Contains the notes on the Retirement Planning study book material for the CFP Board Exam. It covers the numerous qualified and non-qualified retirement plan options and additional employee benefits.
The Notes
- Starred (*) topics are more likely to be on the exam (2021).
- Qualified Plan Basics
- All defined benefit plans are pension plans
- Defined contribution plans can be pension or profit-sharing plans
- Pension Plans (4-types)*
- Defined Benefit
- Defined Benefit Pension Plans
- Cash Balance Pension Plans
- Defined Contribution
- Money Purchase Pension Plans
- Target Benefit Pension Plans
- Defined Benefit
- Profit-Sharing (7-types)*
- Profit-Sharing Plans
- Stock Bonus Plans
- Employee Stock Ownership Plans
- 401k Plans
- Thrift Plans
- New Comparability Plans
- Age-Based Profit-Sharing Plans
- Pension Plan Characteristics*
- Legal Promise = Pay pension at retirement
- In-Service Withdrawals = Not allowed
- Mandatory Funding = Yes
- Invest in Employer Securities = up to 10% of plan
- Must Provide QJSA/QPSA = Yes
- Profit-Sharing Plan Characteristics*
- Legal Promise = Defer compensation and taxes
- In-Service Withdrawals = After 2 years, if plan permits
- Mandatory Funding = No
- Invest in Employer Securities = Up to 100%
- Must Provide QJSA/QPSA = No
- Defined Benefit Plan Characteristics*
- Contribution Limits = No less than current unfunded liability
- Assumes Investment Risk = Employer
- Forfeiture Allocated = Reduce plan costs
- PBGC Coverage = Yes
- Separate Investment Accounts = No (commingled)
- Credit for Prior Service = Yes
- Defined Contribution Characteristics*
- Contribution Limits = 25% of employee covered compensation
- Assumes Investment Risk = Employee
- Forfeiture Allocated = Reduce plan cost or allocate to other participants
- PBGC Coverage = No
- Separate Investment Accounts = Yes
- Credit for Prior Service = No
- Qualified Plan Advantages*
- Employers
- Employer contributions tax-deductible
- Payroll tax savings on employer contributions
- Does NOT apply to employee deferrals
- Distributions not hit by payroll tax
- Employees
- Can use pre-tax contributions
- Income tax deferral
- ERISA = creditor asset protection
- Lump-sum distribution options
- Employers
- Qualified Plan Disadvantages
- Contribution amounts limited
- Contributions end after distributions begin
- Limited access to funds while employed
- Early withdrawal penalties
- Limited investment options
- Distributions taxed as ordinary income
- Mandatory distributions (age 72)
- Income in Respect of a Decedent asset = distributions subject to estate taxes (no step-up in basis)
- Only owner allowed is account holder
- Can not use as collateral
- No gifts to charity before 70 1/2 (tax consequences)
- Limited enrollment periods
- Plan costs
- Requirements
- Eligibility
- Standard: age 21 or 12 months of service (at least 1,000 hours worked)
- Employers can be more generous — under 21 or less than 12 months
- Beginning 2021 for part-time employees: 500 hours worked minimum for 3 consecutive years
- Entrance Date:*
- Most qualified plans have 2 entrance dates.
- Must wait till next entrance date after eligibility to join plan, so long as next entrance date is not 6 months after elgilibiliy.
- Exception: Special Eligibility Rules
- Deferred to 2 years of service before eligible
- Immediately vested
- Not for 401k
- Coverage
- Must provide to minimum number of non-highly compensated (NHC) employees
- Nondiscrimination
- all eligible employees must be considered, but not all must be covered.
- Coverage Tests
- Must cover at least 70% of non-highly compensated (NHC) employees
- 3 Tests (must pass 1 of 3!)
- General Safe Harbor Test
- % of NHC covered >= 70%
- Ratio Percentage Test
- (% of NHC/% of HC) >= 70%
- Average Benefit Test
- (AB% of NHC/AB% of HC) >= 70%
- Nondiscrimination Test
- General Safe Harbor Test
- Defined Benefit Plans must also pass (in addition to 1 of 3 Coverage Tests):
- 50/40 Test*
- Benefits the lessor of 50 employees or 40% of all nonexcludable (eligible) employees
- Coverage Minimums
- 1 Nonexcludable Employee = 1 Employee must be covered
- 2 to 4 NE = 2 Employees must be covered
- < 125 NE = 40% of Employees
- > 125 NE = 50 Employees
- 50/40 Test*
- Highly Compensated Employees Defined*
- Owner Employees
- Over 5% owner for current or prior plan year, or
- Paid over $130,000 (2021) for prior plan year
- Non-Owner Employees
- Paid over $130,000 (2021) for prior plan year
- Owner Employees
- Vesting
- Ownership of employer contributions transfer to employee
- Termination before 100% vested = loss of portion of employer contributions
- Employee contributions = 100% vested
- Vesting Schedules:
- Cliff
- Immediate 100% vested after a number of years (usually 3)
- Graduated
- Grandual increase in vested percentage over certain number of years (like 2 to 6 years)
- Cliff
- Note: 2 year eligibility deferral = 100% vested after 2 years
- Employers can use faster vesting schedule
- must be better than approved schedules
- Years of Service
- Based on starting date, not date employee is eligible for the plan
- Employer does Not have to count:
- Years of service before age 18 if not participating in a plan
- Years of service before a qualified plan was put in place
- Years of service when employee did not contribute to employee-contributory qualified plan
- Top-Heavy Plans
- Ensures that plans setup to benefit owners/key employees must also provide minimum benefits for other employees.
- Plan is Top-Heavy if:
- More than 60% of benefits or contributions go to key-employees
- Key Employee (1 of following):
- Greater than 5% owner
- Greater than 1% owner, paid over $150,000
- Officer, paid over $185,000 (2021)
- Note: must be owner or officer
- Officer = executive
- If # of officers exceeds 50, than only top 50 by compensation are officers
- Top-Heavy Vesting
- Must use 3 year cliff or 2 to 6 year graduated schedules
- Top-Heavy Funding
- Must provide minimum contributions to non-key employees
- Top-Heavy Defined Contribution Plan = Minimum 3% of compensation
- Exception: when total funding for all key employees is less than 3%, then non-key employee funding must equal key-employee funding.
- Top-Heavy Defined Benefit Plan = At least 2% x Years of Service x Compensation Factor
- Compensation Factor = average annual compensation of test period
- Eligibility
- Benefit/Contribution Limits
- Max Covered Compensation Limit
- Defined Benefit Plan
- $290,000 (2021)
- Defined Contribution Plan
- $290,000 (2021)
- Defined Benefit Plan
- Max Benefit Limit
- Defined Benefit Plan
- Lessor of:
- $230,000 (2021)
- Average 3 highest consecutive paid years
- Lessor of:
- Defined Contribution Plan
- Lessor of:
- 100% of comp
- $58,000 (2021)
- Not including catch-up of $6,500
- Includes: Employer and employee contributions (and forfeitures)
- Lessor of:
- Defined Benefit Plan
- Max Covered Compensation Limit
- Controlled Groups Rules
- Stops owners from splitting businesses to increasing retirement contributions
- 2 or more businesses under common control
- Relationships
- Parent-Subsidiary
- connected through stock ownership
- 80% of the company’s stock is owned by one or more corporations in the group
- Brother-Sister
- 2 or more companies with 5 or fewer common owners with controlling interest and “effective” control
- Control Interest = 80% or more of stock of each corporation
- Effective Control = more than 50% of stock of each company, looking only at each owner’s “lowest common denominator” ownership interest
- 2 or more companies with 5 or fewer common owners with controlling interest and “effective” control
- Combined Group
- 3 or more organizations set up as:
- Each organization is a member of a parent-subsidiary or brother-sister group
- One corporations is parent of parent-subsidiary and member of brother-sister
- 3 or more organizations set up as:
- Parent-Subsidiary
- Affiliated Services Group Rules
- Treats all employees of group members as employed by single employer.
