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
Q
What does Social Security integration do?
A
- Allows for a higher contribution to those who make ABOVE the SS wage base
26
Q
Understanding SS integration in a Defined Contribution Plan
A
- 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
Q
Permitted Disparity Rules for Defined Contribution Plans
A
- 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
- Employee receives 10% contribution from employer and makes 150k
28
Q
Defined contributon positives/negatives
A
- 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
Q
Money purchase pension plans characteristics
A
- 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
Q
Target Benfit pension plans characteristics
A
- 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
Q
Name the profit-sharing plans
A
- Profit-sharing
- 401k
- Thrift
- Age-based profit sharing
- New comparability plans
- Stock bonus
- ESOP
32
Q
Profit sharing plans - Funding/Contributions
A
- 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
Q
Profit sharing plans - Deadline
A
- 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
Q
Profit sharing plans - Forfeitures
A
- 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
Q
Profit sharing plans - Distributions
A
- 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
Q
Profit sharing plans - SS integration
A
- Permitted disparity is allowed using the EXCESS METHOD
37
Q
Age-Based Profit Sharing Plans
A
- 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
Q
New Comparability Plans
A
- 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
Q
CODA plans
A
- Creates a contributory component (deferrals for employees)
- Includes 401k plans, stock bonus plans, profit sharing plans)
40
Q
CODA - Eligiblity
A
- 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
Q
Some key differences between Roth IRA and Roth 401(k)
A
- 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
Q
Thrift Plans
A
- 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
Q
Stock Bonus Plans
A
- 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
Q
Stock bonus plans - Requirements
A
- 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
Q
Stock bonus plan - What happens if employer stock is publicly traded?
A
- Must allow partiicpants to diversify the contributions in the plan
- Meaning that they can sell the stock and diversify their investments
46
Q
Stock bonus plans - other features
A
- Can add a CODA component
- Same requirements as other profit sharing plans (eligilbity, coverage, vesting)
47
Q
Stock bonus plans - distribuitons
A
- 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.
- Employee can defer recognition of stock’s appreciated value until stock is sold (NUA benefit)
- If cash equivlanet is slected, you lose NUA benefit
48
Q
Stock bonus plans - Pros
A
- Business tax deduction = FMV of stock contributions
- Everyone in corp has interest in company success
- NUA benefit potential
49
Q
Stock bonus plans - Cons
A
- 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
Q
What is an ESOP
A
- 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
Q
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?
A
- 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
- Domestic corporaiton including:
- 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
Q
ESOP - Other requierments
A
- 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
Q
ESOP - Pros
A
- 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
Q
ESOP - Cons
A
- 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
