Retirement Planning & Employee Benefits | Lesson 2: Pension & Profit Sharing Plans Flashcards
Basil Leaf, Inc. sponsors a 25% money purchase pension plan for its eligible employees. Brent earns $195,000, Al earns $60,000, Rosie earns $315,000, and Tom, who is ineligible, earns $27,000. What is Basil Leaf’s required deductible contribution for the year? All employees are under age 50.
a) $140,000
b) $146,250.
c) $153,000
d) $245,000.
Answer: A
Basil Leaf’s deductible contribution is equal to 25% of covered compensation. Covered compensation equals payment under $305,000 (2022) for those covered by the plan. In this case, Brent, Al, and Rosie are covered, and their compensation totals $560,000 (after limiting Rosie’s to $305,000). 25% of $560,000 is $140,000. Note that under no circumstances can Brent or Rosie receive more than $61,000, so the additional contribution would have to be reallocated to the other participant (s), in this case, Al. In practice this would never occur. However, this is how the rules would be applied.
Notes:
1 - Rosie’s compensation is limited to $305,000.
2 - the plan does not cover Tom.
Farley opened a fabulous restaurant ten years ago. The food is so exceptional that the restaurant has become one of the top spots in the city. Farley, age 55, is the sole owner with compensation of $315,000. Farley’s son Scott, age 28, is the master chef with a salary of $150,000. Scott has been with the restaurant full-time since he turned 18. Farley also employs 15 other individuals aged between 25 and 35 and has compensation on average of $40,000 per year. Farley wants to establish a profit-sharing plan. Which of the following statements is true?
a) If Farley selected the standard allocation method and the plan contributes 10 percent per individual, the plan will contribute $31,500 to Farley’s account.
b) If Farley selected the permitted disparity method and the plan contributes 10 percent per individual, the contribution the company makes for Farley will be increased.
c) Considering the needs and wants of Farley and Scott. An age-based profit-sharing plan is the best plan for both of them.
d) A new comparability plan is the least expensive, most straightforward way to meet Farley and Scott’s retirement needs.
Answer: B
By using permitted disparity, or integration with Social Security, Farley can increase the contribution to both himself and Scott. Answer A is false because the covered compensation limit is $305,000 for 2022; thus, the maximum that can be contributed to Farley’s account using a standard allocation of 10% is $30,500. Answer C is false because an age-based profit-sharing plan is not necessarily in Scott’s best interest. Because some of the employees are older than Scott, some might be allocated a more significant share of the contribution than Scott. Answer D is false because a new comparability is generally more expensive to administer than other plans.
JMG Company has three employees: Julia, Maria, and Gary. Their compensations are $50,000, $160,000, and $200,000, respectively. JMG is considering establishing a straight 10 percent profit-sharing plan or an integrated profit-sharing plan using a 10 percent contribution for base compensation and 15.7 percent for the excess payment. Which of the following statements is correct?
a) If the integrated plan is selected, then the total contribution for all employees is $44,762.
b) The effect of the integrated plan results in an increase in Maria’s contribution of $1,200.
c) If the integrated plan is selected, the base contribution for all employees is $40,000.
d) If the integrated plan is selected, Gary’s total contribution is $31,400.
Answer: A
If JMG selected the 10 percent profit-sharing plan, the amount for the employer contributions would be $5,000 for Julia, $16,000 for Maria, and $20,000 for Gary. Alternatively, if JMG established an Integrated Plan using a 10 percent base contribution and a 15.7 percent excess contribution, more benefits could be allocated to Maria and Gary. Using an integrated plan, Maria would receive a $16,741 grant ($741 more than with a straight 10 percent profit-sharing plan), and Gary would receive a $23,021 contribution ($3,021 more than a straightforward 10 percent profit-sharing plan).
Logan owns Airliner, Inc. and sold 100 percent of the corporate stock (all outstanding stock) on January 1 to an ESOP for $5,000,000. His adjusted basis in the stock was $2,400,000. Which of the following is correct?
- If Logan reinvests the $5,000,000 in qualified domestic securities within 18 months, he has a carryover basis of $2,400,000 in the qualified domestic security portfolio and no current capital gain.