- Pension Plans
- Defined Benefit Plan Characteristics*
- Actuary annually = yes
- Investment risk = on employer
- Forfeitures = must reduce plan costs
- PBGC Insurance = Yes
- Credit for Prior Service = Yes
- Social Security Integration = Offset of Excess
- Separate Investment Accounts = No (commingled)
- Favors = Older employees
- Defined Contribution Plan Characteristics*
- Actuary annually = No (except target benefit at inception)
- Investment risk = on employee
- Forfeitures = reduce plan costs or fund other participants
- PBGC Insurance = No
- Credit for Prior Service = No
- Social Security Integration = Excess Only
- Separate Investment Accounts = Yes (usually separate)
- Favors = Younger employees
- Other Characteristics
- Life insurance investment
- Any qualified plan can purchase life insurance
- Must not be primary focus of the plan
- Premiums paid by employer are taxable to employee
- Must pass 1 of 2 tests:
- 25% Test
- Term Life = premiums cannot exceed 25% of employers total contributions to participants account
- Whole Life = premiums cannot exceed 50% of employers total contributions to participants account
- 100-to-1 Ratio Test
- Limits death benefit to 100x monthly retirement benefit
- 25% Test
- Benefits*
- Defined Benefit
- Accrued Benefit
- Participant has accrued benefit equal to expected future payments
- Calculated by actuary
- subject to mandatory funding
- Accrued Benefit
- Defined Contribution
- Account Balance
- Benefit is what the participant contributions, non-vested employer contributions, and earnings on contributions.
- Account Balance
- Defined Benefit
- Social Security Integration (Permitted Disparity)
- Allows higher contributions to those who’s pay exceeds Social Security wage base
- Excess Method (DB and DC Plans)
- only applies to income in excess of covered compensation limit
- limited to lessor of:
- 0.75% per year of service
- benefit percentage for earnings below the covered compensation limit per year of service
- max increase of 26.25% = o.75% x 35 years
- Offset Method (DB Plans only)
- applies formula to all earnings then reduces it for earnings below the covered compensation limit
- Reduction of benefit limited to lessor of:
- 0.75% per year of service up to 35 years
- 50% of benefit funding percentage per year of service
- max reduction of 26.25% = o.75% x 35 years
- Reduction of benefit limited to lessor of:
- applies formula to all earnings then reduces it for earnings below the covered compensation limit
- Life insurance investment
- Defined Benefit Plans
- Formulas for Benefits
- Flat Amount Formula
- Provides an amount participants receive at retirement
- Not based on years of service or salary
- Each participant gets the same amount
- Disadvantage: no incentive for employees to continue working after hitting max flat amount
- Flat Percentage Formula
- Benefit is a percentage of salary (usually final salary or average of highest salary)
- Percentage is static, does not increase with years of service
- Disadvantage: no incentive to continue work beyond desired benefit amount
- Unit Credit Formula
- Benefit is based on salary and years of service
- Fixed percentage of salary multiplied by years of service
- Flat Amount Formula
- Formulas for Benefits
- Defined Benefit Plan Characteristics*
- Cash Balance Pension Plans
- Defined Benefit Plan
- Creates a hypothetical account for participant with allocation and earnings
- Contribution/Earnings
- Funding formula based on Pay Credit and Interest Credit
- Pay Credit
- May integrate with Social Security
- May use age and years of service
- Interest Credit
- Guaranteed interest return
- Employer responsible for investment performance
- Benefits younger participants more than older
- 3-year cliff vesting
- Conversions
- Popular choice to replace old, expensive DB plans
- Must meet 3 requirements:
- Participants accrued benefit would be equal or greater than any similarly situated younger participant
- Interest Credit = rate used must not be greater than market rate of return
- 100% vesting after 3 years of service for plan years beginning 2007
- Money Purchase Pension Plans
- Defined Contribution Plan
- Employer promises to make a contributions based on fixed percentage of employees pay
- Does NOT guarantee specific retirement benefit
- Contribution Limit
- Limited to lessor off:
- 100% of compensation
- $58,000 (2021)
- Employer can NOT deduct contributions over 25% of employees pays
- Limited to lessor off:
- Contributions made to separate accounts
- Benefits younger participants more than older
- Subject to shorting vesting requirements (3-year cliff or 2 to 6 year graduated)
- Target Benefit Pension Plans
- Defined contribution plan
- Type of money purchase pension plan
- Benefits older participants more than younger
- Funding formula based on benefit paid at the participants retirement
- Does NOT guarantee specific retirement benefit
- Employee is responsible for choosing investments
- Profit-Sharing Plans
- Contribution/Allocation Formulas
- Social Security Integration (Permitted Disparity)
- Excess method only allowed.
- Applies two rates:
- Base contribution rate
- applies to income up to Social Security wage base
- Excess contribution rate
- applies to income over SS wage base but up to $290,000 (2021)
- Limited to lessor of:
- twice the base rate, or
- 5.7%
- Excess rate is generally 5.7% higher than base rate*
- Base Rate + Permitted Disparity = Excess Rate*
- Permitted Disparity = lessor of Base Rate or 5.7%*
- Base contribution rate
- Age-Based Profit-Sharing Plans
- Contributions based on age and compensation
- Benefits older employees/owners
- New Comparability Plans
- Contributions based on employee classification in company
- Must meet cross-testing rules, to be nondiscriminatory.
- More expensive to manage
- Forfeitures
- Reduce plan contributions or reallocate to remaining participants
- Reallocation can not be discriminatory
- Social Security Integration (Permitted Disparity)
- Vesting
- Standard 3-year cliff or 2 to 6 year graduated
- Exception: 2 year wait period is 100% vested
- Standard 3-year cliff or 2 to 6 year graduated
- Cash Or Deferred Arrangements (CODA)
- Allows employees to defer a portion of pre-tax salary
- Exception: defer salary on a Roth basis
- 401k Plans
- Entities can establish 401k plans?*
- Corporations
- Partnerships
- LLCs
- Proprietorships
- Tax-exempt entities
- Eligibility
- Year of service limits must NOT exceed 1 year
- Vesting
- Employee contributions = 100% vested
- Employer contributions = 3-year cliff or 2 to 6 year graduated (or more generous)
- Participation
- Salary Reduction Agreement = employee agrees to reduce salary for ability to defer contributions to plan.
- Contributions
- Made as:
- Employee elective deferral contributions (traditional or Roth)
- Employee after-tax contributions
- Employer match
- Employer profit-sharing
- Employer contribution to fix ADP/ACP issue
- Employee Deferrals
- Annual Limit = $19,500 (2021)
- Catch-Up Limit = $6,500 (2021)
- Tax Impact
- Deferrals not taxed
- Exception: Roth 401k and thrift plan contributions
- Thrift Plan Contributions
- Allow employee after-tax contributions
- Can save more than elective deferral limit
- Roth 401k Contributions*
- Only after-tax contributions allowed
- Limits
- Annual Limit = $19,500 (2021)
- Catch-Up Limit = $6,500 (2021)
- Limits apply to both 401k and Roth 401k contributions combined.
