot be reallocated to participants’ accounts that have already reached
  their annual additions limit for the year.

A forfeiture policy of reallocation can be combined with integration or an age-based approach to assist the owner in receiving the maximum contribution allowed.

Question 84

Eligibility

Answer 84

Profit sharing plans are subject to standard eligibility rules of other qualified plans.

Question 85

Vesting

Answer 85

The vesting rules for profit sharing plans are the same as for defined contribution plans.

The standard 3-year cliff or a 2-to-6 year graduated vesting apply unless the plan requires a two-year eligibility/waiting period, in which case all contributions must then be 100 percent vested.

Question 86

Exam Question Vesting Schedules

Which of the following vesting schedules may a top-heavy qualified profit sharing plan use?

a) 1-to-5-year graduated.
b) 5-year cliff.
c) 3-to-7-year graduated.
d) 4-to-8-year graduated.

Answer 86

Answer: A

As a result of the PPA 2006, qualified profit sharing plans must use a vesting schedule that provides participants with vested benefits at least as rapidly as either a 2-to-6 year graduated vesting schedule or a 3-year cliff vesting schedule.

This requirement applies without regard to
whether the profit sharing plan is a top-heavy plan. Options B, C, and D all vest less rapidly than
the required schedule.

Question 87

Distributions

Answer 87

Generally, profit sharing plans do not permit employees to receive distributions from the plan except upon termination, hardship, disability, or retirement.

Profit sharing plans, however, may permit in service withdrawals after the participant has fulfilled two years of service in the plan.

Question 88

Cash or Deferred Arrangements (CODA) [401(k) Plans]

Answer 88

A Cash Or Deferred Arrangement (CODA), generally referred to as a 401(k) plan, is a feature that attaches to certain types of qualified plans to create a contributory component.

• Specifically, a CODA is permitted with profit sharing plans and stock bonus plans.
• The CODA permits employees to defer a portion of their salary on a pretax basis to the qualified plan, thereby reducing their current income tax liability.
• These employee elective deferral contributions are tax - deferred - meaning the earnings are not subject to income taxation until such time as the employee takes a distribution from the plan.

Question 89

Establishing a 401(k) Plan

Answer 89

Which entities may establish a 401(k) plan?

• Only certain types of entities are permitted to establish and sponsor a 401(k) plan.
• A 401(k) plan is typically a profit sharing plan (although it may be arranged as a stock bonus plan) that permits employees to make contributions from their salary to the plan on a pretax or Roth basis.
• Because of its qualified status, 401(k) plans must comply with the rules previously discussed regarding eligibility, coverage, nondiscnmination, vesting, etc. HOWEVER, there are some restrictions that come with the addition of a 401(k) as provided below.

Question 90

The ENTITIES Which May Establish a 410(k) Plan?

Answer 90

• Corporations
• Partnerships
• LLCs
• Proprietorships
• Tax-exempt entities

Question 91

Eligibility

Answer 91

An employee cannot be required to complete more than one year of service as a condition of participation in a Section 401(k) arrangement.

The reason for this is that the employee elective deferral contributions are already 100 percent vested.

Question 92

Example of Eligibility for 401(k) Plan

Dash, age 35, has just taken a job at Stafford Company, which sponsors a 401(k) plan that
requires one year of service and has entrance dates on January 1st and July 1st. If Dash started work on February 15, 20x1, he will be entering the plan on?

Answer 92

July 1, 20x2

Question 93

Vesting

Answer 93

All employee deferral contributions and the earnings on those contributions are always 100% vested.

The employer-matching contributions, employer discretionary profit sharing contributions, and the earnings on employer contributions must vest under a schedule at least as generous as the 2 to-6-year graduated or 3-year cliff schedules.

Question 94

Participation

Answer 94

The most popular form of election under a CODA is a salary reduction agreement in which the employee agrees to reduce compensation in exchange for the elective deferral contribution into the plan.

Employee chooses Reduce compensation for elective deferral contribution.

Question 95

Example of Participation with Vesting

The total balance of Greg’s 401(k) profit sharing plan is $200,000. Of this balance, $60,000 is
attributable to employer profit sharing plan contributions and $40,000 is attributable to earnings on the employer profit sharing plan contributions. Greg’s elective deferral contributions to the 401 (k) plan consist of $39,000 and earnings on Greg’s elective deferral contributions consist of $21,000. The remainder of the balance consists of employer matching contributions and the earnings on the employer match. If the 401(k) plan uses a graded vested schedule and Greg has completed two years of service with his employer, what is his vested balance in this 401(k) profit sharing plan?

Answer 95

Question 96

Employee Contributions

Answer 96

Contributions to 401(k) plans can be made as:

• (1) employee elective deferral contributions (either as a traditional elective deferral or as a contribution to a Roth account),
• (2) employee after-tax contributions,
• (3) employer matching contributions,
• (4) employer profit sharing contributions,or
• (5) employer contributions used to solve an ADP/ACP problem (discussed below).

Question 97

(1) Employee Deferrals

Answer 97

Employee elective deferral contributions are limited in 2023 to the following amounts:

• Annual Elective Deferral Limit - $22,500 (including traditional or Roth)
• Catch-Up Contribution (Age 50 or older) - $7,500
• Total Elective Deterral - $30,000

Note that the same annual deferral limits apply to SARSEPs, 403(b) plans, and 457(b) plans.

Tax Impact:

• Besides the mere accumulation of benefits towards retirement, funds deferred in a 401(k) plan are not currently subject to federal income tax (although payroll taxes are still paid).
• Exception: Roth 401(k) and thrift plan contributions are subject to all taxes (discussed below).

Catch-up contributions

• Employees who are at least 50 years old during the plan year may increase their elective deferral limit by up to $7,500 for 2023. There must be sufficient earned income to make the catch-up contribution.
• Catch-up contributions are not limited by plan limits, limits on annual accumulations, or by the
  ADP/ACP testing (discussed below).

