Types of Retirement Plans Flashcards
1
Q
What are qualified retirement plans?
A
- Employer-sponsored plans that must follow a unique set of rules and requirements to maintain its qualified status
- Rules are established in Section 401(a) of the IRC
2
Q
What are the two broad categories of qualified plans?
A
- Pension plans
- Profit sharing plans
3
Q
What are the pension plans?
A
- Defined benefit
- Cash balance pension
- Defined benefit pension
- Defined Contribution
- Target benefit pension
- Money purchase pension
4
Q
What are the profit sharing plans?
A
- These are ALL defined contribution plans
- Profit sharing plans
- 401k plans
- Thrift plans
- Age-based profit sharing plans
- New comparability plans
- Stock bonus
- ESOP
5
Q
Characteristics of Pensions Plans
A
- Pays benefit to participant, usually for duration of their life
- Some pension plans require actuary for minimum funding standards
- Limited in amount they can invest in employer stock (10%)
- Must provide QJSA in pension plans
- Also offers QPSA
- No in-service withdrawals are allowed
- Except for DEFINED BENEFIT PENSIONS PLANS for those over age 62
6
Q
Profit sharing plans characteristics
A
- Allow deferral of compensation and taxation until retirement
- Not subject to minimum funding standards
- Contributions must be “substantial and recurring”
- Not limited in amount to invest in employer securities (100%)
- Does not have to provide QPSA or QJSA
- Can allow in-service withdrawals after two years if plan document permits
7
Q
Defined benefit plans and characteristics
A
- Plans include:
- Defined benefit pension plan
- Cash balance pension plan
- Risk is assumed by employer (employer resonsiblity for investment growth and paying pension benefit)
- Must contribute enough each year to the plan so it is property funded (must be done by actuary each year)
- Commingled accounts rather than indivdiual accounts for employees
- MUST HAVE PBGC insurance (unless firm has less than 25 employees)
- Forfeitures must be allocated toward reducing plan costs
8
Q
Defined contribution plans and characteristics
A
- Can be pension plan (target benefit, money purchase) or any profit sharing plan
- Investmnet risk is assumed by employee to manage assets
- Employer contributions are LIMITED to 25% of covered compensation
- Exceptions are CODA plans where employee can defer up to 100% of their compensation subject to deferral limits
- Individual accounts for employees
- Not subjec to PBGC
- Forfeitures can be allocated to reducing plan costs or toward other participants
9
Q
To be considered a qualified PENSION PLAN, what are the rules and requirements talked about?
A
- Mandatory funding
- In-service withdrawals
- Life insurance
- Employer securities
10
Q
Pension plans - mandatory funding
A
- Requires mandatory funding for ALL PENSION PLANS
- Defined benefit
- Requires actuary EVERY YEAR
- Employer can only DEDUCT the amount required to sufficiently fund the pension pool
- Defined contribuiton pension plan
- Mandatory funding amount is included in plan document and must be made annually
- Defined benefit
11
Q
Pension plans - In-service withdrawals
A
- NONE ALLOWED
- Exception:
- Loans from pension plan, if allowed from plan document
- Defined benefit pension plans only:
- Allow for in-service distribution to participants age 62 and older
12
Q
Pension plans - life insurance
A
- May purchase life insurance as long as it is NOT a primary investment of the plan
- Premiums paid by employer are TAXABLE TO EMPLOYEE
- Must pass ONE of TWO tests in order to remain qualified status:
- 25% test
- 100-to-1 Ratio test
13
Q
Pension plans - life insurance (25% test)
A
- Depends on type of life insurance held:
- Term/universal life held in plan:
- Aggregate premiums paid for policy CANNOT exceed 25% of the employer’s contributions to the account
- Whole life
- Increases to 50% of employer contributions
- Term/universal life held in plan:
14
Q
Pension plans - life insurance (100-to-1 test)
A
- Limits death benefit of life insurance purchased to 100 x the monthly accrued retirement benefit provided under the plan’s defined benefit formula
15
Q
Pension plans - Employer Securities
A
- Assets of a pension plan may be invested in employer securities with limitations:
- Value of employer securities CANNOT exceed 10% of the value of the plan at the TIME OF PURCHASE
- For defined contribution pension plans:
- Employer must allow participants to diversify their holdings:
- At least three different, nonemployer, investment options in the plan (usually cash equivalnets, fixed income, and equities)
- Employer must allow participants to diversify their holdings:
16
Q
Defined benefit pension plan characteristics
A
- Includes defined benefit pension plan and cash balance pension plan
- Actuary
- Raises admin costs
- Commingled accounts
- Employees receive just statements of their accrued benefit
- Investment risk
- Employer bears all risk
- Allocation of forfeitures
- Tor reduce plan costs for employer (requried)
- PBGC
- Pays monthly benefit if plan is ever unfunded or underfunded
- Professional practices (attorney, accountant, etc) with fewer than 25 participants are NOT COVERED
- Credit for prior years’ service
- Must be nondiscriminatory
- Integration with Social Security
- All plans are allowed for this
- Actuary
17
Q
Defined benefit pension plans - integration with social security
A
- Allows for a HIGHER contribution to those who make ABOVE the Social Security wage base
- Two types of integration methods:
- Excess
- Available ONLY for defined benefit pension plan (not cash balance)
- Offset
- Available for ALL plans
- Excess
18
Q
Integration with SS - Excess Method
A
- ONLY for defined benefit pension plan (not the cash balance)
- Provides an excess benefit to those participants who earn more than the average SS wage base over the 35-year period PRIOR to retirement
- Excess benefit is a percentage and is limited to the LESSER of:
- 0.75% per year of service OR
- The benefit percentage of earnigns below the covered compensation limit per year of service
19
Q
Integration with SS - Offset Method
A
- Available to all plans
- Applies a benefit formula to all earnings and then reduces the benefit on the earnings below the average SS wage base
- The reduction in benefit is limited to the LESSER of:
- 0.75% per year of service up to 35 years
- 50% of the overall benefit funding percentage per year of service
20
Q
Defined benefit pension plans - Postives and negatives
A
- Postiive
- Benefiits older employees
- Offset method is available
- Credit for priors’ years service
- Negative for employers
- PBGC in required
- Actuary is required
- Employer bears investment risk
21
Q
Defined benefit pension plan formulas
A
Unit Credit
Takes into account salary AND years of service x a percentage
years of service X avg of hightest 3 years pay X 1.5% = accrued benefit
Flat Amount
Everyone receives same benefit
Example: $6,000/year
Flat Percentage Amount
Avg of highest 3 years pay X 5% (for example)
22
Q
Cash balance pension plans - some differing characteristics
A
- Appears to the particpant as an individual account, however there is actually no separate account for each participiant.
- Employee receives a statement with a hypothetical allocation and hypothetical earnings
- SS integration is only with EXCESS METHOD
23
Q
Conversion from Cash Balance FROM Defined benefit
A
- Requirements required desinged to protect older workers:
- Accrued benefit under the new plan must be equal to or greater than that of any simlarly situated, younger employee.
- Interest rate used to determine the interest credit on the new plan must NOT be greater than the market rate of return
- New plan must provide 100% vesting AFTER THREE YEARS
24
Q
Defined Contribution Pension Plans - Characteristics
A
- Have some characteristics of defined benefit pension plans and profit sharing plans
- Actuary
- Target benefit requires actuary ONLY at beginning of plan (no annual work is required)
- Money purchase does NOT require actuary because annual contribution is predefined
- Commingled Accounts
- Individual investment accounts (employee selects investments)
- Investment risk
- Employee bears all investment risk
- Allocation of forfeitures
- Can be used to reduce future plan costs for employer or allocated to reamining particapnts’ accounts in nondiscrimnatory way
- PBGC
- Does not cover these
- Credit for prior years service
- None
25
What does Social Security integration do?
* Allows for a higher contribution to those who make ABOVE the SS wage base
26
Understanding SS integration in a Defined Contribution Plan
* Permitted disparity
* Through SS integration, plan is allowed a disparity of contributions between HCE and NHCE (so contribution for HCE is increased by a certain rate)
* Social Security Integration
* Attemps to equalize the percentage of contributions for total retirement.
