Retirement: 3 Fundamentals of Defined Contribution Plans

Question 1

Retirement 3-1: Basic characteristics of defined contribution plans

Annual Contribution Limit

Amount necessary to fund a benefit of no more than $210,000 per year in 2016

a. Defined Benefit
b. Defined Contribution

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Answer 1

a. Defined Benefit

Question 2

Retirement 3-1: Basic characteristics of defined contribution plans

Annual Contribution Limit

25% of covered compensation

a. Defined Benefit
b. Defined Contribution

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Answer 2

b. Defined Contribution

Question 3

Retirement 3-1: Basic characteristics of defined contribution plans

How are forfeitures handled?

Must be used to reduce the employer’s contribution

a. Defined Benefit
b. Defined Contribution

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Answer 3

a. Defined Benefit

Question 4

Retirement 3-1: Basic characteristics of defined contribution plans

How are forfeitures handled?

Typically reallocated to other participants, or can be used to reduce the employer’s contribution

a. Defined Benefit
b. Defined Contribution

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Answer 4

b. Defined Contribution

Question 5

Retirement 3-1: Basic characteristics of defined contribution plans

Who assumes the risk?

The employer

a. Defined Benefit
b. Defined Contribution

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Answer 5

a. Defined Benefit

Question 6

Retirement 3-1: Basic characteristics of defined contribution plans

Who assumes the risk?

The employee

a. Defined Benefit
b. Defined Contribution

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Answer 6

b. Defined Contribution

Question 7

Retirement 3-1: Basic characteristics of defined contribution plans

Covered by PBGC?

Yes (except professional firms with less than 25 employees)

a. Defined Benefit
b. Defined Contribution

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Answer 7

a. Defined Benefit

Question 8

Retirement 3-1: Basic characteristics of defined contribution plans

Covered by PBGC?

No

a. Defined Benefit
b. Defined Contribution

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Answer 8

b. Defined Contribution

Question 9

Retirement 3-1: Basic characteristics of defined contribution plans

Separate accounts?

No, commingled

a. Defined Benefit
b. Defined Contribution

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Answer 9

a. Defined Benefit

Question 10

Retirement 3-1: Basic characteristics of defined contribution plans

Separate accounts?

Yes

a. Defined Benefit
b. Defined Contribution

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Answer 10

b. Defined Contribution

Question 11

Retirement 3-1: Basic characteristics of defined contribution plans

Employer’s contribution to the plan

a. Specified by formula in plan documents; typically a percentage of compensation
b. Not Specified by formula in plan documents; typically a percentage of compensation

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Answer 11

a. Specified by formula in plan documents; typically a percentage of compensation

Question 12

Retirement 3-1: Basic characteristics of defined contribution plans

Amount of retirement benefit

a. Certain
b. Uncertain

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Answer 12

b. Uncertain: depends on factors such as investment earnings or losses, expenses, amounts contributed, and forfeitures

Question 13

Retirement 3-1: Basic characteristics of defined contribution plans

Annual additions: Employer and employee contributions and forfeitures applied to a participant’s account may not exceed the lesser of 100% of plan compensation or $___ in 2016.

a. $53,000
b. $210,000
c. $265,000

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Answer 13

a. $53,000

Question 14

Retirement 3-1: Basic characteristics of defined contribution plans

The percentage of any contribution allocated to a particular employee is also limited by the requirement of the Internal Revenue Code (IRC) that no morethan $265,000 in annual compensation (in 2016, indexed) can be considered in formulating the allocation. Thus, if a plan calls for each participant to receive a contribution equal to 10% of annual compensation, the $300,000-per-year CEO
could receive only

a. $26,000
b. $26,500
c. $30,000

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Answer 14

a. $26,000

10% of $265,000

Question 15

Retirement 3-1: Basic characteristics of defined contribution plans

The limitation on annual additions to a participant’s account is the lesser of $53,000 (2016, indexed) or 100% of the participant’s compensation. The annual addition for any year is the sum of all EXCEPT

a. employer contributions
b. employee contributions
c. forfeitures
d. earnings

3-1

Answer 15

d. earnings

An annual addition is when “new” money is added to the account. Earnings are not “new” money; so earnings are not considered to be an annual addition.

Question 16

Retirement 3-2: Basic characteristics of money purchase plans

Pension plans can hold no more than __% of the employer’s stock

a. 2%
b. 5%
c. 10%

3-2

Answer 16

c. 10%

Question 17

Retirement 3-2: Basic characteristics of money purchase plans

Although the money purchase plan is a pension plan that requires the employer to contribute a fixed percentage of each participant’s annual compensation to individual participants’ accounts, they are, by definition:

a. defined contribution plans
b. defined benefit plans

Answer 17

a. defined contribution plans

Question 18

Retirement 3-2: Basic characteristics of money purchase plans

EGTRRA (Economic Growth and Tax Reconciliation Act of 2001) equalized the contribution limits for employers and now all defined contribution plans have a __% limit

a. 15%
b. 25%
c. 35%

Answer 18

b. 25%

Question 19

Retirement 3-2: Target benefit plans

Target benefit plan is one of three types of plans that skew employer contributions in favor of ____ plan participants—the other two plans that do the same are the defined benefit and age-weighted profit sharing plan

a. younger
b. older

Answer 19

b. older

Question 20

Retirement 3-2: Target benefit plans

Mandatory funding?

Yes

a. Pension Plans
b. Profit Sharing Plans

Answer 20

a. Pension Plans

Question 21

Retirement 3-2: Target benefit plans

Mandatory funding?

No (but “substantial and recurring”)

a. Pension Plans
b. Profit Sharing Plans

Answer 21

b. Profit Sharing Plans

Question 22

Retirement 3-2: Target benefit plans

Employer stock limitation?

Yes, no more than 10%

a. Pension Plans
b. Profit Sharing Plans

Answer 22

a. Pension Plans

Question 23

Retirement 3-2: Target benefit plans

Joint and survivor annuity, and pre-retirement annuity required?

Yes

a. Pension Plans
b. Profit Sharing Plans

Answer 23

a. Pension Plans

Question 24

Retirement 3-2: Target benefit plans

Joint and survivor annuity, and pre-retirement annuity required?