Question 98

(2) Employee After-Tax Contributions - Thrift Plans

Answer 98

Thrift plans allow employees to make after-tax contributions.

Generally these plans are utilized by individuals who want to save more than the elective deferral limit or more than the amount allowed under the ADP/ACP test (discussed below).

Question 99

(1) Roth Contributions (Roth Accounts)

(1) Deferrals like the 1st one.

Answer 99

A plan may permit an employee who makes elective contributions under a qualified cash or
deferred arrangement to designate some or all of those contributions as Roth contributions.

The same dollar limits that apply to employee pretax deferrals also apply to Roth contributions in total. Therefore, for 2023, an employee could contribute up to $22,500 to a Roth 401(k) account, but not to both.

Question 100

Chart Comparing Roth IRA and Roth 401(k) retirement accounts.

EXAM TIP: Expect a question on Roth 401(k) accounts.

Answer 100

Question 101

Employer Contributions

Answer 101

(3) Matching Contributions

Non-elective Contributions

(4) Profit Sharing (Stock Bonus) Contributions

Question 102

(3) Matching Contributions

Answer 102

Plan sponsors often provide a matching contribution available only to those who contribute to the 401(k).

Employer matching contributions must vest at least as rapidly as either a three-year cliff vesting schedule or a 2-to-6 year graduated vesting schedule.

Question 103

Non-elective Contributions

Answer 103

As an alternative, plan sponsors may elect to contribute to ALL eligible employees, whether they elect to defer or not, such contributions are called non-elective contributions.

Question 104

(4) Profit Sharing (Stock Bonus) Contributions

Answer 104

Because 401(k) plans consist of a CODA attached to a profit sharing plan or stock bonus plan, employers may also make a contribution to the profit sharing (or stock bonus) plan.

The employee elective deferral contributions do not count against the plan contribution limit of 25 percent so the employer does have the flexibility to make profit sharing plan contributions.

• The annual additions limit (415(c)), however, still limits contributions to $66,000 per person for 2023 ($73,500 if the participant is age 50 and over).

Question 105

Example of Employer Contributions for Profit Sharing, Elective Deferrals, and Catch-Up Contributions

Answer 105

Question 106

Nondiscrimination Testing

Answer 106

All qualified plans are required to meet certain nondiscrimination tests, but qualified plans with CODA provisions MUST meet two additional nondiscrimination tests.

These special tests are known as the:

• Actual Deferral Percentage (ADP) test
• Actual Contribution Percentage (ACP) test

Because of the burdensome nature of annually complying with these rules, the IRC provides a safe harbor provision that eliminates the need for annual testing.

In addition, the Pension Protection Act of 2006 has provided an optional nondiscrimination safe
harbor for automatic enrollment plans.

Thus, after December 31, 2007, employers will have three options with respect to 401(k)
nondiscrimination testing. They can:

• (1) perform the ADP and ACP tests and take corrective action if the plan fails the test,
• (2) institute a qualified automatic enrollment feature and comply with the
  new safe harbor, or
• (3) comply with the old safe harbor.

Question 107

Exam Question

A non-safe harbor 401(k) plan allows plan participants the opportunity to defer taxation on a portion of regular salary simply by electing to have such amounts contributed to the plan instead of receiving them in cash. Which of the following statements are rules that apply to 4010) salary deferrals?

1. Salary deferral into the 401(k) plan are limited to $22,500 for individuals younger than 50
   for 2023.
2. A nondiscrimination test called the actual deferral percentage test applies to salary deferral amounts.

a) 1 only.
b) 2 only.
c) Both 1 and 2.
d) Neither 1 nor 2.

Answer 107

Answer: C

Both statements are correct.

Question 108

Actual Deferral Percentage (ADP) Test

Answer 108

The Actual Deferral Percentage (ADP) test is designed to test the elective deferrals of the employees to ensure that the nonhighly compensated employees are not being financially discriminated against. The goal is to either limit the Highly Compensated employees (HC) from deferring significantly more than the Non-Highly Compensated employees (NHIC) or to raise the amount being received by the NHC.

IRC section 401(k)(3) states that the actual deferral percentage for eligible highly compensated employees for the plan year is limited by the actual deferral percentage for all other eligible employees for the preceding plan year and must meet either of the following tests:

• Test 1: The actual deferral percentage for the group of eligible highly compensated employees is not more than the actual deferral percentage of all other eligible employees multiplied by 1.25 (the 1.25 requirement).
• Test 2: The excess of the actual deferral percentage for the group of eligible highly compensated employees over that of all other eligible employees is not more than two percentage points, and the actual deferral percentage for the group of eligible highly compensated emplovees is not more than the actual deferral percentage of all other eligible employees multiplied by 2 (the 200%/2% test).

Question 109

Chart Summarizing Various Permissible Levels of ADP for NHC and HC

If the ADP for NHC Employees is:
- 0% to 2%
- 2% to 8%
- 8% and over

EXAM TIP: Make a flashcard of the following chart.

Answer 109

The Permissible ADP for HC Employees is:

• 2 times ADP for NHCs
• 2% plus ADP for NHCs
• 1.25 times ADP for NHCs

Question 110

Plans can choose either the Prior Year Method or Current Year Method for ADP testing.

Answer 110

The Prior Year Method calculates the maximum permissible deferral for highly compensated employees by using the nonhighly compensated employee’s ADP from the previous year.

While not as certain about the deferral limits, the Current Year Method will usually provide a greater deferral percentage to the HC. The Current Year Method also provides more flexibility to the plan sponsor in the event of ADP failures.

Question 111

How is the ADP Calculated?