27
Permitted Disparity Rules for Defined Contribution Plans
* Permitted disparity is the LESSER of:
* Base contribuiton percentage (whatever the employer contributes) OR
* 5.7%
* Example:
* Employee receives 10% contribution from employer and makes 150k
* 10% x 150k = 15,000
* 5.7% x (150k - SS wage base) = $974
* Total contribution permitted = 15,000 + 974
28
Defined contributon positives/negatives
* Positives
* Less expensive than defined benefit plans
* No annual actuary required
* No employer risk for investments
* NO PBGC insurance premiums
* Can allocate forfeitures to particpants
* Negatives
* Cannot grant credit for piror years' service
* Cannot integrate with SS using offset method
29
Money purchase pension plans characteristics
* Defined contribution
* Provides a contribution each year of a fixed percentage of employees' compensation
* No specific benefit guaranteed, although the contribuiton is guranteed
* Separate accounts for particpants
* Benefits younger particpants
* Employer cannot deduct contributions more than 25% of total covered compensation paid
30
Target Benfit pension plans characteristics
* Is a type of money purchase plan
* Contributions to each particpant are actuarially equivalent
* Older participants will receive a larger contribution since they are closer to retirement
* Younger will receive less of a contribution
* Actuary is required for establishment of plan, but not after
* Contribution based on the original plan document and funding formula
31
Name the profit-sharing plans
* Profit-sharing
* 401k
* Thrift
* Age-based profit sharing
* New comparability plans
* Stock bonus
* ESOP
32
Profit sharing plans - Funding/Contributions
* Employer is not obligated to make contributions
* Contribution limit of 25% of covered compensation
* Contribuitons are discretionary, but funding must be substantial and recurring
* Contributions are not necessarily correlated with actual profit from company (they don't need to contribute in high profit years and they could contribute in low profit years)
33
Profit sharing plans - Deadline
* Must establish qualifeid plans as late as the due date of the tax return (inlcuding extensions) for the year that the plan is to be adopted
* Same time frame for funding the plan
* For CODA plans;
* Must be set up prior to start of the year so employees can be notified and have time to make elective deferrals
34
Profit sharing plans - Forfeitures
* Can be used to reduce empoyer contributions to plan OR reallocated to particpiants' accounts
* If employees ALREADY HAVE MAX CONTRIBUTION in account, they cannot be given this forfeiture amount
35
Profit sharing plans - Distributions
* Not allowed except for:
* Hardship
* Termination
* Disability
* Retirement
* Can allow for in-service withdrawals after participant has completed TWO YEARS of service under the plan.
36
Profit sharing plans - SS integration
* Permitted disparity is allowed using the EXCESS METHOD
37
Age-Based Profit Sharing Plans
* Uses age and compensation for allocating contributions to employee's account (rather than just compensation like other profit sharing plans)
* Contributions are greater for older employees
38
New Comparability Plans
* Profit shraing plan
* Bases contributions on the employee's CLASSIFICATION in the company as defined by the plan
* MORE expensive to administer because of the several nondiscrimination tests to be met
39
CODA plans
* Creates a contributory component (deferrals for employees)
* Includes 401k plans, stock bonus plans, profit sharing plans)
40
CODA - Eligiblity
* To participate in a 401k:
* Employee cannot be required to complete more than 1 year of service
* Employees under 21 can be exluded (like other plans)
* Plan MUST HAVE TWO ENTRANCE DATES PER YEAR
41
Some key differences between Roth IRA and Roth 401(k)
* Income Limits
* None for ROTH 401K
* Conversions from Traditional IRA
* NO CONVERSIONS allowed for ROTH 401K
* Loan availabliyt
* YES for ROTH 401K
* Qualified Distribuitons
* Both must be held for at least 5 years, but qualified distributions differ from IRA and qualified plan rules
42
Thrift Plans
* These are CODA plans that allow employees to make AFTER TAX contributions
* These contributions are usually made AFTER the elective deferral limit for the year has been met
43
Stock Bonus Plans
* Ideal for employers who want to create a profit sharing plan for employees BUT do NOT have the ability to contribute large amounts of cash.