- Roth 401k Distributions
- Follows minimum distribution rules
- To be qualified = must be held for 5 years and made because of disability, death, or after age 59 1/2
- Employer Contributions
- Matching Contributions
- Provided to employees that contribute
- Vesting limits = 3-year cliff or 2 to 6 year graduated (or quicker)
- Non-elective Contributions
- Contribute to ALL employees if they contribute or not
- Profit-Sharing Contributions (Stock Bonus)
- Does not count against contribution limits of 25%
- Still limited to $58,000 or $64,500 age 50 or more (2021)
- Matching Contributions
- Made as:
- Nondiscrimination Testing
- Must meet 2 more tests
- Test whether non-highly compensated employees (NHC) are discriminated against
- Actual Deferral Percentage Test (ADP)*
- Permissible Levels
- If ADP for NHC is 0% to 2% = permissible ADP for HC is 2x ADP for NHCs
- If ADP for NHC is 2% to 8% = permissible ADP for HC is 2 + ADP for NHCs
- If ADP for NHC is 8% or more = permissible ADP for HC is 1.25x ADP for NHCs
- Methods
- Prior Year
- uses prior years ADP for NHC employees to calculate max permissible deferrals for HCs
- Current Year
- uses current years ADP for NHC employees to calculate max permissible deferrals for HCs
- offers higher deferral percentage to HCs (usually) and more flexibility in case of ADP failure
- Prior Year
- Failure
- At risk of disqualification
- Fixes:
- Corrective Distributions
- Easiest/cheapest
- Return funds to HCs
- Earnings on returned funds must also be returned
- Must be done within 2 1/2 months after end of plan year or 10% excise tax imposed on amount
- Recharacterization
- Excess recharacterized as after-tax contributions
- Recharacterized become taxable income to employee
- Must be done within 2 1/2 months after end of plan year or 10% excise tax imposed on amount
- Qualified non-elective contributions (QNEC)
- Employer makes non-elective contribution to ALL NHC employees
- Discrimination test sees it as an elective deferral by employee
- Increases ADP of NHC
- 100% vested
- Qualified matching contributions (QMC)
- Match only made to NHC employees that participate
- Increases ADP of NHC
- 100% vested
- Corrective Distributions
- Permissible Levels
- Actual Contribution Percentage Test (ACP)
- Tests after-tax contributions and employer-matching contributions
- Calculated the same as ADP
- If failed, uses same corrective measures as ADP
- Safe Harbor 401k Plans
- Avoids the ADP/ACP and top-heavy tests
- Employer Contributions either:
- 3% minimum non-elective contribution
- ALL employees
- Match
- 100% of first 3% employee elective deferrals, and
- 50% of next 2% deferrals
- 3% minimum non-elective contribution
- Immediate 100% vested
- Convert 401k to Safe Harbor 401k
- Must elect to convert within 30 days of plan’s year end
- Non-elective contributions must be at least 4% for ALL employees
- Only for plans beginning after 12/31/19
- Automatic Enrollment
- Negative Election feature = automatic enrollment
- Employee must opt-out (opt-out must be an option)
- Plans that offer “qualified automatic enrollment” eligible for nondiscrimination safe harbor
- Treated as meeting ADP/ACP tests
- Requirements (employee contribution must be at least):
- 3% of comp the first year
- 4% the second year
- 5% the third year
- 6% the fourth year and after
- Percentage must be applied uniformly to ALL eligible employees
- Matching Contributions
- 3% non-elective contribution, or
- NHC Match of 100% of first 1%, 50% of next 5% and
- rate of HCs match is not greater than NHCs
- Vesting = 2-year cliff (or sooner)
- Entities can establish 401k plans?*
- Plan Loans
- Permitted but not required
- If offered:
- must be equally available
- must be limited in amounts
- must be paid back in certain time period
- must charge reasonable interest rate
- must be adequately secured
- Characteristics
- Usually with 401k or 403b plans
- Limits to lessor of:
- 1/2 vested plan benefit
- $50,000
- If vested benefit >= $10,000
- limits to greater of:
- $10,000
- vested benefit
- limits to greater of:
- $50,000 max loan reduced by highest outstanding balance in prior 12 months
- Repayment
- Must be repaid in 5 years
- Repayment is done at a “substantially level amortization” rate
- Exception: loan for personal residence — repaid up to 30 years
- Usually done through payroll deduction
- Failure to repay treated loan as distribution — 10% penalty possible
- Must be repaid on termination (grace period allowed)
- Distributions
- Hardship Distributions
- Limited to maximum distribution amount
- Max = employee’s total elective deferrals (less previous distributions)
- Can include (not required) QNECs, QMCs, safe harbor contributions, and earnings on those amounts
- Qualified Disaster Distributions
- Up to $100,000 from qualified plan, IRA, 403b, 457 made before 6/25/2021
- Taxes on amount spread over 3 years
- Repayment in 3 years is not considered a rollover
- NO 10% early withdrawal penalty
- Hardship Distributions
- Allows employees to defer a portion of pre-tax salary
- Contribution/Allocation Formulas
- Stock Bonus Plans
- Allow employers to contribute stock to qualified plan
- Requirements
- Must have pass through voting rights on stock
- Be able to demand stocks on distributions
- Employer must repurchase stocks if not publicly traded
- Distributions must began within 1 year of normal retirement age, death, disability
- Or 5 years of other termination
- Distributions must be fully paid in 5 years\
- Advantages
- Employees
- May encourage contributions
- Increased stock value at retirement
- Net Unrealized Appreciation (NAU) tax treatment on lump-sum stock distributions
- Employers
- FMV of stock tax deductible to employer = lower tax costs
- Employees have vested interest in company’s success
- Employees
- Disadvantages
- Employees
- Diversification risk — 100% employer stock
- Employers
- Share dilution
- Repurchase option requirement could deplete cash
- Employees
- Distributions
- In stock or cash (if cash, NAU benefit is lost)
- Taxation
- Lump-sum Distribution
- Ordinary income tax on stocks FMV at time of contribution
- Net Unrealized Appreciation (NAU) not taxed until sold — LTCG on appreciation
- Installment Distribution
- Everything taxed as ordinary income (NAU is lost)
- Exception: stock bought with after-tax contributions
- Everything taxed as ordinary income (NAU is lost)
- Lump-sum Distribution
- Deductible Contribution Limits
- 25% of covered comp
- Valuation
- Appraisal generally needed
- Eligibility
- Same as Qualified Plans (21 and 1 year of service or 2 years w/ 100% vesting)
- Allocation Method
- % of comp or formula based on age and service
- Social Security Integration = Allowed
- Vesting
- 3-year cliff or 2 to 6 year graduated
- In-Service Withdrawals
- Allowed (not required) after 2 years
- Loans
- Allows but not required (not usually)
- Employee Stock Ownership Plans (ESOPs)
- ESOP is controlled by a trust
- Trust borrows money to buy stock
- Companies repay loan with tax-deductible contributions to ESOP (income and principal payments are tax-deductible)
- Lets owners sell all/part interest in company and defer capital gains.
- Requirements:*
- ESOP must own at least 30% of stock after sale.
- Seller(s) must reinvest proceeds into replacement securities within 12 months after sale and hold for 3 years
- Qualified replacement securities = domestic company stocks, bonds, warrants, debentures (receive no more than 25% of income from passive investments).
- Stock not tradable on exchange
- Sellers, sellers relatives, and 25% shareholders cannot get stock through ESOP
- ESOP may not sell stock from rollover for 3 years
- Stock must be common or convertible preferred stock
- Seller must own stock for 3 years before selling.