Answer 111

1. Separate the eligible employees into HC and NHC groups.
2. Calculate the Actual elective Deferral Ratio (ADR) for each of the eligible employees by
   dividing the elective deferral contribution by the employee’s compensation.
3. Once the ADR is determined for each eligible employee, the amount of the ADP is calculated by
   averaging the ADRs for the employees within each group (HC or NHC).
4. Plug the ADP for the NHC into the chart above and calculate the maximum ADP allowed for the
   HC.
5. Compare the “desired/required” ADP to your actual ADP. If the HC are higher, employer failed
   the ADP Test.

EXAM TIP: You must be able to do at least 4 & 5.

Question 112

Failing the ADP or ACP test puts the plan at risk for disqualification

Answer 112

Failing the ADP or ACP test puts the plan at risk for disqualification. Corrective action must be
taken and the plan sponsor has several options to choose from or to use in conjunction with the
other. The four alternative remedies available to bring the plan into compliance are:

• (1) corrective distributions,
• (2) recharacterization,
• (3) qualified non-elective contributions (QNEC), or
• (4) qualified matching contributions (QMC).

Question 113

Example Part 1

Answer 113

Question 114

Example Part 2

Answer 114

Following Alternative A (without the top 20 percent election), the ADP of the HCs is 7.5 percent, while the ADP for the NHCs is 4. 5 percent. Referring to the table above, with the NHCs ADP equal to 4.5 percent, the ADP for the HCs should be no greater than 6.5 percent - two percentage points more than the ADP for the NHCs. Therefore, the plan fails the ADP test.

Following Alternative B (with the top 20 percent election), the ADP of the Hs is 6.25 percent, while the ADP for the NHC employees is 5.19 percent. Based on these figures, the plan complies with the ADP test because the HC could defer as much as 7.19% (5.19 + 2) but are only
deferring 6.25%. Notice that in this example, the difference between passing the ADP and not
passing is how the plan defined the definition of highly compensated. By electing the top 20
percent of paid employees, Employee C shifted from the HC category to the NHC category.
This example illustrates one reason an employer might choose the 20 percent election as the
definition of highly compensated.

Question 115

Exam Question ADP Testing

Hard Rock Construction sponsors a 401(k) profit sharing plan. In the current year, Hard Rock Construction contributed 25 percent of each employees compensation to the profit sharing plan. The ADP of the 401(k) plan for the NHC was 3.5 percent. If Jeff, age 57, earns $100,000 and is a six percent owner, what is the maximum amount that he may defer into the 401 (k) plan for this year?

a) $7,500
b) $13,000
c) $22,500
d) $30,000

Answer 115

Answer: B

Jeff is highly compensated because he is more than a five percent owner, so the maximum that
he can defer to satisfy the ADP test requirements is 5.5 percent (3 .5% + 2%) and because he is
over 50, he can defer the additional $7,500 (2023) as a catch-up contribution. Jeff can defer
$5.500 (5.5% x $100,000) and $7,500 (the catch-up) for a total of $13,000.

Question 116

(1) Corrective Distribution

Answer 116

When a plan fails the ADP test, the easiest (and usually cheapest) solution is to reduce the
elective deferrals of the HCs by distributing or returning funds to the HCs. This distribution is referred to as a corrective distribution. Corrective distributions must be completed within 2½ months after the end of the plan year; otherwise, a 10 percent excise tax is imposed on the
amount that should have been distributed.

In addition to the excess contributions being returned to the HC employees, any earnings on those contributions must also be returned or distributed to the HC employees.

Question 117

(2) Recharacterization

Answer 117

Another solution available to the plan sponsor is
to recharacterize the excess deferrals (pretax) as after-tax employee contributions.

Recharacterization must be completed within 2½ months after the end of the plan year, at which time these recharacterized contributions are taxable to the employee. If the excess
contributions are not recharacterized within 2.5 months of the plan year end, then the employer
is subiect to a 10 percent excise tax (penalty) on the amount of excess contributions (the amount that should have been recharacterized).

Recharacterization of the pretax contributions to after-tax contributions may cause a problem
for the plan’s ACP test (see below).

Question 118

(3) Qualified Non-elective Contributions (QNEC)

Answer 118

An employer may choose to make a qualified non-elective contribution (QNEC) to all eligible
NHC employees CODA accounts to** increase the ADP of the NHC employees** for purposes of passing the ADP test.

The QNEC is made by the employer to all eligible NHC employee covered by the plan. No
consideration is given to the employee’s election to participate by electively deferring.

QNEC’s are considered to be elective deferrals made by the employee for purposes of the discrimination testing. Because the contribution is treated as an employee elective deferral, it is also 100 percent vested when contributed.

Question 119

Example of QNEC

Answer 119

The ADP of the HC employees is six percent and the ADP of the NHC is 3.75%. To pass the ADP test, the NH employees must have an ADP at least equal to 4%. To increase the ADP of
the NHC, the plan sponsor may elect to make a QNEC to all eligible employees that will increase the ADP of the NHC to 4%, The amount of QNEC contributions made will be considered 100% vested in the NHC employees.

Question 120

(4) Qualified Matching Contributions

Answer 120

A Qualified Matching Contribution (QMC), like a QNEC, is a contribution made by the plan
sponsor that increases the ADP of the NHC employees.

Unlike the QNEC, however, the QMC is only made to those eligible NHC employees who participated in the plan during the plan year.

Essentially, the QMC is also treated as an additional deferral by the employees to increase the deferral percentage of the NHC’s and, as such, it is immediately vested

Question 121

Example of QMC

Answer 121

The ADP of the NHC employees was 6% for the plan year, and the ADP of the HC employees
was 8.20% for the year. To pass the ADP nondiscrimination test, the plan sponsor could make a QMC to all NHC employees who had elected to defer during the plan year to increase the ADP of the NHC to 6.20%. Those employees who had not deferred during the year would not receive any QMC. The QMC is 100% vested in the employee.

Question 122

Annual Contribution Percentage (ACP)

Answer 122

The ACP test calculates a contribution percentage for both the HC and the NHC for the express purpose of determining if the NHC are subject to financial discrimination. The ACP tests the sum of the employee’s after-tax contributions and employer-matching contributions.