- Logan has a long-term capital gain of $2,600,000 reduced by the 20 percent small business credit; therefore, his gain is $2,080,000 if he does not reinvest in qualified domestic securities within 18 months.
a) 1 only.
b) 2 only.
c) 1 and 2.
d) Neither 1 nor 2.
Answer: D
The $5.000,000 must be reinvested within 12 months, and there is not a 20 percent small business credit. In addition, to qualify for nonrecognition of gain treatment, the Airliner, Inc. stock must have been owned by Logan for at least three years.
If a participant’s accrued benefit from a qualified defined benefit pension plan is $2,000 per month, what is the maximum life insurance death benefit coverage that the plan can provide based on the 100-to-1 ratio test?
a) $0. b) $2,400. c) $200,000. d) $240,000.
Answer: C
A qualified pension plan is limited in the amount of term life insurance it can purchase with plan assets. The plan must pass either one of two tests, the 25 percent test or the 100 - to - 1 ratio test. Under the
100-to-1 ratio test, the plan can purchase $200,000 ($2,000 × 100) of term life insurance death benefit.
Which of the following actuarial assumptions is not used by the actuary who determines the mandatory funding range for a defined benefit plan?
a) Mortality.
b) Turnover.
c) Divorce rate.
d) Disability rate.
Answer: C
An actuary determining the mandatory funding range for a defined benefit plan may consider mortality, turnover, disability, salaries, retirement ages, and interest rates.
Which pension plans would allocate a higher percentage of the plan’s current costs to a particular class or group of eligible employees?
1. Defined benefit pension plan.
2. Target benefit pension plan.
3. Money purchase pension plan with permitted disparity.
a) 1 only.
b) 1 and 2.
c) 2 and 3.
d) 1, 2, and 3.
Answer: D
All the pension plans listed would allocate a higher percentage of the plans’ current costs to a particular class or group of eligible employees. A defined benefit pension plan and a target benefit pension plan would allocate a higher percentage of the plans’ current cost to the older participants. A money purchase pension plan with permitted disparity would assign a higher rate of the plan’s current cost to those participants whose earnings are over the Social Security wage base (or integration level if different).
A defined benefit pension plan has a funding formula equal to one percent times years of service times final salary. If George’s final salary is $600,000 and George has earned 30 years of service, what is George’s retirement benefit in 2022?
a) $61,000. b) $91,500. c) $245,000. d) $305,000.
Answer: B
1% × 30 × $305,000 = $91,500.
Recall that when calculating the benefit payable from a qualified plan, the compensation over the covered compensation limit ($305,000 for 2022) is not considered.
Jacob is the owner of Office Mart, Inc., and he would like to establish a qualified pension plan. Jacob would like most of the plan’s current contributions to be allocated to his account. He does not want to permit loans, nor does he want Office Mart to bear the investment risk of the plan’s assets. Jacob is 47 and earns $300,000 per year. His employees’ ages 25, 29, and 32, earn $25,000 annually. Which of the following qualified pension plans would you recommend that Jacob establish?
a) Defined benefit pension plan.
b) Cash balance pension plan.
c) Money purchase pension plan.
d) Defined benefit pension plan using permitted disparity.
Answer: C
Because Jacob does not want Office Mart to bear the investment risk of the plan assets, the money purchase pension plan is the option listed that would fulfill his requirements.
Which of the following statements regarding target benefit pension plans is true?
a) A target benefit pension plan cannot allocate plan forfeitures to remaining plan participant accounts.
b) Target benefit pension plans may not be established after 2010.
c) Assuming equal salaries, a target benefit pension plan would allocate a higher percentage of its current contributions to an older employee.
d) target benefit pension plan may permanently exclude any participant who has not attained the age of 26 and completed one year of service.
Answer: C
A target benefit pension plan utilizes a combination of age and compensation to determine the contribution to the plan on behalf of a participant. An older participant with a salary equal to a younger participant would receive a higher allocation for the year. Answer A is false because a target benefit pension plan can allocate plan forfeitures to other plan participants’ accounts. Answer B is incorrect because target benefit pension plans may be established after 2010. Answer D is false because a target benefit pension plan must follow the general eligibility rules of 21 and 1.
