Retirement Savings and Income Planning

[SPECIAL RULES FOR SELF-EMPLOYED (KEOGH) PLANS]- TYPES OF RETIREMENT PLANS FOR THE SELF-EMPLOYED BUSINESSOWNER

1. In general, any type of qualified or tax-advantaged plan can be designed to cover self-employed persons. 2. The plan is usually designed as one of the following: a. A profit-sharing plan b. A 401(k) plan c. A defined benefit pension plan 1.) Not generally chosen because of the high mandatory annual employer contribution requirement 2.) Good choice for older self-employed individuals with high, stable cash flows from the business

3. Purchasing power preservation model a. More conservative approach

b. Maintains the purchasing power of the original pure annuity capital balance at retirement Students should note the difference between the capital preservation model and the purchasing power preservation model is the assumed interest rate. Capital preservation uses a gross interest rate and purchasing power preservation uses an inflation-adjusted interest rate

ONE-TIME ONLY IRA TO HEALTH SAVINGS ACCOUNT (HSA) ROLLOVERS

1. A qualified HSA funding distribution is a one-time transfer from an individual's IRA to an HSA. 2. In general, a qualified HSA funding distribution from an eligible individual's IRA or Roth IRA to an HSA is not included in gross income. 3. The amount contributed to the HSA through a qualified HSA funding distribution is not allowed as a deduction and counts against the individual's maximum annual HSA contribution for the tax year of the distribution. 4. Requirements and rules a. Only certain IRAs 1.) A qualified HSA funding distribution may be made from a traditional IRA or a Roth IRA but not from an ongoing SIMPLE IRA or SEP IRA. b. Maximum qualified HSA funding distribution 1.) A qualified HSA funding distribution must be less than or equal to the IRA or Roth IRA account owner's maximum annual HSA contribution. c. Generally, only one qualified HSA funding distribution is allowed during the lifetime of an individual. d. A qualified HSA funding distribution relates to the tax year in which the distribution is actually made. e. An individual must be eligible at the time of the qualified HSA funding distribution. The distribution must be a direct transfer from an IRA or Roth IRA to an HSA, but a check from the IRA payable to the HSA trustee is acceptable. f. Testing period rules 1.) If a qualified HSA funding distribution is made from the individual's IRA or Roth IRA to his HSA and he remains an eligible individual during the entire testing period, the amount of the qualified HSA funding distribution is excluded from his gross income and the 10% additional tax does not apply. 2.) The testing period begins with the month in which the qualified HSA fund-ing distribution is contributed to the HSA and ends on the last day of the 12th month following that month. g. HSA distributions not used for qualified medical expenses 1.) An HSA distribution not used for qualified medical expenses is included in gross income and subject to a 20% additional tax (with certain exceptions), regardless of whether the amount contributed to the HSA under the qualified HSA funding distribution is included in the account beneficiary's income and subject to the additional tax.

Social Security Administration reports the following primary sources of retirement income: (2017)

-Private pensions 12% -Government employee pensions 8% -Other 4% -Social Security 33% -Earnings 34% -Asset income 9%

DB(K) PLAN

1. A DB(k) is a hybrid plan designed to address the potential shortfalls in 401(k) plans and a decline in the establishment of defined benefit pension plans. 2. A traditional defined benefit pension plan will be permitted to accept 401(k)-type (pretax) employee contributions. 3. A sponsoring employer with no more than 500 employees may offer the DB(k) plan. 4. As a part of this plan, the 401(k) component must include an automatic enrollment feature and a fully vested 50% match on the first 4% of compensation deferred by an employee. Additional requirements apply. 5. Advantages for employees a. Guaranteed monthly income at retirement b. Encourages employers without a pension plan to establish one c. Combines the security employees get through traditional defined benefit plans with individual investment control d. Allows automatic enrollment provisions that encourage employees to save more than they may have in a traditional 401(k) plan 6. Advantages for employers a. Exemption from the top-heavy rules b. Allows small employers to sponsor a defined benefit pension plan with more predictable costs and lower premiums because of the 401(k) matching c. Defines specifications and defined benefit formula d. Offers simplified administration and potentially lower cost than having two individual plans e. Requires only one plan document, one trust, one Form 5500 filing, one SPD, and one set of statements

[TAX-SHELTERED ANNUITY (TSA)/403(B) PLANS]- DESCRIPTION

1. A TSA plan is a tax-deferred employee retirement plan under 403(b) that is adopted only by certain tax-exempt organizations, governmental organizations, and certain public schools and colleges. 2. Employees have individual accounts to which employers contribute (or employees contribute through salary reductions). a. Contributions are not currently taxable to employees. b. Account balances accumulate tax deferred until distribution. 3. A 403(b) plan is often referred to simply as a TSA. 4. 403(b)/TSA plans are very similar to 401(k) plans for a tax-exempt 501(c)(3) organization or public school. a. In the past, these organizations could not adopt 401(k) plans, so the TSAs provided similar benefits. b. Today, these organizations are generally permitted to adopt either a 401(k) or 403(b)/ TSA, or both. c. These can include public school employees, hospital employees, and church employees. d. A 501(c)(3) private school is also eligible.

FULLY INSURED DEFINED BENEFIT PENSION PLANS

1. A fully insured pension plan is a type of traditional defined benefit pension plan funded exclusively by cash value life insurance or annuity contracts under Tax Code Section 412(e)(3). a. No qualified plan trust exists. b. Offers several advantages 1.) Employer has the ability to contribute and deduct more money to an otherwise overfunded qualified plan. 2.) Using insurance as a funding vehicle guarantees the payment of a death benefit to plan beneficiaries, usually a surviving spouse and children. 3.) The defined benefit pension plan that is fully insured is exempt from minimum funding standards, unless there is an outstanding loan against the insurance policy funding the defined benefit pension plan. 4.) Such plans are eligible for simplified reporting requirements (Form 5500 series). 5.) Fully insured plans are not required to be certified by an enrolled or licensed actuary. c. Fully insured funding may be incorporated into a new or existing defined benefit pension plan, although it is most prevalent with a newly designed plan. d. Benefits from the plan are guaranteed by the insurance company (the employer transfers all investment risk to the third party). e. The premium paid for the insurance is based on the guaranteed interest and annuity rates, which are typically conservative. 1.) This results in larger initial deposits than in the normal uninsured plan. 2.) Any excess earnings generated beyond the guaranteed interest rate are then used to reduce future insurance premiums paid by the employer-sponsor. f. A fully insured plan is inappropriate for an employer who cannot commit to regular premium payments. g. A stable business, rather than one experiencing or anticipating fluctuating cash flow, is the best prospect for a fully insured plan under Section 412(e)(3).

HIGHLY COMPENSATED EMPLOYEE

1. A highly compensated employee (HCE) is an employee who meets one of the following criteria: a. Was a greater than 5% owner of the employer at any time during the current year or preceding year (5% exactly is not enough ownership to be an HCE) b. For the preceding year, had compensation greater than $130,000 (2020) from the employer 1.) If the employer makes an election, only persons ranked in the top 20% of compensation and having income greater than $130,000 (2020) are included as HCE. This exception is often for large employers and helps the plan pass the coverage or actual deferral percentage (ADP) test for 401(k) plans. It is important to understand a "top 20% election" will only remove a participant from the HCE group if the participant qualifies based on compensation only. The election will not remove a participant from the HCE group if the participant is a greater than 5% owner. For example, someone owning 5.1% of the company and making $10,000 a year is an HCE due to ownership. Therefore, it is possible for the HCE group to include greater than 20% of the total number of participants in the plan. NOTE: In IRS publications, the terms 5% owner and 1% owner are used interchangeably with the terms greater than 5% owner and greater than 1% owner. This is because in the Tax Code 5% owner and 1% owner are titles, not specific percentages of ownership. An HCE is defined in the Tax Code as an employee who is a 5% owner at any time during the current or preceding year as defined in Section 416(i)(1). Percentage owners are specifically defined in Section 416(i)(1): ■ A 5% owner is an individual who owns more than a 5% interest in the company. ■ A 1% owner is an individual who owns more than a 1% interest in the company. ■ For IRS purposes, if an individual owns 2% of the company, he is considered a 1% owner and if an individual owns 7% or 90% of a company, he is considered a 5% owner. ■ The 1% owners are discussed further in the key employees section of this volume. ■ Family ownership attribution rules apply to determine 5% owners and 1% owners. [Other family member's (spouse, child, grandparent, or parent) ownership is added to the employee's ownership. For example, if the employee owns 4% and his father owns 2%, then they are both HCEs, even though neither worker individually owns more than 5%.] 2. Nonhighly compensated employees (non-HCE) are those employees who do not meet the previous definition. 3. The HCE definition deals with minimum participation/nondiscrimination rules for retirement plans and group health insurance issues. 4. The key employee definition (covered in the following section) deals with retirement plans being top heavy or not top heavy and group life insurance issues.