The ACP is calculated exactly the same way as the ADP testl

After calculating the ACP for both NHC employees and HC employees, should the employer fail the
ACP test, the same corrective measures may be used to bring the plan back into compliance.

Question 123

Safe Harbor 401(k) Plans

Answer 123

Safe Harbor Provision + Elections Can be Made

Minimum Contribution Must be 100% Vested

100% Match for Safe Harbor 401(k)

Automatic Enrollment Safe Harbor 401(k) Plans
- Pension Protection Act of 2006
- To Satisy the Automatic Deferral Requirement

Question 124

Safe Harbor Provision + Elections Can be Made

Answer 124

The IRC provides a safe harbor provision whereby the employer is not required to comply with the ADP test, the ACP test, or the top-heavy testing.

For plan years beginning after December 31, 2019, an election can be made at least 30 days prior to the close of the plan year to convert a 401(k) plan to a non-elective 401(k) safe harbor status. If the elections is made to convert within 30 days of the plan year end, then:

• The non-elective contribution must be at least 4% for all eligible employees.
• The plan bust be amended no later than the last day for distributing excess contributions for the plan year.

Question 125

Minimum Contribution Must be 100% Vested Nonelective Contribution

Answer 125

To comply with safe harbor status, the plan must provide a minimum contribution that must be immediately 100 percent vested. The permissible contributions can either be a three percent minimum non-elective contribution or a matching contribution (discussed below). Under the non-elective contribution, all eligible employees would receive a 100 percent vested contribution equal to three percent of their compensation from the employer each year.

Question 126

If Employer Uses Safe Harbor Match

Answer 126

If the employer elects to use a match rather than the non-elective contribution, the standard safe harbor match formula requires the employer to match 100 percent of the first three percent of employee elective deferrals and 50 percent of employee elective deferrals greater than three percent and less than five percent.

Question 127

Exam Question

Golden Reef Spa has 325 employees (300 NHC and 25 HC). Of these employees. 300 are non excludable (275 NHC and 25 HC). If 208 of these NHC are covered under the Golden Reef Spa qualified profit sharing plan, and 25 of these HC are covered under the Golden Reef Spa qualified profit sharing plan, with certainty, which of the following coverage tests does Golden Reef Spa Pass?

a) Safe Harbor Test.
b) Ratio Percentage lest.
c) Average Benefits Test.
d) Both the Safe Harbor Test and the Ratio Percentage Test

Answer 127

Answer: D

Both the Safe Harbor Test and the Ratio Percentage Test are certainly passed. The plan covers 208 of the nonexcludable NHC employees which is 75.6%-greater than the 70% required to pass the Safe Harbor Test. The ratio of the NHC covered to the HC covered is 75.6% (75.6% ÷
100%, so the plan passes the Ratio Percentage Test also. The information does not provide the
average benetit percentages of the employees to determine whether the plan passes the Average
Benefits Test.

Question 128

100% Match for Safe Harbor 401(k)

Answer 128

Many safe harbor 401(k) plans provide a 100%
match up to 4% of compensation in lieu of the standard match formula. The standard match is 100% on the first 3% of deferral and 50% on the next 2% of deferral.

• An election must be made to become a Safe Harbor 401 (k), simply providing an employer match equal to the Safe Harbor rules does not make a plan a Sate Harbor 401(k)

Question 129

Automatic Enrollment Safe Harbor 401(k) Plans

Answer 129

Some 401(k) plans have an “automatic enrollment” or “negative election” feature.

Such plans provide that elective contributions by the employee are made at a specified rate unless the employee elects otherwise(i.e., elects not to make contributions or to make contributions at a
different rate). The employee, however, must have an effective opportunity to elect to receive
taxable wages in lieu of contributions

Question 130

Example of Automatic Enrollment Safe Harbor 401 Plans

Answer 130

After one year of service, Phil meets the eligibility requirements for the ABC company 401(k) plan. The plan provides for a negative election in which the employer will deposit five percent of participants’ compensation to the 401(k) plan. If Phil earns $40,000, the plan sponsor will contribute $2.000 of her compensation to the plan unless she aftirmatively elects to increase or decrease the contabuton

Question 131

Exam Question Automatic Enrollments

Which of the following clauses in a 401(k) plan can assist the plan in meeting the requirements of the ADP test?

a) Attestation clause.
b) Contest clause
c) Negative election clause
d) Deferral plan clause

Answer 131

Answer: C

A negative election clause can assist a 401(k) plan in meeting the ADP test because it automatically deems that an emplovee defers a specific amount unless he elects out of the automatic deferral amount. Answers A and D do not exist and answer B is a clause commonly found in a will.

Question 132

Pension Protection Act of 2006 - Automatic Enrollment Safe Harbor 401(k) Plans

Answer 132

Under the Pension Protection Act of 2006, plans that contain a “qualified automatic enrollment feature” are eligible for a new nondiscrimination safe harbor and are treated as meeting the ADP test and the ACP test, and are not subject to the top-heavy rules. This safe harbor option is also known as a Qualified Automatic Contribution Arrangement (QACA). A qualified automatic enrollment feature must meet certain requirements with respect to:
- automatic deferral;
- matching or nonelective contributions;
- notice to employees.

Question 133

To Satisfy the Automatic Deferral Requirement

Answer 133

To satisfy the automatic deferral requirement, a qualified automatic enrollment feature must provide that, unless an employee elects otherwise, the employee is treated as making an election to make elective deferrals equal to a stated percentage of compensation not in excess of 15 percent after the first year and at least equal to:

• three percent of compensation for the first year the deemed election applies to the participant,
• four percent during the second year;
• five percent during the third year; and
• six percent during the fourth year and thereafter.
• The stated percentage must be applied uniformly to all eligible employees.
• Matching Contribution Requirement - A plan must provide a non-elective contribution of 3%
  or a matching contribution, as described below:

1. a plan generally satisfies the matching contribution requirement if, under the arrangement
   - ii. the employer makes a matching contribution on behalf of each nonhighly compensated employee that is equal to 100 percent of the employee’s elective deferrals up to one percent of compensation and 50 percent of the employee’s elective deferrals between
   one and six percent of compensation; and
   - ii, the rate of match with respect to any elective deferrals for highly compensated employees is not greater than the rate of match for nonhighly compensated employees.
2. the non-elective or matching contributions must vest no later than a two-year cliff vesting

Question 134

Exam Question

Which of the following is true regarding negative elections?