- If seller buys/holds replacement securities for 3 years = no taxable event
- Requirements:*
- Advantages
- Employee
- Retirement vehicle and ownership w/ voting rights
- job preservation — buys companies from owner
- Vested in company’s success
- NAU tax treatment
- Employers
- ESOP is ready/available buyer with deferred tax treatment for retiring owners
- Loan repaid with tax-deductible contributions
- Owner can created diversified portfolio with sale proceeds
- Employee
- Disadvantages
- Employee
- Diversification risk — 100% employer stock
- Exception: age 55 and 10 years service, employer must offer diversification options
- Stock value subject to appraiser and fluctuations
- Illiquidity
- Diversification risk — 100% employer stock
- Employers
- Dilutes ownership
- Higher costs — admin and appraisal
- Repurchase option requirement could deplete cash
- Trustees of ESOP have personal liability concerns
- Employee
- Distributions
- Subject to minimum distribution requirements
- Lump-sum Distribution
- Ordinary income tax on stocks FMV at time of contribution
- Net Unrealized Appreciation (NAU) not taxed until sold — LTCG on appreciation
- Equal Periodic Payments
- NAU is lost
- Taxed as ordinary income
- Period no longer than 5 years
- Exception: balances over $1,650,000 (2021), period is extended 1 year per each additional $230,000 up to 10 years max.
- Deductible Contribution Limits
- 25% of covered comp plus interest paid on loans
- Valuation
- Appraisal generally needed plus dividends
- Eligibility
- Same as Qualified Plans (21 and 1 year of service or 2 years w/ 100% vesting)
- Allocation Method
- % of comp or formula based on age and service
- Social Security Integration = NOT allowed
- Vesting
- 3-year cliff or 2 to 6 year graduated
- In-Service Withdrawals
- Allowed (not required) after 2 years
- Loans
- Allows but not required (not usually)
- Qualified Plan Distributions
- Any money taken out with no intention of being returned (includes loans not being repaid)
- Options
- Pension Plans
- Early Termination (before retirement age)
- Lump-sum distribution – taxed as ordinary income
- Rollover assets to IRA or other plan
- Leave funds in pension
- Forced payout = balanced under $5,000 may auto-rolled into IRA without timely decision.
- Normal Retirement
- Standard: single life annuity payable over participants life
- Subject to ordinary income tax
- Married persons must be offered QJSA
- Qualified Joint and Survivor Annuity (QJSA)
- Must be offered to married participants or pension and profit sharing plans
- Pays benefit as long as either spouse lives.
- Payment ranges from 50% to 100% after first death
- Nonparticipant spouse can waive right to QJSA via written notarized waiver
- Must be waived during 90 day period before annuity start date
- Qualified Pre-Retirement Survivor Annuity (QPSA)
- Must be offered to married participants or pension and profit sharing plans
- Provides benefit to spouse if participant dies before retirement age.
- Nonparticipant spouse can waive right to QJSA via written notarized waiver
- Subject to ordinary income and estate tax
- Early Termination (before retirement age)
- Profit Sharing Plans
- Early Termination
- Lump-sum distribution – taxed as ordinary income
- Rollover to IRA or other plan
- Annuitize the account
- Normal Retirement
- Not required to offer annuity options
- Early Termination
- Pension Plans
- Distribution Taxation
- Taxed as ordinary income (if pre-tax contributions)
- Mandatory 20% withholding from qualified plan distributions
- Rollovers
- Direct Rollover
- Balanced rolled “directly” into account in another plan or IRA
- NO 20% withholding
- Indirect Rollover
- Balanced given to participant who transfers it to account in another plan or IRA
- 20% withholding applies
- Must transfer the full amount (including 20% withholding) to another plan or IRA within 60 days
- After-Tax Contributions
- Plans with after-tax dollars can only be rolled into other qualified plans that allow after-tax dollars or Traditional IRA
- Direct rollover only
- Direct Rollover
- Adjusted Basis in Distributions if:
- Made after-tax contributions to a plan, or
- Taxed on life insurance premiums held in plan
- Annuity Payments
- Return of adjusted basis = tax free
- Ordinary income
- Think Exclusion Ratio
- Lump-Sum Distribution
- May get special tax treatment
- Requirements (all 4 needed to qualify):
- Must be entire accrued benefit/account balance
- On account of death, age 59 1/2, disability, separation from service
- 5 years of participation prior to distributions
- Must elect lump-sum via Form 4972 attached to tax return
- Special Tax Options Lum-Sum Distributions
- 10-Year Forward Averaging
- Not likely tested
- Born before 1/2/1936 is eligible
- Take taxable portion of lump-sum, divide by 10, apply 1986 income tax rates on amount, then multiple by 10 for tax owed.
- Paid in year of lump-sum
- Pre-1974 Capital Gains Treatment
- Not likely tested
- Born before 1/2/1936 is eligible
- 20% capital gains tax on portion of lump-sum attributed to pre-1974 participation
- Net Unrealized Appreciation (NAU)*
- For lump-sum employer stock (or other securities) distributions
- NAU = FMV at Date of Distribution – Value at date of Employer Contribution
- Value at date of Employer Contributions = taxed as ordinary income
- NAU = taxed as long term capital gains at sale of securities
- Gains after the date of distribution is treated as short or long term capital gains
- Potential Issues
- Must qualify for lump-sum
- NUA portion should be large enough to be worth the savings
- Diversification Risk = large allocation in 1 stock
- Inherited Securities w/ NUA
- Step-up in basis to FMV at death less unrecognized NUA
- Tax paid when heirs sell
- 10-Year Forward Averaging
- Qualified Domestic Relations Order (QDRO) on Retirement Distributions
- Order recognizing the right of a third-party to benefits from qualified plan
- Two options:
- Shared Payment Approach
- splits the benefit payments between participant and third-party
- Separate Interest Approach
- divides participants benefit into two separate portions
- Shared Payment Approach
- Third-party may deposit distribution into IRA or qualified plan tax free.
- Distributions Before 59 1/2
- Subject to 10% early withdrawal penalty
- Exceptions to 10% penalty:*
- Death
- Age 59 1/2
- Disability
- Substantially equal periodic payments (72t)
- Medical expenses over 7.5% of AGI
- $5,000 per taxpayer for Birth or Legal Adoption
- Qualified Domestic Relations Order (QDRO)
- Qualified public safety employee separated from service after age 50
- Age 55 and separated from service
- Dividends paid within 90 days of plan year end from ESOP
- Tax levy on plan = used to pay unpaid income taxes
- IRA Exceptions to 10% penalty*
- First time home purchase
- health insurance
- death
- disability
- higher education
- medical expenses
- equal periodic payments
- age
- 72t — Substantially Equal Periodic Payments
- Avoids 10% penalty if:
- Must be made at least annually for life of participant or life of participant and beneficiary
- Must begin after participant separates from service
- 3 Payment Options:
- Required Minimum Distributions
- RMDs taken annually
- Fixed Amortization Method
- Fixed installment payments based on participants life expectancy (joint life expectancy if married)
- Fixed Annuitization Method
- Fixed distribution payments based on account balance and mortality tables
- Required Minimum Distributions
- Payments must continue for later of 5 years or reaching age 59 1/2
- Any payment changes = participant seen as taking a distribution of full account balance in first year of “substantially equal periodic payments”
- Avoids 10% penalty if:
- Minimum Distributions*
- Required minimum distributions must start:
- At age 70 1/2 if reach 70 1/2 before/by 12/31/2019
- At age 72 if reach 70 1/2 after 12/31/2019
- 50% excise tax on RMD amount (less anything taken) if NOT taken by required date.
