Qualifies Employer Plans

Question 1

Name 2 types of Retirement Plans

Answer 1

Retirement plans can be broadly categorized as either qualified or nonqualified.

Qualified plans are those retirement plans that qualify for special federal income tax treatment.

Nonqualified plans do not receive such favorable tax treatment. (A deferred compensation agreement for a key employee is an example of a nonqualified plan.)

Qualified retirement plans are available for the following:

• employers for the benefit of their employees
• individuals
• self-employed people

People can use to fund college tuition on a tax-favored basis.

Question 2

Qualified vs. Nonqualified Employer Retirement Plans

What does ERISA do?

What are 3 characteristics about nonqualified retirement plans?

Answer 2

To be deemed a qualified retirement plan (and thus eligible for favorable income tax treatment), a plan must adhere to the requirements of the Employee Retirement Income Security Act of 1974 (ERISA).

ERISA protects the rights of employees covered under an employer-sponsored plan by stipulating minimum participation and funding requirements.

A retirement plan that does not meet ERISA’s requirements does not qualify for favorable tax treatment.

Under a nonqualified employer retirement plan, an employer cannot deduct as a business expense its contributions to the plan.

1. Funds that the employer contributes to a nonqualified plan may be taxed as income to the employees in the year the funds are contributed.
2. Though lacking the tax benefits of a qualified plan, nonqualified plans (e.g., deferred compensation plans) remain popular with key executives.
3. Employers are not restricted by ERISA’s nondiscrimination rules when nonqualified plans are involved; they can pick and choose the employees to whom they offer these plans.

Question 3

5 characteristcs of Tax Incentives that Encourage Qualified Plans

Answer 3

By offering tax incentives, the federal government encourages employers to set up qualified retirement plans for the benefit of their employees.

Tax incentives are also provided to employees to participate in such plans. These tax incentives include the following:

1. A business can deduct the contributions it makes to a qualified plan as a business expense.
2. The earnings within a qualified plan are exempt from income tax until distributed.
3. Employer contributions to the plan on behalf of the employee-participants are not taxable to the employees when they are made.
4. Employee contributions made with pre-tax dollars. which lower the employee’s taxable income.
5. Benefits are taxed when withdrawn or otherwise distributed from the plan to the employee.

Question 4

What are the 7 basic ERISA requirements for an employer plan to be QUALIFIED?

Answer 4

For an employer plan to be deemed qualified and to receive favorable tax treatment, it must meet very specific standards that ensure that the plan is set up, maintained, and operated for the benefit of the employee-participant.

Basic ERISA-mandated plan qualification requirements include:

1. The plan must be in writing and communicated to employees.
2. The employer must set up the plan for the sole benefit employees
3. The employer, the employees, or both must make contributions consistently to the plan.
4. The plan cannot discriminate in coverage (that is, the employer cannot set up the plan mainly for the benefit of key employees or the business owners).
5. The plan must comply with set limits on contributions and benefits.
6. The plan must meet minimum funding levels.
7. The plan must provide for comprehensive vesting schedules; must provide a way for employee-participants to achieve full rights to the contributions the employer makes on their behalf.

Question 5

Name 2 types of Vesting Schedules

Answer 5

Generally speaking, there are two common vesting schedules that conform to IRS requirements:

• cliff vesting
• graded vesting

Question 6

3 characteristics of Cliff Vesting

Answer 6

Under a cliff vesting schedule, the participant is

1. 0% vested in a plan’s contributions or benefits for the first four years of participation.
2. Then, in the 5th year 100% vested.
3. If the plan includes employer-matching contributions (as 401k), cliff vesting is reduced to a 3-year schedule.

Question 7

Describe Graded Vesting

Answer 7

Under a graded vesting schedule, the participant gradually becomes vested over the first 7 years of participation, as shown in the table.

Question 8

Under a plan that provides for matching employer contributions, a graded vesting schedule…

Answer 8

is reduced to six years.

• at the end of the second year, the employee is 20% vested
• then vests in 20% per year
• becoming 100 percent vested in six years.

A plan that provides for employee contributions, such as a 401(k) plan, cannot impose a vesting schedule on employee contributions. At all times, an employee is fully vested in amounts he or she contributed or deferred into the plan.

Question 9

3 characteristics of Qualified Plan Distributions

Answer 9

An important point is that funds that are not taxed when contributed are taxed when distributed.

1. Benefit pension plans typically pay their benefit in the form of monthly annuitized income payments.
2. These payments begin when at age 65 or the Social Security full retirement age.
3. At that point, the income payable to the plan participant is generally fully taxed.

Question 10

Distributions Before Age 59½

List 2/3 primarly characteristics.

4 exceptions to the tax penalty?

If the plan is a SEP or SIMPLE plan, pre-59½ distributions can be taken without penalty for the previous reasons as well as… (list 3)

Answer 10

Qualified employer plans to which an employee contributes provide for immediate vesting of employee contributions.

• An employee controls the amounts in which he or she has vested.
• The employee can access vested amounts at any time.
• When taken, qualified plan funds are taxed. And if taken before the employee’s age 59½, they may also be subject to a 10 percent tax penalty.

The tax laws do provide exceptions to the 10 percent premature distribution penalty. If a distribution is taken from a qualified plan before age 59½ for any of the following reasons, it is taxed but not penalized:

1. The participant dies.
2. The participant becomes disabled.
3. The participant has medical expenses that exceed 10 percent of his or her adjusted gross income.
4. The participant takes the distribution in substantially equal periodic payments over his or her life.

If the plan is a SEP or SIMPLE plan, pre-59½ distributions can be taken without penalty for the previous reasons as well as

1. for a first-time home purchase;
2. to pay for qualifying higher education expenses; and
3. to pay health insurance premiums while unemployed.

Question 11

Required Minimum Distributions

Distributions from a qualified employer plan must begin no later than ________of the year following the year the participant turns ______ or upon retirement, whichever is later.

Failure to take an RMD results in one of the stiffest penalties the IRS imposes. This penalty is ___ percent of the difference between the amount that was taken and the amount that should have been taken.

Answer 11

The tax laws that apply to qualified employer plans are such that a plan cannot be used to endlessly shelter funds from tax.

Distributions from a qualified employer plan must begin no later than April 1 of the year following the year the participant turns 70½ or upon retirement, whichever is later.

These distributions must also be taken yearly in no less than minimum amounts prescribed by the tax laws. Fittingly, these distributions are known as required minimum distributions, or RMDs.

Failure to take an RMD results in one of the stiffest penalties the IRS imposes. This penalty is 50 percent of the difference between the amount that was taken and the amount that should have been taken.