1. A negative election is a provision whereby the employee is deemed to have elected a specific deferral unless the employee specifically elects out of such election in writing.
2. Negative elections are no longer approved by the IRS.
3. When an employer includes a negative election in its qualitied plan, the employer must also provide 100% immediate vesting

a) 1 only
b) 1 and 3.
c) 2 and 3
d) 1, 2, and 3.

Answer 134

Answer. A

Negative elections are approved by the IRS, and they are available for both current and new
employees. Negative elections do not require 100% immediate vesting. All employee contributions, however, are 100% vested.

Question 135

Plan Loans

Answer 135

Qualified plans are permitted, but not required, to provide loans from the plan to participants

However, plan loans must be made available to all participants and beneficiaries on an effectively equal basis, must be limited in amount, must be paid back within a certain time period, must bear a reasonable rate of interest, must be adequately secured, and the administrator must maintain proper accounting for the loans - see Lesson 1.

Question 136

Characterisitcs of Plan Loans

Answer 136

Oualified plans may permit loans up to the lesser of:

• One-half of the vested plan accrued benefit up to $50,000 (Reduce by the highest outstanding loan balance within the prior 12 months), OR (for balances of $20,000 or lower) the greater (I think Lower) of $10,000 or the vested accrued benefit.
• Loans are usually associated with 401(k) and 403(b) plans.
• Loans must generally be repaid within five years with an exception for loans associated with the purchase of personal residences, which must be reasonable and could be as long as 30 vears

Question 137

SECURE 2.0 Act of 2022 Loan Provision Enhancements

Answer 137

Loans from qualified plans to a taxpayer residing in $100,000 and up to the full value of their nontorteitable balance.

• Loan repayment for qualified individuals taking qualified disaster loans are allowed additional repayment time. Payments due during the period beginning on the first day of the incident period, and ending on the date 180 days after the last day of the incident period may be delayed up to one year.
• The provision is effective for disasters occurring (retroactively) on or after January 26, 2021

Question 138

Repayment of Loans

Answer 138

Loans from qualified plans are usually repaid through payroll deductions and must generally be repaid within five years from the date the loan commences.

• The five-year repayment rule does **not apply to loans that are used for the purchase of a principal residence; **the terms on these loans are generally more flexible.

Failure to repay the loan in accordance with the plan’s term will result in the loan being treated as a distribution as of the date of the original loan.

Loans are not only required to be repaid within a specific period of time, but are also required to be repaid in a specific manner over the repayment period. Substantially level amortization of the loan is required over the term of the loan.

Impact of Loans When an Employee is Terminated:

• Most plan documents require that loans be repaid upon termination of employment: however, this is not a requirement under the law. Plans may also provide a grace period for repayment.
• If loans are not paid back ratably, then they violate the exception for loans and must be treated as a deemed distribution (subject to income tax and possible 10% penalty). Loans not repaid at termination follow the same rules in that they will be treated as a deemed distribution.
• Plans may, however, provide that the outstanding loan balance reduce the amount of a direct rollover distribution. This is known as a plan offset amount, which can be subsequently rolled over to another qualified plan or IRA within the standard 60-day period. The 2017 TCJA has
  extended this rollover pend in certain circumstances from 60 days to the due date of the return (including extensions)

Question 139

Exam Question - Plan Loans

Retirement plan participants who wish to take advantage of a qualified plan’s loan provision
must agree to the following restrictions on the amount of the loan and how it is repaid:

a) A participant may borrow no more than $50,000, or one-half of the vested account balance, whichever is less.

b) A participant’s loan must be repaid within 5 years, unless the loan is used to acquire a
participant’s principal residence.

c) A participant is allowed to repay the loan any time within the 5-year period.

d) Both A and B.

Answer 139

Answer: D

Option C is incorrect. It describes “sham” repayments. Sham repayments are the reason that the rules were designed so that the $50,000 loan limit is reduced by the highest outstanding loan balance during the one-year period ending the day before the loan date. The rules also added a restriction that requires level amortization of loan repayments of principal and interest being made at least quarterly.

Question 140

Exam Question - Plan Loans

Shredders, a shop that specializes in confetti has a 401(k) plan that allows plan loans up to the legal limit allowed by law. Participants must repay the loans under the most generous repayment schedule available by law. Shredders plan has the following employee information:

Which of the following statements is correct?

a) If Jill repays her $19,000 loan by the end of 20x1, she may take a loan of $50,000 anytime in 20x2.

b) Diana can borrow $100,000 (50% of her vested account balance) from her account.

c) The maximum Laura can borrow from her account is $8,000.

d) John could borrow $17,500 from his plan for the purchase of a personal residence, but he would have to repay the loans within ten years.

Answer 140

Answer: C

The maximum loan is the lesser of 50% of a participant’s vested account balance, or $50,000,
reduced by the highest outstanding loan balance within the last 12 months. Thus, the maximum
loan Jill could take would be $50,000 less $19,000, or $31,000. Diana can only borrow
$50,000. Laura can borrow up to $10,000 from her 401(k) plan based on her accrued balance
being under $20,000. Since Lara’s outstanding loan balance is $2,000, she can borrow an additional $8,000. John will not have to repay the loan within 10 years because the loan proceeds
are being used for a home purchase

Question 141

Distributions

Answer 141

All CODA-type plans, including 401(k) plans, provide that in addition to the normal distribution options, plan participants may take distributions for hardships. Specifically, distributions may occur after:

• The retirement, death ^ or separation of service of the participant and attainment of age 55 ^
• The termination of the plan without the establishment of another plan;
• Certain acquisitions of the company or company assets
• The attainment of age 59½ by the participant ^; or
• Certain hardships.