- Apply to qualified plans, 401k, 403b, SEP, SIMPLE, 457, Roth 401k, Roth 403b, Roth 457, inherited Roth IRA
- Do NOT apply to Roth IRA
- Taken By:
- First RMD Distribution
- taken by April 1 of year after year attain age 72 (if reach 70 1/2 after 12/31/2019)
- Otherwise, taken by 12/31 of same year
- First RMD Distribution
- Exception:
- If still employed by plan sponsor at age 72
- Begin taking RMDs on April 1 of year after terminates employment
- NOT available for greater than 5% owners of plan sponsor
- Calculating RMDs
- Divide account balance at 12/31/xx in year before distribution year by Distribution Period (based on age at END of distribution year) on Uniform Life Table
- Exception:
- If spouse is over 10 years younger than participant, use Joint Life Expectancy Table
- Multiple Plans/IRAs
- Qualified Plans — RMDs must be taken from EACH qualified plan i.e. RMD from each plan
- IRAs — RMDs from IRAs can be taken from 1 or more IRAs based on total balance of all IRAs
- RMDs and Participants Death*
- RMDs are required after participants death
- RMD calculated as though participant did not die
- Death After Starting RMDs (death on/prior to 12/31/19)
- Uses beneficiary’s life expectancy factor at the END of the year following year of death
- Life expectancy is reduced by 1 every year after.
- More than 1 beneficiaries = use oldest beneficiary (shortest life expectancy)
- Can also divided plan into separate accounts and use life expectancy for each beneficiary
- Trust as Beneficiary = use the beneficiary of trust, provided:
- trust is valid
- irrevocable trust (or will be at death)
- can identify trust beneficiaries
- documents get to plan admin
- Spouse Beneficiary
- Surviving spouse can get RMDs over remaining life based on single-life expectancy
- If sole beneficiary, can rollover plan into own account and wait until they reach age 70 1/2
- No Beneficiary
- Distributions continue remaining period (reduced by 1) of deceased owner
- Death Before Starting RMDs (death on/prior to 12/31/19)
- If participant dies before the required beginning date, then rules depend on beneficiaries.
- Spouse Beneficiary
- Start RMDs in year deceased participant hit age 70 1/2.
- If sole beneficiary, rollover plan and wait till they hit age 70 1/2
- Distribute entire balance within 5 years of participants death
- Nonspouse Beneficiary
- Distribute entire balance within 5 years of participants death
- Distribute based on remaining life expectancy (minus 1 year) of beneficiary (not recalculated)
- Rollover plan but distribute within 5 years or remaining life expectancy of beneficiary
- No Beneficiary
- Distribute entire balance within 5 years of participants death
- RMDs and Death Post 12/31/19
- All eligible designated beneficiaries can distribute assets over their life expectancy
- Eligible Designated Beneficiaries are:
- Surviving Spouse
- can rollover assets to own IRA
- If deceased participant was under 72, can postpone RMDs until participant hit 72
- Child participant, not age of majority
- Distribute within 10 years after reaching age of majority
- Disabled/Chronically Ill Person
- Anyone else not more than 10 years old younger participant
- If eligible beneficiary dies, their beneficiary must distribute assets within 10 years
- Surviving Spouse
- Designated Beneficiary
- Does not meet criteria for Eligible Designated Beneficiaries
- Balance paid out within 10 years
- Non-designated Beneficiary
- Includes estates, charities, trusts
- Use pre-Secure Act rules
- After RMD
- Use owners age as of birthday in year of death
- Reduce life expectancy by 1 each year
- Take RMD for year of death
- Before RMD
- Take entire balance within 5 years
- Required minimum distributions must start:
- Administration of Qualified Plans
- Steps to Picking a Plan
- Establish objectives for the plan.
- to benefit owner, all employees, key employees, retain/reward employees, encourage early retirement, etc.
- Prepare employee census to identify who benefits from various plans and the financial costs of those plans on business
- Identify types of plan that meet objectives
- Assess characteristics of each plan
- Select plan
- Establish objectives for the plan.
- Employee Census
- Identifies employees, age, pay, years employed, ownership interest
- Sees which employees benefit from various plans
- Review employee turnover and potential forfeitures
- Establish a Qualified Plan
- Adopting Written Plan
- Plan must be detailed in writing.
- Master/Prototype Plan
- Standard forms, pre-approved by IRS, used by most companies
- Individually Designed Plans
- For companies with specific needs not in master/prototype plan
- Plan must be permanent
- Determination Letter
- Used when plan is adopted, amended, terminated
- Filed Form 5300
- Notifying Eligible Employees
- Info on plan must be sent to eligible and ineligible employees
- Employer must provide IRS evidence in notified employees before it issues a determination letter
- Summary Plan Description = summary of plan — must be provided to employees free of charge
- Same for any plan changes
- Summary Annual Report must be provided to participants
- Qualified Trusts
- Assets must be in a qualified trust or custodial account
- Investing Plan Assets
- Either managed by sponsor or participant depending on plan
- Sponsors generally considered fiduciaries of plan
- Must offer at least 3 investment option that meets this Criteria:
- Be diversified
- Different risk/return characteristics
- Each option, when combined, with another should minimize overall risk
- Adopting Written Plan
- Administration
- Ongoing admin and maintenance
- Plan Operations
- Cover Eligible Employees
- run annual coverage testing
- Make Appropriate Contributions
- Meet Minimum Funding Requirements for pension plans each year
- done by due date — due date of tax return
- No promissory notes
- Nondeductible contributions are allowed by participants
- Take Deductions
- Employer deductions
- DC Plans – deductions can not be more than 25% of comp paid
- DB Plans – deductions depend on actuarial assumptions for mandatory funding
- Both DC and DB Plans — Max deduction is greater of 25% of comp paid or required minimum funding for DB plan
- Employee elective deferrals not included
- Self Employed Deduction Limits (Keogh Plans)
- Self-Employed Contribution Rate = Contribution Rate/(1 + Contribution Rate)
- Self-Employment Tax = (Net Income x 92.35%) x (12.4% up to $142,000 + 2.9%)
- Self-Employed Contribution = (Net Income – 1/2 Self-Employment Tax) x Self-Employed Contribution Rate
- The 25% limit is actually only 20% for Self-Employed contributions (Keogh Plans)*
- Because self-employed pays employer’s share of self-employment tax
- Employer deductions
- Carryover Excess Contributions
- Excess contributions by employer carried forward to future years.