No

a. Pension Plans
b. Profit Sharing Plans

Answer 24

b. Profit Sharing Plans

Question 25

Retirement 3-2: Target benefit plans

Joint and survivor annuity, and pre-retirement annuity required?

No

a. Pension Plans
b. Profit Sharing Plans

Answer 25

b. Profit Sharing Plans

Question 26

Retirement 3-2: Target benefit plans

Conway, age 53, was hired at a salary of $288,000 to fill the post of chief of operations for Scrub-A-Dog. The next year, he became eligible to participate in the target benefit plan. Like everyone else, Conway had the expectation of receiving 40% of compensation during each year of retirement. The rules governing defined contribution plans permit company contributions of up to $_____ (2016, indexed) to be allocated to Conway’s account.

a. $53,000
b. $265,000
c. $288,000

Answer 26

a. $53,000

Question 27

Retirement 3-2: Target benefit plans

Advantages of a Target Benefit Plan

Older employees who enter the program can receive larger annual contributions.

Greater certainty of final retirement benefits is provided, as compared to profit sharing plans.

a. For the employee
b. For the employer

Answer 27

a. For the employee

Question 28

Retirement 3-2: Target benefit plans

Advantages of a Target Benefit Plan

These plans are easier and less expensive to administer than defined benefit plans.

Employers that offer target benefit plans do not have to pay PBGC premiums.

Owner-employees and other higher-paid employees, who generally are older, get a larger share of annual employer contributions.

a. For the employee
b. For the employer

Answer 28

b. For the employer

Question 29

Retirement 3-2: Target benefit plans

Disadvantages of Target Benefit Plans

Greater allocations to more recent but older employees, who make the same income as their younger colleagues, can create issues over equity.

Target benefit plans are defined contribution plans, so they are not insured by the Pension Benefit Guaranty Corporation (PBGC).

a. For the employee
b. For the employer

Answer 29

a. For the employee

Question 30

Retirement 3-2: Target benefit plans

Disadvantages of Target Benefit Plans

Once it commits to the plan, the company must make annual contributions, even if it is experiencing business distress.

The goal of heavy allocations to the owner-employee’s account is constrained by the 25% employer deduction limit and the $53,000 individual account limit (2016, indexed).

a. For the employee
b. For the employer

Answer 30

b. For the employer

Question 31

Retirement 3-4: Profit Sharing Plans

A plan in which the employer shares profits with its employees by making a contribution to a company profit sharing retirement plan. The amount contributed often varies, depending upon the profitability of the company.

a. Profit sharing plan
b. Thrift plan
c. Stock bonus plan
d. Employee stock ownership plan (ESOP)
e. Age-weighted profit sharing plan
f. Cross-tested (comparability) plan
g. 401(k) plan

Answer 31

a. Profit sharing plan

Question 32

Retirement 3-4: Profit Sharing Plans

A type of profit sharing plan funded by the employer, but it also allows for the employee to make contributions to the plan with after-tax dollars

a. Profit sharing plan
b. Thrift plan
c. Stock bonus plan
d. Employee stock ownership plan (ESOP)
e. Age-weighted profit sharing plan
f. Cross-tested (comparability) plan
g. 401(k) plan

Answer 32

b. Thrift plan

Question 33

Retirement 3-4: Profit Sharing Plans

This profit sharing plan is funded entirely with employer company stock.

a. Profit sharing plan
b. Thrift plan
c. Stock bonus plan
d. Employee stock ownership plan (ESOP)
e. Age-weighted profit sharing plan
f. Cross-tested (comparability) plan
g. 401(k) plan

Answer 33

c. Stock bonus plan

Question 34

Retirement 3-4: Profit Sharing Plans

Like a stock bonus plan, this is funded with employer stock. A major difference, however, is that these can use leverage and borrow

a. Profit sharing plan
b. Thrift plan
c. Stock bonus plan
d. Employee stock ownership plan (ESOP)
e. Age-weighted profit sharing plan
f. Cross-tested (comparability) plan
g. 401(k) plan

Answer 34

d. Employee stock ownership plan (ESOP)

Question 35

Retirement 3-4: Profit Sharing Plans

This plan weights contributions in favor of older employees, which is often the owner(s).

a. Profit sharing plan
b. Thrift plan
c. Stock bonus plan
d. Employee stock ownership plan (ESOP)
e. Age-weighted profit sharing plan
f. Cross-tested (comparability) plan
g. 401(k) plan

Answer 35

e. Age-weighted profit sharing plan

Question 36

Retirement 3-4: Profit Sharing Plans

A profit sharing plan that discriminates in favor of a certain class of employees, while providing a certain minimum benefit to the other employees.

a. Profit sharing plan
b. Thrift plan
c. Stock bonus plan
d. Employee stock ownership plan (ESOP)
e. Age-weighted profit sharing plan
f. Cross-tested (comparability) plan
g. 401(k) plan

Answer 36

f. Cross-tested (comparability) plan

Question 37

Retirement 3-4: Profit Sharing Plans

Actually a provision, not a stand-alone plan. This provision can be added to either a profit sharing plan or a SIMPLE plan to allow for the addition of employee pretax contributions.

a. Profit sharing plan
b. Thrift plan
c. Stock bonus plan
d. Employee stock ownership plan (ESOP)
e. Age-weighted profit sharing plan
f. Cross-tested (comparability) plan
g. 401(k) plan

Answer 37

g. 401(k) plan

Question 38

Retirement 3-4: Profit Sharing Plans

Advantages of Profit Sharing Plans

Contributions can be discretionary but must be “substantial and recurring.” While the plan must specify how employer contributions will be allocated, the employer with a discretionary plan is not required to make contributions of any specified amount on an annual basis.

a. For the employee
b. For the employer

Answer 38

b. For the employer

Question 39

Retirement 3-4: Profit Sharing Plans

Advantages of Profit Sharing Plans

Plan contributions are deductible from current taxable income.

Profit sharing plans are relatively easy and inexpensive to establish and administer.