Distributions on account of any of these items are taxable as ordinary income to the extent the participant does not have an adjusted basis in the 401(k) plan and may also be subject to a 10% penalty.

^Note: not subject to 10% penalty.

Question 142

Hardship Distributions

Answer 142

Distributions on account of hardship must be limited to the maximum distributable amount.

The maximum distributable amount is equal to the employee’s total elective deferral contributions as of the date of distribution, reduced by the amount of previous distributions of elective contributions. Effective January 1, 2020, the maximum distributable amount can also include (but is not required to), Qualified Non-elective Contributions (QNECs), Qualified Matching Contributions (QMCs) and safe harbor contributions and earnings on these amounts regardless of when contributed or earned.

Hardship distributions are taxed as ordinary income and may be subject to the 10% early
withdrawal penalty. Distributions are not subject to the 20 percent statutory withholding requirements since hardship distributions are not eligible for rollover treatments.

SECURE 2.0 Act of 2022 allows for hardship distributions from a 401(k) or 403(b) used to
purchase or build a home in a federally declared disaster area can be recontributed and treated as a rollover contribution if the initial distribution was received between 180 was before the first day of the incident period and 30 days atter the last day of the incident period.

Question 143

Stock Bonus Plans and Employee Stock Ownership Plans!

Answer 143

In some instances, an organization or company may wish to establish a profit shanng plan, but be unable to contribute large amounts of cash. In such an instance, both stock bonus plans and Employee Stock Ownership Plans (ESOPs) are available as alternative qualified plans to profit sharing plans.

A stock bonus plan is a plan established and maintained by an employer to provide benefits similar to those of a profit sharing plan except that contributions to and distributions from a stock bonus plan are generally in the
form of employer stock.

An Employee Stock Ownership Plan (ESOP) is a qualified plan that invests primarily in “qualifying employer securities” typically shares of stock in the corporation creating the plan.

Question 144

Stock Bonus Plans

Answer 144

Stock bonus plans are defined contribution protit sharing plans that allow employers to contribute stock to a qualified plan on behalf of their employees.

Generally, stock bonus plans must satisty the following requirements:

• Unlike profit sharing plans, stock bonus plan participants must have pass through voting rights on employer stock held by the plan.
• Participants must have the right to demand employer securities on plan distributions
• Participants must have the right to demand that the employer repurchase the emplover’s securities if they are not publicly traded (the put option).
• Distributions must begin within one year of normal retirement age, death, or disability, or within five years for other modes of employment termination.
• Distributions must be fully paid within five years of commencement of distributions

Question 145

Advantages of Disadvantages of Stock Bonus Plans

Answer 145

Similar to profit sharing plans, stock bonus plans are designed to provide benefits to both employers and to employees:

• Advantages to the Employees
• Advantages to the Employer
• Disadvantages to the Employees
• Disadvantages to the Employer

Question 146

Advantages to the Employees

Answer 146

Employer’s reduced cash outlay may encourage regular contributions.

Employee’s efforts mav be rewarded at retirement by increased stock value.

Employee’s are eligible for preferred Net Unrealized Appreciation (NUA) tax treatment on lump-sum distributions of emplover stock.

Question 147

Disadvantages to the Employees

Answer 147

There is the risk associated with the non-diversified investment portfolio of employer stock.

Question 148

Advantages to the Employer

Answer 148

The fair market value of contributions of employer stock are tax deductible to the employer which can result in decreased income tax costs for the corporation with virtually no cash outlay since the contribution is made with employer stock.

The employees now share a vested interest in the success of the companv. which irrevocably binds their financial well-being to the employers.

Question 149

Disadvantages to the Employer

Answer 149

One disadvantage to the employer is that the ownership and control of the corporation is
diminished or “diluted” as shares are granted to the employees.

With stock bonus plans, the required “repurchase option” (put option) could deplete the cash of the
corporation.

• A repurchase option allows a terminating employee the choice to receive the cash equivalent of the employer’s stock if the stock is not readily tradeable on an established market.

Question 150

Features of Stock Bonus Plans as Compared to Profit Sharing Plans

Answer 150

Stock bonus plans are a particular type of profit sharing plan and share profit sharing characteristics and requirements. Like profit sharing plans they are subject to all the eligibility, coverage and vesting requirements.

If a CODA provision is attached, then they must comply with the ADP/ACP testing also.

There are special issues unique to stock bonus plans, which include:

• Portfolio Diversification
• Voting Rights
• Distributions

Question 151

Portfolio Diversification

Answer 151

Unlike profit sharing plans, stock bonus plans are usually funded with 100% percent employer stock.

The Pension Protection Act of 2006 requires that stock bonus plans of publicly traded companies
allow plan participants to diversify their pretax deferrals, after-tax contributions, and employer
contributions that have been invested in emplover securities

Question 152

Voting Rights

Answer 152

Participants in a stock bonus plan must have pass-through voting rights on employer stock that is held by the plan on their behalf.

“Pass-through” voting rights means the participant can vote the shares of stock allocated to his stock bonus plan account.

Question 153

Distributions

Answer 153

Stock bonus plan distributions are generally made in the form of employer stock, but the plan may provide the employee with the choice of receiving the cash equivalent.

• If a cash equivalent is received, however, the deferral of income tax on the stock’s appreciated
  value until the stock is sold is lost (the NUA benefit).

Distributions of employer stock or securities from stock bonus plans are taxed depending on
whether the distribution is a lump-sum distribution or an installment distribution.