- May be subject to 10% excise tax
- Prohibited Transactions*
- Transactions between plan and disqualified persons like:
- Fiduciary of plan
- Person providing service to plan
- Employer, with employees in plan
- Employee organization, members covered by plan
- Direct or indirect owner of 50% of any of the following:
- Combined voting power of all stock of corporation
- Capital interest/profits interest of partnership
- Beneficial interest of trust
- Family member of the above
- Examples:
- Transfer plan income/assets to use for benefit of disqualified person
- Self-delaing by fiduciary
- Receipt of consideration by fiduciary for own account when working with another party (attorney, accounting)
- Sell, exchange, lease, buy, lend, borrow between disqualified persons and plan
- Penalty
- No penalty if corrected in 14 days
- Initial Penalty = 15% excise tax on amount involved
- Additional 100% excise tax if not corrected in tax year
- Transactions between plan and disqualified persons like:
- ERISA and Filing Requirements
- Imposes fiduciary responsibility
- Requires admin provide benefits statement
- quarterly to participants who direct their own accounts
- annually to participants with own account in plan
- to other beneficiaries on written request
- Pension Benefit Guaranty Corporation (PBGC)
- guarantees pension benefits
- does NOT cover DB plans w/ 25 or fewer participants
- does NOT cover DC plans
- Cost to plan of $86 per participant per year and $38 per $1,000 of underfunding per year (2021)
- Cover Eligible Employees
- Amend/Terminate Plan
- Employers can change or terminate the plan
- Reasons
- Changed to maximize benefits to key employees
- Law changes make plan obsolete
- Plan becomes too costly
- No longer meets needs/objectives
- Reasons
- Amending Plan
- Amend plan document
- Must revise Summary Plan Description
- Terminating Plan
- Participants become fully vested (assuming funds are available)
- Permanency Requirement
- “permanency” is not forever, just can not be temporary benefit to owners/key employees
- DB Plan Termination
- Standard Termination
- Voluntary — employer has enough assets to cover all benefits
- Distress Termination
- Voluntary — employer in financial trouble unable to continue plan financially
- Involuntary Termination
- Involuntary — initiated by PBGC for plans unable to pay benefits
- Standard Termination
- DC Plan Termination
- Pass corporate resolution to terminate plan
- Complete final contributions and distribute assets
- Pan Freeze
- Employer ends contributions but no termination
- DC Plans — employer no longer contributes
- DB Plans — participants no longer accrue benefits, sponsor maintains previous accrued benefits
- Employers can change or terminate the plan
- Steps to Picking a Plan
- Other Tax-Advantaged Plans
- Individual Retirement Accounts (IRAs)
- Traditional IRAs
- Two Forms
- IRA account — holds a variety of investments through variety of custodians
- IRA annuity — held by insurance company
- Contribution Limits
- Requires Earned Income to contribute — lessor of earned income or annual limit
- Limit — $6,000 (2021)
- Age 50 catch-up limit – $1,000 (2021)
- Note: Age 70 1/2 — no age restriction on contributions (removed by Secure Act)
- Earned Income
- No earned income — no contribution
- Note: Alimony from divorce agreement after 2018 is NOT income
- Exception: Spousal IRA
- can be established for spouse with no earned income if other spouse has enough earned income
- Earned Income Is:*
- W-2 Income
- Schedule C net income
- K-1 income from LLC
- K-1 income from partnership (material participant)
- Alimony if divorce agreement prior to 12/31/18
- NOT Earned Income:*
- Earnings/profits from property — rental, interest, dividend income
- Capital gains
- Pension/annuity income
- Deferred compensation received
- Partnership income (non-material participant)
- Anything excluded from income — foreign income
- Alimony if divorce agreement after 12/31/18
- Unemployment benefits
- Investment returns (from limited partnership)
- S-Corp income
- Social Security benefits
- Worker’s Comp
- Excess Contributions
- Subject to 6% excise tax per year excess remains in IRA
- Contribution Due Date
- April 15th after the tax year
- Made in cash
- Contribution Deductibility*
- No Qualified or Other Retirement Plan
- No income limits
- Fully deductible
- Active-Participant of Qualified or Other Retirement Plan
- Fully deductible up to the AGI Phaseout
- No deduction over the phaseout
- AGI Phaseout
- MFJ — $105k to $125k (2021)
- Single — $66k to $76k (2021)
- Solo Spouse Participant
- one spouse is active participant, other is not
- Fully Deductible for nonparticipant spouse if joint AGI does not exceed $208,000
- AGI Phaseout = $198k to $208k (2021)
- Active Participant Status
- Employee with benefits from one following plans:
- Qualified plan
- Annuity Plan
- 403b (Tax-Sheltered Annuity)
- Government Plans
- SEPs
- SIMPLEs
- Employee with benefits from one following plans:
- No Qualified or Other Retirement Plan
- NonDeductible Contributions
- Allowed — adjusted basis on after-tax contribution
- Withdrawals are mix of return of basis and taxable income
- Disributions
- Taxed as ordinary income
- Exception: nondeductible contributions — return of basis and taxable ordinary income
- Adjusted Basis Portion calculated:
- AB Ratio = AB before withdrawal/FMV of account
- Multiply ratio by distribution amount
- Taxable Portion calculated:
- OI Ratio = 1 – AB Ratio
- Multiply ratio by distribution amount
- Adjusted Basis Portion calculated:
- RMDs
- Must start no later than April 1 of year after owner hits age 72
- 50% excise tax on RMDs not taken
- 10% Early Withdrawal Penalty
- 10% penalty on withdrawals before 59 1/2
- Exceptions:
- Death
- Age 59 1/2
- Disability
- 72t — substantially equal periodic payments
- Medical expenses over 7.5% of AGI
- $5,000 for birth or adoption of child
- Higher education expenses
- First-time home purchase up to $10,000
- Health insurance premiums if unemployed
- IRA Annuity
- Not transferable
- Benefits not forfeitable
- Benefits must go to owner or beneficiary
- Premiums can not exceed $6,000 (2021)
- If premiums cease, owner has the right to a paid-up annuity and forgo further premiums
- Same distribution rules apply
- Two Forms
- Roth IRAs
- Main Differences to Traditional IRA*
- Contributions = not deductible
- Distributions = nontaxable income
- NO RMDs required (only after death)
- Contributions
- Funded with earned income
- Limit — $6,000 (2021)
- Age 50 catch-up limit – $1,000 (2021)
- Must be within AGI Limits to contribute
- AGI Phaseout
- Single = $125k to $140k
- MFJ = $198k to $208k
- MFS = $0 to $10k
- Conversions
- Convert Traditional IRA to Roth IRA
- Conversion amount is taxable income in year of conversion!
- Convert Traditional IRA to Roth IRA
- Recharacterized Contributions
- Owners may “recharacterize” contributions to one type of IRA, to another type for the year by tax return due date.
- Cannot be used to for Roth conversions
- Distributions
- Not included in gross income if qualified
- Qualified Distributions*
- Must be:
- Made after a 5 taxable year period beginning Jan. 1st of year of first contribution
- Meets one of following:
- Made at or after age 59 1/2
- Made to beneficiary, owner’s estate, or after owner’s death
- Due to disability
- For first-time home purchase up to $10,000
- Must be:
- NonQualfied Distributions
- Treated on a FIFO basis
- 1st = Regular annual contributions
- 2nd = Conversion contributions
- 3rd = Earnings on contributions
- Treated on a FIFO basis
- 10% Early Withdrawal Penalty
- Applies to portion included in gross income (earnings portion)
- Applies to non-qualified distributions of conversion contributions taken inside the 5-year window.
- Main Differences to Traditional IRA*
- IRA Issues
- Prohibited Investments*
- Life Insurance
- Collectibles
- art
- antiques
- metal
- gems
- stamps
- coins
- wines
- etc.