NEW COMPARABILITY PLAN—DESCRIPTION

1. A new comparability plan is a defined contribution plan that is either a money purchase pension plan or a profit-sharing plan. a. More expensive to administer b. Type of cross-tested plan c. Nonhighly compensated employees must receive certain minimum contribution levels d. Contributions favor highly compensated employees 2. The common design factor is that new comparability plans have an allocation or contribution formula that results in one group or class of employee receiving a given contribution level and another group receiving a different level. a. For example, the owner/executive class may receive the full annual additions limit ($57,000 in 2020), and other employee classes may receive less. 3. This type of plan works well where owners are different ages, thus precluding an aged-based plan 4. The plan can define particular classifications of employees in a number of ways: a. Service with the employer b. Job title, such as officer or partner c. Employment at a particular division or subsidiary d. Compensation level e. Age f. Class of employee, such as salaried or hourly g. Any combination of a. through f. 5. For example, a plan may be written to provide officers a contribution of 20% of compensation and all other employees a contribution of 5%. 6. Allocations are restricted in that the employer must design the contribution structure in such a way that the plan passes the nondiscrimination tests. 7. In the event the plan fails the nondiscrimination tests: a. the plan should have provisions to reallocate or shift contributions from highly compensated employees to selected nonhighly compensated employees to satisfy the nondiscrimination rules; and b. it should be designed to increase accrual rates for nonhighly compensated employees one at a time until the nondiscrimination test is passed

TYPES OF QUALIFIED RETIREMENT PLANS

1. A qualified retirement plan is either a pension plan or a profit-sharing plan. a. Characteristics of a pension plan 1.) Employer's promise to pay a specific retirement benefit or make a contribution 2.) Mandatory annual funding 3.) In-service withdrawals from certain pension plans permitted for employees age 62 or over 4.) Types of pension plans a.) Traditional defined benefit pension plan ■ Fully insured defined benefit pension plan—Section 412(e)(3) b.) Cash balance pension plan c.) Money purchase pension plan ■ New comparability money purchase pension plan d.) Target benefit pension plan e.) DB(k) plan (a hybrid plan) b. Characteristics of a profit-sharing plan 1.) The promise to defer taxes 2.) In-service withdrawals are allowed if the plan document permits. 3.) Does not require mandatory annual funding, although to remain qualified, the plan must make substantial and recurring contributions (usually interpreted as meaning contributions in three out of five years) 4.) Types of profit-sharing plans a.) Traditional profit-sharing plan ■ Age-based profit-sharing plan ■ New comparability profit-sharing plan b.) Stock bonus plan c.) ESOP (employee stock ownership plan) d.) 401(k) plan e.) Thrift plan f.) SIMPLE 401(k) 2. Defined benefit pension plans a. Provide a specific benefit to the employee 1.) Plans require annual actuarial work (may be costly to administer). 2.) The annual funding amount is greater for employees who are older at plan-entry age. This makes defined benefit pension plans attractive to professionals and closely held businessowners who may be the older employees in the plan and want to fund a significant benefit in a relatively short period of time. b. Retirement eligibility 1.) Early retirement provisions may cause a reduced periodic benefit amount as a result of the extended retirement life expectancy. 2.) Eligibility can be a service-only requirement, an age-only requirement, an age and service requirement, or a sum of age and service requirement. c. Determination of benefits 1.) Benefits may be determined by an earnings based formula. 2.) Defined benefit pension plans specify time and benefit formula in the plan document 3. Defined contribution plans a. The employer establishes and maintains an individual account for each plan participant. 1.) The benefit is based on the total balance in the participant's account when the participant becomes eligible to receive benefit payments, usually at retirement or termination of employment. 2.) The account balance includes employer contributions, employee contributions, and earnings on the account for the years of deferral. a.) The account balance may also include reallocated forfeitures. b. The employer does not guarantee the amount of benefit a participant will ultimately receive, but the employer must make contributions under a formula specified in the plan. 4. Defined contribution pension plans a. The employer must make mandatory annual contributions to each participant's account under a formula established in the plan document. b. The employee bears the risk of varying investment results.

[SPECIAL RULES FOR SELF-EMPLOYED (KEOGH) PLANS] DESCRIPTION

1. A self-employed plan is an employer-sponsored retirement plan that covers one or more self-employed individuals, such as a sole proprietor or a partner. a. Self-employed retirement plans are seldom currently marketed or labeled as Keogh plans (an obsolete term). 1.) Typically referred to as a retirement plan for the self-employed and their employees b. The three most common types of qualified plans adopted by the self-employed are profit-sharing, money purchase pension, and target benefit pension plans, all of which are defined contribution plans. 2. A self-employed plan is fundamentally like any other qualified or tax-advantaged plan (it must comply with the same technical requirements). There are only two primary differences that result for a plan for the self-employed individual. a. First, self-employed individuals must calculate their retirement plan contribution on the basis of net self-employment income instead of W-2 income. b. Second, self-employed individuals must use a net contribution rate in determining their allowable contribution to a defined contribution plan. 3. For a defined contribution plan covering a self-employed individual, the annual additions limit applies—the lesser of $57,000 (2020) or 100% of compensation. a. Annual additions equal employer contributions, employee elective deferrals, and reallocated plan forfeitures.

TERMINATIONS

1. A standard termination requires that the plan have sufficient assets to cover benefits accrued to the date of termination. 2. A distress termination requires either that the employer be liquidated or that the termination be necessary for the company's survival. 3. If a defined benefit pension plan is terminated without sufficient assets to pay accrued benefits, the PBGC is liable for the balance (limited).

TOP-HEAVY REQUIREMENTS

1. A top-heavy plan is one that provides more than 60% of its aggregate accrued benefits or account balances to key employees [see definition in Section G (5)]. Top-heavy plans must meet certain additional qualification rules. a. A defined benefit pension plan is top heavy if the present value of accrued benefits for key employees is greater than 60% of the present value of accrued benefits for all employees. b. A defined contribution plan is top heavy if the aggregate of account balances of key employees exceeds 60% of the aggregate account balances of all employees. 2. Vesting a. If a defined benefit pension plan is top heavy for a given year, it must provide more rapid vesting than is generally required. Such a plan can provide either 100% vesting after three years of service (three-year cliff vesting replaces five-year cliff vesting) or 2-6-year graduated vesting (2-6-year graded vesting replaces 3-7-year graded vesting) as follows. b. All defined contribution plans must use the accelerated vesting schedule (three-year cliff or 2-6-year graded) for all employer contributions whether or not the plan is considered top heavy. 1.) The vesting schedules here are the most restrictive. The employer can provide a faster vesting schedule if so inclined. 3. Funding a. A top-heavy defined benefit pension plan must provide a minimum benefit accrual of 2% multiplied by the number of years of service (up to 10 years). 4. For a defined contribution plan that is top heavy, the minimum contribution is 3% of total covered compensation. If the contribution for key employees is less than 3%, the contribution to non-key employees can be equal to the contribution for key employees. 5. Key employee defined a. A key employee is an employee who at any time during the plan year or prior year met one of the following definitions: 1.) An officer with compensation in excess of $185,000 (2020) 2.) A greater than 5% owner 3.) A greater than 1% owner with compensation >$150,000 (not indexed) 4.) The number of officers who may be considered key employees is limited to the lesser of: a.) 50 employees; or b.) the greater of three employees or 10% of all employees b. The key employee definition is important for top-heavy rules for retirement plans and group life insurance issues. For retirement plans, being top-heavy requires accelerated vesting for defined benefit plans and increased benefits or contributions. It is easy to overlook that a top-heavy defined contribution plan usually requires a 3% contribution for eligible non-key employees.