* Contributions are made in the form of employer stock
44
Stock bonus plans - Requirements
* Participants must have pass-thorugh voting rights on the employer stock held (full voting rights)
* Participants have the right to demand that the employer repurchase the employer stock if stock is NOT publicly traded
* Particpatns have the right to demand the stock be distriubted when requesting a distribuiton from the plan
* Distribuions must begin WITHIN ONE YEAR of NRA, death, or disaiblity, OR WITHIN FIVE YEARS for any other type of employee termination
* Distributions must be FULLY PAID WITHIN FIVE YEARS of the start of distribution
45
Stock bonus plan - What happens if employer stock is publicly traded?
* Must allow partiicpants to diversify the contributions in the plan
* Meaning that they can sell the stock and diversify their investments
46
Stock bonus plans - other features
* Can add a CODA component
* Same requirements as other profit sharing plans (eligilbity, coverage, vesting)
47
Stock bonus plans - distribuitons
* Can allow employee to receive cash insteaad of stock, if availalbe
* IF an employee distributes stock IN KIND:
* Employee can defer recognition of stock's appreciated value until stock is sold (NUA benefit)
* Must be distributed as LUMP SUM for this special recognition of income.
* If cash equivlanet is slected, you lose NUA benefit
48
Stock bonus plans - Pros
* Business tax deduction = FMV of stock contributions
* Everyone in corp has interest in company success
* NUA benefit potential
49
Stock bonus plans - Cons
* Ownership is diluted (only a problem for closely held companies)
* Repurchase option of employees could create cash flow issues for company
* Non-diversified wealth and risk
50
What is an ESOP
* Employee stock owenership plan
* Type of stock bonus plan that provides employees with ownership in the coporation WHILE ALSO PROVIDING OWNERS with TAX ADVANTAGES
* Strucutre of ESOP beings with a trust, which controls the ESOP
* Owner of coporation recieves a tax deduction for any stock that is contributed to the trust from the corporation.
* The ESOP then allocates the stock to separate accounts for each employee participating.
* Common element of ESOP is a leveraged ESOP
* When the retirement plan trust borrows money from a bank to purchase the employer stock
* Corporation repays loan through contributions to ESOP
* These contributions (both interest and principal) are TAX DEDUCTIBLE
51
ESOPs allow owners of a business to selll a portion (or all) of their interest in the corporation and defer the recongition of gain - What requirements are needed to be met to qualify for this?
* ESOP must own at least 30% of the corporation's stock immediately after the inital sale to the ESOP
* Owner (seller) must reinvest the proceeds of the sale into qualified replacement securities WITHIN 12 months of sale
* These replacement securities cannot be sold wtihin THREE YEARS of reinvestment
* Qualified replacemetn securities include reinvestment in:
* Domestic corporaiton including:
* Stocks, bonds, debentures, warrants, stock in S corp
* Qualified replacement securities must receive NO MORE than 25% of their income from passive investments
* Corporation establising the ESOP must have NO CLASS OF STOCK that is tradable on an established securities exchange market (publicly traded)
* Sellers, relatives of sllers, of 25% shareholders in the corporation cannot receive stock through the ESOP
* ESOP cannot sell stock acquired through the rollover transaction for THREE YEARS
* Stock sold to the ESOP must be common stock or preferred stock and must have been owned by seller for THREE YEARS prior to sale to ESOP
52
ESOP - Other requierments
* Participants have same voting rights
* Employer contributions to ESOPs are deductible like any other profit sharing plan
* ESOP can hold 100% of corporate stock
* Participant must be offered diversification within 90 days after close of the plan year
* NOT ELIGIBLE For SS integration (stock bonus plans are)
53
ESOP - Pros
* Business owners may sell company and create diversified portfolio w/o recognzing capital gains
* Business tax deduction = FMV of stock contributions
* Compnay can borrow against stock to make leveraged ESOP
* Everyone in company has interest in comapny success
* NUA potential
* Employees can sell stock to company after certain requiremetns are met
54
ESOP - Cons
* Diluted ownership (problem for closely held corporations)
* Repurchase option of employees could create cash flow problem for corporation
* Costs of regular appraisals of stock value are required, increasing plan costs
* Non-diversified wealth and risk
* Non-liquid stock
* Value of non-traded stock is based on appraisal
