Retirement Flashcards
1
Q
Alternatives to compensate for projected cash flow shortfalls
A
- Save more each pre-retirement year
- Increase investment risk to achieve higher returns
- Retire later than expected
- Work part-time in the early retirement years
2
Q
Serial Payments
A
Increasing payments (either savings or distributions) meant to keep pace with inflation or aid a client who can’t save the full amount needed to reach their goals to potentially do so in the future (gives them something to shoot for).
3
Q
Self-determination/Self Efficacy
A
Rather than selling products, empowering clients to be involved in their own planning and decision making process is the most effective way to apply behavioral finance.
4
Q
OASDI (AKA Social Security)
A
Old Age, Survivor and Disability Insurance
5
Q
Fully Insured Worker (for SS)
A
40 quarters of coverage. Effectively 10 full years of working and paying into the SS system. Can also be called Social Security Credit which is a dollar amount of FICA-taxed earned income. Once fully insured, you are fully insured for life and eligible for survivor and retirement benefits.
6
Q
Currently Insured Worker (for SS)
A
6 quarters of coverage. Only eligible for lump sum death benefit of $255 for spouse or dependent, a survivor spouse’s benefit (if children are under 16) or a dependent benefit.
7
Q
Employment Categories not covered by SS
A
Federal employees who have been continuously employed since before 1984 unless they elected to switch
Some Americans working abroad
Student Nurses and students working for a college or college club
Railroad employees
A child under 18 employed by a parent in an unincorporated business
Ministers, members of religious orders, Christian Science practitioners who claim exemption
Members of tribal councils
Some state employees and teachers
8
Q
Eligibility for SS Benefits
A
A fully insured worker age 62 or older is entitled to retirement benefits
A worker under 65 who has been disabled for 12 months, is expected to be disabled for at least 12 months, or has a disability which is expected to result in death and has satisfied a 5 month waiting period is eligible for disability benefits under SS
9
Q
Spousal Benefits for SS
A
The spouse of a retired or disabled worker qualifies for SS payments if:
They are over 62 or
Any age if they care for a child under 16 or
Any age if they care for a child over 16 who was disabled before age 22
A spouse (including ex-spouse, if marriage was 10 years and did not remarry) of a deceased worker qualifies for SS payments if the widow(er) is 60 or older or
Any age if they care for a child under 16 or became disabled before age 22
NOTE: A divorced spouse who is at least 62 and has been divorced for at least 2 years can receive retirement benefits based on the worker’s earnings even if the worker claims no retirement benefits.
10
Q
Dependent Benefits for SS
A
The surviving dependent, unmarried child of a deceased, disabled, or retired insured worker qualifies for SS payments if the dependent is:
Under 19 and a full-time elementary or secondary school student
Age 18 or over but has a disability that began before age 22
11
Q
Taking SS Before FRA
A
For the 36 months prior to FRA, the benefit amount is reduced by 5/9 of 1% (1/180).
Calculate using PIA - [(Number of months before FRA/180) X PIA]
12
Q
Working After Retirement (reduction in benefits before FRA)
A
Workers who have attained their FRA may keep all benefits regardless of how much they earn.
If a worker is younger than their FRA, there is a limit as to how much they can earn. For workers younger than FRA, $1 is deducted for every $2 earned above $19,560
Workers who reach FRA in the current year will have $1 deducted for every $3 earned over $51,960 until the month full retirement is reached. (note, earnings are calculated in the partial year before the month FRA is reached)
13
Q
Taxation of SS Benefits
A
0% is taxable if income plus half of SS is less than $25,000 single/$32,000 joint
50% is taxable if income plus half of SS is greater than $25,000 single/$32,000 joint
85% is taxable if income plus half of SS is greater than $34,000 single or $44,000 joint
Note: Municipal Bond interest counts for purposes of income to calculate taxable SS
Review Page 2-7 in retirement
14
Q
File and Suspend (repealed)
A
Prior to April 2016, a fully insured worker was able to apply for benefits then suspend them choosing spousal benefits instead. They would then claim their own benefits at FRA or Age 70
15
Q
Withdrawing SS Application
A
One time right to withdraw an application for benefits within 12 months of the initial claim. Any benefits received must be repaid (no interest)
16
Q
Qualified vs. Nonqualified Retirement Plans
A
Qualified Plans are subject to IRC Section 401(a). A nonqualified deferred compensation plan is any employer, retirement, savings or deferred compensation plan for employees that does not meet ERISA requirements.