DEFINED BENEFIT PENSION PLANS- DISADVANTAGES

1. Actuarial and PBGC aspects of defined benefit pension plans result in higher installation and administration costs than costs for defined contribution plans. 2. They are complex to design. 3. Employees who leave before retirement may receive relatively little benefit from the plan. 4. The employer is subject to a recurring annual mandatory funding obligation, regardless of profit or loss. 5. The employer assumes the risk of poor investment results in the plan. 6. They require costly annual actuarial work

[SIMPLIFIED EMPLOYEE PENSION (SEP) PLAN]- TAX IMPLICATIONS

1. An employer may deduct contributions to a SEP plan up to the contribution limit. 2. The major SEP plan requirements are as follows. a. A SEP plan must cover all employees who are at least age 21 and who have worked for the employer during three of the preceding five calendar years. b. Part-time employment counts in determining service. c. Contributions need not be made on behalf of employees whose compensation for the calendar year was less than $600 (2020). d. The plan can exclude employees who are members of collective bargaining units if retirement benefits have been the subject of good faith bargaining. 3. If an employer maintains a SEP plan and also maintains a regular qualified plan, contributions to the SEP plan reduce the amount that can be deducted for contributions to the regular plan. 4. In a SEP plan, each participating employee maintains an IRA. 5. Distributions to employees from the plan are treated as distributions from an IRA. 6. Investments are limited to investments permitted in an IRA (no collectibles and no life insurance). 7. A 10% excise tax is assessed on excess employer contributions. 8. Participation in a SEP plan counts as active participant status for purposes of determining the deductibility of separate traditional IRA contributions. a. Active participant status pertains to years in which the employer makes a contribution to the SEP.

SAVINGS/THRIFT PLA

1. Description a. A savings plan (or thrift plan) is a qualified defined contribution plan with features that provide for and encourage after-tax employee contributions to the plan. b. A typical savings plan provides after-tax employee contributions with matching employer contributions. c. Pure savings plans, featuring only after-tax employee contributions, have generally been replaced by the 401(k) type of plan, especially the Roth 401(k).

[SIMPLIFIED EMPLOYEE PENSION (SEP) PLAN]- DESCRIPTION

1. An employer-sponsored individual retirement account or individual retirement annuity arrangement that is similar from a contribution perspective to a qualified profit-sharing plan 2. Combines simplicity of design with a high degree of flexibility from the employer's perspective 3. An employer agreement to contribute on a nondiscriminatory basis to IRAs opened and maintained by employees a. All contributions are made by the employer (no employee elective deferrals). 4. The limits for contributions are the lesser of the following: a. 25% of compensation [covered compensation is limited to $285,000 (2020)] b. $57,000 (2020) 5. Employer contributions are discretionary.

LOANS

1. Any type of qualified plan or 403(b) plan may permit loans; however, usually only 401(k) and 403(b) plans have loan provisions. 2. All loans must be repaid within five years (except loans used to acquire a principal residence) and include interest. a. Loans for the purpose of acquiring a principal residence must be repaid over a reasonable period. b. The plan document will generally set forth the repayment for these loans. c. Plan loans must be available to all participants on a reasonably equivalent basis and must not be available to highly compensated employees in an amount greater than the amount made available to other employees. 1.) Plan loans are available to participants who are also self-employed owners or partners. d. Plan loans must: 1.) be adequately secured; 2.) be made in accordance with specific plan provisions; and 3.) bear a reasonable (market) rate of interest. 3. Generally, loans are limited to one-half the present value of the participant's nonforfeitable accrued benefit or vested account balance and cannot exceed $50,000. However, when a participant's vested account balance is less than $20,000, exceptions to the 50% limit may be made, as illustrated as follows. a. When account balances are $10,000 or less, the vested account balance is available for loan. b. When account balances are less than $20,000, loans up to $10,000 are available. c. Loans must be amortized on a level basis with payments made by the participant-borrower at least quarterly. d. The following table summarizes the maximum loan that may be taken. 4. The maximum loan amount may be further reduced by any loan balance the participant had in the one-year period preceding the loan. If it weren't for this reduction, participants could abuse the five-year repayment rule by repaying the loan on the last possible date and then immediately taking out the loan again. 5. Generally, loans must be repaid in full upon separation from service; if not, the outstanding balance at the time of separation is treated as a taxable distribution and possibly subject to the 10% early distribution penalty. 6. Interest paid on plan loans secured by elective deferrals is nondeductible. 7. Starting in 2020, retirement loans cannot be offered using a credit card or similar arrangements.

[SIMPLIFIED EMPLOYEE PENSION (SEP) PLAN]- APPLICATION

1. Appropriate a. When the employer is seeking an alternative to a qualified profit-sharing plan that is easier and less expensive to install and administer (usually for small employers) b. When an employer wants to install a tax-deferred plan and it is too late to adopt a qualified plan for the year in question (after December 31) 1.) SEP plans can be adopted and funded as late as the tax return filing date, including extensions, for the year in which they are to be effective. 2. SARSEP plans (salary reduction SEP plans), which feature employee pretax contributions, can no longer be established, but existing SARSEP plans can be maintained.

PBGC PREMIUMS

1. Benefit payments by the PBGC are financed by premiums paid by the sponsors of defined benefit plans. 2. The PBGC premium consists of two components: a. A base premium paid by all employers b. A variable premium with no overall maximum

INTERNAL REVENUE SERVICE (IRS)

1. Carries out the administrative duties of the qualified plan system (and, to a lesser extent, the non-qualified plan system) by: a. supervising the creation of new retirement plans and monitoring and auditing the operation of existing plans; b. interpreting federal legislation, especially with regard to the tax consequences of certain pension plan designs; and c. administering the qualified plan system

MONEY PURCHASE PENSION PLANS

1. Characteristics a. A money purchase pension plan is a qualified defined contribution retirement plan. 1.) The employer makes annual mandatory contributions to each employee's account under a nondiscriminatory contribution formula (either a fixed percentage or a flat dollar amount). a.) The formula requires a contribution by the employer of a specified percentage of each employee's annual covered compensation. b.) Contribution is further limited to the lesser of 100% of the employee's covered compensation or $57,000 (2020). c.) Total deductible employer contributions to the plan are limited to 25% of total covered compensation paid to employees. d.) Simplicity of administration ■ A money purchase pension plan is a relatively simple pension plan to administer as compared to a defined benefit pension plan. ■ The plan does not require the services of an actuary. ■ The employer is not required to purchase plan benefit insurance from the PBGC. ■ The costs of administering a money purchase pension plan are lower than those of all other pension plans (no actuary, no insurance). ■ Money purchase pension plans favor younger employees because of the long compounding periods. ■ Employees may make after-tax contributions to the plan (if plan document permits). 2. Appropriate uses a. When an employer wants to install a qualified retirement plan that is simple to administer and easy to explain to employees and the employer does not mind mandatory funding b. When the employees to be benefited are relatively young c. When a self-employed person has no employees and does not mind mandatory funding d. When employees are willing to accept the investment risk in their plan accounts e. When some degree of retirement income security in the plan is desired f. In most cases, a profit-sharing plan is a better choice than a money purchase pension plan, as it has the same funding limits with greater flexibility 3. Advantages a. It is relatively simple and inexpensive to design, administer, and explain. b. The plan formula can provide a deductible annual employer contribution of up to 25% of aggregate covered compensation. c. Distributions 1.) Lump sum 2.) Single annuity or joint annuity 3.) Rollover d. There are known funding cost 4. Disadvantages—employer perspective a. The plan retirement benefits may be inadequate and not very enticing for employees entering the plan at older ages. b. The plans require mandatory funding (inflexible). c. The plans cannot have more than 10% of plan assets invested in qualifying employer securities. d. There is no mechanism to influence employee retirement and turnover decisions. 5. Disadvantages—employee perspective a. Retirement benefits are uncertain and hard to project (depends on time, contributions, and investment expense) b. Employees bear the investment risk. c. Money purchase pension plans typically do not permit withdrawals before separation from service, retirement, death, disability, or termination of the plan. 1.) In-service distribution may be permissible for participants who have attained age 62. d. Loan provisions are allowed but are extremely unusual in money purchase pension plans. 6. Design features a. Money purchase pension plans have a benefit formula requiring a mandatory employer contribution that is typically a flat percentage of each employee's compensation. b. Up to a 25% contribution may be made and deducted by the employer. c. The plan benefit formula can be integrated with Social Security. 7. Tax implications a. Employer contributions to the plan are immediately deductible. b. Taxation of employer contributions to the plan is deferred until distribution. c. The plan is subject to the minimum funding standards. d. The plan is subject to ERISA reporting and disclosure rules. 8. Nondiscrimination requirements a. The plan may not, in general, discriminate in favor of highly compensated employees. b. The plan must meet the nondiscrimination requirements. c. Uniform contributions are defined as the same percentage of pay or the same dollar amount for every covered employee. d. If the plan is integrated with Social Security so that there is a higher contribution rate for pay above a specified level, the plan must meet a permitted disparity requirement 9. Forfeitures a. Forfeitures are created when nonvested or partially vested employees terminate employment. b. The unvested portion of the account reverts back to the plan. c. In money purchase plans, as in all defined contribution plans, employers can use the forfeitures alternatively to either: 1.) reduce future employer contributions; or 2.) allocate among the remaining participants. a.) Increasing remaining participants' account balances (annual additions limits apply) d. Forfeitures must be allocated on a nondiscriminatory basis.