Caleb, the 100 percent owner of Caleb’s Car Wash (a sole proprietorship), would like to establish a profit-sharing plan. Caleb’s Car Wash’s tax year ends July 31 to coincide with the school year. What is the latest day Caleb can establish and contribute to the plan?
a) Caleb must establish and contribute to the plan by December 31 of the year in which he would like to establish the plan.
b) Caleb must establish and contribute by May 15 of the following year, assuming he has filed the appropriate extensions.
c) Caleb must establish the plan by July 31 of the year in which he would like to establish the plan and contribute by December 31.
d) Cale must establish the plan by December 31 of the year in which he would like to establish the plan and contribute to the plan by April 15 of the following year.
Answer: B
Caleb must establish and fund the plan by the due date of the tax return, plus extensions. Since his tax year ends July 31, his initial return is due November 15th (the 15th of the fourth month after the end of the tax year), and with extensions (6 months after the due date), they will be due May 15th.
Becca’s Uniform Shoppe has 4 employees. The company has a profit-sharing plan that has made contributions every year. The plan is designed to maximize the contribution to Becca and has reached Becca’s 415(c) limit each year. The company made a 20 percent contribution yesterday on behalf of all employees. The employee census and account balances are as follows:
(See Image)
Today, after a huge blow-up, Becca fired Laurie. Which of the following statements regarding forfeitures is correct (assume the plan meets all necessary testing requirements)?
a) If the plan document permitted allocation of forfeitures based on compensation, Becca would receive $6,400 of Laurie’s unvested plan balance.
b) If the plan document permitted a reduction of plan contributions for forfeitures, Laurie’s $8,000 balance could be used to offset future plan contributions.
c) Since Becca fired Laurie, Laurie becomes 100 percent vested in her plan assets, and there is no forfeiture of plan assets.
d) Given the company census and plan information, the appropriate plan choice for forfeitures is to use
them to reduce future plan contributions.
Answer: D
The most appropriate plan choice would be to use plan forfeitures (in the amount of $6,400) to reduce plan contributions. The facts state that the plan is designed to maximize the benefits to Becca. Allocating the contributions would not maximize the benefit to Becca because Becca has already maximized her contribution to the plan. The plan could not allocate any forfeitures to Becca (thus, answer A is incorrect).
Super Skate, the city’s most popular roller skating rink, has a profit sharing plan for their employees. Super Skate has the following employee information:
(See Image)
The plan requires the standard eligibility and the least generous graduated vesting schedule available. The plan is not top heavy. All of the following statements are correct except:
a) Peter and Cindy are 20 percent vested in their benefits.
b) Greg and Marsha became 100 percent vested when they had been employed for six years.
c) Three of the seven people are eligible to participate in the plan.
d) Mike is not eligible for the plan.
Answer: A
The standard vesting schedule requires individuals to be 21 years of age and have one year of service before becoming eligible for the plan. Greg, Marsha, and Peter are the only individuals that meet those criteria. The least generous vesting schedules are 3-year cliff, and 2-to-6-year graduated vesting. Therefore, Peter is 20 percent vested, and Marsha and Greg became 100 percent vested in the 6th year. Mike is not eligible because he is 16 years old. Cindy is not vested because she is not qualified due to her age.
Lisa’s Saxophone Shop has a profit-sharing plan. The plan requires employees to be employed for two years before entering the plan. The plan has two entrance dates per year, January and July Ist. Assume today is December 1, 20×3, and the shop has the following employee information.
(See Image)
Which of the following statements is true?
a) As of today, three individuals have entered the plan.
b) Marge entered the plan on 5/1/20×3.
c) Bart will enter the plan on 1/1/20×4.
d) As of today, three individuals are eligible for the plan.
Answer: D
Only three individuals are eligible for the plan: Lisa, Marge, and Homer. Lisa and Marge are both in the plan, but Homer is not yet in the plan because there has not been an entrance date since he became eligible.
Bart would not enter the plan until 7/1/20×4.
Which of the following is true regarding negative elections?
1. A negative election is a device where the employee is deemed to have elected a specific deferral unless the employee specifically elects out of the such election in writing.
2. The IRS no longer approves of negative elections.
3. Negative elections are only available for employees who enter the plan when it is first established and is not available for new employees.
a) 1 only.
b) 1 and 2.
c) 2 and 3.
d) 1,2, and 3.
Answer: A
The IRS approves negative elections, which are available for current and new employees.