17
Q
Qualified Plan Features
A
May not discriminate
ERISA
Immediate tax deduction for employer for contributions (though may not be vested for employee)
Earning accrue tax deferred until distribution
Distributions are taxable at ordinary income tax rates with the exception of 10-year averaging and NUA under Stock Bonus, ESOPs and 401(k)s
18
Q
Nonqualified Plan Features
A
May discriminate
Exempt from most of ERISA requirements
No employer tax deductions for contributions until employee is taxed
Plan earnings are taxable to the employer
Distributions taxable at ordinary income tax rates
19
Q
Qualified Defined Contribution (DC) Plans
A
Money Purchase Pension
Target Benefit Pension
Profit-Sharing
Profit-Sharing w/ 401(k) provision
Stock Bonus/ESOP
20
Q
Retirement Plans (not qualified)
A
SEP
SIMPLE
SARSEP
Thrift or Savings Plan
403(b)
21
Q
Factors affecting employees benefits under DC plans
A
- Years to retirement
- Investment Returns (employee bears risk)
- Salary Levels (contributions based on salary level not retirement needs)
- Employer contributions (minimum funding standards as low as 3%)
- Forfeitures - used to fund other participants or reduce employer contributions
22
Q
Money Purchase Pension Plan
A
Benefit Formula requires a flat percentage of each employee’s compensation (subject to salary cap of $305,000 and section 415 limit of $61,000)
Employer can contribute up to 100% of each employee’s compensation, but can only deduct up to 25% of total plan compensation (eligible payroll)
Benefit determined by account balance
Employee assumes investment risk
No annual actuarial determination is required
Forfeitures can be reallocated or reduce employer contributions
Contributions are mandatory (not necessarily fixed)
23
Q
Section 415 limit (maximum contributions to DC plans)
A
The lesser of 100% salary (salary capped at $305,000 for calculation) or $61,000
NOTE: This includes employer contributions, salary reductions, and plan forfeitures)
If exceeded - employer has the following options:
Reallocated to employees who did not exceed the limit
Applied in a later year for the same employee
Used to reduce future plan contributions
NOTE: there is a separate 415 limit for DB plans (maximum benefits from a DB plan)
24
Q
Selection/Requirements of a Money Purchase Pension Plan
A
Retain key employees
Simple to administer and explain
Employees are relatively young and well-paid
Must have stable cash flow and profit. Contributions are mandatory (not necessarily fixed)
25
Target Benefit Pension Plan
Maximum contribution is 100% of compensation or the section 415 limit (fixed %)
Benefit is determined by account balance (annuitized at retirement)
Employee assumes investment risk
No annual actuarial determination required (Actuary does determine initial contribution level, which cannot exceed 415 limit)
Forfeitures can be reallocated or reduce employer contributions
Contributions are fixed and mandatory
26
Selection/Requirements of a Target Benefit Pension Plan
Benefits older employees
Fixed mandatory contributions
Contributions will not change except to reflect new participants and increases in compensation of participants
Seeks but does not guarantee a specific target benefit amount
Lower cost and simpler than a DB plan that can provide for older employees
27
Profit Sharing Plan
Qualified defined contribution plan that features flexible employer contribution provisions up to 25% of compensation
2001 tax act eliminated the need for a tandem plan to get to 25%
Purely discretionary contributions that could be nothing at all
Contributions must be substantial and recurring, but no clear rules define this
If contributions are too infrequent or too little dollars are contributed, the IRS could come in and retroactively disqualify the plan and terminate it.
Each participant has an account, the balance of which consists of employer contributions, returns and forfeitures.
Forfeitures are unvested terminated employee account balances
Forfeitures in a Profit Sharing Plan are generally reallocated to remaining participants
28
Selecting a Profit Sharing Plan
Profit margin or financial stability varies from year to year
Incentivize employees to make the firm profitable
Employees are young, well-paid and have substantial time to accumulate assets for retirement
29
401(k) plan (Cash or Deferral Arrangement - CODA)
Provision of a profit share or stock bonus plan
Option to put money in the plan (defer)
Deferrals are subject to FICA and FUTA but not federal tax withholding
Limit is $20,500 for employee deferrals
$6,500 catch up for participants 50 or older
Can be part of a section 125 (cafeteria) plan
30
Selecting a 401(k) plan
Wants to provide a qualified retirement plan but can only afford minimal extra expense beyond existing salary and benefit costs
Employee wants to increase savings on a tax-deductible basis
31
Solo 401(k)/Uni-401(k)
401(k) type plan for owner, owner and spouse or owner and partner (2 people max)
No coverage testing applies
Contributions consist of deferrals and employer contributions
$20,500 max deferral (employee)
Up to $61,000 combined (employee deferral and employer contributions)
$6,500 catch up (age 50) is permissible as well (total $67,500)
32
Safe Harbor 401(k)
Automatically satisfies nondiscrimination tests involving HCEs with either matching contribution or non-elective contribution
Statutory safe harbor contribution is $1/$1 on first 3% AND $0.50/$1 on next 2%
Non-elective deferral method is a 3% employer contribution regardless of whether the employee is deferring or not.
Employer contributions must be immediately vested
Exempt from top heavy (key employee) rules if only deposits are ee deferrals and er contributions (otherwise top heavy employer contributions may be required
33
Stock Bonus and Employee Stock Ownership (ESOP) plans
A stock bonus plan may invest plan assets in employer stock, however an ESOP MUST invest primarily in employer stock
Participants' accounts are stated in shares of employer stock
Benefits are generally distributable in employer stock certificates
Employers may deduct dividends with respect to stock held in an ESOP
To be deductible, dividends must satisfy at least one of the following:
Paid in cash directly to participants or beneficiaries
Paid to the plan and subsequently distributed in cash to participants or beneficiaries no later than 90 days after close of plan year
Used to make payments (principal and interest) on loans used to acquire employer securities
Paid to the plan and reinvested in qualifying employer securities
34
Selecting a Stock Bonus or ESOP
Company wants to broaden ownership or create a market for its stock
Provide liquidity for shareholder's estates or to provide for business continuity
Provide employees with a tax-advantaged means to acquire company stock
Wants workers to feel a sense of ownership
Availability of NUA
35
Leveraged Employee Stock Ownership Plan (LESOP)
An ESOP is a stock bonus plan that allows an employer to borrow money from a bank or other financial institution. When the ESOP is used to borrow money, it becomes a LESOP.
36
ESOP diversification rules
Participants 55 years or older who have 10 years in an ESOP generally have a right to diversify up to 50% of their account balance. The ESOP must offer at least 3 alternative investment options OR distribute cash or certificates to participants
37
New Comparability Plan
Contribution percentage formula for one category of participants is greater than the contribution percentage for other categories. These plans, like age-based plans, are cross-tested.
38
Cross-tested Plans (except ESOPs)
Cross-testing seeks to provide maximum benefits to HCEs while providing minimum benefits to non-HCEs under nondiscrimination regulations.
Differentiates HCEs from non-HCEs
Generally results in higher contributions for older employees (presumably due to higher compensation) and are sometimes referred to as age-weighted, however age-weighting is available without cross-testing
HCEs might get full $61,000 contribution (section 415 limit) while non-HCEs get the lesser of 1/3 highest HCE contribution rate (%) or 5%
39
Traditional Defined Benefit (DB) Plan
Qualified employer sponsored pension plan that guarantees a specific benefit amount at retirement. DB and cash balance pension plans are required to carry PBGC insurance. (money purchase and target benefit DC pension plans are NOT)
40
Selecting a traditional DB plan
Employer wants to maximize contributions to older employees
Older controlling employee wants to maximize tax-deferred retirement savings for their benefit
41
Section 415 limit (defined benefit plans maximum benefit)
For a benefit beginning at 65, the maximum annual life annuity benefit is the lesser of $245,000 or 100% of the average compensation the employee earned over their highest earning 3 consecutive years.