PROHIBITED INVESTMENTS

1. Collectibles a. Collectibles include artworks, rugs, antiques, metals, gems, stamps, coins, alcoholic beverages, and certain other tangible personal property. 1.) An exception exists for IRA investments in one, one-half, one-quarter, or one-tenth ounce U.S. gold coins, or one ounce silver coins minted by the Treasury Department. An IRA also can hold certain platinum coins, as well as gold, silver, platinum, and palladium bullion. b. If an individual's IRA invests in collectibles, the amount invested is considered distributed to the individual in the year invested. 1.) The individual also may have to pay the 10% tax on premature distributions. 2. Life insurance a. Life insurance is not permitted as a funding vehicle for an IRA

[SIMPLE IRA AND SIMPLE 401(K)]- TAX DEDUCTIBILITY

1. Contributions by the employer are deductible if made by the due date of tax return (including extensions). a. Employer contributions are not subject to payroll tax. 2. Contributions made by employees are excludable from the employee's gross income for income tax purposes. a. Employee contributions are subject to payroll tax

RELATED EMPLOYERS TREATED AS A SINGLE EMPLOYER

1. Controlled groups a. Employers that have a significant degree of common ownership will be treated as a single employer for purposes of qualification under IRC Section 401, employer deduction, participation (coverage), vesting, limits on contributions or benefits, top-heavy rules, and limits of SEPs. b. Common types of controlled groups 1.) Brother-sister 2.) Parent-subsidiary

(IRAs)-TAX IMPLICATIONS

1. Deductibility rules a. When single taxpayers and when both MFJ spouses are not active participants in a qualified plan, SEP plan, SARSEP plan, SIMPLE, or 403(b) plan, contributions to a traditional IRA are fully deductible, regardless of the taxpayer's MAGI. b. For taxpayers who are active participants in a qualified plan, SEP plan, SARSEP plan, SIMPLE, or 403(b) plan, the deduction for traditional IRA contributions is limited (or eliminated) when a taxpayer's modified adjusted income reaches phaseout levels of $65,000-$75,000 for single and $104,000-$124,000 for married filing jointly in 2020. c. An individual will not be considered an active participant in an employer-sponsored retirement plan solely because the individual's spouse is an active participant. d. When only one spouse is an active participant, the nonparticipant spouse will have deduction phased out at MAGI levels between $196,000-$206,000 (2020). NOTE: It is important to understand that when one spouse is an active participant and one spouse is not an active participant, two separate phaseout thresholds apply. The MFJ active participant applicable threshold is $104,000-$124,000 (2020). The MFJ nonactive participant applicable phaseout is $196,000-$206,000 (2020). e. An individual participating only in a 457 plan is not considered an active participant for purposes of IRA contribution deductibility. 2. Active participant a. The plans that are considered for purposes of deducting IRA contributions include: 1.) qualified retirement plans; 2.) 403(b) plans; 3.) SEP plans; and 4.) SIMPLEs. a.) In addition, federal, state, and local government plans are also taken into account (with the exception of a 457 plan). b. Active participation is determining whether a taxpayer is benefiting under one of the previously mentioned plans. c. There are different rules for defined benefit pension plans and defined contribution plans 1.) Defined benefit pension plans a.) Unless an employee is excluded from participation, he is considered an active participant in a defined benefit pension plan when he is eligible to accrue benefits under the plan. b.) If an employee is not eligible or is excluded from the plan, she is not con-sidered an active participant. 2.) Defined contribution plans a.) An employee is considered an active participant for the year if an annual addition is made to the plan during the year. An annual addition is any of the following: ■ An employee contribution to the plan, such as an elective deferral to a 401(k) plan ■ An employer contribution to the plan, either matching or nonelective ■ A forfeiture reallocation to the participant's account b.) Employees who are participants in a defined contribution pension plan are considered active participants because pension plans require mandatory funding. c.) Employees who are participants in a profit-sharing plan may not be active participants for a particular year if there is no employer contribution, employee contribution, or forfeiture reallocation. d. If a taxpayer is an active participant for any part of the year, the taxpayer is considered an active participant for the entire year. e. Vesting has no effect on active participant status. f. Contributions to a Roth IRA may preclude contributions to a traditional IRA. 1.) The total contributions in aggregate, for Roth and traditional IRAs, cannot exceed $6,000 (2020) per individual per year, plus any allowable catch-up. g. Earned income does not include the following: 1.) Earnings and profits from property such as rental income, interest income, divi-dend income, and investment income 2.) Pension or annuity income 3.) Any nonqualified deferred compensation received (compensation payments postponed from a prior year) 4.) Foreign earned income or housing cost amounts that are excluded from income 5.) Any other amounts that are excluded from income h. Earned income does include alimony received; however, alimony agreements entered into starting in 2019 are not deductible to the payer or taxable to the recipient. 3. Excess contribution penalty results in a 6% excise tax (each year) if excess contribution is not withdrawn. 4. Contribution due date is the due date of the taxpayer's tax return without extension (generally April 15).

DEFINED BENEFIT PENSION PLANS- DESIGN CHARACTERISTICS AND PROVISIONS

1. Defined benefit pension plan formulas and benefit determination a. Flat amount formula 1.) A flat amount formula does not differentiate among employees with different compensation. 2.) A flat benefit formula does not use an accrued benefit actuarial cost method. b. Flat percentage formula 1.) Provides a retirement benefit that is a percentage of the employee's average earnings (average earnings can be calculated numerous ways) 2.) Typically requires certain minimum service, such as 25 years, to obtain the full percentage benefit with the percentage scaled back for fewer years of service c. Unit benefit formula (unit credit formula) 1.) Based on the employee's service with the employer. The formula may provide 1.5% of earnings for each of the employee's years of service. 2.) This is the most common type of benefit calculation in a defined benefit plan. d. Two methods generally used to compute average earnings for these formulas 1.) Career average method uses earnings averaged over the employee's entire career with the employer. The risk is a loss of purchasing power. 2.) Final average method uses earnings averaged over a number of years, usually three to five years immediately before retirement. The results may be as much as double the benefits of the career average method, thus producing a larger benefit. e. These formulas may be further modified by integration with Social Security benefits. f. A unit benefit method must use an accrued benefit cost actuarial method. 2. Contributions are allowed up to the amount actuarially determined to fund future benefits. 3. Funding is mandatory. 4. Earnings and forfeitures affect funding. a. Earnings in excess of projected earnings lower annual funding costs. b. Terminations lower annual funding cost to the extent of forfeiture. 1.) Plan forfeitures must be used to offset plan costs; forfeitures are not reallocated to remaining participants. c. Poor earnings increase annual plan costs by requiring increased funding. 5. Multiple variables affect the costs of a defined benefit pension plan a. Many are related, either inversely or directly, in that change in one variable affects another. b. An inverse relationship between variables exists when the increase or decrease in variable A causes the opposite effect in variable B. 1.) If plan investment returns increase and the plan has increased in value, the cost to the employer in the form of a plan contribution for that year decreases. 2.) If the investment return decreases, then the plan costs increase. c. A direct relationship occurs where the increase in variable A causes an increase in variable B. 1.) If the life expectancies of plan participants increase, then the plan costs to the employer also increase.

