TOPIC 75: TYPES OF RETIREMENT PLANS in Visual Studio .NET

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TOPIC 75: TYPES OF RETIREMENT PLANS
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1 Characteristics A Quali ed retirement plans (QRP) (1) The retirement plan is afforded special tax treatment for meeting a multitude of requirements of the Internal Revenue Code (IRC) Obvious tax advantages for a QRP include (a) Employer (E/ER) is allowed an immediate tax deduction for amount contributed to the plan for a particular year (b) Employee/participant (E/EE) pays no current income tax on the amounts contributed by the E/ER on his or her behalf (c) Earnings are tax-exempt, allowing for tax-free accumulation of income and gains on investments (d) Reduced income tax may apply to lump sum distributions to certain participants (e) Income taxes on certain types of distributions may be deferred by rolling over (R/O) the distribution to an individual retirement account (IRA) or another (quali ed or nonquali ed) retirement plan (f) Incomes taxes on certain types of distributions to a deceased participant s spouse may be deferred by R/O distribution to an IRA (g) Installment or annuity payments are taxed only when they are received (2) Two major types of quali ed plan categories (a) De ned bene t plan (DBP) i The maximum allowable bene t payable from the plan is the lesser of 100 percent of salary or $160,000 per year (in 2003) ii The maximum compensation base that can be used is $200,000 (in 2003)
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240 - Retirement Planning Generally subject to Pension Bene t Guaranty Coporation (PBGC) insurance Must satisfy minimum participation rule of Code Section 401(a)(26) Retirement bene t is certain Each DBP is subject to the minimum funding standard Deductible contribution is based on actuarial calculations and can vary from year to year (b) De ned contribution plan (DCP) i The maximum allowable annual contribution is the lesser of 100 percent of salary or $40,000 (in 2003) ii The maximum compensation base that can be used is $200,000 (in 2003) Note that $40,000 is only 20 percent of $200,000 iii Not subject to PBGC insurance iv Not subject to minimum participation rule v Deductible contribution limited to 25 percent of aggregate compensation vi Retirement bene t is uncertain B Nonquali ed plans (1) Characteristics and objectives (a) Alternative to quali ed plans for executives (b) Few design restrictions regarding bene t structure, vesting requirements, or coverage (c) Designed to defer the payment of income taxes by employees until bene ts are paid out (d) Employer deduction is deferred to the time of payout; deduction is matched to employee income (e) Assets must be available to pay claims of creditors in order to avoid current taxation (f) Limited bene t security for participants (2) Nonquali ed deferred compensation plan designs (a) Salary reduction plan Gives participants the option to defer regular compensation, bonuses, or commissions (b) Supplemental executive retirement plan (SERP) Additional employer-provided bene ts C Government plans (Section 457 plans) (1) Section 457 of the Internal Revenue Code gives rules for governing nonquali ed plans of government entities and nonpro t organizations (2) Characteristics (a) Election to defer compensation must be made before the compensation is earned (b) The employer may discriminately choose any employee for coverage (c) Such plans are similar to a 401(k) plan, in which the maximum deferral limit that applies is $12,000 for 2003 2 Types of quali ed plans A Money purchase (1) Employer is required to make contributions based on contribution formula contributions are allocated as a percentage of compensation regardless of age (unlike target bene t plan) iii iv v vi vii
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Topic 75: Types of Retirement Plans - 241 (2) The plan is subject to minimum funding standard, whether or not the company made a pro t (3) Forfeitures may be reallocated to remaining participants accounts or applied to reduce employer contributions (4) Investment in sponsoring company s stock is limited to 10 percent (5) The plan can be integrated with Social Security (6) Younger employees accumulate more than they would with a DBP (7) The plan generally does not produce as large a contribution and deduction for older employees as DBP (8) No guarantee of future bene ts; the investment risk rests on the employee B Pro t sharing (1) Employer contributions must be substantial and recurring (2) Pro ts are not required in order to make contributions (3) Forfeitures may be reallocated among the remaining participants (4) Nondiscriminatory allocation of contributions (5) No limit on how much can be invested in the sponsoring company s stock (6) Can be integrated with Social Security (7) Bene ts the younger employee more than the older employee (owner) Younger employees accumulate more than they would with a DBP over time because of earnings, forfeitures, compounding effect, tax-deferred accumulation (8) Pro t sharing plans are usually recommended for upstart companies because: (a) Pro ts may be nonexistent in the beginning years (b) Contributions are exible (c) Earnings uctuate from year to year (9) Do not provide as large a contribution deduction as a DBP (10) No guarantee of future bene ts; the investment risk rests on the employee C Age-weighted (1) An age-weighted pro t sharing plan uses age and compensation to allocate contributions to participants In this way, its concept is similar to that of a target bene t plan The plan, therefore, bene ts older employees because they have fewer years to retirement (2) To satisfy nondiscrimination requirements, this plan is tested under cross-testing rules D New comparability plan (1) A new comparability plan is a pro t sharing plan or money purchase pension plan in which the contribution percentage formula for one group of participants is greater than for another group of participants (2) To satisfy nondiscrimination requirements, this plan is tested under cross-testing rules E Tandem plan (1) Employer adopts a money-purchase plan and a pro t sharing plan (2) Employer gains exibility in plan (a) Pro t sharing contributions are not required annually (b) Money-purchase contributions are still required annually (3) Oriented toward younger, higher-paid employees
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242 - Retirement Planning F Section 401(k) plan (also called cash or deferred arrangement or CODA) (1) A Section 401(k) plan cannot exist on its own it is not a stand-alone plan (a) Must be combined with a quali ed retirement plan i Pro t sharing plan ii Stock bonus (employee stock ownership plan, ESOP) iii Pre-ERISA (Employment Retirement Income Security Act) money-purchase plan (b) May be combined with a salary reduction simpli ed employee pension (SARSEP) if established before January 1, 1997 (c) May be combined with a Savings Incentive Match Plan for Employees (SIMPLE) (2) Types of 401(k) plans (a) Traditional Section 401(k) is much like a pro t sharing plan i Can be funded entirely from employee salary reduction ii Nondiscrimination testing, such as actual deferral percentage (ADP) and topheavy rules apply (b) SIMPLE 401(k) plans and safe harbor 401(k) plans i Exempt from nondiscrimination testing (ADP/ACP) actual contribution percentage ii Funding requirements for employer (3) Traditional and safe harbor 401(k) plans Employee elective deferral amount is $12,000 in 2003 Catch-up contributions by employees age 50 or older is $2,000 in 2003 (4) SIMPLE 401(k) plans Lower annual elective deferral limits of $8,000 in 2003; catchup amount is $1,000 in 2003 (5) Two types of contributions (a) Cash or deferred arrangement (CODA) Employee has the option of receiving an employer contribution (eg, annual bonus) i In cash and having it taxed currently, or ii Deferring the cash by making it a tax-deferred retirement plan contribution (ie, 401(k) plan) (b) Salary reduction Employee defers the receipt and taxation The reduction amount is deducted from the paycheck and contributed to a retirement fund and accumulates tax-deferred (6) In-service withdrawals by employees for certain hardships are permitted; these are not available in quali ed pension plans (7) May not provide adequate retirement savings for employees who enter the plan at later ages (8) All elective deferrals from all employer plans that cover the employee must be aggregated; deferrals are characterized as employer contributions to ensure that the sum of employee and employer tax-favored contributions do not exceed the 25 percent payroll limit and the limit on annual additions (9) Employees bear investment risk under the plan (10) Meets the employer s requirement of substantial and recurring contributions in pro t sharing plans (11) No integration with Social Security for just 401(k) plan