• If a lump-sum distribution is made, the employee is subject to ordinary income tax in the year of the distribution based on the securities’ fair market value at the time of the contribution.
• The Net Unrealized Appreciation (NUA) of the stock (i.e., the appreciation of the stock while
  being held in the plan) is not taxed at the time of the distribution but rather follows the stock as
  deferred long-term capital gain until the stock is ultimately sold. (See Lesson 3 for more details on NUA treatment.)

On the other hand, if the distribution of the employer stock or securities is made in installments, the employee may only defer recognition of the appreciation on the stock purchased with after-tax emplovee contributions; everything else will be subject to ordinary income tax rates.

Question 154

Chart of Stock Bonus Plans and Profit Sharing Plan Comparisons

Answer 154

a. Secure ACT 2019 changed the plan establishment date to match those of the SEP plans pre-SECURE Act.

Question 155

Exam Question Stock Bonus Plan Distributions

Question 156

Exam Question Stock Bonus Plan Distributions

Drew, age 61, is a participant in a stock bonus plan. The value of the employer stock contributons to the plan over the course of his participation totaled $165,000. On December 1, 20x1, Drew takes a full distribution of the employer stock from the plan at a value of $550,000. Fourteen months later, Drew sells all of the stock for $400,000. Which of the following statements is true?

a) Drew has a long-term capital gain of $385,000 for 20x1.

b) Drew has ordinary income of $165,000 in 20x1.

c) Drew has a long-term capital loss of $235,000 in 20x2

d) Drew has ordinary income of $165,000 and long-term capital gain of $385,000 in 20x1

Answer 156

Answer: B

Because Drew is taking a lump-sum distribution from a qualified plan of employer stock, he will not have to recognize the net unrealized appreciation until he disposes of the employer stock. At the time of the distribution, however, the value of the stock, as of the date of contribution to the plan, will be taxable as ordinary income. Any gain on the subsequent sale of the stock will be taxable as long-term capital gain, In this case, Drew will recognize $165,000 of ordinary income
at the date of the distribution (20x1) and long-term capital gain of $235,000 ($400,000 -
$165,000) at the date of sale (20x3).

Question 157

Exam Question Stock Bonus Plan Distributions

On January 15, of last year, Sean retired from Peyton, Inc. with 1,000 shares of Peyton, stock in his stock bonus plan. Peyton, Inc. took deductions equal to $20 per share for the contributions made on Sean’s behalf. At retirement, Sean took a lump-sum distribution of the employer stock. The FMV of the stock at distribution was $35 per share. On July 15 of this year, Sean sold the stock for $40 per share. Which of the following will Sean report on his tax return when he sells the Peyton, Inc. stock?

a) $0 of ordinary income and short-term capital gain, $20,000 of long-term capital gain.
b) $20,000 of ordinary income, $20,000 of short-term capital gain.
c) $35,000 of ordinary income, $5,000 long-term capital gain.
d) $40,000 of ordinary income.

Answer 157

Answer: A

Sean will not be subject to ordinary income at the date the stock is sold. At the date the stock
was distributed to Sean, $20,000 ($20 x1,000) would have been subject to ordinary income tax.
At the date of sale, Sean would have had $0 of short-term capital gain (the gain after the date of
distribution) and $20,000 of long-term capital gain (NUA of $15,000 plus LTCG of $5,000
based on the time from distribution to sale of the stock)

Question 158

Employee Stock Ownership Plans

Answer 158

Employee Stock Ownership Plans, referred to as ESOPs, are a special form of stock bonus plans that reward employees with both ownership in the corporation and provide owners with substantial tax advantages.

An ESOP is controlled through a trust. The sponsor company receives tax deductions for contributions of stock from the corporation. The ESOP then allocates the stock to separate accounts for the benefit of individual employee-participants.

A key characteristic of the ESOP is that the trust may borrow money from a bank or other lender to purchase the employer stock. The corporation generally repays the loan through tax-deductible contributions to the ESOP. Both the interest and the principal repayments for the loan are income tax deductible. The ESOP can thus be “leveraged” (aka LESOP).

Just like any other qualified plan, the ESOP must satisfy applicable rules of employee vesting, participation, eligibility, and coverage.

Question 159

Chart of Leveraged ESOP Transactions

Answer 159

The following chart visually depicts the various parts of the LEVERAGED ESOP Transaction,

Question 160

Practical Uses of ESOPs and Nonrecognition of Gain Treatment

Answer 160

The establishment of ESOPs allow owners of closely held businesses to sell all or part of their
interest in the corporation and defer recognition of the capital gain. In order to qualify for
nonrecognition of gain treatment, the following requirements apply

Question 161

In order to qualify for nonrecognition of gain treatment, the following requirements apply:

Answer 161

The ESOP must own at least 30 percent of the corporation’s stock immediately after the sale.

The seller or sellers must reinvest the proceeds from the sale into qualified replacement securities within 12 months after the sale and hold such securities three years.

• Qualified replacement securities are securities in a domestic corporation, including stocks,
  bonds, debentures, or warrants, which receive no more than 25 percent of their income
  from passive investments. The qualified replacement securities can be in the form of stock in an S Corporation.

The corporation that establishes the ESOP must have no class of stock outstanding that is
tradable on an established securities market.

The seller or sellers, relatives of the seller or sellers, and 25 percent shareholders in the
corporation are precluded from receiving allocations of stock acquired by the ESOP through the rollover.

The ESOP may not sell the stock acquired through the rollover transaction for three years.

The stock sold to the ESOP must be common or convertible preferred stock and must have been owned by the seller for at least three years prior to the sale.

NOT A REQUIREMENT: If the seller purchases and retains qualified replacement securities, there will be no taxable event.