CASH BALANCE PENSION PLAN

1. Description a. A cash balance pension plan is a type of defined benefit pension plan that incorporates features similar to a defined contribution plan. 1.) The plan provides for annual employer contributions at a specified rate to hypothetical individual accounts that are maintained for each plan participant. 2.) The employer guarantees not only the contribution level but also a minimum interest rate credit to each participant's account. 3.) The interest rate credit may be fixed or tied to a market rate, such as a Treasury rate. b. A cash balance pension plan is similar to a money purchase pension plan but has an employer-guaranteed rate of return. 1.) There are certain important differences. a.) The funds that are contributed to the plan are often invested more aggressively than is reflected by the guaranteed interest rate credit. ■ Allows plan sponsors to contribute less than would be necessary in a money purchase pension plan, assuming investment performance is reasonable ■ Subject to broader investment risk than in a money purchase pension plan (With a money purchase plan, if the investments decrease, the worker loses. With a cash balance plan, when the investments decrease, the employer must contribute more.) b.) Although participants receive an account statement reflecting contributions and earnings, this amount may not be the amount received in the event of a lump-sum distribution. ■ Cash balance and other defined benefit pension plans have a method for converting the normal defined benefit (such as a joint and survivor annuity) into a current lump-sum value. c.) Cash balance pension plans must use three-year cliff vesting. 2. Application a. A cash balance pension plan is appropriate in the following situations: 1.) When the employee group is relatively young 2.) When employees are concerned with security of retirement income 3.) When the work force is large and the employees are primarily middle-income wage earners 4.) When the employer is able to spread administrative costs over a relatively large group of plan participants b. Some companies have amended their defined benefit pension plans and have adopted cash balance pension plans. 1.) Most cash balance pension plans in force today are converted defined benefit pension plans, not new plans. 3. Advantages a. A tax-deferred savings medium for the benefit of employees b. Plan distributions may be eligible for special lump-sum distribution tax treatment. c. Employer guarantee of return removes investment risk from employee. d. Plan benefits are guaranteed by the PGBC (limited). e. The advantages and benefits of a cash balance pension plan are easily communicated. f. Benefits methods are flexible. 1.) Employers may provide the same benefit to all employees, as in the case of a fixed percentage of compensation. 2.) Alternatively, contribution percentages can be higher for employees with lon-ger service. g. Cost savings when compared to a traditional defined benefit pension plan 4. Disadvantages a. Retirement benefits may be inadequate for older plan entrants. b. Because of the annual actuarial work and PBGC insurance requirement, the plan is more complex administratively than a qualified defined contribution plan. c. The investment risk is that of the employer and increases employer costs. 1.) The guaranteed investment return is usually low (3-4%). 2.) The participant is not credited with actual returns when the plan return exceeds the guaranteed interest rate credit. 5. Tax implications a. Employer contributions to the plan are deductible when made. b. The benefit paid from a defined benefit pension plan at normal retirement age cannot exceed the lesser of the following: 1.) 100% of the participant's covered compensation averaged over the three high-est consecutive years of compensation 2.) $230,000 (2020) c. Taxation to the employee on employer contributions is deferred. d. Distributions from the plan must follow the rules for qualified plan distributions. e. The plan is subject to the minimum funding standards. f. A cash balance pension plan is a type of defined benefit pension plan and is subject to mandatory insurance coverage by the PBGC and annual actuarial work. g. The plan is subject to ERISA reporting and disclosure rules.

ROTH IRAS

1. The treatment of traditional IRAs and Roth IRAs is the same for the following: a. Prohibited transactions b. Permitted investments c. Maximum allowable contribution d. Spousal IRA limits e. Definition of earned income 2. Contributions a. For 2020, the nondeductible contribution is an amount up to $6,000 per individual. b. Individuals who have attained age 50 may make additional catch-up contributions of $1,000. c. Like traditional IRAs, contributions to Roth IRAs cannot exceed earned income. d. Contributions can be made as late as the due date of the individual's return without extension (generally April 15) for the previous year. e. Only taxpayers with income below certain limits are permitted to make contributions to a Roth IRA. Contributions are phased out between modified AGI of: 1.) $196,000-$206,000 for married filing jointly; 2.) $124,000-139,000 for single; and 3.) $0-$10,000 for married filing separately. f. Modified AGI does not include income that is attributable to the conversion of a traditional IRA to a Roth IRA. 1.) Like a traditional IRA, there are no age restrictions on contributions to a Roth IRA. This has been the law since Roth IRAs were established. What is new is allowing contributions at any age for traditional IRAs starting for the tax year 2020 due to the SECURE Act. 3. Converting traditional IRAs to Roth IRAs a. An amount in a traditional IRA may be converted to an amount in a Roth IRA without regard to a taxpayer's MAGI. 1.) The amount converted must satisfy the definition of a qualified rollover contribution, which includes any of the following three methods. a.) An amount distributed from a traditional IRA is contributed to a Roth IRA within 60 days after the distribution. b.) An amount in a traditional IRA is transferred in a trustee-to-trustee transfer from the trustee of the traditional IRA to the trustee of the Roth IRA. c.) An amount in a traditional IRA is transferred to a Roth IRA maintained by the same trustee. b. Distributions from a qualified plan can be converted directly to a Roth IRA without an initial rollover to a traditional IRA. Additionally, if a plan offers both pretax elective deferrals and Roth account deferrals, participants may elect to convert amounts in pretax accounts into a Roth account in the same plan via a taxable in-plan rollover. c. Aggregation rule 1.) The Tax Code requires that all deductible and nondeductible traditional IRAs be aggregated together and treated as one IRA for the purpose of calculating the basis of a distribution. 2.) Even if the nondeductible traditional IRA contributions are segregated in separate IRAs from the deductible traditional IRA contributions, the aggregation rules require that any distribution be treated as a partial return of nontaxable basis and a partial taxable distribution of contributions and earnings. 3.) When calculating the nontaxable portion of the distributions made during a given tax year, all distributions in that year are also aggregated as though there was only one distribution in the year. 4.) The rule prevents a taxpayer from choosing to convert or distribute only the nontaxable portion of a traditional IRA and leaving the taxable contributions and earnings untouched. 5.) Once the IRAs are combined, the basis in the distribution is allocated as ... formula page 3:23 6.) Any amount converted that is a return of basis is not included in income. 7.) The 10% early withdrawal penalty does not apply. 4. Distributions a. A distribution from a Roth IRA is not includable in the owner's gross income if it is a qualified distribution or to the extent that it is a return of the owner's contributions (basis) to the Roth IRA (FIFO basis recovery). b. A qualified distribution is a distribution from a Roth IRA that satisfies both of the following tests. 1.) The distribution must be made after a taxable five-year period (which begins January 1 of the taxable year for which the first regular contribution is made to any Roth IRA of the individual or, if earlier, January 1 of the taxable year in which the first conversion contribution is made to any Roth IRA of the individual) 2.) In addition to the five-year test, the distribution must satisfy one of the follow-ing requirements: a.) Made on or after the date on which the owner attains age 591⁄2 b.) Made to a beneficiary or estate of the owner on or after the date of own-er's death c.) Is attributable to the owner being disabled d.) Used for first-time home purchase (lifetime cap of $10,000 for first-time homebuyers includes taxpayer, spouse, child, or grandchild who has not owned a house for at least two years) NOTE: In addition to the five-year holding period requirement, any of the listed circumstances can satisfy the second requirement. Age 591⁄2 is simply one of the possibilities; it is not an absolute requirement. c. The taxable five-year period is not redetermined when the owner of a Roth IRA dies. 1.) The beneficiary of the Roth IRA must wait only until the end of the original taxable five-year period for the distribution to be a qualified distribution. d. Distributions that are taxable but not subject to 10% early withdrawal penalty include the following: 1.) Higher education expenses 2.) Unreimbursed medical expenses in excess of 7.5% of AGI 3.) Medical insurance premiums while unemployed 4.) Substantially equal periodic payments e. Any amount distributed from an individual's Roth IRA is treated as made in the following order (determined as of the end of a taxable year and exhausting each category before moving to the following category): 1.) From regular contributions [i.e., the $6,000 (2020) annual contribution] 2.) From conversion contributions, on a first-in, first-out basis (FIFO) a.) In addition to FIFO ordering, distributions of conversion amounts is fur-ther ordered as follows: first, taxable amounts at the time of conversion, then, nontaxable (basis) amounts at the time of conversion. 3.) From earnings f. The significance of the distribution ordering is for distributions that are not qualified distributions. 1.) In the event of a distribution that is not a qualified distribution, the first layer will be return of basis (or contribution) followed by conversion contributions that also have been included in income (because of the conversion). g. Taxation of nonqualified distributions from Roth IRAs 1.) A distribution that is not a qualified distribution, is neither contributed to another Roth IRA in a qualified rollover contribution, nor constitutes a cor-rective distribution is includable in the owner's gross income to the extent that the amount of the distribution, when added to the amount of all previous distributions from the owner's Roth IRAs (whether or not they were qualified distributions), exceeds the owner's contributions (both regular contributions and conversion contributions) to all her Roth IRAs. 2.) Distributions will generally not be taxable to the extent that total distributions do not exceed total contributions and conversions. 3.) The 10% early withdrawal penalty will generally apply to any distribution from a Roth IRA that is includable in gross income (earnings). 4.) The penalty also applies to a nonqualified distribution, even if it is not includ-able in gross income, to the extent it is allocable to a conversion contribution, if the distribution is made within the taxable five-year period beginning with the first day of the individual's taxable year in which the conversion contribu-tion was made. [This protects against the abuse of Roth IRA conversions in which the real point of the "conversion" would have been to avoid the 10% penalty (e.g., convert today and pull the money out of the Roth tomorrow for something that does not qualify as an exception to the 10% penalty). After the conversion is past the five-year mark, the law does not apply the 10% penalty on the converted amount.] 5.) For purposes of applying the penalty, only the amount of the conversion includ-able in gross income as a result of the conversion is taken into account. a.) It is important to note that although a nonqualified distribution may be subject to the 10% penalty in accordance with the Roth IRA rules, the penalty may be avoided if the distribution falls within one of the excep-tions under IRC Section 72(t). h. Another important distinction from traditional IRAs is that minimum distribution rules do not apply to Roth IRAs while the Roth IRA owner is alive. 5. Inherited Roth IRAs a. The distribution rules that apply to an inherited Roth IRA are the same as the rules used for traditional IRAs when death occurs prior to the required beginning date for required minimum distributions. (See section XV. H.2. to review the rules) 1.) The decedent spouse's holding period carries over, and the five-year holding period must be satisfied for distributions to be tax free. b. Nonspouse beneficiary 1.) A nonspouse beneficiary must begin distributions from an inherited Roth IRA account no later than the year following the year of death of the Roth IRA owner. c. Spouse beneficiary 1.) A spouse beneficiary may elect to be treated as the beneficiary or the owner of the Roth IRA. a.) If the spouse beneficiary elects to be treated as the beneficiary, distribu-tions may be deferred until the year in which the original owner would have attained age 72. b.) If the spouse beneficiary elects to be treated as the owner of the Roth IRA, there are no required minimum distributions during the spouse ben-eficiary's remaining lifetime. ■ If eligible, the spouse, as owner, may continue making contributions or conversions into the Roth IRA. ■ The decedent spouse's holding period carries over, and the spouse beneficiary may make tax-free distributions upon satisfying the qualified distribution requirements. 6. Effect a. Young people should maximize contributions to Roth IRAs. b. Individuals should evaluate the rollover/conversion option, especially younger people currently in low tax brackets and expecting to be in higher income tax brackets later in life.