Profit sharing is a proven employee motivator.

a. For the employee
b. For the employer

Answer 39

b. For the employer

Question 40

Retirement 3-4: Profit Sharing Plans

Disadvantages of Profit Sharing Plans

If the profit sharing plan is the only retirement plan available to employees, older individuals who join the company are at risk of accumulating very few retirement benefits, particularly if the company’s contributions are discretionary and the company has experienced wide fluctuations in profits and losses.

a. For the employee
b. For the employer

Answer 40

a. For the employee

Question 41

Retirement 3-4: Profit Sharing Plans

Disadvantages of Profit Sharing Plans

A defined benefit plan may, in certain situations, provide older, more highly compensated employees with an annual benefit that far exceeds the $53,000
(in 2016, indexed) annual additions limit for a profit sharing plan participant

a. For the employee
b. For the employer

Answer 41

a. For the employee

Question 42

Retirement 3-4: Profit Sharing Plans

Disadvantages of Profit Sharing Plans

For certain employers, the amount of deductible employer contributions allowed is considerably less than that permitted under a defined benefit plan.

a. For the employee
b. For the employer

Answer 42

b. For the employer

Question 43

Retirement 3-4: Profit Sharing Plans

Give the employer the greatest contribution flexibility. If business results for the year produce no profits, the board has the option of contributing or not contributing. Of course, too many years of zero contributions may not be allowed. The IRS may declare the plan terminated. When this happens, all nonvested amounts in participants’ accounts become 100% vested.

a. discretionary contributions
b. formula based contributions

Answer 43

a. discretionary contributions

Question 44

Retirement 3-4: Profit Sharing Plans

A plan may contain a provision specifying that the company will contribute to the plan in all profitable years. The IRC leaves it to the employer to establish its own definition of “profits,” although most plans define profits as “before tax” earnings. The actual formula is generally expressed as a percentage of all profits, or, alternatively, as a percentage of all profits in excess of a certain dollar amount

a. discretionary contributions
b. formula based contributions

Answer 44

b. formula based contributions

Question 45

Retirement 3-4: Profit Sharing Plans

Ernie has been a participant in his company’s qualified plan for a number of years and is now 60% vested in his plan benefits, which are calculated at $30,000. A better opportunity, however, has induced Ernie to leave the company. On his departure, he is entitled to

a. $12,000
b. $18,000
c. $30,000

Answer 45

b. $18,000

Question 46

Retirement 3-4: Profit Sharing Plans

The definition of a _____ in the IRC is any of the following:

an officer of the employer with a level of compensation in excess of $170,000 in 2016;

a more than 5% owner of the employer; or

a more than 1% owner of the employer having an annual compensation from the employer of more than $150,000 (not indexed).

a. key employee
b. top heavy plan

Answer 46

a. key employee

Question 47

Retirement 3-4: Profit Sharing Plans

A top-heavy defined contribution plan is one in which the sum of account balances of “key employees” exceeds __% of the sum of the account balances of all participants (excluding former key employees). When a defined contribution plan becomes top heavy, the plan must provide minimum contributions on behalf of all non-key participants equal to at least 3% of compensation (or less only if the key employees are also receiving less).

a. 40%
b. 50%
c. 60%

Answer 47

c. 60%

Question 48

Retirement 3-5: Stock Bonus Plans

Stock bonus plans are essentially profit sharing plans in which a corporate employer’s contributions are most often made with shares of its own stock. When distributions are made, they too take the form of _____.

a. cash
b. stock

Answer 48

b. stock

Question 49

Retirement 3-5: Stock Bonus Plans

Advantages of Stock Bonus Plans

Like other qualified plans, employer contributions are not taxable and may accumulate on a tax-deferred basis.

Since benefits are distributed in the form of stock, the retired or terminated employee can continue to defer tax on the appreciated value of the stock until such time that she sells the shares; the employee can then pay tax at capital gains rates (more on this later).

If the plan permits it, loans may be arranged.

a. For the employee
b. For the employer

Answer 49

a. For the employee

Question 50

Retirement 3-5: Stock Bonus Plans

Advantages of Stock Bonus Plans

If a publicly traded company offers a stock bonus plan, after meeting defined service requirements, an employee-participant must be permitted to direct
that her plan assets invested in employer securities be reinvested in other suitable investments.

If the company is closely held, employees can vote their shares on certain important issues, like mergers, sales, and recapitalization; if publicly held, they can vote on all issues.

If the company is private (not publicly traded), then participants upon termination must have the right to demand that the employer repurchase shares (“put option”).

a. For the employee
b. For the employer

Answer 50

a. For the employee

Question 51

Retirement 3-5: Stock Bonus Plans

Advantages of Stock Bonus Plans

Providing employees with company shares is likely to align their interests more keenly with the interests of the company.

Since it is a cashless transaction, a contribution of stock to the plan leaves the employer’s cash available for other business purposes: plant expansion, financing inventories, debt payments, and such.

A tax deduction can be taken even though no cash was contributed.

a. For the employee
b. For the employer

Answer 51

b. For the employer

Question 52

Retirement 3-5: Stock Bonus Plans

Advantages of Stock Bonus Plans

Similar to a profit sharing plan, employer contributions do not have to be
made every year.

Stock bonus plans may provide for permitted disparity (sometimes referred to as Social Security integration). An employer that uses permitted disparity provides plan benefits that favor highly compensated employee-participants by taking into account employer-provided Social Security contributions on behalf of each participant.

a. For the employee
b. For the employer

Answer 52

b. For the employer

Question 53

Retirement 3-5: Stock Bonus Plans

Disadvantages of Stock Bonus Plans

They may become too narrowly invested—even dangerously so. If the company were to go broke, employees would lose not only their jobs, but the value in their retirement accounts. The experience of employees of Enron Corp. and Lucent Technologies Inc. in 2001, WorldCom in 2002, or Lehman Brothers in 2008, illustrate the devastating consequences of employee retirement plans or employee investments being too narrowly invested in the employer’s stock.

a. For the employee
b. For the employer

Answer 53

a. For the employee

Question 54

Retirement 3-5: Stock Bonus Plans

Disadvantages of Stock Bonus Plans

The down side of contributing stock instead of cash is dilution of ownership and control. Employee participants have the right to vote the shares held in
their accounts. This matter is not an issue for the large, publicly held corporation, but is an issue for the small, closely held business. Accordingly, stock bonus plans are rarely implemented by closely held businesses.