- Exception: certain US minted coins and bullion and gold, silver, platinum, palladium
- Purchase of either is treated as distribution, subject to tax and/or penalty
- Tax-Free Charitable Distributions
- Excluded from gross income up to $100,000 per taxpayer per year
- Must be made directly from IRA to charity
- IRA Rollovers
- From Qualified Plans
- Employees can roll qualified plan balance to IRA upon termination
- IRA rollover funds can be rolled into another qualified plan, if permitted
- To Qualified Plans
- Only if permitted by qualified plan
- Indirect Rollover
- Distribution to participant then to IRA account
- Must be completed in 60 days
- Only one 60 day rollover from any one IRA per year
- No direct rollover limits
- From Qualified Plans
- ERISA Protections
- IRAs exempt from debtor’s estate
- $1 million in IRA assets is protected
- Does not include rollover contributions or earnings on rollover contributions
- $1 million in IRA assets is protected
- IRAs exempt from debtor’s estate
- Prohibited Transactions*
- Ceases to be an IRA if owner/beneficiary does:
- Sell, exchange, lease property to IRA
- Lend money to IRA
- Receive unreasonable compensation for managing IRA
- Using IRA to secure loan
- Borrowing from IRA
- Buying property for personal use with IRA money
- Treated as the entire balance is distributed! Subject to ordinary income tax on distribution and 10% penalty
- Ceases to be an IRA if owner/beneficiary does:
- Transfers Incident to Divorce
- QDROs
- Distributions subject to ordinary income tax and maybe 10% penalty
- Exception:
- change name on account to spouse’s name
- Transfer funds directly to spouse’s IRA
- QDROs
- Prohibited Investments*
- Traditional IRAs
- SEPs — Simplified Employee Pension
- Used by small businesses and sole proprietors
- Easy to setup and no filing requirements
- Eligibility
- Employers must provide SEPs to almost all employees (even part-timers)
- Requirements
- age 21 or older
- Performed service for 3 of last 5 years
- Minimum compensation of $600 (2021) for year
- Establishment Steps
- Can be setup and funded no later than tax return due date (including extension)
- 3 Steps
- Formal written agreement to provide benefits to all employees
- Give notice to all eligible employees
- Setup SEP-IRA (receptacle account) for each employee
- Contributions
- limited to lesser of 25% of comp or $58,000 (2021)
- Self-employed the 25% is really 20%
- Employer contributions are discretionary
- If made, must be to all employees
- Cannot discriminate
- May integrate with Social Security
- limited to lesser of 25% of comp or $58,000 (2021)
- Vesting
- NO vesting of employer contributions
- SARSEPs — Salary Reduction Simplified Employee Pension
- NO new SARSEPs after 1996, but old SARSEPs exist
- Easy to setup, minimal reporting and testing requirements
- Establish:
- At least 50% of employees must defer comp
- No more than 25 eligible employees totals
- Highly compensated had to meet ADP test
- ADP Test
- No more than 125% of ADP of all nonhighly compensated employees
- ADP = elective employee deferral/Employee compensation
- Elective Deferral Limit
- Employee Limit = $19,500 (2021)
- Age 50 Catch up = $6,500
- NO double dipping. Limit applies to deferrals in SARSEP and other plans (401k, 403b, SIMPLEs)
- Employer Limit = lesser of 25% of employee comp or $58,000 (2021)
- Employee Limit = $19,500 (2021)
- Excess Deferrals
- Must be given notice 2.5 months after year-end
- No notice = employer pays 10% penalty on excess
- Must be removed
- Must be given notice 2.5 months after year-end
- SIMPLEs — Savings Incentive Match Plans for Employees
- Avoid nondiscrimination rules
- No annual filing requirements
- Characteristics:
- Employee elective deferrals not taxed but subject to payroll tax
- Employer match tax deferred, no payroll tax
- Requirements*
- Companies with 100 or less employees with at least $5,000 comp for year
- 2 year grace period for companies to exceed 100 employees limit
- Entities:
- C Corp
- S Corp
- LLC
- Partnership
- Proprietorship
- Government entity
- NO other plans allowed!
- Employee Eligibility
- Earned $5,000 any 2 previous years
- Expected to earn $5,000 current year
- Vesting
- 100% vested
- Companies with 100 or less employees with at least $5,000 comp for year
- SIMPLE IRAs*
- Companies with 100 or less employees with at least $5,000 comp for year
- Establish By Date: Oct. 1 in year plan starts
- NO other plans allowed!
- NO annual filing requirements, low costs
- NO testing for contributions requirements
- Contributions
- 100% fully vested
- Employee Elective Deferrals
- $13,500 Limit (2021)
- $3,000 Catch up Limit at age 50
- Employee Contributions Either:
- Dollar for dollar match up to 3% of pay
- Employer can elect to reduce 3% match for a year if:
- reduced to no less than 1%
- not more than 2 years out of a 5 year period
- employees notified in reasonable time
- Employer can elect to reduce 3% match for a year if:
- 2% nonelective contribution (up to limit) for all eligible employees
- Dollar for dollar match up to 3% of pay
- NO loans allowed
- In-Sevice Withdrawals allowed but 10% penalty if under 59 1/2
- If in the first 2 years of participation, becomes a 25% penalty
- SIMPLE 401k*
- Companies with 100 or less employees with at least $5,000 comp for year
- Establish By Date: Oct. 1 in year plan starts
- NO other plans allowed!
- Annual filing requirements, admin costs
- NO testing for contributions requirements
- Contributions
- 100% fully vested
- Employee Elective Deferrals
- $13,500 Limit (2021)
- $3,000 Catch up Limit at age 50
- Employee Contributions Either:
- Dollar for dollar match up to 3% of pay
- 2% nonelective contribution (up to limit) for all eligible employees
- Loans allowed
- In-Sevice Withdrawals allowed but 10% penalty if under 59 1/2
- 403b Plans — Tax Sheltered Annuities (TSAs)
- Available to qualified nonprofits, public education systems, certain ministers
- NOT a qualified plan
- Two types:
- Salary Reduction Plan — only employee deferrals
- Employer Funded Plan — employee and employer contributions
- Eligibility
- Max wait period of 2 years and age 21 or 1 year and age 26 (education system only)
- Exception: No immediate vesting = 1 year wait period and age 21
- Contributions
- 100% Vested
- Employee Deferrals
- $19,500 Limit (2021)
- Catch-Up Contributions*
- Age 50 Catch-Up
- $6,500 limit (2021)
- 15-Year Rule
- Employees with at least 15 years of service, limit is the lessor of:
- $3,000
- $15,000, less elective deferrals previously excluded
- $5,000 x employees years of service less total deferrals made
- Note: lifetime limit of $15,000
- Employees with at least 15 years of service, limit is the lessor of:
- Age 50 Catch-Up
- Employer Contributions
- Lessor of $58,000 or 100% employee comp
- Investment Options = limited to annuities or mutual funds
- Loans are allowed
- In-Service Withdrawals not allowed
- Subject to 10% early withdrawal penalty
- Exception: Hardship distributions allowed
- Rollovers to IRA, qualified plan, and other 403b
- NOT subject to ERISA unless setup as qualified plan (is part of overall pension/retirement plan)
- 457 Plans
- Not qualified plan
- Deferred compensation plan = deferrals do NOT count against 401k or 403b deferrals
- 3 Types
- Eligible government plans — Public 457b Plan — state, local governments
- Eligible tax-exempt plans — Private 457b Plan — private hospitals, trade associations, religious orgs, cooperatives, unions, charities
- Ineligible plans — 457f Plan — offer higher deferrals
- Public 457b Plan
- For government entities
- Protected by trust
- Participants
- Rank and file and key employees
- Contributions
- Employee Deferral Limits
- $19,500 Limit (2021) — for employer and employee contributions
- $6,500 Catch-up at 50
- 3-Year Catch Provision = $19,500 (2021)
- Employers match or nonelective deferrals allowed but rare.
- Contributions do NOT count against other plans
- Employee Deferral Limits
- Distributions
- taxed as ordinary income
- Must begin no later than age 72
- NO age 59 1/2 withdrawal rule
- NO 10% early withdrawal penalty
- Exception: Rollover contributions from other qualified plans and IRAs
- Rollovers
- Rollovers from other plans allowed
- Rollover to new 401k, 403b, 457b plan or IRA allowed if permitted by new plan
- Private 457b Plan
- Tax-exempt organizations
- Not protected by trust, available to creditors
- Participants
- Key and highly compensated employees
- Contributions
- Employee Deferral Limits
- $19,500 Limit (2021) — for employer and employee contributions
- 3-Year Catch Provision = $19,500 (2021)
- Employers match or nonelective deferrals allowed but rare.