Question 162

Exam Question - Qualified Replacement Securities

Gordon owns Advertising Solutions, Inc. (ASI) and sells 100% of the company stock on July 1 of the current year to an ESOP for $3,000,000. Gordon had an adjusted basis in the ASI stock of $450,000. If Gordon reinvests in qualified replacement securities before the end of the current year, which of the following statements is true?

a) Gordon will not recognize long-term capital gain or ordinary income in the current
year,

b) Gordon must recognize $2,550,000 of long-term capital gain in the current year.

c) Gordon must recognize $450,000 of ordinary income in the current year.

d) If Gordon dies before selling the qualified replacement securities, his heirs will have an
adjusted taxable basis in the qualified replacement securities of $450,000, Gordon’s
carryover adjusted basis

Answer 162

Answer: A.

A major advantage for an ESOP is the ability of the owner to diversify his interest in a closely
held corporation. In this case, if Gordon reinvests in qualified replacement securities within 12
months of the sale to the ESOP, he will not recognize capital gain or ordinary income on the sale to the ESOP. If Gordon dies the heirs will receive the securities with an adjusted taxable basis equal to the FMV at Gordon’s date of death or the alternate valuation date.

Question 163

Advantages and Disadvantages of ESOPs

Answer 163

Advantages to the Employer
Advantages to the Employees
Disadvantages to the Empolyees
Disadvantages to the Employer

Question 164

Advantages to the Employees

Answer 164

From the employees’ perspective, the ESOP provides them with a type of retirement vehicle as well as ownership in their employer.

Provides a vehicle to acquire a business when employees may have little or no cash available to do so - job preservation.

The employee-participant may also benefit from Net Unrealized Appreciation (NUA) at the time of stock distributions because of favorable capital gains rates and deferred recognition.

Question 165

Disadvantages to the Employees

Answer 165

There is an inherent lack of diversification of the individual “investment’ portfolio because ESOPs must invest primarily in the stock of the corporation.

There is some limited relief on this, once employee reaches age 55 and 10 years of service, the emplover must offer some diversification options.

Question 166

Advantages to the Employer

Answer 166

The shareholder is often the owner who is looking to retire. The ability to sell shares to the
plan, which is a ready and available buyer with deferred income tax consequence is a HUGE
benefit.

Without the ESOP, there may not be a market for the privately held corporate stock.

The corporation or trust is allowed to borrow money in order to provide contributions
resulting in funds being provided immediately to the ESOP, while the employer repays the loan to the ESOP with tax-deductible contributions.

Question 167

Disadvantages to the Employer

Answer 167

From the shareholder’s perspective, ESOPs “dilute” ownership in the corporation by reducing the concentration of shares from the sellers to broaden the employees’ holdings.

Moreover, the repurchase option for stock (put option) that is not readily tradable can create cash flow problems and administrative concerns.

Plan administration can also be costly, and the annual appraisals create significant and recurring expenses for closely held corporations. These appraisals are necessary to determine the value of the tax deduction for the employer and to determine the price that an employer or trust would pay for the repurchase of ESOP distributed shares.

Question 168

Chart Summarizing the Advantages and Disadvantages of ESOPs.

Answer 168

Question 169

Voting

Answer 169

Generally, ESOP participants have the same voting rights with their allocated shares as other
shareholders, including the right to vote the shares, and the right to earn dividends.

Question 170

Contributions to ESOPs

Answer 170

Employer contributions to ESOPs are deductible by the employer just like any contribution to a
qualified profit sharing plan or stock bonus plan, and are subject to the 25 percent limit of covered compensation.

If the employer’s stock is obtained by virtue of a loan (leveraged ESOP), however, then the employer is allowed to deduct all interest paid on the loan over and above the 25 percent deduction of total eligible payroll of the plan participants. The interest deduction is unlimited.

Question 171

Distributions

Answer 171

An ESOP is subject to minimum distribution requirements.

HOWEVER, plan participants can elect to receive substantial equal periodic payments of their account balance not less than once per year after the participant separates from service.

• The substantially equal periodic payments must be for a period no longer than five years, unless the participants account balance is valued at more than $1,330,000 for 2023, in which case the
  distribution period may be extended one year for each additional $265,000 for 2023 of account
  value up to a total of ten years.

An distribution from an ESOP that is not a lump-sum distribution of the emplover securities will not be eligible to receive NUA treatment and will be taxed as ordinary income. These distributions may also be subjected to the 10 percent early withdrawal penalty.

Question 172

Valuation of Employer Stock in ESOPs

Answer 172

Valuations are necessary for various reasons, which include:

• When contributions are made to an employee’s account, the employer must know the value of the contribution for the corporation’s tax deduction purposes.
• When contributions are made to an employee’s account, the employee must know the value of the contribution for future NUA calculation.
• If a lender lends money to leverage the ESOP, the lender must know the value of the stock to
  determine if and how much money to lend to the corporation.
• If an employee exercises the put or repurchase option, the value of the stock must be determined.
• Valuations are needed for financial statements and reports.

Question 173

Diversification Issues

Answer 173

ESOPs are permitted to hold 100 percent of the corporate stock in the trust.

Under the IRC, qualified participants may force diversification of their holdings if they are at least 55 years old and have completed at least 10 years of participation in the ESOP.

• The qualified participant must be offered a diversification election within 90 days after the close of each plan year beginning with the year after the employee becomes qualified.
• The participant may elect to diversify up to 25 percent of the account balance into one of the plan’s alternate investment options.
• In the final year of the 6-year election period, the cumulative diversifiable percentage is, increased to 50%.

Question 174

Put Options

Answer 174

Once a plan meets the distribution requirements and a participant is entitled to a distribution from the plan, the participant has the right to demand that the benefits be distributed in the form of employer securities.

• If the employer securities are not readily tradable on an established market, the participant has the right to require that the employer repurchase the employer securities under a fair market valuation formula. This is referred to as a “put option” or “repurchase option.”

The rank-and-file employees are protected with the put option because the employee may force the corporation to “buy back” the stock at the fair market value.

Question 175

Similarities and Differences between Stock Bonus Plans and ESOPs

Answer 175