Types of Retirement Plans Flashcards
Qualified vs nonqualified
Qualified
- subject to IRC code 401a (ERISA)
- may not discriminate
- tax deduction for contributions
- earnings accrue tax deferred until distribution
- distributions taxed ordinary (except 10 yr av, NUA stock bonus, ESOP, 401k
Nonqualified
- retirement plan that does not meet the laws of ERISA
- may discriminate
- no employer tax deduction until employee is taxed
- plan earnings taxable to employer
- distributions taxed ordinary
Defined benefit pension (qualified)
- favors older employees (50+)
- guaranteed benefit amount
- requires stable cash flow
- past service credits allowed
- cash balance plan (pension type of DB)
Defined contribution
- individual account per participant, benefit amount tied to individuals account
- qualified
- vesting schedule
- admin costs
- exempt from creditors
- integrated with SSA
- dont allow past service credit
Money purchase pension
DC
- flat employer contribution based on eligible employee compensation . Only first $330k can be taken into account
1. up to 25% employer deduction (could contribute 100%)(irs website says 25%)
- Section 415: contribution limited to lesser of 100% salary or $66k
2. fixed mandatory contributions
3. stable cash flow needed
When to choose
- employer wants stable workforce (retain key employees)
- employer wants a simple plan
- employees are young and paid well
Target benefit pension
DC (with some DB features)
1. up to 25% employer deduction (could contribute 100%)
- Section 415: contribution limited to lesser of 100% salary or $66k
2. fixed contributions
3. stable cash flow needed
4. favors older employees
5. employee assumes investment risk
6. no annual accrual determination needed (actuary determines initial contribution level)
7. retirement benefit determined by account balance (projected value is actuary targeted amount) (can be lower or higher due to investment performance)
8. forfeitures can be reallocated or reduce employer contribution
when to choose
- alternative to DB plan, provides adequate benefits to older employees but has lower cost and simplicity of DC plan
Profit sharing plan
DC
1. up to 25% employer contribution
2. flexible contribution (must be recurring and substantial)
3. 401k provisions $22,500 (FICA) (hardship withdrawal)
4. SIMPLE 401k is exempt from creditors
5. participant has individual account
6. Balance consists of ER contributions, investment returns, and foreitures
when to choose
- when employer profit varies from year to year
- when employer want to adopt qualified plan with incentive feature to motivate profits
- when employees are young, well paid, and have time to accumulate
Stock bonus plan
DC
1. up to 25% employer deduction if dividends are (cash, used to pay loan, paid to plan and reinvested)
2. flexible contributions
3. 100% of the contribution can be invested in company stock
4. ESOP cannot be integrated with SSA or cross tested
- participant accounts are stated in shares of employer stock
- benefits distributable in employer stock
SIMPLE IRA
DB
1. for small employers (100 or fewer)
2. requires employer match (immediate vesting)
3. salary reduction limit up to $15,500
4. company cannot have another plan
SEP IRA - no salary deferral
DB
1. up to 25% contribution for owner, up to 18.59% contribution for self employed
2. account immediately vested
3. can be integrated with SSA
4. special eligibility: 21+ y/o, paid at least $750, worked 3 out of 5 prior years
SARSEP
DB
1. may have up to 25 employees and 50% of eligible must defer
2. must have been in existence before 12/31/96
3. salary deduction limit $22,500
4. employer contributions may be subject to vesting schedule
403b
DB
1. for 501c3 organizations and public schools
2. subject to ERISA only if employer contributes
3. salary reduction limit up to $22,500
4. employer contributions may be subject to vesting schedule
Factors affecting employee benefits - DC
Years to retirement: benefits can be inadequate for employees entering plan at older ages
Investment return: employees assume the investment risk
Salary levels: contributions based on salary level for each working year rather than salary at retirement
Employer contributions: subject to minimum funding, employees can make contributions as low as 3%
Forfeitures: can be reallocated to participants or applied to reduce employer contributions
401k plan
- provision added to qualified profit sharing or stock bonus plan
- participants have option to put money in plan or receive same amount as taxable cash compensation
- if employee elects to defer, deferral is subject to FICA and FUTA but not federal tax
- $22,500 limit with $7,500 catch up above 50
- Section 415: contribution limited to lesser of 100% salary or $66k
when to choose
- employer wants to provide a qualified plan for employees but can afford only minimal extra expense beyond salary and costs
- employee wants to increase their savings on a tax deductible basis
Solo 401k
- not subject to coverage testing and nondiscrimination rules necessary for typical 401k
- usually permitted when only participants are owner, spouse, and two partners
- 2 different contributions
1. elective deferral up to $22,500 (7.5k catch up over 50)
2. employer contribution up to $66k
Safe harbor 401k
- automatically satisfies the nondiscrimination tests which involve highly compensated employees
- two choices: employer match or non elective contribution
- employer will match 4%, if employee contributes 5% (safe harbor match is $1/$1 on first 3% employee deferral and $.5/$1 on next 2%)
- if chosen nonelective deferral: employer must contribute 3% of all eligible employee compensation regardless of if employee is deferring
- employer contributions immediately vested
- exempt from top heavy rules only if deposits are employee deferrals and employer contributions
Employee stock ownership plan (ESOP)
stock bonus plan that employer can use to borrow money from bank
- must invest plan assets primarily in employer stock
- employers may deduct dividends with respect to stock held in ESOP, need to satisfy one requirement
1. paid in cash directly to participants/ beneficiaries
2. paid to plan then distributed in cash to participants/ benes no later than 90 days after close of plan year
3. used to make payments on loans used to aquire employer securities
4. paid to the plan and reinvested in qualifying employer securities
when to choose
- company wants to broaden ownership of its stock, to create market for stock, provide liquidity to shareholders
- company wants to provide its employees with tax advantaged means to acquire company stock
- wants employees to feel sense of ownership
ESOP diversification
- 55+ having 10 years of participation in ESOP have right to diversify up to 50% of their account balance
- must offer at least 3 investment alternatives or distribute cash
New comparability plan
- contribution percentage formula for one category of participants (managers) is greater than the contribution percentage for other categories
Cross testing (except ESOPs)
- “age weighted” : results in higher contribution rates for older employees
- measures DC plans for nondiscrimination on the basis of benefits
- measure DB plans for nondiscrimination on basis of contributions
- plan designed to provide max benefit to highly compensated while meeting minimum required under nondiscrimination for other employees
- lesser of 1/3rd of HCE contribution percent or 5%?
- optimally average NHCE ages should be 15 years younger than average HCE age
Traditional DB plan
- qualified employer pension plan that guarantees a specified benefit amount at retirement
- required to carry PBGC insurance
when to choose
- an employer wants to maximize plan contributions to older employees
- older controlling employee wants to maximize tax deferred retirement savings for her own benefit
Section 415 limit
Section 415 years old- for DB limit
- max limit on annual benefit that DB can provide
- benefit beginning at 65, max benefit is lesser of 265k or 100% compensation averaged over 3 highest earning years
Unit benefit formula
- DB formula
aka: % of earnings / yr of service formula - factors both service and salary in determining the participants pension benefit
annual pension = (% earning * # years) * av annual comp
Final average method
- earnings are averaged over a number of years (usually 3-5 prior to retirement)
- produces benefit that is better matched to the employees income at retirement rather than career average
- only first 330k of comp taken into account
Past service credits
- service with the employer prior to the inception of the plan
- important to employer setting up new plan with long service employees
- can provide for 2% x final 3 yrs av salary x all years of service with employer
DB caps
- salary cap is 330k
- annual benefit cap is 265k
Benefit formulas
- Unit benefit formula: factors service and salary
- flat % of earnings formula: factors salary
- flat amount formula: treats all employees alike
- final average method: considers comp at retirement
Contributions - DB
- annual funding obligation
factors - participants proximity to retirement
- past service
- forfeitures must be applied to reduce employer contribs
- investment return assumptions
- salary scale assumptions
Cash balance pension plan
- DB
- provides annual employer contributions at specified rate to hypothetical individual accounts for each plan participant
- employer guarantees contribution level and minimum rate of return
when to choose
- looking for less expensive and simpler DB plan
disadvantages
- older, long service employees receive lower benefits when DB is converted to cash balance plan
- lump sum payout generally smaller
412(i) plan
- DB
- funded entirely with insurance
- exempt from minimum funding standards
when to choose
- employers who have need for LI
- allows large contribution but return is lower
Nonqualified retirement plans
- not subject to ERISA
- have no vesting schedule
- simplier and less expensive
- benefits are based on account balance at retirement
- SEP
- SIMPLE
-SARSEP - 403b