- Contributions do NOT count against other plans
- Employee Deferral Limits
- Distributions
- Taxed as ordinary income
- Must begin no later than age 72
- NO age 59 1/2 withdrawal rule
- NO 10% early withdrawal penalty
- Exception: Rollover contributions from other qualified plans and IRAs
- Rollovers
- Rollovers from other plans allowed
- Rollover only to another 457b plan, if permitted by new plan
- 457f Plans
- Ineligible aka Top Hat Plans
- Participants
- Key and highly compensated employees
- No contribution limits
- Rollover not allowed
- Disadvantages:
- Participant may forfeit all funds if terminated before stated payment period
- Participant may be taxed on value of plan once funds vest (without a distribution occurring)
- Individual Retirement Accounts (IRAs)
- NonQualified Plans
- Used to:
- Defer compensation for key group of employees without limits/restrictions
- Increase wage replacement ratio for highly paid employees
- In lieu of a qualified plan — only for key employees
- Characteristics:
- No tax advantages like qualified plans
- Employer gets NO tax deduction until key employee gets payment (recognized as taxable income)
- Substantial risk of forfeiture requirement (to avoid constructive receipt)
- Examples:
- Golden handshake — severance package, may encourage early retirement
- Golden parachute — payments to terminated execs
- Golden handcuff — encourages employees to stay at company
- Tax Benefits
- Employee
- Defer comp to future period in lower tax bracket
- Employer
- Public companies can only deduct $1 million of comp for top 5 executives.
- Deferrals over the $1 million limit are deductible when the executive is paid in the future
- Employee
- Income Tax Issues*
- Constructive Receipt
- Income is “received”, and subject to taxes, when it is credited to account
- Deferred Comp plans AVOID constructive receipt
- Substantial Risk of Forfeiture
- Income subject to forfeiture is NOT taxed until forfeiture is removed.
- Economic Benefit Doctrine
- Funds that are unrestricted or nonforfeitable are taxed to employee
- Payroll Tax
- Subject to payroll tax at the time it is earned income or forfeiture expires
- Property Transfers in Performance of Service (Section 83)
- Ordinary Income tax paid on difference between FMV and price paid for the property
- Apply to stock grants, restricted stocks, employee stock options
- Employer Income Tax Deduction
- Matching Principle = employer gets the deduction when employee recognizes taxable income
- Constructive Receipt
- NonQualified Deferred Compensation Plans (NQDC)
- Employer promises to pay executive an amount in the future
- Advantages to Employer
- Unfunded promise to pay
- Deferred cash outflows
- Not a qualified plan
- Saves on payroll taxes (except 1.45% Medicare match)
- Income tax deduction deferred until paid
- Useful is comp. exceeds $1 million
- Only offer it to specific employees (discrimination allowed)
- Advantages to Employee
- No current taxable income
- Saves on payroll taxes
- May offer future cash flows at lower tax rate
- Types
- Salary Reduction Plans
- Reduces employee salary, defers it to future
- Salary Continuation Plans
- Provides benefits after retirement for ongoing or specific period of time
- SERPS — Supplemental Executive Retirement Plans
- Provide added benefits at retirement
- Salary Reduction Plans
- Unfunded Promise to Pay*
- NOT funded — literally a promise to pay in the future
- Risk of forfeiture if company is insolvent
- Taxed as income when constructive received by employee
- Deductible to employer when employee receives payment
- Secular Trust*
- Funded
- Irrevocable trusts used to hold deferred comp
- removes risk of forfeiture
- Immediately taxed as income for employee
- Immediately deductible to employer
- Vesting schedule or employment term requirement fixes the deferral objectives
- Rabbi Trust*
- Funded
- Treated as unfunded (purposes of ERISA)
- Risk of forfeiture if company is insolvent
- Taxed as income when constructive recieved by employee
- Deductible to employer when employee receives payment
- Funding with Insurance
- Insurance products allow employers to avoid paying taxes on earnings in the plan
- Increases in cash surrender value is not taxed
- Phantom Stock Plans
- Employer grants fictional shares to key employee
- Employee, at termination/retirement, is paid the difference between stock value and value at time of grant
- no stock changes hands
- 401k Wrap Plans
- Salary reduction plan that allows for higher contributions beyond typical 401k plan.
- Employer Stock Options
- Incentive Stock Options (ISOs)*
- Right to purchase employer’s stock at stated exercise price
- Taxation*
- At Grant Date — Employee does NOT recognize taxable income
- At Exercise Date — Employee NOT subject to income tax on difference between FMV and exercise price
- Difference is a positive AMT adjustment
- Adjusted Basis — Equal to exercise price
- At Sale Date — Difference between sale price and exercise price is LTCG (if holding period is met)
- Difference is a negative AMT adjustment
- Requirements
- Grated to an employee of corp. issuing ISO
- Plan must be approved by stockholders
- Must be granted within 10 years of plan date
- Exercise is limited to 10 year period (5 years for over 10% owners)
- Exercise price must be greater than or equal to FMV of stock at grant date
- Cannot be transferred at death
- ISOs for over 10% owners must-have exercise price 110% of FMV at grant date
- Aggregate FMV of ISO grants when first exercisable must be less than or equal to $100,000 based on grant price per year per employee.
- Excess is treated as NQSO
- Qualified Sale = 2 years from grant date and 1 year from exercise date
- Must be employed with company from grant date til 3 months before exercise.
- Disqualifying Disposition
- Sold before 2 years from grant or 1 year from exercise date
- Lose favorable tax treatment
- Ordinary income = difference between FMV at exercise and exercise price
- Capital Gain (short or long term) = difference between sale price and FMV at exercise
- Cashless Exercise (Disqualifying Disposition)
- Third party lender lends employee cash to exercise option, stock is immediately sold, and lender is repaid
- Fails to meet holding period requirements
- Gifting ISOs NOT allowed
- NonQualified Stock Options (NQSOs)*
- Bonus program that is nonqualified or does NOT meet requirements of ISO
- No favorable tax treatment
- Taxation*
- At Grant Date — NO taxable income to employee
- At Exercise Date — Employee recognizes ordinary income on difference between FMV and exercise price
- Adjusted Basis — Equal to FMV of stock at exercise
- At Sale Date — Treated as capital gain/loss
- Gifting NQSOs
- NQSO can be gifted only if plan allows it.
- No tax immediate tax consequences on transfer
- At exercise — employee hit with ordinary income on difference between FV and exercise price
- Donee’s Adjusted Basis — Equals FMV at exercise
- NQSO can be gifted only if plan allows it.
- Stock Appreciation Rights
- Rights that grant holder cash equal to difference between FMV and exercise price of stock
- Included in gross income at exercise
- May be used to provide cash to exercise ISO/NQSO
- Restricted Stock Plans
- Pays employees in employer’s stock
- Restricted from selling/transferring shares for a period of time
- Employer can buy back stock for a period of time
- Employee NOT taxed at receipt (risk of forfeiture exists)
- Employee taxed as W-2 income on FMV of stock when forfeiture is removed.
- Employer tax deduction when employee recognizes income
- Employee Stock Purchase Plans (ESPP)
- Gives employees chance to buy employer’s stock at a discount and get favorable tax treatment on gains
- Discounted stock price can be no less than 85% of average stock price of date-determined price
- Employee Limits
- $25,000 of employer stock per year based on FMV at grant date
- Qualifying Disposition
- Must hold stock for 2 years from grant date and 1 year from exercise date
- At Sale — Discount portion at purchase is ordinary income and excess gain is LTCG.
- Disqualified Disposition
- Fails to hold stock for 2 years from grant date or 1 year from exercise date
- At Sale — gain is W-2 income
- Incentive Stock Options (ISOs)*
- Used to:
