Qualified Retirement Plans, Group Life Insurance and OASDHI
AGE RELATED distributions
AGE RELATED distributions made after age 59½ are referred to as qualified retirement distributions. Any distribution that represents an employee's cost basis is received tax-free. Any amount received that is appreciation (or an employer contribution) is taxed as ordinary income. Therefore, distributions from qualified plans are considered qualified if they occur at age 59½ or beyond (or if due to a qualifying event such as death, disability, first time home purchase, etc.).
General Requirements of a Qualified Plan
As previously mentioned, QUALIFIED PLANS = are approved by the Internal Revenue Service to receive favorable tax treatment. This means contributions to qualified plans are tax-deductible. non-qualified plans are (taxable) not tax-deductible.
EMPLOYEE RETIREMENT INCOME SECURITY ACT (ERISA)
EMPLOYEE RETIREMENT INCOME SECURITY ACT (ERISA) = The purpose or applicability of ERISA is to protect the interests of plan participants and beneficiaries in employee benefit plans. In addition, this federal law was also intended to protect the interests of beneficiaries of participants as well. Sometimes referred to as the Pension Reform Act, ERISA usually applies to pension plans, group insurance plans and other employee welfare benefit plans.
Education IRA's
Education IRA's (Coverdell Education Savings Account) are also available where an investor can make non-deductible contributions of up to $2,000 per child under age eighteen. The funds saved can be used for primary and secondary school expenses (i.e., tuition, books) higher education fees (i.e., college). Any funds left over (i.e., if a child does not attend college), may be rolled over into an Educational IRA prior to age 30.
More on Distributions
Federal income tax AND penalty-free distributions may be made from the Roth IRA in the following situations: The Roth IRA must have existed for five years after the first taxable year for which a contribution was made, and must either be made: (1) after the attainment of age 59½ (2) due to the owner's death or disability (3) for qualifying first-time home buyer expenses (may borrow up to $10,000 in Roth or traditional IRA). Withdrawals that are made from a Roth IRA that do not meet the IRS requirements for qualified distributions will be included in income. * Nondeductible contributions are always distributed first and are always tax and penalty-free. There is no requirement that funds must begin to be withdrawn at age 70.
Characteristics of Group Term Life Insurance
Group life insurance differs from individual life insurance contracts in several ways. One of the differences between the two is that group insurance is most often comprised of annual renewable term life insurance whereas individual insurance contracts may be term life or whole life insurance. Underwriting is handled differently and varying types of policy provisions appear in a group life policy. Group life insurance coverage is characterized by the underwriting of numerous individuals rather than one. Group term life insurance, like all insurance contracts previously mentioned, is a two party contract between the policyholder and the insurer (just like an individual contract). The employer providing the group life coverage pays all or a portion of the premium and is the policyholder. The employer or plan sponsor receives the master policy while the covered employee receives a booklet or certificate of coverage which describes the benefits, the coverage provided and how long coverage will last. The covered employee is also known as the certificate holder. Types of groups that eligible include employees of a single employer, credit groups, labor unions and multiple employer groups.
In order to receive tax "qualified" treatment, the pension or profit plan MUST MEET SEVERAL CRITERIA
In order to receive tax "qualified" treatment, the pension or profit plan MUST MEET SEVERAL CRITERIA including but not limited to: (1) be a formal and written document and be communicated to all employees (2) be provided for the exclusive benefit of employees and their beneficiaries and established with the intent to be ongoing (3) satisfy minimum age and service standards (i.e., age 21 and at least one year of service) (4) may be discriminatory as long as it's fair (e.g., cannot discriminate in favor of highly compensated employees) (5) contributions of the plan must be actuarially determined (6) must provide survivor benefits (7) must meet minimum vesting standards (8) must satisfy top-heavy plan rules (i.e., 60% rule) (9) assets of the plan must be legally segregated. Non-qualified plans, while legal, do not provide for tax deductions of contributions since they are not approved under the Internal Revenue Code (IRC) for such benefits. An employer may discriminate with regard to a non-qualified deferred compensation plan.
Adverse Selection
MORE BAD RISK THAN GOOD RISK This concept involves the tendency of poorer risks to seek insurance coverage or the chance that an insurer will accept applicants who are bad risks (i.e., those in poor health). Sound and competent individual or group underwriting will decrease the probability or chance of adverse selection.
Social Security
Social insurance is provided by Social Security, also referred to as OASDHI (Old Age Survivors Disability Health Insurance program). Social Security is "funded" by payroll taxes collected from employees, employers and those who are self-employed. Social Security provides several benefits to those who are eligible including but not limited to retirement income, disability income, a lump sum death benefit and survivor benefits. To receive maximum benefits the eligible individual must be "fully insured." This means that the eligible person must have forty quarters of coverage. In other words a person must have worked for ten years to be fully insured.
Pension Plans
* employer sponsored and maintained * retirement income benefits to eligible employees. * Employees must satisfy certain minimum service requirements in order to be eligible for benefits. A retirement age will be identified in the pension plan when benefits will begin. There will also be a provision for EARLY retirement if desired which would result in a benefit DECREASE. However, if the employee desires to put off or DEFER retirement to a later age, he or she would receive a benefit INCREASE. BENEFIT FORMULA Defined benefit and contribution terminology is used to describe the benefits or contribution limits that will be provided in the future by qualified (IRS approved) retirement or pension plans. DEFINED BENEFIT plan identifies the amount of the installment benefit to be paid to the retired employee upon retirement. DEFINED CONTRIBUTION plan is characterized by an individual account for each employee. The plan specifies the contribution amount the employer must make each year but does not promise any specific future installment (i.e., monthly) benefit.
Chapter Key Concepts
401(k) plans 457 deferred compensation Group life Industrial life IRA Keogh plans Pension plans Profit sharing plans Retirement plans Rollovers SEPs Simple plans Tax considerations TSAs
Tax Exempt Employer Plans 403(b) Tax-Sheltered Annuities (TSA)
403(b) Tax-Sheltered Annuities (TSA) — This type of retirement plan is available to employees of qualified or tax-exempt organizations. The Internal Revenue Code, 403(b), stipulates that funds may be contributed to a qualified annuity with before-tax dollars. According to IRC guidelines, ("Tax Facts") THIS TYPE OF PLAN IS AVAILABLE TO "public, private, and parochial school teachers; social workers; college professors; school superintendents; clergymen and clergy women; and other employees of qualified organizations (i.e., school systems, nonprofit organizations, welfare agencies, research foundations or church or religious organizations, etc.). --Employees of the government are NOT eligible." A TSA is CHARACTERIZED BY SALARY REDUCTION RATHER THAN A TAX DEDUCTION. TWO BENEFITS: (1) a REDUCTION OF TAX liability (2) CONTRIBUTIONS to the TSA accumulate on a TAX-DEFERRED basis. MAXIMUM ANNUAL CONTRIBUTION = $19,000. CHARACTERIZED BY salary reduction provides tax deferral and a reduction of annual tax liability. --This means that the participant does not pay income ---tax on interest earned by contributions while funds -----are accumulating. **when interest income is received it is taxable as income. In addition, because the salary has been reduced, the participant's annual income tax payable will also decrease. The same rules apply to a TSA with regard to a premature distribution (i.e., 10% penalty if the withdrawal is made prior to age 59½).
Simplified Employee Pension (SEP)
According to "Tax Facts," these are retirement vehicles for self-employed individuals and their eligible employees. They offer employers a method in which to provide funds for their own and an employee's retirement years, as long as certain eligibility requirements have been satisfied. _______________________________________________________________________________ "Tax Facts" also identifies these qualified plans as (AKA, EMPLOYER SPONSORED IRAS) The plan requires an employer to make contributions, based on a formula contained in the plan, for all employees who have reached the age of 21. In addition, the employee must have been employed for at least 3 out of the past 5 years as well. Contributions to the SEP by the employer are deductible and are deposited directly into the plan for each employee. EMPLOYER CONTRIBUTIONS PERMITTED each year is the lesser of 25% of earned income not to exceed $56,000. Earnings accumulate on a tax-deferred basis. SEPs were primarily created as an alternative to Keogh Plans which have strict and complicated reporting requirements. SEPs have simplified administration and reporting requirements. SIMPLY, SEPs offer the ease of administration with minimal reporting requirements. An individual simply records the amount of the SEP contribution on the appropriate area of his or her tax form just as is done with an IRA.
Group Life Underwriting (cont.)
All group policies contain a conversion privilege. A covered employee has the option of converting his or her group term life coverage to his or her own plan when employment is terminated. Termination of employment includes an employee who is laid-off or who leaves a job voluntarily. In most cases, when an employee is converting group term life insurance, he or she is usually only permitted to convert to whole life insurance. A terminated employee has 31 days after being fired to convert from their group plan to an individual plan without proving insurability. If death occurs during the conversion period (31 days after employment termination), even if the employee does not plan to convert to an individual policy, the death claim will be paid by the group policy. No medical exam or other proof of insurability is required to convert coverage to an individual policy if the conversion is effected during the 31-day period. An individual is allowed to convert group coverage to an individual plan after the 31-day conversion period but must prove insurability. If a conversion occurs, the premium is based on the employee's current age at normal premium rates are used. While the employer is the policyholder in a group life policy, he or she retains all rights of ownership EXCEPT the right to name or change the beneficiary. This means that the covered employee or "certificate holder" possesses an "incident of ownership" in the group plan. In addition, in recent years, many insurers have been permitted by modifications of State laws to include an assignment provision (the owner may transfer or "assign" any or all of his or her policy rights to another) in group life policies. Of course, any assignment must be in writing and be filed with the insurer.
Vesting
All qualified plans must satisfy specific standards that set forth a vesting schedule. VESTING = the right each employee has to employer contributions in his or her fund. This means that benefits that are vested belong to an employee even if he or she terminates employment prior to retirement. An employee always, at all times, has a full or 100% vested interest in his or her own contributions.
Traditional IRA'S (Individual Retirement Accounts) CHARACTERISTICS AND CONTRIBUTIONS AND ROLLOVER
Although an IRA has some common characteristics of a qualified plan, it is not classified as such. IMPORTANT CHARACTERISTIC OF IRA'S: Annual Contributions to an IRA may be equal to 100% of earned income not to exceed $6,500 per year ($7,000 for age 50 and above). A spousal IRA contribution may not exceed $6,000 per year. This is an IRA created for an eligible individual and a non-wage earning spouse. Part-time Income he or she may contribute up to the maximum amount to an IRA. IRAs may be rolled over into another higher yielding (i.e., higher interest rate) account if desired without penalty. A ROLLOVER IS A TAX-FREE EVENT However, the roll over must be accomplished within 60 days after withdrawal.
Primary Insurance Amount (PIA)
Benefits payable by Social Security are based upon what an individual worker has contributed to the program. In other words, this is the average indexed monthly earnings (i.e., average income over one's working lifetime). This is known as the worker's primary insurance amount. Therefore, retirement income payable by Social Security is based upon a worker's primary insurance amount or PIA. Retirement income begins on the first day of the month in which the individual becomes age 65 (and the individual must apply for benefits). An individual who begins to collect retirement income benefits at age 65 is still allowed to work and there is no longer any reduction or offset from Social Security income. The program also provides for a lump sum death benefit to be paid to the eligible spouse of a deceased worker. The lump sum death benefit is $255.
Premium Payment of Group Plans
Group life insurance premiums may be paid by an employer or may be shared by the employer and employees. _______________________________________________________________________________ non-contributory group plans = Premiums paid by the employer (AKA, employer pay-all plans). non-contributory = the insurer will not write the coverage unless 100% of all eligible employees participate. _______________________________________________________________________________ contributory group plan = Premium is shared by the employer and employees. contributory = the insurer will (probably) not write coverage unless at least 75% of the eligible employees choose to be covered. _______________________________________________________________________________ an enrollment period = A specific time frames when new employees may secure coverage without taking a medical exam or answering any health questions.
Traditional Individual Retirement Accounts
INDIVIDUAL RETIREMENT ACCOUNT (IRA) = an investment vehicle available to all individuals who possess earned income EARNED INCOME = as defined by the IRS, does NOT include income from rents or royalties. Also referred to as an Individual Retirement Arrangement or "deemed IRA," this plan is a tax qualified and IRS approved plan which provides the advantages of tax deferral and a possible tax deduction for those who qualify. IRA's are offered by banks insurance companies investment firms. They can be funded by cash or cash type vehicles (i.e., an annuity) and accumulate based upon a fixed interest rate. When an IRA is funded, proceeds can be used to purchase any of several investments from certificates of deposit to stocks and mutual funds. Once funds are contributed to the account they are owned by the individual immediately. However, they are also characterized by heavy withdrawal penalties in the early years after they are purchased, even if funds are withdrawn in order to be "rolled over." "Tax Facts," provides the following excerpts with regard to IRAs. A deemed IRA is subject to IRA rules and not qualified plan rules.
Tax Treatment of Group Life
Premiums paid by employers for group life insurance are deductible as a legitimate business expense. However, a sole proprietor or partner may not deduct premiums for group life covering his own life since he is not considered to be an employee. The cost of the first $50,000 of group term life is tax-exempt to an employee. The cost of coverage amounts in excess of $50,000 may be taxable (as ordinary income) to the employee. Death proceeds under group life are received income tax free (whether term or whole life insurance is used). _______________________________________________________________________________ Retired Lives Reserve (RLR) is a group life insurance product with the objective of providing continuing life insurance protection beyond retirement. RLR provides annual renewable term insurance and a reserve account that accumulates funds prior to retirement which will be used to pay premiums on the term insurance after a person's retirement. Under this plan an employer can make a tax-deductible contribution to the fund (i.e., reserve account) on behalf of employees and the contributions are not tax-deductible to employees. This fund or reserve account can be administered by a life insurance company or trust.
IRA and Selected Qualified Retirement Plan Vehicles...pg. 20
QUALIFIED PLAN CONTRIBUTION AMOUNT LIMITS ELIGIBILITY TAX TREATMENT Traditional Individual Retirement Account (IRA) 100% of earned income not to exceed $6,000 per year. $6,000 limit also for non-wage earning spouse. Anyone with earned income. Tax-deferred. May be tax-deductible. Simplified Employee Pension (SEP) 25% of self-employment income per year not to exceed $57,000 (employee up to $19,500 in 2020). Self-employed. Tax deferral. Tax-deductible. Keogh Plan (HR-10) 25% of self-employment income per year not to exceed $57,000 in 2020. Non-corporate self-employed (sole proprietor). Tax-deferred. Tax-deductible. 403(b) Tax-Sheltered Annuity (TSA) $19,500 in year 2020. Employees of non-profit, religious or educational organizations. Tax deferral. Reduced tax liability through salary reduction. Section 457 Deferred Compensation Nonqualified Plan In 2020, the lesser of 25% of taxable compensation or $19,500. Employees of government entities (i.e., state, city, county, etc.). Tax deferral. Reduced tax liability through salary reduction. 401(k) Plan Adjusted annually for inflation (2020 limit is $19,500). Employer matching generally. Employees of businesses which desire to provide this type of plan. Tax deferral. Contributions excluded from income.
ROLLOVER
ROLLOVER — This is the transfer of funds from one qualified plan to another. When the rollover is accomplished from plan to plan (i.e., trustee to trustee), the owner does not receive any funds. If the employee / individual withdraws such funds in order to deposit them in another plan, a 20% withholding tax may apply. This tax is not applicable if one premium rolls over funds into a second pension. to avoid any other penalties or adverse tax considerations, a rollover must be effected within 60 days of withdrawal.
401(k) Plans
Section 401 of the IRC provides favorable tax treatment to those who participate in a qualified plan for retirement purposes. CONTRIBUTIONS The 401(k) allows contributions by employees to be invested in various vehicles. Contributions made to this qualified plan are excluded from the individual's gross income up to a maximum limit. This limit is adjusted annually for inflation. Some 401(k) plans provide for a matching of the employee contribution by an employer. Employers match a percentage of the dollar amount that an employee contributes in the aforementioned plans. utilizes a salary reduction which reduces the employee's tax liability as well. Interest earned on contributions are tax-deferred. WITHDRAWALS withdrawals are not permitted prior to age 59½ unless the employee becomes disabled, dies, retires, changes jobs or demonstrates financial hardship. Like all qualified plans, an employee may borrow from such plans without receiving a distribution penalty. A 401(k) plan provides current as well as future tax savings for employees. TAX BENEFITS A 401(k) plan provides current as well as future tax savings for employees. A 401(k) plan may be arranged by using a thrift plan, a salary reduction plan or a bonus plan. MAXIMUM annual pretax CONTRIBUTION limit is $19,500.