Tyler’s Kitchenwares has a 401 (k) plan that offers an employer match of dollar-for-dollar up to four percent of employee deferral contributions. Although the plan provides for the least generous graduated vesting schedule available, it does allow employees to enter the plan on their hire date. The employee census is as follows:
(See Image)
Tyler established the plan ten years ago to benefit himself and his only employee, his son Mario. Since then, Tyler hired his other son, Bobby, and his new wife, Rachel. Tyler wanted to establish the 401(k) plan to encourage his children to save for their future. He also wanted a vesting schedule to ensure they would learn the responsibility of sticking to their employment commitments. The family has come to you for recommendations to help them maximize their plan contributions. Tyler is willing to make some alterations to the plan to increase the retirement savings for all of them. Which of the following would not be one of your recommendations?
a) Tyler and Bobby should increase their contributions to reach the total maximum deferral limit.
b) Rachel should enter the plan and contribute 20%.
c) Bobby is not 100 percent vested in the employer match; he should stay employed for at least one more year.
d) Tyler should consider adding a profit-sharing contribution to the plan to increase the contributions.
Answer: B
Yes, Rachel should enter the plan, but she would not be able to contribute 20 percent because the limit for a 401(k) contribution is $20,500 for 2022, and thus she can only contribute 16.4%. Tyler and Bobby should both increase their contributions. Bobby is far from making the maximum contribution and should increase his contribution. The least generous graduated vesting schedule for matching contributions is 2 to 6 years. Thus, Bobby is not 100% vested in the employee match and should stay an additional year. Tyler could increase the contribution for all of them by adding a profit-sharing contribution to the plan. This addition would allow them to reach the annual additions limit of $61,000 for 2022. As you recall, the profit-sharing plan contribution will enable the company to make an additional contribution to increasing employee balances.
Sew What, the best alterations shop in town, sponsors a 401(k) plan. The plan provides a dollar-for-dollar match for employee contributions up to six percent and has immediate vesting for all contributions. For ADP purposes, the company has made the top 20 percent election to determine who is highly compensated. The company has the following employee information:
(See Image)
Which of the following statements is correct?
a) Alice, Brett, and Carmen are all highly compensated.
b) The plan passes the ADP test.
c) Evelyn and Grace are not considered when calculating the ADP test because they do not contribute.
d) Assuming Sew What has made the necessary safe harbor elections, the ADP is irrelevant.
Answer: D
Alice and Brett are the only highly compensated individuals. Alice is the only one that meets the ownership test of greater than five percent. Alice and Brett initially meet the earnings test. Since the company makes the top 20% election, only two people will be considered based on earnings (7 people × 20% = 2 people).
Thus only Alice and Brett will be considered highly compensated because of the election. The plan fails the ADP test. The NHC average ADP is 5%, while the HC ADP is 7.72% [(6.97% + 8.48%) ÷ 2]. Thus using the test, 2 is added to the NHC ADP of 5%, requiring the HC ADP below 7%. Since the HC ADP is 7.72% (.72 over 7%), the plan fails the ADP test. But, since Sew What follows the Safe Harbor rules, the ADP testing is irrelevant if the company has made the necessary, safe harbor elections.
Ethan, age 60, is a participant in the stock bonus plan of Galloway, Inc., a closely held corporation. Ethan received contributions in shares to the stock bonus plan, and Galloway, Inc. took income tax deductions as follows:
(See Image)
Ethan terminates employment and takes a distribution from the plan of 975 shares of Galloway, Inc., having a fair value of $19,500. What are Ethan’s tax consequences?
a) There are no immediate tax consequences because he has not sold the stock.
b) Ethan has an ordinary income of $14,650 at distribution.
c) Ethan has a net unrealized appreciation of $19,500 at distribution.
d) Ethan has an ordinary income of $19,500 at distribution.
Answer: B
Ethan’s ordinary income equals Galloway, Inc.’s deduction at the time of contribution, $14,650 (see chart below). Ethan’s net unrealized appreciation is $4,850 ($19,500 - $14,650) and will be taxed as long-term capital gains when the stock is sold.
shares value per share total amount
100 X $10 = $1,000
125 X $12 = $1,500
150 X $13 = $1,950
200 X $15 = $3,000
400 X $18 = $7,200
$14,650