TARGET BENEFIT PENSION PLANS

1. Description a. A target benefit pension plan is a type of defined contribution pension plan under which contributions are made for each participant to fund the participant's target benefit at the plan's normal retirement age. b. In the establishment of the plan, based on the target benefit assumptions, an actuary determines the contributions needed for participants entering the plan at various ages. 1.) Unlike a defined benefit pension plan, there are no periodic actuarial valua-tions and the target benefit is not guaranteed to be achieved. 2.) Contributions are made to participant individual accounts and the participant bears investment risk and employer contributions are not adjusted year to year. 3.) Benefit payments a.) The target in a target benefit pension plan is a retirement benefit similar to that provided in a traditional defined benefit plan. b.) It provides benefits similar to other types of defined contribution plans, particularly money purchase pension plans. c.) A target benefit pension plan must provide for a qualified joint and survivor annuity as its automatic benefit, unless waived by the participant with the consent of spouse. 4.) Nondiscrimination regulations a.) Under proposed nondiscrimination regulations, target plans generally must apply the rules for defined benefit plans to the target formula. b.) A defined contribution plan can be tested on the basis of its projected benefits at retirement, and a defined benefit pension plan can be tested on the basis of annual employer contributions (cross-testing). c.) Cross-testing makes age-weighted defined contribution plans permissible. ■ Such plans are discriminatory on the basis of their annual contribution levels but are designed through cross-testing to be nondiscriminatory regarding benefits. d.) If projected benefit levels in an age-weighted plan are not discriminatory, the plan meets nondiscrimination tests of proposed regulations. e.) Cross-testing can be used to design a defined contribution plan that has the maximum permissible level of contribution discrimination. ■ The planner works backward from the projected benefit levels that minimally meet cross-testing requirements and then calculates those projected benefit levels. f.) Age-weighted plans permit low contribution levels for younger, lower-paid participants and extremely high contributions for older employees 5.) Other provisions a.) Vesting and investment features of target benefit pension plans are similar to those for money purchase pension plans. b.) Target benefit pension contribution formulas can be integrated with Social Security 2. Similarities with defined benefit pension plans: a. Favor older participants b. Require an actuary when established c. Type of pension plan d. Mandatory funding—employer is required to contribute 3. Similarities with defined contribution plans: a. PBGC insurance is not required. b. Employee bears investment risk. c. It minimizes costs for lower-paid employees. d. Actual benefit may be less than targeted benefit because of investment results. e. Each employee has own individual account. f. The maximum annual addition in 2020 is the lesser of 100% of covered compensation or $57,000 (2020).

AGE-BASED PROFIT-SHARING PLAN

1. Description a. An age-based profit-sharing plan is a defined contribution profit-sharing plan in which compliance with the nondiscrimination rules is tested in accordance with benefits rather than contributions (cross-testing). b. Cross-testing 1.) Allocations to participants are made in proportion to each participant's age-adjusted compensation. 2.) A participant's compensation is age-adjusted by multiplying the participant's actual compensation by a discount factor based on the participant's age and interest rate elected by the employer. 3.) Under an age-based allocation formula, each participant's equivalent accrual rates will, in theory, be the same. 4.) Equivalent accrual rates will be the basis of nondiscrimination testing. 5.) The employer contribution is then allocated to the plan participants' accounts so as to create a benefit at the normal retirement age under the plan that is actuarially equivalent for each plan participant (typically, when the participant reaches age 65). c. Older employees (the businessowner is usually among them) receive the greatest allocation