Group Life Underwriting
Sound group underwriting can prove profitable to an insurer especially since it REDUCES adverse selection. _______________________________________________________________________________ ADVERSE SELECTION (anti-selection) = more bad risks than good risks. There is a greater probability of bad risk being included in group policies. Because, there is a greater tendency for individuals of bad risk to seek insurance coverage. HOWEVER, the insurer is hoping the good risk will far outweigh the bad risk. (HOPE IS NEVER A GOOD INVESTMENT STRATEGY). ______________________________________________________________________________ Writing large groups of individuals also helps to reduce adverse selection based on the law of large numbers. Other group term life characteristics include: Proof of insurability may not be required of larger groups. Insurers do generally require some type of insurability for smaller groups since the risk is greater. However, employees with physical impairments are generally eligible for group life insurance coverage. A number of people may not form a group just to secure group insurance coverage. The securing of such coverage must be incidental to the group's formation. In other words, a group of people cannot form an organization whose main purpose is to secure life insurance coverage. A business is founded in order to produce a product and earn a profit. Therefore, they are eligible to purchase group insurance. A group of persons who are engaged in occupations of a common industry may form an association (i.e., all hat manufacturers) and later purchase group coverage. There generally must be an employment relationship present in order for group coverage to be secured. Underwriters take persistency into account as well. The insurer may shy away from groups that change insurers regularly. Therefore, the insurer feels that writing insurance on such groups do not represent a good risk.
TAXATION OF DISTRIBUTIONS —ANY DISTRIBUTIONS
TAXATION OF DISTRIBUTIONS —ANY DISTRIBUTIONS from qualified plans prior to age 59½ are taxed on a pro-rata recovery of cost basis. A 10% PENALTY is also imposed on the premature distribution except in the cases of death, disability, divorce, financial hardship, loans from the plan or if the distribution is part of a qualified rollover. These are sometimes referred to as pre-retirement distributions.
Federal Tax Considerations
Tax incentives are provided by the IRC to persuade or promote savings for retirement years. Tax advantages are provided to employers and employees and for distributions, income or rollovers. EMPLOYER AND EMPLOYEE ADVANTAGES — Contributions made by employers to qualified plans are tax-deductible since they are considered to be a legitimate business expense. The interest earned on these plans accumulates tax free to both the employer and employee. Whenever distributed, the amounts received are taxable as ordinary income.
Tax Exempt Employer Plans Section 457 Deferred Compensation
The following are a nonqualified and a qualifed plan receiving special tax treatment since they are available to certain tax-exempt organizations. Other Non-qualified plans are reviewed briefly in chapter 6. Section 457 Deferred Compensation — This non-qualified plan,Section 457 of the IRC, allows any State or local government entity to provide a deferred compensation program for its employees. In this arrangement, the employer agrees with each employee to reduce his or her pay by a specified amount and to invest the deferrals in one or more investment outlets that may include insurance products. Deferred amounts cannot exceed certain limitations. The maximum amount is 25% of one's post-deferral taxable compensation or $19,000, whichever is less. Section 457 plans vs. 403(b) plans The primary difference Investments in a Section 457 plan are owned by the employer. In many cases, the vehicles used in these deferred compensation plans are fixed or variable deferred annuities. _______________________________________________________________________________
Types of Plans and Their Characteristics
There are numerous plans available which assist an individual in saving funds for retirement and provide tax advantages including but not limited to: Simple Plans Simplified Employee Pension (SEP) Keogh Plans 401(k) Plans Pension Plans Tax Exempt Employer Plans IRA and Selected Qualified Retirement Plan Vehicles
Roth IRA
This IRA allows one to make non-deductible contributions which are tax free when withdrawn (at age 59½ and beyond). The owner forfeits deductibility when he or she contributes, but does not have to pay any taxes on any of the earnings. A Roth IRA is beneficial for individuals with large savings that may leave them in the same or even a higher tax bracket after retirement. It is also advantageous for those who will continue to work after age 70½ and would prefer to delay IRA distribution. Additionally, it is also good for those who are looking for estate planning benefits for their beneficiaries since distributions to beneficiaries will pass income tax free. Eligibility — This is based on the amount of adjusted gross income of an individual each year. Age Requirements — An individual (with earned income) may continue to contribute to the Roth IRA after reaching age 70½. * There is no mandatory distribution age. Restrictions — A person may contribute the lesser of $6,000 or 100% of earned income per year (age 50 and above is $7,000). This is a combined limitation of all IRAs owned. * Catch-up allowances are also available in the same - amounts as a traditional IRA. Distributions — Penalty-free withdrawals may be made from the Roth IRA prior to age 59½ for qualified education expenses for the taxpayer, spouse, or any child or grandchild of either. Qualified higher education expenses include tuition, fees, supplies, books, room and board, and graduate courses. However, even though these distributions are penalty-free, they may still be subject to income taxation.
