Retirement: 3 Fundamentals of Defined Contribution Plans Flashcards
1
Q
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
3-1
A
a. Defined Benefit
2
Q
Retirement 3-1: Basic characteristics of defined contribution plans
Annual Contribution Limit
25% of covered compensation
a. Defined Benefit
b. Defined Contribution
3-1
A
b. Defined Contribution
3
Q
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
3-1
A
a. Defined Benefit
4
Q
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
3-1
A
b. Defined Contribution
5
Q
Retirement 3-1: Basic characteristics of defined contribution plans
Who assumes the risk?
The employer
a. Defined Benefit
b. Defined Contribution
3-1
A
a. Defined Benefit
6
Q
Retirement 3-1: Basic characteristics of defined contribution plans
Who assumes the risk?
The employee
a. Defined Benefit
b. Defined Contribution
3-1
A
b. Defined Contribution
7
Q
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
3-1
A
a. Defined Benefit
8
Q
Retirement 3-1: Basic characteristics of defined contribution plans
Covered by PBGC?
No
a. Defined Benefit
b. Defined Contribution
3-1
A
b. Defined Contribution
9
Q
Retirement 3-1: Basic characteristics of defined contribution plans
Separate accounts?
No, commingled
a. Defined Benefit
b. Defined Contribution
3-1
A
a. Defined Benefit
10
Q
Retirement 3-1: Basic characteristics of defined contribution plans
Separate accounts?
Yes
a. Defined Benefit
b. Defined Contribution
3-1
A
b. Defined Contribution
11
Q
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
3-1
A
a. Specified by formula in plan documents; typically a percentage of compensation
12
Q
Retirement 3-1: Basic characteristics of defined contribution plans
Amount of retirement benefit
a. Certain
b. Uncertain
3-1
A
b. Uncertain: depends on factors such as investment earnings or losses, expenses, amounts contributed, and forfeitures
13
Q
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
3-1
A
a. $53,000
14
Q
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
3-1
A
a. $26,000
10% of $265,000
15
Q
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
A
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.
16
Q
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
A
c. 10%
17
Q
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
A
a. defined contribution plans
18
Q
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%
A
b. 25%
19
Q
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
A
b. older
20
Q
Retirement 3-2: Target benefit plans
Mandatory funding?
Yes
a. Pension Plans
b. Profit Sharing Plans
A
a. Pension Plans
21
Q
Retirement 3-2: Target benefit plans
Mandatory funding?
No (but “substantial and recurring”)
a. Pension Plans
b. Profit Sharing Plans
A
b. Profit Sharing Plans
22
Q
Retirement 3-2: Target benefit plans
Employer stock limitation?
Yes, no more than 10%
a. Pension Plans
b. Profit Sharing Plans
A
a. Pension Plans
23
Q
Retirement 3-2: Target benefit plans
Joint and survivor annuity, and pre-retirement annuity required?
Yes
a. Pension Plans
b. Profit Sharing Plans
A
a. Pension Plans
24
Q
Retirement 3-2: Target benefit plans
Joint and survivor annuity, and pre-retirement annuity required?
No
a. Pension Plans
b. Profit Sharing Plans
A
b. Profit Sharing Plans
25
Retirement 3-2: Target benefit plans
Joint and survivor annuity, and pre-retirement annuity required?
No
a. Pension Plans
b. Profit Sharing Plans
b. Profit Sharing Plans
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
a. $53,000
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
a. For the employee
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
b. For the employer
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
a. For the employee
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
b. For the employer
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
a. Profit sharing plan
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
b. Thrift plan
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
c. Stock bonus plan
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
d. Employee stock ownership plan (ESOP)
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
e. Age-weighted profit sharing plan
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
f. Cross-tested (comparability) plan
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
g. 401(k) plan
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
b. For the employer
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
b. For the employer
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
a. For the employee
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
a. For the employee
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
b. For the employer
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
a. discretionary contributions
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
b. formula based contributions
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
b. $18,000
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
a. key employee
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%
c. 60%
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
b. stock
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
a. For the employee
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
a. For the employee
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
b. For the employer
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
b. For the employer
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
a. For the employee
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
b. For the employer
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
b. increase
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
a. $2,500 (100 × $25).
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
b. sells
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
b. long term or short term capital gain
depending on the holding
period, not as ordinary income.
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
a. He would have to pay ordinary income on $65,000
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
a. The NUA of $75,000 will be taxed as a long-term capital gain
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
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
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.
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.
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.
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.
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.
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.
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
b. most
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
a. For the employee
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
a. For the employee
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
b. For the employer
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
b. For the employer
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
a. For the employee
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
b. For the employer
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
a. For the employee
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
b. For the employer
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
a. For the employee
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
b. For the employer
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%
b. 20%
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%
c. 25%
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%
b. 16.67%
It would be .20/1.20 = .1667, or 16.67%.
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
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.
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
b. lesser
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%
c. 11.7%
6% + 5.7%
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
a. Plans that allow Social Security integration
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
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
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
b. stock bonus plan
A stock bonus plan is one type of profit sharing plan.
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
c. cash balance plan
A cash balance plan is a defined benefit plan; a defined benefit plan's funds are pooled.
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
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.
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
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.
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.
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.
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.
It is an age-weighted plan.
The closer a participant is to retirement (the "target"), the larger their contribution amount will typically be.
90
Retirement 3-2)
7. Which of the following is not a pension plan?
money purchase plan
cash balance plan
profit sharing plan
profit sharing plan
A profit sharing plan is not a pension plan.
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)
employee stock ownership plan (ESOP)
An ESOP does not allow Social Security integration.
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
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.
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.
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.
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
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.
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
profit sharing plan
A profit sharing plan is appropriate because Jim can avoid fixed employer contributions and still make maximum contributions for his retirement.
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.
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.
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
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.
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%
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%.
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
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.
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.
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.
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).
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.
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.
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.
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.
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.
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.
sole proprietors and partners are also permitted to take loans from a Keogh plan.
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.
A target benefit plan will favor George and the other older employees.
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.
The maximum vesting schedule for defined contribution plans is either six-year graded or three-year cliff.
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
$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.
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.
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.
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.
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.
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%.
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.
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.
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.
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.
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.
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.
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.