Nonpublicly traded companies must stand ready to buy back stock distributed to terminated employees and retirees at a fair market price (put option). This requires them to periodically hire an independent appraiser to establish the value of shares—an expensive proposition.

Publicly traded companies must comply with the diversification and investment requirements of ERISA Section 204(j).

a. For the employee
b. For the employer

Answer 54

b. For the employer

Question 55

Retirement 3-5: Stock Bonus Plans

Stock Distributions—Net Unrealized
Appreciation

This _____ in the value of the employer stock from the time it was contributed to the plan until the time that the stock is distributed to the participant is known as net unrealized appreciation, or NUA

a. decrease
b. increase

Answer 55

b. increase

Question 56

Retirement 3-5: Stock Bonus Plans

Net Unrealized Appreciation

John is a participant in his company’s stock bonus plan. Nine years ago, the company contributed 100 shares of its stock to John’s plan account. At that time, the shares were each valued at $20. John took a lump-sum distribution of his shares from the plan this year. He was pleased to find that now his 100 shares were each worth $45—a gain of $25 per share. The NUA of John’s shares is

a. $25
b. $2,500
c. $4,500

Answer 56

a. $2,500 (100 × $25).

Question 57

Retirement 3-5: Stock Bonus Plans

Net Unrealized Appreciation

How are the distributed shares handled for tax purposes? If the account balance is taken as a lump-sum distribution (i.e., the entire account balance from all plans of the same type during the same taxable year), then:

The employee-recipient is immediately taxed on the cost, or basis, of the securities received, and at ordinary income tax rates.

The NUA, however, is not taxed until the recipient actually ____ the shares.

a. accepts
b. sells

Answer 57

b. sells

Question 58

Retirement 3-5: Stock Bonus Plans

Net Unrealized Appreciation

When these shares are ultimately sold the NUA is taxed as

a. ordinary income
b. long term or short term capital gain

Answer 58

b. long term or short term capital gain

depending on the holding
period, not as ordinary income.

Question 59

Retirement 3-5: Stock Bonus Plans

Net Unrealized Appreciation

Ace Anderson, age 62, has just retired. He worked with Zarathustra Industries for over eight years. He participated in their stock bonus plan, and his current account balance is valued at $140,000. His basis, based upon contributions that his employer made to the plan, is $65,000. If Ace takes a full distribution from the plan, and does not sell the stock, what would be his tax ramifications?

a. He would have to pay ordinary income on $65,000
b. He would not have to pay ordinary income on $65,000
c. He would have to pay long term capital gains on $65,000

Answer 59

a. He would have to pay ordinary income on $65,000

Question 60

Retirement 3-5: Stock Bonus Plans

Net Unrealized Appreciation

Ace Anderson, age 62, has just retired. He worked with Zarathustra Industries for over eight years. He participated in their stock bonus plan, and his current account balance is valued at $140,000. His basis, based upon contributions that his employer made to the plan, is $65,000. If Ace takes a full distribution from the plan, and does not sell the stock, what would be his tax ramifications?

a. The NUA of $75,000 will be taxed as a long-term capital gain
b. The NUA of $75,000 will be taxed as a short-term capital gain

Answer 60

a. The NUA of $75,000 will be taxed as a long-term capital gain

Question 61

Retirement 3-5: Stock Bonus Plans

Net Unrealized Appreciation

Ace Anderson, age 62, has just retired. He worked with Zarathustra Industries for over eight years. He participated in their stock bonus plan, and his current account balance is valued at $140,000. His basis, based upon contributions that his employer made to the plan, is $65,000. If Ace takes a full distribution from the plan, and does not sell the stock, what would be his tax ramifications?

a. He does have the option of paying taxes on the NUA amount when he takes the distribution, not just when he sells the stock
b. He does not have the option of paying taxes on the NUA amount when he takes the distribution, not just when he sells the stock

Answer 61

a. He does have the option of paying taxes on the NUA amount when he takes the distribution, not just when he sells the stock

Question 62

Retirement 3-5: Stock Bonus Plans

Net Unrealized Appreciation

Ace Anderson, age 62, has just retired. He worked with Zarathustra Industries for over eight years. He participated in their stock bonus plan, and his current account balance is valued at $140,000. His basis, based upon contributions that his employer made to the plan, is $65,000. If Ace takes a full distribution from the plan, and does not sell the stock, what would be his tax ramifications?

Six months later Ace sells his stock for $150,000. What would be his tax ramification?

a. the NUA of $75,000 would be taxed as a long-term capital gain, and the additional appreciation of $10,000 as a short-term capital gain.
b. the NUA of $75,000 would be taxed as a short-term capital gain, and the additional appreciation of $10,000 as a short-term capital gain.

Answer 62

a. the NUA of $75,000 would be taxed as a long-term capital gain, and the additional appreciation of $10,000 as a short-term capital gain.

Question 63

Retirement 3-5: Stock Bonus Plans

Net Unrealized Appreciation

Ace Anderson, age 62, has just retired. He worked with Zarathustra Industries for over eight years. He participated in their stock bonus plan, and his current account balance is valued at $140,000. His basis, based upon contributions that his employer made to the plan, is $65,000. If Ace takes a full distribution from the plan, and does not sell the stock, what would be his tax ramifications?

What if he sold the stock for $150,000 fifteen months later? What would be his tax ramification?

a. the NUA of $75,000 would be taxed as a long-term capital gain, and the additional appreciation of $10,000 as a short-term capital gain.
b. If Ace were to sell the stock for $150,000 fifteen months later, both the NUA of $75,000 and the additional appreciation of $10,000 would be taxed as long-term capital gains.

Answer 63

b. If Ace were to sell the stock for $150,000 fifteen months later, both the NUA of $75,000 and the additional appreciation of $10,000 would be taxed as long-term capital gains.

Question 64

Retirement 3-5: Stock Bonus Plans

Net Unrealized Appreciation

Ace Anderson, age 62, has just retired. He worked with Zarathustra Industries for over eight years. He participated in their stock bonus plan, and his current account balance is valued at $140,000. His basis, based upon contributions that his employer made to the plan, is $65,000. If Ace takes a full distribution from the plan, and does not sell the stock, what would be his tax ramifications?

Six months later Ace sells his stock for $125,000. What would be his tax ramification?

a. Ace would pay long-term capital gain taxes on $60,000, which is the difference between his sale price of $125,000 and his basis of $65,000.
b. Ace would pay short-term capital gain taxes on $60,000, which is the difference between his sale price of $125,000 and his basis of $65,000.

Answer 64

a. Ace would pay long-term capital gain taxes on $60,000, which is the difference between his sale price of $125,000 and his basis of $65,000.

Question 65

Retirement 3-6: Employee Stock Ownership Plans

Employee stock ownership plans (ESOPs) are defined contribution plans whose funds are invested in the securities of the employer company. The ESOP is the ____ common type of stock bonus plan.

a. least
b. most

Answer 65

b. most

Question 66

Retirement 3-6: Employee Stock Ownership Plans

Advantages of ESOPs

Like other qualified plans, employer contributions are not taxable and may accumulate on a tax-deferred basis.

NUA treatment is available on stock distributions from the plan, and there is no 20% mandatory withholding on these distributions.

If the plan permits it, loans may be arranged.

a. For the employee
b. For the employer

Answer 66

a. For the employee

Question 67

Retirement 3-6: Employee Stock Ownership Plans

Advantages of ESOPs

As with stock bonus plans, if the company is closely held, employees can vote their shares on certain important issues, like mergers, sales, and
recapitalization. If publicly held, they can vote on all issues.

ESOPs can distribute dividends to participants, which would be taxable as ordinary income, but there is no 10% early withdrawal penalty tax if the participant is under age 59½.

a. For the employee
b. For the employer

Answer 67

a. For the employee

Question 68

Retirement 3-6: Employee Stock Ownership Plans

Advantages of ESOPs

A tax deduction can be taken, even though no cash was contributed.

Similar to a profit sharing plan, employer contributions do not have to be made every year.

a. For the employee
b. For the employer

Answer 68

b. For the employer

Question 69

Retirement 3-6: Employee Stock Ownership Plans

Advantages of ESOPs

Providing employees with company shares is likely to align their interests more keenly with the interests of the company.

Since it is a cashless transaction, a contribution of stock to the plan leaves the employer’s cash available for other business purposes: plant expansion, financing inventories, debt payments, and such.

a. For the employee
b. For the employer

Answer 69

b. For the employer

Question 70

Retirement 3-6: Employee Stock Ownership Plans

Disadvantages of ESOPs

They may end up with too many eggs in one basket: their jobs and their retirement funds are both invested in a single company.

If this is a small business, with less than great future prospects, the value of the investment may not grow and could even collapse.

Also, generally a participant’s right to diversify their investments is fairly limited (available to 55-year-olds with 10 years of participation).

a. For the employee
b. For the employer

Answer 70

a. For the employee

Question 71

Retirement 3-6: Employee Stock Ownership Plans

Disadvantages of ESOPs

Ownership is diluted due to distributing stock to employees (who then can vote on important issues).

The cost of establishing and managing the plan can be high. According to the National Center for Employee Ownership, startup costs alone run in the vicinity of $40,000. This makes ESOPs uneconomical for many companies of fewer than 20 employees.

Nonpublic companies must pay for an annual share price valuation and stand ready to buy back all shares of departing employees—both of which are costly endeavors.

ESOPs and LESOPs cannot provide permitted disparity (also referred to as Social Security integration).

a. For the employee
b. For the employer

Answer 71

b. For the employer

Question 72

Retirement 3-7: Age-Weighted Profit Sharing Plans

Advantages of Age-Weighted Profit Sharing Plans

Owner-employees and other higher-paid employees, who are generally older, get a larger share of annual employer contributions.

a. For the employee
b. For the employer

Answer 72

a. For the employee

Question 73

Retirement 3-7: Age-Weighted Profit Sharing Plans

Advantages of Age-Weighted Profit Sharing Plans

As with a profit sharing plan, contributions can be discretionary. Thus, in times of business distress or anemic cash flow, there is no requirement to make a contribution. From the employer’s perspective, having discretionary funding and the same employer contribution limitation as a target benefit plan makes an age-weighted profit sharing plan very appealing.

As stated above, owner-employees, who are generally older, get a larger share of annual employer contributions.

a. For the employee
b. For the employer

Answer 73

b. For the employer

Question 74

Retirement 3-7: Age-Weighted Profit Sharing Plans

Disadvantages of Age-Weighted Profit Sharing Plans

Younger employees may resent the inequity of greater contributions being allocated to older employees who are doing the same work.

If the plan makes contributions discretionary or predicated on profits, actual retirement benefits will be highly uncertain.

a. For the employee
b. For the employer

Answer 74

a. For the employee

Question 75

Retirement 3-7: Age-Weighted Profit Sharing Plans

Disadvantages of Age-Weighted Profit Sharing Plans

The “annual additions” limitation on all defined contribution plans may restrict contributions allocated to the owner-employee and other highly compensated individuals. According to the annual additions limitation, the contribution to each individual’s account cannot exceed the lesser of 100% of compensation or $53,000 (2016, indexed).

a. For the employee
b. For the employer

Answer 75

b. For the employer

Question 76

Retirement 3-9: Keogh Plans

The 2016 maximum annual deduction for an employer contribution to a profit sharing Keogh on behalf of a self-employed individual is __% of self-employment
earnings or earned income (not to exceed $265,000 for 2016), up to a maximum of $53,000. (This maximum amount is scheduled to increase in future years.)

a. 10%
b. 20%
c. 25%

Answer 76

b. 20%

Question 77

Retirement 3-9: Keogh Plans

The maximum Keogh profit sharing contribution by a self-employed individual is __% of his Schedule C income reduced by the deductible amount of self employed taxes less the Keogh contribution itself

a. 10%
b. 20%
c. 25%

Answer 77

c. 25%

Question 78

Retirement 3-9: Keogh Plans

The maximum Keogh profit sharing contribution by a self-employed individual is 25% of his Schedule C income reduced by the deductible amount of self employed taxes less the Keogh contribution itself

If, for example, the contribution percentage for common law employees is 25%, then the maximum contribution rate (percentage) for a self-employed individual who participates in a Keogh profit sharing plan is 20%. The math is shown below:

Self-employed contribution rate = 0.25/1.25

If the amount contributed to common law employees is 20%, how much could the owner of an unincorporated business contribute?

a. 15.67%
b. 16.67%
c. 17.67%

Answer 78

b. 16.67%

It would be .20/1.20 = .1667, or 16.67%.

Question 79

Retirement 3-9: Keogh Plans

Example. A sole proprietor had business profit of $60,000. The company maintains a 25% money purchase Keogh plan. What is the amount that the owner can contribute to the plan on his own behalf?

a. $10,152
b. $11,152
c. $12,152

Answer 79

Step 1: Determine the adjusted contribution percentage for the owner.

0.25% contribution for employee participant (EE %)
÷ 1.25 Divided by (1 + employee %)
= 0.20 adjusted contribution percentage for owner

Step 2: Calculate self-employment tax

  $60,000 Schedule C net income
- 7.65% 
 $55,410 Self-employment income subject
to self-employment taxes 
* 15.3%
= $8,478 Self-employment tax

Step 3: Calculate owner’s contribution

  $60,000
- $4,239 (1/2 Self-employment tax)
= $55,761 
* 0.20 adjusted contribution percentage for owner
= $11,152 Owner’s contribution

Note: You can check your math as follows: the $11,152 owner’s contribution is 25% of $44,609, which is the amount you get from taking the net earnings of $55,761 and subtracting $11,152.

Question 80

Retirement 3-10: Social Security Integration for Defined Contribution Plans

The permitted disparity definition limits the difference between the excess contribution percentage and the base contribution percentage. The permitted disparity in a defined contribution plan is the _____ of

1. the base contribution percentage (base formula), or
2. 5.7% (subject to increase when the tax attributable to old age insurance exceeds 5.7%).
   a. greater
   b. lesser

Answer 80

b. lesser

Question 81

Retirement 3-10: Social Security Integration for Defined Contribution Plans

The permitted disparity definition limits the difference between the excess contribution percentage and the base contribution percentage. The permitted disparity in a defined contribution plan is the lesser of

1. the base contribution percentage (base formula), or
2. 5.7% (subject to increase when the tax attributable to old age insurance exceeds 5.7%).

If the base contribution percentage is 6%, the excess contribution percentage cannot exceed

a. 5.7%
b. 6%
c. 11.7%

Answer 81

c. 11.7%

6% + 5.7%

Question 82

Retirement 3-10: Social Security Integration for Defined Contribution Plans

Social Security Integration

Defined benefit pension plan 
Cash balance pension plan 
Money purchase pension plan 
Target benefit pension plan 
Profit sharing plans 
Stock bonus plan 
SEPs 

a. Plans that allow Social Security integration
b. Plans that do not allow Social Security integration

Answer 82

a. Plans that allow Social Security integration

Question 83

Retirement 3-10: Social Security Integration for Defined Contribution Plans

Social Security Integration

401(k) plans
SIMPLEs 
SARSEPs
Section 457 plans 
ESOPs 
Cross-tested (“new comparability” defined contribution plans) 

a. Plans that allow Social Security integration
b. Plans that do not allow Social Security integration

Answer 83

b. Plans that do not allow Social Security integration

SIMPLEs, SARSEPs, and Section 401(k) and 457 plans allow employee deferrals and do not allow Social Security integration. An ESOP is the only other
type of plan (other than the ones that have employee deferrals) that does not allow Social Security integration. All of the other plans (which are employer funded) do allow Social Security integration. Remember that defined
contribution plans can only use the excess method of Social Security integration

Question 84

Retirement 3-4

Module Check

1. Which one of the following is a type of profit sharing plan?
   a. cash balance plan
   b. stock bonus plan
   c. flat benefit plan

Answer 84

b. stock bonus plan

A stock bonus plan is one type of profit sharing plan.

Question 85

(Retirement 3-2)

2. Which one of the following is a type of defined benefit plan?
   a. target benefit plan
   b. money purchase plan
   c. cash balance plan

Answer 85

c. cash balance plan

A cash balance plan is a defined benefit plan; a defined benefit plan’s funds are pooled.

Question 86

Retirement 3-5)

3. Which one of the following qualified plans provides the potential for a cashless contribution?
   a. simplified employee pension plan
   b. stock bonus plan
   c. money purchase plan

Answer 86

b. stock bonus plan

An employer can contribute treasury stock instead of cash to a stock bonus plan; this provides the potential for a cashless contribution.

Question 87

Retirement 3-6)

4. Which one of the following qualified plans has the ability to use leverage?

stock bonus plan

profit sharing plan

employee stock ownership plan

Answer 87

employee stock ownership plan

An employee stock ownership plan (ESOP) can borrow money to purchase employer stock; this is an important difference between an ESOP and other qualified plans.

Question 88

Retirement 3-6)

5. Which one of the following is a correct statement about an ESOP’s put option requirement?

It must pass through the voting rights attributes of stock held by the plan for participants.

It must give participants the right to require that benefits be distributed in the form of employer securities.

It must allow participants to require the employer to repurchase distributed securities that are not publicly traded.

Answer 88

It must allow participants to require the employer to repurchase distributed securities that are not publicly traded.

ESOP participants must be allowed to require the employer to repurchase the distributed securities if they are not publicly traded; this requirement is called the put option.

Question 89

Retirement 3-3)

6. Which one of the following statements best describes a target benefit plan?

It is a defined benefit plan.

It can be funded entirely with employer stock.

It is an age-weighted plan.

Answer 89

It is an age-weighted plan.

The closer a participant is to retirement (the “target”), the larger their contribution amount will typically be.

Question 90

Retirement 3-2)

7. Which of the following is not a pension plan?

money purchase plan

cash balance plan

profit sharing plan

Answer 90

profit sharing plan

A profit sharing plan is not a pension plan.

Question 91

Retirement 3-6)

8. Which one of the following types of qualified plans does not allow Social Security integration?

profit sharing plan

target benefit plan

employee stock ownership plan (ESOP)

Answer 91

employee stock ownership plan (ESOP)

An ESOP does not allow Social Security integration.

Question 92

Retirement 3-2)

9. Qualified defined contribution pension plans are subject to which one of the following limits on employer contributions?

10% of the participants’ total payroll

15% of the participants’ total payroll

25% of the participants’ total payroll

Answer 92

25% of the participants’ total payroll

A qualified defined contribution pension plan (a profit sharing plan, target benefit plan, or money purchase plan) allows the employer/sponsor to contribute up to 25% (not 10%) of the participants’ total compensation to the plan.

Question 93

Retirement 3-3)

10. Which one of the following is an incorrect statement about a fixed contribution plan?

A target benefit plan is an age-weighted plan.

A target benefit plan is a defined benefit plan.

A money purchase plan is a pension plan.

Answer 93

A target benefit plan is a defined benefit plan.

A target benefit plan is a defined contribution plan, not a defined benefit plan. A cash balance plan is a defined benefit plan.

Question 94

Retirement 3-2)

11. Which one of the following retirement plan arrangements is a tandem plan?

a Section 401(k) plan and a simplified employee pension plan

a stock bonus plan and an employee stock ownership plan

a target benefit plan and a profit sharing plan

Answer 94

a target benefit plan and a profit sharing plan

An arrangement of a target benefit plan and a profit sharing plan is a tandem plan. Tandem plans are a combination of defined contribution profit sharing and pension plans that give an employer the flexibility to contribute 10% to 25% of the participants’ total compensation each year. Profit sharing plans now allow contributions from 0 to 25% and have displaced the tandem plan.

Question 95

Retirement 3-4)

12. Jim Hanson, age 35, is the 100% shareholder and president of an incorporated business that has no retirement plan for its 20 full-time and 28 part-time employees. Jim’s goal is to maximize his retirement contributions; however, Jim wants to avoid fixed employer contributions. Which one of the following retirement arrangements should the corporation adopt?

tandem plan

target benefit plan

money purchase plan

profit sharing plan

Answer 95

profit sharing plan

A profit sharing plan is appropriate because Jim can avoid fixed employer contributions and still make maximum contributions for his retirement.

Question 96

Retirement 3-9)

13. All of the following are significant differences between Keogh plans and corporate plans except

the contribution formula applied to owners and partners.

the limits on benefits and contributions.

the requirements for lump-sum distribution treatment.

Answer 96

the limits on benefits and contributions.

Limits on Keogh plan benefits and contributions are the same as the qualified plan limits on contributions and benefits for corporate plans.

Question 97

Retirement 3-9)

14. Generally a loan from a Keogh plan must be repaid within how many years?

three years

five years

eight years

Answer 97

five years

A loan from a Keogh plan must be repaid within five years, which is generally the case with any loan from a qualified plan.

Question 98

Retirement 3-9)

15. Assume a Keogh plan’s employer contribution rate for common law employees is 25%. What is the Keogh plan’s employer contribution rate for the owner–employee?

18%

20%

22%

Answer 98

20%

If the Keogh plan’s employer contribution rate for common law employees is 25%, then the Keogh plan’s employer contribution rate for the owner-employee is 20%, not 18%.

Question 99

Retirement 3-1)

16. An employer’s annual contributions to a qualified defined contribution plan must be within statutory limits regarding the allowable amount. An employer’s annual contribution to a defined contribution plan is limited to ____% of the participants’ covered payroll.

15

20

25

Answer 99

25

An employer’s annual contributions to a qualified defined contribution plan must be within statutory limits regarding the allowable amount. An employer’s annual contribution to a defined contribution plan is limited to 25% of the participants’ covered payroll.

Question 100

Retirement 3-4)

17. Which of the following statements is correct regarding profit sharing plans?

Annual contributions to a profit sharing plan may vary each year (both in amount and as a percentage of covered payroll), which accommodates fluctuating business performance.

The actuary determines what future contributions will be to reach the benefit target.

The plan adoption agreement sets the annual contribution which may be specified as a percentage of compensation and must be followed each year.

Answer 100

Annual contributions to a profit sharing plan may vary each year (both in amount and as a percentage of covered payroll), which accommodates fluctuating business performance.

While a profit sharing plan must specify how employer contributions will be allocated, the employer is not required to make contributions of any specified amount on an annual basis. However, contributions must be substantial and recurring.

Question 101

Retirement 3-7)

18. An employer is permitted to make what level of contributions to an employee stock ownership plan (ESOP)?

An ESOP is a stock bonus plan that permits a maximum contribution to a non-leveraged ESOP of 35% (rather than the 25% that would otherwise apply).

An ESOP is a defined contribution plan. Defined contribution plans limit employer contributions to 25% of covered payroll.

An ESOP is a stock bonus plan that permits a maximum contribution to a leveraged ESOP of 27% (rather than the 25% that would otherwise apply).

Answer 101

An ESOP is a defined contribution plan. Defined contribution plans limit employer contributions to 25% of covered payroll.

An employee stock ownership plan (ESOP) is a defined contribution plan. Defined contribution plans limit employer contributions to 25% of covered payroll.

Question 102

Retirement 3-2)

19. In a money purchase pension plan, annual employer contributions

are a fixed percentage of covered payroll.

are set by the employer and announced to participants at least 90 days prior to each plan year

may be adjusted by an actuary based upon past investment performance, rate of participant turnover, or changes in expected life expectancy.

Answer 102

are a fixed percentage of covered payroll.

Money purchase pension plans require the employer to contribute a fixed percentage of compensation to the employee-participants’ accounts.

Question 103

Retirement 3-1)

20. Which of the following is a correct statement regarding defined benefit and defined contribution plans?

Unlike defined benefit plans in which the employer assumes the investment risk, with defined contribution plans the employee assumes the investment risk.

Unlike defined benefit plans in which the employee assumes the investment risk, with defined contribution plans the employer assumes the investment risk.

Employees assume the investment risk with both defined benefit and defined contribution plans.

Answer 103

Unlike defined benefit plans in which the employer assumes the investment risk, with defined contribution plans the employee assumes the investment risk.

With defined contribution plans, the contribution is defined, not the benefit. The ultimate benefit to the participant will be determined by how much is contributed and how the investments perform.

Question 104

Retirement 3-9)

21. Under a Keogh plan,

sole proprietors and partners are also permitted to take loans from a Keogh plan.

as stipulated in the Pension Protection Act of 2006, only common-law employees who own less than 5% of the capital interest or profits interest in a partnership are allowed to take loans from a Keogh plan.

persons owning more than 10% of the capital interest or profits interest in a partnership are prohibited under Tax Equity and Fiscal to take loans from a Keogh plan.

Answer 104

sole proprietors and partners are also permitted to take loans from a Keogh plan.

Question 105

Retirement 3-3)

22. George is the majority shareholder-employee of a closely held corporation. George, age 58, is 10 years older than the next oldest employee of the corporation. He is considering different retirement plan options. Which of the following statements would you use to advise him about a target benefit plan?

If the corporation installs a target benefit plan, this type of plan will favor the younger employees.

A target benefit plan will favor George and the other older employees.

With the additional cost of having an actuary review the plan every year, a target benefit plan is almost as expensive to administer as a defined benefit plan.

Answer 105

A target benefit plan will favor George and the other older employees.

Question 106

Retirement 3-4)

23. The Pension Protection Act (PPA) of 2006 set which of the following vesting schedules for defined contributions plans?

The maximum vesting schedule for defined contribution plans is either six-year graded or four-year cliff.

The maximum vesting schedule for defined contribution plans is either six-year graded or three-year cliff.

PPA provides that the maximum vesting schedule for defined benefit or defined contribution plans to be either a five-year cliff or three-to-seven year graded.

Answer 106

The maximum vesting schedule for defined contribution plans is either six-year graded or three-year cliff.

Question 107

Retirement 3-4)

24. John works for ABC Corp., which has a 10% profit sharing plan. If John’s compensation is $275,000, how much will be contributed to the plan on his behalf?

$17,500

$26,500

$27,500

Answer 107

$26,500
The maximum amount of includible compensation for qualified plans is $265,000 in 2016, and only 10% of that maximum of $265000 can be contributed—$26,500.

Question 108

Retirement 3-6)

25. Jane, age 54, has retired and taken a full distribution from her ESOP plan. Over the years, her employer made a total of $40,000 in contributions into the plan for her, and the stock is currently valued at $110,000. Which one of the following statements best describes the tax implications of the distribution that Jane has taken?

Jane will owe just ordinary income taxes on $40,000.

Jane will owe long-term capital gain taxes on $70,000, which she must pay this year.

Jane will owe ordinary income taxes and a 10% penalty tax on $40,000.

Answer 108

Jane will owe ordinary income taxes and a 10% penalty tax on $40,000.

Since Jane was not at least age 55 when she separated from service, she will owe, not only ordinary income taxes, but also a 10% early withdrawal penalty tax on the $40,000 basis. She will be taxed at the long-term capital gains rate for the $70,000 of NUA, but doesn’t need to recognize and pay this tax until she actually sells the stock.

Question 109

Retirement 3-5)

26. Which of the following statements is correct regarding the diversification requirement for employer contributions made to a stock bonus plan?

The diversification requirement for employer contributions made to a stock bonus plan of a publicly traded company is that, after three years of service, the employee must be permitted, if they so choose, to diversify entirely out of company stock into qualified alternative investments.

The diversification requirement does not apply to stock bonus plans of partnerships with less than 20 employees.

The diversification requirement for employer contributions made to a stock bonus plan of a publicly traded company is that, after the later of attaining age 55 or ten years of service, the employee must be permitted, if they so choose, to diversify entirely out of company stock into qualified alternative investments.

Answer 109

The diversification requirement for employer contributions made to a stock bonus plan of a publicly traded company is that, after three years of service, the employee must be permitted, if they so choose, to diversify entirely out of company stock into qualified alternative investments.

This is the diversification requirement for publicly traded companies that maintain a stock bonus plan.

Question 110

Retirement 3-10)

27. With an integrated defined contribution plan, what is the maximum permitted disparity?

In an integrated defined contribution plan, if the base contribution percentage is 5%, then the permitted disparity is 5.7%.

For an integrated defined contribution plan, the permitted disparity is the base amount; the disparity can go up to only a maximum of 5.7% for plans with a base percentage of 5.7% and above.

The maximum permitted disparity is 25%, so if the base benefit percentage is greater than 25% then the permitted disparity would be capped at 25%.

Answer 110

For an integrated defined contribution plan, the permitted disparity is the base amount; the disparity can go up to only a maximum of 5.7% for plans with a base percentage of 5.7% and above.

Question 111

Retirement 3-1)

28. The amount of contributions allocated to a particular employee is further restricted by the IRC’s limit on “annual additions.” The limitation on annual additions in 2016 to a participant’s account in any defined contribution plan

is the greater of $53,000 or 100% of compensation.

cannot exceed the lesser of $53,000 or 100% of compensation.

for persons 50 and over is the lesser of $24,000 or 100% of compensation.

Answer 111

cannot exceed the lesser of $53,000 or 100% of compensation.

The maximum allowed for annual additions is the lesser of $53,000 or 100% of compensation.

Question 112

Retirement 3-3)

29. If Titan Industries contributes 15% to its target benefit plan for the year, then Jack Jones, with compensation of $275,000, will receive a contribution amount of
    a. $26,000.
    b. $39,750.
    c. $41,250.

Answer 112

b. $39,750.

The maximum amount of includible compensation for qualified plans is $265,000 (2016), so Jack would receive 15% of $265,000, which is $39,750.

Question 113

Retirement 3-2,3

30. What is the amount of employer stock allowed in a defined contribution plan?
    a. Defined contribution pension plans can have no more than 10% of employer stock, but profit sharing plans are not limited in the amount of employer stock.
    b. The Job Protection Act of 2012 limits employer securities to no more than 25% of annual contributions to defined contribution plans and 10% to defined benefit plans.
    c. Defined contribution pension plans can have any employer stock, but profit sharing plans are limited to using 33% of employer stock for annual contributions.

Answer 113

Defined contribution pension plans can have no more than 10% of employer stock, but profit sharing plans are not limited in the amount of employer stock.

Pension plans have a limit of no more than 10% of employer securities allowed in the plan—this is true for money purchase and target benefit plans. Profit sharing plans, however, allow up to 100% to be invested in employer stock, which is often the case with stock bonus plans and ESOPs.