Simple Plans
This is a savings incentive match plan for employees who work for small employers. It provides for a retirement option that is not required by the IRC to satisfy many of the qualified plan rules. Assets of the plan are not taxed until they are distributed. Contributions to the plan are tax-deductible to the employer making them. An employer will be eligible to contribute if he or she has 100 or fewer employees who received at least $5,000 each in compensation for the preceding year. In addition, the employer will not be eligible for participation in a Simple Plan if he or she already maintains another employer-sponsored plan to which contributions were made (or where benefits have already accrued). This type of plan may be structured as a 401(k) plan or as an IRA. The latter would be known as a Simple IRA. The limit is $13,500 ($16,500 for age 50 and over). The employer is required to: (1) match any elective contributions by an employee on a dollar for dollar basis up to a limit of 3% of the employee's compensation OR (2) make a non-elective contribution of 2% of each employee's compensation. Non-elective means that the employee has no choice in the matter. An advantage of this type of plan is that all employees are vested as soon as contributions are made. Employees are taxed on distributions from Simple Plan accounts. Early distribution penalty taxes apply for withdrawals prior to age 59½. If the distributions are made within the first two years of participation in the Plan, the employee is subject to a 25% penalty tax. If the distributions are made after the first two years of participation in the Plan, the employee is subject to a 10% penalty tax. There are exceptions to the early distribution penalties including but not limited to the permanent and total disability of a participant or his or her death. An employer is also provided with a two-year grace period to maintain the Plan once he or she becomes ineligible to participate because the number of employees exceeds 100.
Traditional IRA'S (Individual Retirement Accounts) WITHDRWALS
WITHDRAWALS (with no intent to roll over) early withdraw penalty prior to age 59½. If a withdrawal is made prior to this age, a 10% penalty will be charged based on the amount of the withdrawal. For example, $2,500 prior to age 59½, 10% or $250 will be deducted from the withdrawal request. receives $2,250. the $2,500 withdrawal must be included as taxable income on the tax return in the year received. Withdrawals from the account must also begin prior to age 70 ½ as well. When the owner begins to receive benefit payments or monthly retirement income, an annuity phase commences. If the annuitant dies, the value may be included in his or her estate. However, if there is a beneficiary to whom proceeds are paid, there will be a taxable event. In addition, excess contributions to an IRA will be subject to an additional 6% penalty. A tax deduction is available to individuals who contribute to an IRA and are not covered by an IRS qualified pension plan or an employer sponsored retirement program, no matter what their annual taxable income. A full or partial deduction is available to an individual wage earner or those who file jointly based on adjusted gross income each year. A new "catch-up" provision allows investors age 50 and over to contribute an additional $1,000 per year beginning in year 2006 and thereafter. IRAs may be funded by cash payments or any type of annuity. They may not be funded by a life insurance policy itself, although a cash portion of a death benefit or cash surrender value may be utilized to fund an IRA.
Keogh Plans
a NON-CORPORATE retirement savings vehicle also referred to as an HR-10 plan, named for the House of Representatives bill passed by Congress. DESIGNED for the self-employed person or the sole proprietor and employees. Someone who owns his or her own business and is not incorporated is eligible for a Keogh Plan. TAX DEDUCTIONS Like an IRA or SEP, a Keogh Plan provides a combination of tax deferral and a tax deduction which reduces the participant's annual tax liability. CONTRIBUTION limits 25% of earned income not to exceed $57,000 per year (this year). WITHDRAWALS not permitted without penalty prior to age 59½. They must begin prior to age 70½. Penalties will be assessed for a violation of these requirements (i.e., 10% penalty and inclusion in taxable income). strict REPORTING requirements. A great deal of documentation must be provided to the IRS to verify contribution and deductible amounts.