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Topic 75: Types of Retirement Plans - 243 G Employee stock ownership plan (ESOP) (1) An ESOP must invest primarily in employer stock (2) Portfolio is 100 percent company stock; there are special diversi cation requirements for participants over age 55 with 10 years of service (3) May borrow to buy company stock: leverage ESOP (LESOP) (4) ESOP can be integrated with Social Security; a LESOP cannot be integrated with Social Security (5) An ESOP plan (and stock bonus plan) makes sense for a corporation by (a) Providing a market for the owner s closely held stock (b) Giving tax deductions while having no effect on cash ows (c) Protecting company stock from hostile takeovers H Stock bonus plan (1) Bene t payments are usually made in shares of company stock The participant can receive cash in lieu of stock (2) Diversi ed portfolio (3) May not borrow to buy company stock (4) Can integrate with Social Security I Thrift or savings plan (1) Contributions are after-tax dollars; earnings are tax-deferred (2) Employees are required to contribute (up to 6 percent) in order to be eligible to receive the employer s matching contribution (3) Hardship withdrawals are more liberal than with 401(k) plans (4) In a rollover: after-tax money to participant and earnings to IRA J Target bene t (1) Forfeitures may be reallocated to remaining participants accounts or applied to reduce employer contributions (2) Allocation of employer contributions is based on age-weighted formula favors older employee (3) Investment in sponsoring company s stock is limited to 10 percent (4) Can be integrated with Social Security (5) Provisions shared with de ned contribution plan (a) Employee assumes investment risk no guarantee of future bene ts (b) No ongoing actuarial determinations (c) Forfeitures may be reallocated or used to reduce employer contribution (6) Provisions shared with de ned bene t plan (a) Plan bene ts older employees (older employees may not receive a bene t as great as with a DBP) (b) Actuarial determination for initial contribution level and formula for allocation contributions (c) Subject to minimum funding standard: mandatory annual employer contributions K De ned bene t plan (1) Retirement bene ts are de nitely determinable the bene t is de ned by the formula in the plan (2) When the interest rate earned on plan assets is higher or lower than the actuarial assumptions, the employer increases or decreases its future contributions to the plan as needed to match the promised bene t (unlike target bene t plan)
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244 - Retirement Planning (3) Plan formulas are geared to retirement bene ts and not contributions (unlike cash balance plans) (4) Actuary determines required contribution each year minimum funding standard (5) Forfeitures must be used to reduce the employer s contribution (6) Employees accrue retirement bene ts when eligible to participate, but are not vested until a minimum period of time is worked (7) Bene ts must be paid to plan participants even if the plan is terminated (8) The plan can be integrated with Social Security (9) Greater tax-deductible contributions than through DCP (10) Rewards long-term employees with a substantial bene t even if close to normal retirement age (11) Larger contribution to older employee more bene cial to participants closer to retirement (12) Investment risk rests on employer (13) Higher administration costs (14) Plan bene ts are not portable (15) Retirement bene ts/distributions are not adjusted for cost of living (ie, in ation) L Cash balance plan (1) A cash balance plan is a de ned bene t plan with features similar to those of a de ned contribution plan (2) The distinguishing feature of a cash balance plan is that a separate account is established for each participant, using a hypothetical account balance These hypothetical allocations and earnings are designed to imitate the actual contributions and earnings that would occur to an employees account under a de ned contribution plan (3) Employee balances grow based on hypothetical earnings (ie, interest credits) The interest rate varies from year to year and is communicated to the employee at the start of each year The rate is not tied to actual performance of investments and is determined independently; the minimum rate cannot be more than the lowest standard interest rate, and the maximum rate cannot be less than the highest standard interest rate (4) Actuary determines required contribution each year minimum funding standard (5) Plan can be integrated with Social Security (6) Greater tax-deductible contributions than through DCP (7) Forfeitures must be used to reduce employer s contribution (8) More bene cial to younger participants (9) Employer must pay bene ts in accordance with plan provisions even in low- or nopro t years (10) Investment risk rests on employer (11) Higher administration costs (12) Bene ts must be paid to plan participants even if the plan is terminated (13) Plan bene ts are not portable (14) Retirement bene ts/distributions are not adjusted for cost of living (ie, in ation)
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Topic 76: Quali ed Plan Rules and Options - 245
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