Plan is not required to reduce benefits to a participant who retires as early as 62
NOTE: there is a separate 415 limit for DC plans (maximum contributions to a DC plan)
42
Unit Benefit Formula for Pensions
Percentage of earnings per year of service formula (do not confuse with flat amount per year of service or flat percentage of earnings formula AKA fixed benefit formula)
Factors salary and service to determine pension benefit
E.G. 1.5% of earnings for each year of service
1.5% times annual earnings times years of service = annual pension amount
Most frequently used formula
Benefits long-tenured the most
43
Final Average Formula for Pensions
Usually better matched to employees pre-retirement income vs. career averaged compensation (unit benefit method)
Uses average earnings over a specific number of years (usually 3 to 5 prior to retirement)
Only $305,000 (salary cap) can be taken into consideration for calculating
44
Past Service Credits
Past service is service with the employer before inception of the pension plan
Defined benefit and cash balance pension plans may offer credit for past service.
DC plans CANNOT provide credit for past service
45
Fixed Benefit Formula
Flat amount per year of service or flat percentage of earnings used to calculate pension benefit
46
Income Replacement Ratio
Amount of pension benefit divided by average salary
47
Employer Contributions to Pension Plans (disadvantage to employer)
Potentially large funding obligation regardless of profitability
Actuarily determined contributions cannot be predetermined
Factors that affect contributions
Proximity to Retirement Age (closer/older = more, further/younger = less)
Past Service
Forfeitures MUST be applied to reduce employer contributions (contributions cannot be more or less than actuarily determined amount)
Investment return assumptions (lower assumptions = higher contributions, higher assumptions = lower contributions)
Salary scale assumptions (older/longer tenured employees are paid more, newer/younger employees are paid less)
48
Cash Balance Pension Plan
A defined benefit pension plan that provides for annual employer contributions at a specified rate to hypothetical individual accounts for each participant.
Employer guarantees the contribution level AND a minimum rate of return.
Very similar to Money Purchase DC plan, except a Money Purchase does not require employers to guarantee a minimum rate of return.
Actual rates of return DO NOT affect actual value of the benefit to the employee in the future. Only the guaranteed rate does.
Actual rates of return CAN affect future employer contributions. If plan assets experience a higher rate of return than guaranteed, future contributions can be reduced and vice versa.
Account balance is annuitized at retirement to provide the end benefit
49
Selecting a Cash Balance Pension Plan
Less expensive option compared to traditional DB plan
50
Disadvantage of Cash Balance Pension Plan for Employees
Older, longer-tenured employees receive a lower benefit when a traditional DB plan is converted to a cash balance plan.
Older employees generally get a smaller lump sum and annuity payout
Cash balance contribution is based on all working years vs traditional DB plan which uses average highest 3 years
Cash Balance contribution is generally fixed
Traditional DB plan may be higher
See page 3-17 in retirement for comparison of traditional DB to Cash Balance
51
412(i) Plan
A defined Benefit Plan funded entirely with insurance products and annuities
Insurance company actuarial assumption determines the contribution due
Exempt from minimum funding standard
412(i) is IRC section for fully insured plans
Also known as a 412(e) 3 insurance contract plan
52
Selecting a 412(i) plan
Appeals to employers that have some need for life insurance
Allows for large contribution, but plan returns will typically be lower than other DB plans
53
Non-discrimination and eligibility requirements for Qualified Plans
Must cover a broad group of employees
Two requirements must be satisfied:
Age/Service (21/1 or 2-year/100% rule)
Coverage (Ratio Percentage Test or Average Benefit Test)
54
Age/Service Rules for Qualified Plans
Maximum Age/Service is 21 years old, 1 year of service (21/1 rule) subject to vesting
Special provision requires 2 years of service, but employee is 100% vested at the end of 2 year (2-year/100% rule). This rule is not available with most 401(k) plans.
An employee who meets the Age/Service requirement must be allowed to participate no later than the first day of the first plan year following completion of the requirement or 6 months after the conditions are met.
Year of Service = 1,000 hours worked during initial 12 month period
Employees also become eligible if they average 500 hours worked for at least 3 consecutive years (instead of 1,000 in the single 12 month period)
55
Coverage Tests for Qualified Plans
Ratio Percent Test:
The percentage of non-HCEs is at least 70% of the percentage of HCEs that are covered.
E.G. 50% of HCEs are covered (given). At least 35% of non-HCEs must be covered (50%X70%)
Average Benefit Test:
The average benefits for all non-HCEs must be at least 70% of the benefits for HCEs
E.G. $200,000 of benefits go to HCEs. At least $140,000 must go to non-HCEs ($200,000X70%)
Be careful of question phrasing. May ask how many must be included or how many can be excluded.
56
Additional minimum participation requirements for Qualified DB plans
Must benefit at least the lesser of:
50 employees
The greater of 40% of all employees or 2 employees (or if only 1, that employee)
E.G. - Two doctors are employed by LM, each wants their own DB plan. They have to participate in the same plan.
E.G. - O.S. employs 10 doctors and 40 staff. Minimum participation is the lesser of 50 employees or 40% of all employees (20 employees in this case - 50X.40)
57
Highly Compensated Employee (HCE)
Either a greater than 5% owner, or an employee that earned more that $135,000 in the previous year (2021).
HCE concept relates to discrimination (ADP/ACP testing)
58
Key Employee
Either a greater than 5% owner, an officer with compensation greater that $200,000 (2022), or a greater than 1% owner with compensation greater than $150,000 (2022).
Key Person concept relates to plan vesting
59
Top-Heavy Plans
A plan is top heavy if more than 60% of its aggregate accrued benefits or account balances are allocated to key employees. The salary cap if $305,000 applies when calculating.
A top-heavy plan requires minimum benefits (DB) and minimum contributions (DC) for non-Key employees:
DB Plans (2nd letter of Alphabet) - benefit = 2% of non-Key employee compensation multiplied by years of service up to a maximum of 10 years
DC Plans (3rd letter of the Alphabet) - contribution = 3% of non-Key employee compensation
60
Vesting Schedule for Top-Heavy DB plans and ALL DC plans
3-year cliff OR
2-6 year graded (20% vesting in years 2,3,4,5,6) OR
100% vested with 2-year eligibility (2-year/100% rule)
61
Vesting Schedule for non-Top-Heavy DB plans only
5-year cliff OR
3-7 graded (20% vesting in years 3,4,5,6,7)
100% vested with 2-year eligibility (2-year/100% rule)
62
Family Attribution Rules
Attribution rules can affect who is a key or highly compensated employee for the >5% ownership rule. An individual may be deemed a >5% owner based on their relationship to an actual >5% owner.
Spouse, grandparent, parent or children of a >5% owner are deemed to be >5% owners
Only a parent (not a grandparent) is deemed to own stock on behalf of children under 21
63
Special Note from Page 4-10 of Retirement Book
The CFP exam generally has no calculation questions on the non-discrimination rules. ESOPs, 401(k)s, and matched 403(b)s are not tested on a benefits basis but must satisfy the ADP and ACP tests which are both focused on contributions. However, cross-tested profit-sharing plans are tested in terms of benefits.
64
Actual Deferral Percentage and Actual Contribution Percentage Tests
Employee Elective Deferral and Employer matching and profit-sharing contribution discrimination tests.
Compares percentages of HCEs versus non-HCEs
Not more than 125% of the NHCE Rate (ADP is 8% or greater)
Not more than 200% of the NHCE Rate (ADP is between 1% and 8%)
*Shortcut - take NHCE ADP/ACP and multiply by 2% for 0-2%, add 2% for 2-8%
E.G.
NHCE actual deferral HCE deferral allowed
1% X2 2%
2% X2 4%
3% +2 6%
65
Catch-up Deferral
Lesser of $6,500 or the amount of the participant's compensation reduced by any other elective deferrals by the participant for the year.
66
Controlled Groups
Parent-subsidiary - One entity (the parent) owns 80% or more of one or more other entities.
Brother-sister - Five or fewer owners of two or more entities own 80% or more of each entity
Affiliated service group (ASG) - Apply primarily to PSCs (HEAL - health, engineering, accounting, law)
Employee leasing - Employee is directly employed by one organization, but is leased to another unrelated organization (for instance on a project basis)
Importance of Controlled Groups - Annual additions to a participant's qualified plan account are limited to $61,000/annually. This must be aggregated for participants between multiple plans offered by a single employer OR related employers. However, if a participant works for two unrelated employers, the plans are treated separately, and the participant could in theory receive $122,000 in annual additions.
67
Integration with Social Security/Disparity Limits
Purpose is to equalize employer's contributions to qualified retirement plans between higher and lower paid employees.
DC plans handle this differently that DB plans
68
DC Plan Integration
Integration Level - any dollar amount up to the Social Security Wage base ($147,000 in 2022)
Base contribution percentage - Contribution percentage for compensation below integration level.
Excess contribution percentage - Contribution percentage for compensation above integration level.
Permitted disparity is the lesser of base contribution percentage or 5.7%
To calculate (3 steps):
Calculate the base contribution for amount for compensation before $147,000
Calculate the excess contribution amount for compensation over $147,000 but less than $305,000 (salary cap)
Add the two results together. Lesser of result or $61,000
Note: you will be given the variables or will be given enough information to solve the one you need.
69
DB Plan Integration
Integration Level - level of compensation above which a contribution is made. May not exceed the Social Security Wage Base ($147,000 in 2022).
Base benefit percentage - Plan benefit for compensation below integration level.
Excess benefit percentage - Plan benefit for compensation above integration level.
Permitted disparity is the lesser of the base benefit percentage or 26.25%.
To calculate:
Formula is base benefit percentage + permitted disparity = excess benefit percentage
70
Deduction Limits for Employers who sponsor a Qualified Plan (Section 404(c) limit)
The employer may only deduct a maximum of 25% of all participants' (aggregate) eligible compensation. Certain plan participants may exceed the 25% threshold as long as total company contributions do not exceed 25% and do not violate discrimination rules.
71
Definition of Compensation for Qualified Plans
Includes taxable compensation paid or accrued during the tax year
Also includes elective deferrals under 401(k) and Section 457 plans
Generally includes salary reduction contributions to Section 125 plans (FSAs) but that is determined by the plan document
72
Elective Deferrals for workers with more than 1 employer
Aggregated as follows:
401(k)/403(b)/SIMPLE/SARSEP - $20,500 max plus age 50 catch up if applicable ($6,500)
SIMPLE and another SIMPLE - $14,000 max plus age 50 catch up if applicable ($3,000)
73
Annual Additions for workers with more than 1 employer
Lesser of 100% of compensation or $61,000
Aggregated amongst all accounts if plan is offered by single employer or two or more related employers (Controlled group - cannot exceed $61,000)
Separately to each account in unrelated employer plans (two accounts added together could receive more than $61,000)
74
Keogh Plans (HR-10)
Qualified Retirement Plan for sole proprietorships and partnerships (i.e. self-employed)
May operate as DB, money purchase pension or profit-sharing plans.
Contribution is based on net earnings, not salary. Net earnings is Schedule C income (which includes the deduction for non-owner employee plan contributions)
Self-Employment tax must be computed and the 1/2 SE tax deduction must be taken before determining the self-employed deductible contribution.
Shortcut for Self-Employed deductible contribution amounts:
15% plan (non-owner employee contribution) - 12.12%
25% plan (non-owner employee contribution) - 18.59%
Note - same calculation for self-employed SEP contribution
Note - If this calculation appears, it will use a wage base under $147,000
75
Loans from Qualified Plans (IRC Section 72(p))
Tax free loans from Qualified Plans based on following requirements being met:
Made under enforceable agreement requiring repayment
Total loans do not exceed lesser of 50% of participant's vested benefit or $50,000 (small accounts can borrow up to $10,000 without regard to % limit)
Loan is repaid within 5 years (exception for principal residence not pledged, or leave of absence)
Repayments are made in level installments at least quarterly. If participant fails to make payments according to the schedule, the full balance due is taxable and subject to the 10% early withdrawal penalty
Loan interest is generally not deductible (exception is a pledged residence loan for non-key employee)
Loan interest is never deductible for a key person
Loan provisions are not required. All Qualified Plans, 403(b) and TSA can have loans. IRAs, ROTH IRAs, SEPs, SARSEPs and SIMPLEs cannot.
76
Definition of Compensation for IRA purposes
Wages
Salary
Tips
Professional Fees
Bonuses
Alimony (pre-2019)
Separate Maintenance Agreements (pre-2019)
77
Spousal IRA
Spouse who does not work or has limited compensation can contribute to a spousal IRA as long as the couple has compensation to support funding both.
78
IRA Eligibility
All persons receiving compensation can contribute to an IRA. The IRA contribution may or may not be deductible
79
IRA Deductibility
If neither spouse nor a single person is an active participant in a qualified plan, SIMPLE, SEP, TSA and Union Plan, then IRA contributions are deductible and not subject to AGI limits.
Active participant is defined as someone who is making elective deferrals or receiving annual additions (which consist of employee deferrals, employer contributions and forfeitures)
If one spouse is an an active participant, but the other is not, the non-active spouse can make a deductible IRA contribution subject to AGI phase-out limits.
For all active participants, deductibility is subject to AGI phase-out limits.
The phase out ranges are given.
80
Early IRA Distribution Penalty Exceptions
Death
Total and permanent disability
Qualified education expenses
Medical Insurance premiums after separation from employment (subject to 10% AGI floor unless unemployment is received in the same year as separation or the following year)
Substantially equal periodic payments (72(t)/SEPP)
First home expense up to $10,000
Medical Expense > 10% of AGI
$5,000 for qualified birth/adoption
81
Loans with respect to IRAs
IRA loans are not allowed
IRAs pledged as collateral for a loan is treated as a distribution
82
Roth IRA Conversions
No AGI limit
60 day rule applies to QP, IRA, SEP, SIMPLE, 403(b) or governmental 457 conversions
Roth Conversions DO NOT satisfy RMDs
A QP can be converted to a Roth IRA, but careful considerations should be made
83
Non-Spouse Beneficiaries
A non-spouse beneficiary who inherits a QP is eligible to convert the plan to a Roth IRA via direct transfer (a non-spouse beneficiary cannot make a 60-day rollover)
A non-spouse beneficiary who inherits an IRA cannot convert it to an Inherited Roth IRA
84
Roth IRA 5-year rule (only applies to Conversions and Earnings)
For purposes of withdrawing earnings tax-free (income and penalty), a Roth IRA must be established for at least 5 years and experience a qualified triggering event (59 1/2, Death, Disability, First Time Home up to $10,000).
Earnings are subject to income tax but NO penalty if the the Roth IRA meets the 5 year rule and the remaining special purposes (medical expense, medical insurance, SEPP, Higher Education birth/adoption) OR existed for less than 5 years and meets all special purposes (including 59 1/2, Death, Disability or First Time Home up to $10,000).
There is one 5-year clock for earnings that starts when the first Roth IRA is opened and it carries over to new accounts.
For purposes of withdrawing converted Roth assets tax-free, each conversion has its own 5-year clock. If it meets the 5 year holding, no tax or penalty applies. If it fails to meet the 5-year rule, only the penalty applies. If it fails to meet the holding period, but does meet one of the special exceptions, no tax or penalty applies.
85
Roth IRA Distribution Rules (not RMD)
Roth IRAs must be distributed in the following ways due to death of the owner:
Within 5 years if no designated beneficiary
By the 10th year following death to designated beneficiary
Is the sole beneficiary is a surviving spouse, they can delay distributions until the owner would have attained 72 or roll it to their own Roth IRA and no distributions would be required.
86
Recharacterizations of IRA contributions
TCJA eliminated all but corrective IRA recharacterizations. A taxpayer who cannot contribute to a Roth IRA due to AGI limits can recharacterize to a traditional IRA (deductible or non-deductible)
87
Roth 401(k)
Roth 401(k) contributions are subject to the 5-year rule on contributions
To be tax free, the distribution has to be after 5 years and post 59 1/2, death, or disability
No in-service distribution for Roth 401(k) (55)
Roth 401(k) is subject to RMD rules
Roth 401(k) provisions are optional for employers
88
ABLE Accounts
Achieving a Better Life Experience Act expands IRC Section 529 to create tax-advantaged accounts for the disabled. $16,000 annual contribution limit (gift exclusion).
Distributions for disability are excluded from gross income if beneficiary was disabled before 26
ABLE account is exempt from the $2,000 asset limit for Medicaid and SSI
Maximum 1 ABLE account per beneficiary
89
SEP
Form 5305-SEP
Employer contributions only, employees get same % as owner
Contributions are non mandatory (flexible)
Lesser of 25% of Compensation ($305,000 maximum) or $61,000
Self-Employed Owners subject to KEOGH Rules (20% of net income max) (12.12%/18.59%)
Fully vested immediately
Use when employer wants an alternative to a qualified profit share that's easy to install
Must cover all employees over 21 who have worked 3 out of 5 previous calendar years
Part-time work counts for years of service
Contributions do not need to be made for employees whose compensation for a calendar year is less than $650
Can be integrated with Social Security
Not flexible when it comes to participation requirements
Short-term employees make this an advantage.
Long-term part time employees make this a disadvantage
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Salary Reduction SEP (SARSEP)
SARSEPs are no longer available (12/31/96), but old plans are grandfathered
No more than 25 employees
50% of all eligible employees must participate (make a deferral)
Limit is $20,500 and $6,500 age 50 catch up
New employees can join the grandfathered plan
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SIMPLE IRA
5304-SIMPLE or 5305 SIMPLE
100 employees max. 2 year grace period if this is exceeded
$14,000 max contribution ($10,000 indexed for inflation)
Mandatory employer contributions $1/$1 up to 3% of employee comp (matching based on employee deferral)) OR non-elective 2% contribution (regardless of whether the employee does anything)
Lower % not less than 1% can be used in no more than 2 out of 5 years (ending current year)
No compensation cap for matching purposes
Vested immediately
No non-discrimination testing
Deferrals are subject to FICA and FUTA
Termination of SIMPLE can only happen January 1 of the year following notification (contributions available until then)
Cannot maintain any other qualified plan, 403(b), or SEP at the same time
Must cover any employee who earned $5,000 in any 2 previous years and is reasonable expected to earn $5,000 in the current year.
60-day notice of election period just prior to the calendar year to make a deferral election or modify a previous election
Contributions to SIMPLE IRA for domestic employees (housekeeper) are non-deductible
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SIMPLE 401(k)
Exempt from ADP/ACP Tests
Exempt from Top-Heavy requirements
An ERISA plan
Same $14,000 deferral plus $3,000 age 50 catch up
Does not have special 1% match election of a SIMPLE IRA
Salary cap of $305,000 applies for matching
Other rules of SIMPLE IRAs apply to SIMPLE 401(k)s
Employers interested in a SIMPLE will generally go with the IRA and not the 401(k)
93
403(b) (TDA/TSA)
Can only be adopted by certain tax-exempt organizations and certain public school systems (501(c)(3) organizations - religious, charitable, scientific, literary or educational)
Public schools must have a regular faculty and curriculum and a regular student body
Reductions are subject to FICA and FUTA
$20,500 plus $6,500 age-50 catch up for deferrals
Special 15-year service rule allows an additional $3,000 deferral
$61,000 limit on all contributions
Annuity Contracts or Mutual Funds only (cash value life insurance may be incidental)
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Section 457 Plans
IRC Section 457 governs all non-qualified deferred compensation plans of governmental units, governmental agencies, and certain non-church controlled tax-exempt organizations. (no church, mosque or synagogue)
$20,500 or 100% of compensation
$6,500 catch up for age 50 only by governmental employer (not non-profit)
Special catch up applies for the final 3 years of participation
No coordination with elective deferrals of 401(k), 403(b), or a SARSEP
Only governmental 457s can be rolled into an IRA, Roth IRA or qualified plan
Non-governmental 457s can only be rolled into other non-governmental 457s
Section 457 plans are subject to QDROs
FICA taxes apply when constructive receipt occurs or substantial risk of forfeiture is removed.
95
ERISA
Employee Retirement Income Security Act
Protects the interest of participants
the DOL enforces ERISA
the DOL and PCGC issue interpretive guidelines on ERISA provisions
DOL issues advisory opinions on specific situations affected by ERISA
DOL has the authority to issue prohibited transaction exemptions (PTE)
Occasionally, a PTE may apply to qualified plans generally
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Fiduciary Liability Issues
Discharge duties:
Solely in the interest of participants and beneficiaries
While providing benefits to participants and their beneficiaries while defraying reasonable plan expenses
With care, skill, prudence and diligence under the circumstances then prevailing, that a prudent person familiar with such matters would
By diversifying investments of the plan so as to minimize the risk of large losses unless, under the circumstances it is clearly prudent not to do so.
Can be sued for failing to diversify
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ERISA Prohibited Transactions
Between a plan and a party in interest or fiduciary
Fiduciary should avoid the following conflicts of interest
Furnishing goods or services or facilities between the plan and the party in interest with respect to the plan.
Transfer to, or use by or for the benefit of, a party in interest, any assets of the plan.
ERISA also prohibits self-dealing and transactions violating the anti-kickback rule
98
Pension Benefit Guaranty Corporation (PBGC)
Insure payment of guaranteed benefits
Funded by annual premiums paid by DB plan sponsors
Only guarantees DB plans (traditional and cash balance)
Guarantees monthly benefits payable (nonforfeitable) or payments already being paid
Does not guarantee lump sums
PBGC is part of the DOL
99
DB Plan Terminations
May be voluntary or involuntary (by PBGC)
Voluntary Termination is also called Standard Termination (sufficient assets to fund)
Distress Termination (insufficient funds) can only occur when:
1. The employer is in bankruptcy (either liquidation or reorganization)
2. The employer can prove to the PBGC that plan termination is necessary to pay debts
Only the PBGC can initiate an involuntary DB plan termination. Termination cannot be the result of unpaid premiums.
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Pension Welfare Benefits Administration (PWBA)
Enforces reporting, disclosure, and Fiduciary provisions of ERISA
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Key Factors Affecting Plan Selection for Business
Maximizing benefits for the owner, highly compensated, or older employees
Maximizing or Minimizing employer contributions
Maximizing employer contribution flexibility
Vesting to minimize employee turnover
Allowing employees to make before-tax salary deferrals
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Establishing Qualified Plans
Plan document must be executed within the tax year for which the employer wishes to take the tax deduction for its contribution. The following are exceptions:
Safe-Harbor 401(k) must be adopted before the beginning of the plan year
Standard 401(k) with deferrals must be established before deferrals can be made.
SIMPLE 401(k) plans may be adopted any time on or after January 1, but not later than October 1.
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Methods to make deductible employer contributions
Cash
Borrow from a bank
File an extension for tax purposes
104
Pension Protection Act of 2006
Allows annuity-LTC combinations
Allows "safest available annuities" to be included in 401(k) plans
105
Diversification in ERISA plans
Trustees have the requirement to diversify available investments to minimize risk of large losses
DC plans of publicly traded employers must allow participants to diversify employer contributions after 3 years of service
Participant investment, model-driven, and flat fee advice is permitted
Automatic investments may be invested in balanced accounts with stocks and bonds
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Unrelated Business Taxable Income (UBTI)
If UBTI exceeds $1,000, the UBTI is subject to income tax in the current year. Income from a limited partnership or dividends from a margined account are considered UBTI.
107
Life Insurance in a qualified plan
Must be incidental to the primary purpose of the plan. Must meet the following tests:
Aggregate premiums are less than the following percentages of the benefit for that participant:
Ordinary Life/Whole Life - 50%
Term Insurance - 25%
Universal Life - 25%
The death benefit amount must be no more than 100 times the expected monthly benefit.
DC plans usually use the premium limits, DB plans usually use the death benefit limit.
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Using Life Insurance in a Qualified Plan
Satisfies the need for life insurance protection of the owner of a small business and provide a tax deduction to the business
The pure life insurance cost is usually taxed to the participant at the table 2001 cost
If the death benefit is payable, the difference between the total and the cash value is treated as death proceeds and is received by the beneficiary tax-free (assuming the table 2001 cost was paid). The cash surrender value is taxed at ordinary income.
Can reduce the actuarial assumptions in a DB plan and allow for additional contributions
Only profit sharing plans can hold second-to-die policies
109
Using Disability Insurance in a Qualified Plan
Qualified Plans are eligible to hold disability insurance.
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In-Service Distributions
May be allowed in three situations:
Attainment of a specific age or number of years of service
Hardship
Attainment of age 62 for DB plans (Pension Protection Act rule - considered as retirement income)
Note: Governmental 457s do not allow for in-service distributions until 70.5.
111
Hardship tests
Financial needs test - need must be immediate and heavy
Resources test - the withdrawal must not exceed the amount needed, and the participant must have no other sources to meet the need
112
Hardship 10% penalty exemptions
Medical expenses for participant, spouse or dependents
Tuition, room and board, and other educational expenses for the next 12 months
Principal residence purchase
To prevent eviction/foreclosure
Funeral expenses
Certain repair expenses for damage to the principal residence
Cannot exceed the immediate need
Employer cannot force loans, and cannot limit deferrals for 6 months
Hardship withdrawals are limited to deferrals and vested matching/earnings amounts
113
10% Penalty Exceptions for Early Distributions (qualified plans)
Death
Disability
SEPP (72(t)) following separation of service
Separation of service at 55 or later
QDRO
Medical expenses in excess of 10% of AGI
$5,000 distribution for qualified birth/adoption
114
SEPP (72(t))
Avoids the 10% penalty following separation of service
Must be paid at least annually
Paid without changing the amount for a minimum of 5 years or age 59 1/2 (if changed outside of the exception below, the 10% penalty is applied retroactively)
Based on life expectancy
Based on reasonable rate of interest
Based on reasonable mortality assumptions
Generally, no modification to the payments is allowed, but there is a one-time election which allows participants to change from the annuity or amortization method to the RMD method. There is no penalty for this change. The change sharply reduces the payout.
115
Qualified Joint and Survivor Annuity (QJSA - pension plans)
Annuity option that provides a benefit for a survivor (usually a spouse)
Survivor benefit not less than 50% nor greater than 100% of the annuity payable while participant is still living.
116
Qualified Optional Survivor Annuity (QOSA - pension plans)
PPA requires a second survivor annuity option. Must be a 50% joint and survivor annuity at a minimum. Participant can only opt out of this benefit with written spousal consent. Election must be made within 180 days of annuity start. Participant must be given notice explaining the right to defer and potential consequences.
117
Qualified Preretirement Survivor Annuity (QPSA)
Pre-retirement death benefit payable to the plan participant's spouse upon the death of a participant before the starting date of the QJSA. The benefit must not be less than the QJSA.
118
Rollover Rules (aside from standard ones)
Non-deductible IRA contributions cannot be rolled into a qualified plan
Non-governmental 457 plans can only roll to another 457 plan
Hardship Withdrawals cannot be rolled over
Qualified plans, 403(b) plans or a 457 plan may roll into a SIMPLE, but only if the SIMPLE was opened for at least 2 years.
SIMPLEs can be rolled into qualified plans and IRAs, but only if the SIMPLE was open for 2 years.
119
RMDs
April 1st of the year following the year in which an individual turns 72, then by December 31st every year after.
IRA distributions start at 72 no matter what
Qualified Plans, Governmental 457s and 403(b)s allow for later RMDs for participants who work beyond age 72. RMDs apply April 1st the year following retirement.
5% owners must begin distributions by April 1st following 72, but can still contribute to their plan until they retire.
120
QCD
Available at 70.5
Up to $100,000 annually
Satisfies RMD
121
SECURE Act 10 year rule exceptions
Owner's surviving spouse
Owner's child under 18 (once they reach 18, the 10 year rule applies)
Disabled Individual (may use their own life expectancy)
Chronically ill individual
Any person not more than 10 years younger than the owner
122
Pension Protection Act (Updated by the SECURE Act)
Non spouse beneficiaries can transfer 401(k) proceeds to an inherited IRA and withdraw the funds over 10 years. Applies to 403(b) and governmental 457s as well.
Must roll directly (direct transfer) to an inherited IRA
If money is distributed or goes to a traditional IRA, taxes will be due
Non spouse beneficiaries can tap into 401(k) funds for qualifying medical or financial emergencies.
123
Retiring Early (401(k) plans only)
Participants who retire between 55 and 59 1/2 can take withdrawals without paying the 10% penalty. Does not apply to IRAs.
124
Special Penalty Waiver for Public Service Employees
10% penalty is waived for distributions for non-457 governmental plans for qualified public safety employees beginning at age 50.
Law enforcement, customs and border patrol, and firefighters
125
NUA
Net unrealized appreciation of stock in a qualified plan is not taxable until the stock is sold. The basis is taxable at ordinary income rates. The appreciation is long-term capital gain regardless of holding period.
If the stock appreciates after distribution from the qualified plan (but before sale) the additional appreciation must be held for long-term to qualify for LTCG rates
NUA can be considered income in respect of the decedent (IRD)
126
Nonqualified Deferred Compensation
May discriminate
Exempt from most ERISA requirements
No employer deduction for contributions until employee is taxed
Funds earnings may be taxable to employer
Distributions are taxable at ordinary income rates (except for ISOs)
127
Choosing a nonqualified plan
Additional benefits for executives already receiving max benefits or contributions under a qualified plan.
Used as a way to recruit/retain talent
Can be created just for 1 employee
Usually effectively implemented by C Corps
128
Salary Reduction (Pure Deferred Compensation)
Use some portion of employee's current compensation to fund the ultimate compensation benefit.
129
Salary Continuation
Employer contributions fund the future compensation benefit.
130
Unfunded Deferred Compensation Plans (Informally Funded)
To maintain deferral, a plan must be unfunded (naked promise to pay) or informally funded (with life, annuities, mutual funds or other investments)
Unfunded and Informally funded plans are subject to employer's creditors.
Employee has no access to the compensation that has been deferred.
No tax deduction for contributions until the employee is taxed (constructive receipt or economic benefit)
131
Life Insurance and 162 (for Deferred Compensation)
Employer Owns the policy and is the beneficiary
Premiums are NOT currently deductible
Death proceeds paid to the employer are not taxable to the employer (because premiums were taxed)
Benefits paid to the employee (or surviving dependents) are a deductible expense to the employer and taxable to the ultimate receiver. Constructive receipt (employee) or economic benefit (survivors of covered employee) requirements are met.
Payments to the surviving beneficiaries are included in the employee's gross estate for estate tax purposes. This is because of incidents of ownership (right to name a beneficiary)
132
Rabbi Trust
Result of an IRS letter ruling involving a Rabbi and his congregation
Assets in the Rabbi Trust must be available to all general creditors
The participant does not have greater rights than other unsecured creditors
Plan must provide clear rules describing when benefits will be paid.
Company must notify the trustee of any bankruptcy or financial hardship. Trustee must suspend payment to the trust beneficiary and hold assets for general creditors (trap door)
133
When a Rabbi Trust is used
Possibility that management may change before deferred compensation benefits are paid (takeover/acquisition)
New management might be hostile to the key employee in the future and fail to honor the arrangement.
Risk that litigation to enforce payment of deferred compensation would be too costly to be practical.
134
Secular Trusts
Irrevocable Trust that is established for the sole benefit of the employee.
Assets are beyond the reach of the employer's creditors.
Deduction for the employer and taxation to the employee occurs when assets are placed into the trust, or when substantial risk of forfeiture no longer exists.
Considered a FUNDED nonqualified deferred compensation arrangement.
Tradeoff for creditor protection is the taxation of compensation in the year it is transferred to the trust.
135
Employer Tax Implications of Informally Funded Nonqualified Deferred Compensation Plans
Double taxation is possible
First, the funds set aside in the plan must be taxed at the corporate level as accumulated earnings
Second, the earnings from the plan may create an additional tax
136
Constructive Receipt
Income is taxable to a cash basis taxpayer in the year during which it is paid or made available. It is not considered constructively received if there is substantial risk of forfeiture or other restrictions.
137
Substantial Risk of Forfeiture
Substantial Risk of Forfeiture exists if the employee's right to the enjoyment of the property are conditioned upon the performance of services for a period of time. Two tests:
1. The employee's relationship to other stockholders and the degree of their potential control.
2. The employee's relationship to corporate officers.
138
Economic Benefit Doctrine
If any economic or financial benefit is conferred on an individual by an employer as compensation in a taxable year, it is taxable to the individual in that year.
139
Incentive Stock Options
Generally cannot be exercised by cashless transaction because they lose their favored tax treatment.
Only the first $100,000 of ISOs granted can get special tax treatment. All others are NSO
An ISO can be called a qualified employer stock plan, but is not a qualified plan
ISOs sold 1 year from exercise and sold 2 years from grant (egg) maintain favored status
140
Bargain Element
The spread between the exercise price and the market value of a stock option.
141
Disqualifying Disposition of ISOs
If ISOs are sold in the same calendar year as they were exercised, the bargain element is taxable compensation and subject to FICA and FUTA
If the ISOs are sold within 12 months of exercise, but the following calendar year, the bargain element is taxable at ordinary income, but not subject to FICA or FUTA
If both the 1 year from exercise to sale and 2 years from grant to sale (egg) rules are violated, the ISO bargain element is taxable and subject to FICA and FUTA
Gifting an ISO is a disqualifying disposition
142
Offering ISOs
ISOs reward employees, most often key employees to motivate productivity. The employer receives no tax deduction when shares are exercised.
143
Section 83 Election vs. Section 83(b) Election for NSOs and Restricted Stock
Section 83 election is the standard NSO tax process (option gains are taxed as ordinary income at exercise)
Section 83(b) election accelerates the ordinary income taxation on the difference between the exercise and market price to the grant date. Any appreciation is taxable at favorable gains rates. This may be appropriate if the stock is expected to appreciate substantially.
144
Restricted Stock
Sale of stock to an employee at a bargain price. No taxation occurs if substantial risk of forfeiture exists.
145
Stock Appreciation Rights
SARs are rights to be paid an amount of money equal to the difference between the value of a specified number of shares of stock on the date the SARs are granted and the value of the stock on the date the SARs are exercised.
146
Phantom Stock
The right to a cash bonus based on the performance of phantom shares of a corporation's common stock over a specified time.
147
SARs and Phantom Stock Similarities
The amount is paid in cash, stock, a combination, or any other form of consideration.
148
SARs and Phantom Stock Differences
Phantom Stock holders have no choice on the specified date of exercise
Phantom stock is not granted in tandem with options
Phantom stock typically carries dividend equivalent rights
149
Choosing SARs and Phantom Stock
Company owners what to share economic value of equity, but not actual equity
The company is a division of another company, but it can measure its equity value and wants employees to have a share in that
The company is actually a non-profit or government entity
The company cannot offer traditional types of ownership because of restrictions (for example, an S corp can only have 100 shareholders)
150
Junior Class Shares
A JCS is a junior stock plan. After expiration of substantial risk of forfeiture, junior class (B) shares are converted to regular (A) shares.
151
ESPP (Section 423 stock plan)
Discounted stock purchase plan for employees. Can offer up to 15% discount.
Similar tax treatment to ISOs.
Available to all employees.