401(K) PLAN

1. Description a. A traditional 401(k) plan (also known as a qualified cash or deferred arrangement or CODA) is part of a qualified profit-sharing plan under which plan participants have an option to make elective salary deferrals into the plan or receive taxable cash compensation. b. Amounts contributed are not taxable to the participants until withdrawn. 2. Application a. A 401(k) plan is appropriate in the following instances: 1.) When an employer wants to provide a qualified retirement plan for employees without being required to make ongoing employer contributions a.) Can be funded entirely from employee elective deferrals, except for installation and administration costs 2.) When the employee group has one or more of the following characteristics: a.) Employees would like some choice as to the level of savings—that is, a choice between various levels of current cash compensation and tax-deferred savings. ■ A younger, more mobile work force often prefers this choice. b.) Employees are relatively young and have substantial time to accumulate retirement savings. c.) Employees are willing to accept a degree of investment risk in their plan accounts. 3.) When an employer wants an attractive, savings-type supplement to its existing qualified retirement plan. 3. Advantages a. Allows employees a degree of choice in the amount they wish to save b. Can be funded entirely through elective deferrals by employees c. In-service withdrawals by employees for hardship are permitted. d. Loans also may be permitted. 4. Disadvantages a. As with all defined contribution plans, account balances at retirement age may not provide adequate retirement savings for employees who entered the plan at later ages. b. The maximum elective deferral contribution is $19,500 with an additional $6,500 catch-up for individuals age 50 or older (2020). c. Employer deductions for plan contributions cannot exceed 25% of the total compensation of employees covered under the plan. 5. Design features a. Coverage 1.) Must satisfy the coverage tests applicable to qualified plans (See Section V(C): Coverage Tests) 2.) Must satisfy both the actual deferral percentage (ADP) test and the actual contribution percentage (ACP) test if the plan has employer-matching contributions b. Elective deferrals 1.) Virtually all 401(k) plans are funded entirely or in part through elective deferrals by employees. 2.) Elective deferrals must be elected by employees before the compensation is earned. 3.) The participant is always 100% vested in elective deferrals contributed to the plan and any plan earnings attributed to these contributions. c. Employer contributions 1.) Some 401(k) plans provide direct employer contributions to encourage employee participation and make the plan more valuable to employees. Typically, one or more of the following are types of employer contributions: a.) Formula matching contributions b.) Discretionary matching contributions c.) Pure discretionary, nonelective profit-sharing contribution 2.) Qualified nonelective employer contributions, which are nonforfeitable provisions in 401(k) plans, are used to help the plan meet the ADP tests. 3.) A forfeiture from a partially vested participant that is reallocated to other participants is included in the ACP test as an employer contribution. d. Plan distributions 1.) Distributions from 401(k) plans are subject to qualified plan distribution rules. 2.) 401(k) plans often allow participants to make in-service withdrawals (with-drawals before termination of employment). 3.) 401(k) accounts based on elective deferrals cannot be distributed before occurrence of one of the following events: a.) Retirement b.) Death c.) Disability d.) Separation from service with the employer e.) Attainment of age 591⁄2 by the participant f.) Plan termination g.) Hardship 4.) Many preretirement distributions will not only be taxable but may also be subject to the 10% early withdrawal penalty tax. e. A hardship withdrawal must meet the following tests. 1.) Financial needs test: The hardship must be due to an immediate and heavy financial need of the participant-employee. 2.) Resources test: The participant must not have other financial sources sufficient to satisfy the need. 3.) In addition to meeting both of these tests, the money may only be withdrawn for the following reasons: a.) Payment of unreimbursed medical expenses for employee, spouse, or dependents b.) Purchase of a primary residence or repair of casualty loss damages of a primary residence c.) Payment for up to the next 12 months of higher education expenses for the participant, the participant's spouse, or dependent children d.) Payment necessary to prevent foreclosure on the participant's primary residence e.) Burial or funeral expenses for an employee's deceased parents, spouse, children, and dependents f.) Safe harbor: Plan may identify a distribution to satisfy a financial need without the requirement that all other employee resources be exhausted if certain requirements are met. 4.) When a hardship withdrawal is taken, the participant's right to make elective deferrals must be suspended. 5.) Finally, if a hardship withdrawal is approved and made, the distribution is tax-able, and a possible 10% penalty applies. 6. Tax implications a. Employee elective deferrals are not currently taxable income to the employee. b. Elective deferrals are subject to FICA (Social Security and Medicare tax) and FUTA (unemployment). c. Nonelective employer contributions to the plan and employer discretionary contributions are deductible by the employer for federal income tax purposes up to a limit of 25% of the total covered compensation. d. Income tax credit for elective deferral contributions—retirement savings contribution credit (saver's credit) for eligible participants 1.) In general a.) A nonrefundable income tax credit is available for elective contributions made to a 401(k) plan, 403(b) plan, 457 plan, SIMPLE, SARSEP, traditional IRA, or Roth IRA. b.) The credit is in addition to any deduction or exclusion that would other-wise apply with respect to the contribution. c.) The credit is available to individuals who are age 18 or over, other than full-time students and individuals claimed as dependents by another taxpayer. 2.) Amount of credit a.) The maximum annual contribution eligible for the credit is $2,000. b.) The credit rate depends on the taxpayer's adjusted gross income and filing status for the tax year. c.) The amount of contribution eligible for the credit is reduced by tax-able distributions from 401(k) plans, 403(b) plans, 457 plans, SIMPLEs, SARSEPs, traditional IRAs, or Roth IRAs. 7. Nondiscrimination testing requirements a. ADP test 1.) Employee elective contributions must meet a special test for nondiscrimination called the ADP test. The average deferral percentage test compares the average pretax deferrals of the eligible HCE group with the average pretax deferrals of the nonhighly compensated group. The plan must meet one of the following two tests in actual operation: a.) Test 1—The ADP for the eligible highly compensated employee group must not be more than the ADP of all other eligible employees multi-plied by 1.25 b.) Test 2—The ADP for the eligible highly compensated employee group must not exceed the ADP for other eligible employees by more than 2%, and the ADP for eligible highly compensated employees must not be more than the ADP of all other eligible employees multiplied by 2. 2.) The result of the ADP test is that deferrals of highly compensated employees are limited on the basis of deferrals of nonhighly compensated employees. 3.) The matching contributions and loan provisions are often incorporated into 401(k) plans to entice the nonhighly compensated employees to increase their deferrals and increase the ADP for nonhighly compensated employees. 4.) If the plan fails the ADP test, the employer has two options. a.) A corrective distribution can be made, which will decrease the ADP of the highly compensated employees. ■ This distribution is made in the following tax year and will be included in gross income for the taxpayer (highly compensated employee). ■ The excess contribution must be corrected within 21⁄2 months after the end of the year or the employer will be required to pay a 10% penalty (excise tax) on the amount not corrected. b.) An additional contribution can be made for nonhighly compensated employees. This additional contribution can take one of two forms, both of which are required to be 100% vested: ■ Qualified matching contribution—additional contribution for only nonhighly compensated employees who deferred for the plan year ■ Qualified nonelective contribution—additional contribution for all eligible nonhighly compensated employees (even if they had not been participating) b. ACP test 1.) The ACP test applies to employer-matching contributions and employee after-tax contributions and uses the same procedure as the ADP test. 2.) Employer-matching contributions must meet a special test for nondiscrimina-tion called the ACP test. 3.) The plan must meet one of the following two tests in actual operation: a.) Test 1—The ACP for the eligible highly compensated employee group must not be more than the ACP of all other eligible employees multi-plied by 1.25. b.) Test 2—The ACP for the eligible highly compensated employee group must not exceed the ACP for other eligible employees by more than 2%, and the ACP for eligible highly compensated employees must not be more than the ACP of all other eligible employees multiplied by 2. c.) The ACP rules are the same as the ADP rules and can be summarized with the following table. c. Safe harbor 401(k) plan rules (alternative methods of meeting nondiscrimination testing requirements) 1.) Employers can avoid ADP and ACP testing if the plan meets one of the safe harbor provisions under IRC Section 401(k)(12). 2.) The following contributions made by the employer must be 100% vested at all times: a.) Alternative methods ■ Matching contributions for nonhighly compensated employees — 100% match up to 3% of deferred compensation plus 50% match for contributions between 3% and 5% of compensation — Matching contribution percentages for the highly compensated employees cannot exceed those for nonhighly compensated em-ployees ■ Elect to match 100% up to 4% of compensation. b.) Nonelective contributions ■ The employer may choose to make contributions of 3% or more of compensation for all employees who are eligible to participate in the plan, including for those who do not make elective deferrals. 3.) Other requirements include the following. a.) As mentioned, to meet the safe harbor requirements, the matching and qualified nonelective contributions must be 100% vested. b.) The previously listed contributions may not be considered for the pur-pose of permitted disparity. c.) The employer must provide notice to each eligible employee about rights and obligations under the plan. d.) Safe harbor rule for plans with automatic enrollment provisions is the following: ■ The ADP and ACP test will not apply to 401(k) plans with a qualified automatic contribution arrangement (QACA). ■ To qualify, the plan must meet the following requirements: — Unless an employee elects otherwise, the employee must have a qualified percentage of compensation deferred on her behalf under the plan. — The qualified percentage cannot exceed 10% and must be at least equal to the following: (page 68) — The employer must make either a nonelective contribution or a matching contribution on behalf of each nonhighly compensated employee who is eligible to participate in the plan. - The employer nonelective contribution must be at least 3% of compensation for each nonhighly compensated employee eligible to participate in the plan. - Alternatively, the employer can make a matching contribution ■ A QACA also must provide that a participant with two or more years of service will be 100% vested in employer contributions made as part of the QACA. 8. Roth 401(k) a. Overview 1.) A Roth 401(k) is a 401(k) plan in which elective deferral contributions are made on an after-tax basis to a separate account within a 401(k) plan. 2.) Contributions to a Roth 401(k) and earnings on the contributions can be received in a qualifying distribution without the imposition of income taxes. 3.) Companies offering a Roth 401(k) option are required to separately track an individual's regular 401(k) balance and Roth 401(k) balance. 4.) The main difference between a regular 401(k) plan and a Roth 401(k) plan is the tax treatment of the contributions and distributions. 5.) Otherwise, regular and Roth 401(k) plans are basically identical (same creditor protection, nondiscrimination testing, etc.). b. Contributions 1.) The maximum elective deferral contribution to a Roth 401(k) is $19,500 (2020). 2.) Individuals age 50 or older can contribute an additional $6,500 (2020). 3.) Elective deferral contributions and catch-up contributions are made with after-tax dollars. 4.) Unlike a Roth IRA, the ability to make contributions to a Roth 401(k) is not phased out on the basis of the taxpayer's adjusted gross income. 5.) 401(k) plans that permit Roth contributions may allow participants to convert pretax amounts that qualify as eligible rollover distributions into Roth accounts within the same plan. The IRS has determined that the 10% early distribution penalty does not apply for this type of conversion. Upon distribution, all of the conversion rules apply. The mandatory 20% withholding from the conversion does not apply. The conversion amount is still taxable, but the taxpayer may pay the income tax from other funds. c. Distributions 1.) Distributions of basis (contributions) from a Roth 401(k) are received income tax free. 2.) Distributions of earnings from a Roth 401(k) also are income tax free, provided that both of the following tests are met: a.) The distribution must be made after a period of five taxable years, which begins January 1 of the taxable year for which the first regular contribution is made to the Roth 401(k). b.) Additionally, the distribution must satisfy one of the following requirements: ■ Made on or after the date on which the individual attains age 591⁄2 ■ Attributable to the disability of the participant ■ Made to a beneficiary or estate of the participant on or after the date of the participant's death. 3.) The first-time homebuyer exception, which is applicable to Roth IRA distributions, is not applicable to distributions from Roth 401(k) plans. 4.) Required minimum distribution (RMD) rules do apply to Roth 401(k) distributions, usually when the individual attains age 72. 5.) Nonqualified distributions from a Roth 401(k) will be treated as both a distribution of contributions (excludable from income) and a distribution of taxable accumulated earnings (on a pro rata basis). In addition, other taxes may apply, depending on the disqualifying event. 9. SIMPLE 401(k)—See Section XII SIMPLE Retirement Plans for details. (page 71)

EMPLOYEE STOCK OWNERSHIP PLAN (ESOP)

1. Description a. An ESOP is a type of profit-sharing plan in which participant accounts are invested in stock of the employer's company. 2. Design a. ESOPs and stock bonus plans are qualified defined contribution plans similar to traditional profit-sharing plans. b. Participants' accounts are stated in terms of shares of employer stock. c. An ESOP is distinguished from a regular stock bonus plan primarily by the leveraging feature of an ESOP that enables the employer company to borrow money on a favorable basis. 3. Leveraged ESOP (LESOP) a. The ESOP trustee borrows money from a lending institution such as a bank. b. The trustee uses the loan proceeds to purchase stock of the employer from the employer corporation or from principal shareholders of the corporation. c. The employer makes tax-deductible contributions to the ESOP in amounts sufficient to enable the trustee to pay off the principal and interest of the loan to the bank or other lender. 1.) If the employer makes contributions to the plan in excess of the 25% of covered compensation limit, only the amount of the excess that is equal to the interest paid on the loan is deductible to the employer. 2.) For example, if the contribution to the plan is 30% of covered payroll and the excess 5% is entirely attributable to the loan interest, the employer may deduct the full 30%. However, if any portion of the excess 5% is attributable to principal repayment on the loan, that portion is not deductible by the employer. 4. Application a. An ESOP is appropriate: 1.) to provide a tax-advantaged means for employees to acquire company stock at low costs to the employer; 2.) when estate and financial planning for principal shareholders would benefit from the additional market for company stock because it: a.) creates a market, and b.) also provides estate tax benefits for the sale of the stock to the ESOP; 3.) to provide an advantageous vehicle for the company to borrow money for business needs (may be leveraged); 4.) when a company wants to broaden its ownership to help prevent a hostile take-over of the company; and 5.) for an incorporated business. a.) Partnerships do not have stock. b.) S corporations are permitted to issue stock to an ESOP. 5. Advantages of an ESOP a. Employees receive an ownership interest in the employer company that may provide a performance incentive. b. A market is created for employer stock that helps improve liquidity for existing shareholders. c. Employees are not taxed until shares are distributed. d. The employer receives a deduction either for a cash contribution to the plan or a noncash plan contribution in the form of shares of stock e. A shareholder can obtain tax benefits by selling stock to the plan. 1.) The shareholder that reinvests the proceeds received from the ESOP sale in domestic securities pays no current capital gains. 2.) This allows the shareholder to create a diversified retirement portfolio from a previously nondiversified investment without tax consequences. 3.) Nonrecognition of gain treatment on the sale of stock by a shareholder to an ESOP occurs if all of the following three requirements are met. a.) The ESOP must own at least 30% of the stock (either of each class or of total value). b.) The owner must have held the stock for at least three years before the sale. c.) Qualified replacement property must be purchased within one year after the sale (or three months before the sale). ■ Includes publicly traded domestic stock as well as privately owned stock 6. Disadvantages a. Because an ESOP is a qualified plan, all the qualified plan requirements apply (coverage, vesting, funding, reporting and disclosure, and others). b. Issuing shares of stock to employees reduces the relative value of existing shareholders' stock and their control. c. The employer stock may be a very speculative investment. 1.) Such risk can create employee ill will because either the plan is not considered valuable by employees or employees expect too much from the plan. d. ESOPs cannot use Social Security integration. e. When plan participants take distributions from the ESOP, the participant has the right to demand the distribution be in the form of the employer stock. 1.) If not readily tradable on the stock market, participants may require the employer to repurchase the employer stock using a formula to determine a fair market value. a.) Referred to as a put option or a repurchase option in the ESOP. b.) Repurchase or put option must be available for the 60-day period immediately following the distribution and again for 60 days in the following plan year. 7. Tax implications a. Employer contributions to the plan are deductible when made, up to an annual limit of 25% of covered compensation. b. The regular annual additions limit for defined contribution plans applies to both ESOPs and stock bonus plans. c. Within certain limitations, a corporation can deduct dividends paid on stock acquired with an ESOP loan. d. Taxation to the employee on employer contributions is deferred, as with any qualified plan. e. A lump-sum distribution of employer stock may qualify for favorable tax treatment through the NUA election. f. An ESOP plan is subject to eligibility and vesting rules applicable to all qualified plans. 8. ERISA and other regulatory requirements a. An ESOP plan is subject to the usual ERISA eligibility, vesting, and funding requirements for qualified plans. b. Certain directors and policy-making officers with ESOP or stock bonus accounts may be subject to insider trading restrictions under federal securities laws.

TARGET BENEFIT PENSION PLANS/AGE-WEIGHTED PLANS

1. Description a. Broad types of age-weighted plans 1.) A target benefit pension plan is an age-weighted money purchase pension plan. It is a hybrid between a defined contribution pension plan and a defined benefit pension plan. a.) Similarity with defined benefit pension plan—The funding of each par-ticipant's account is aimed at producing a target amount, or benefit, at retirement. b.) Similarity with defined contribution plan—The actual benefit to which the employee is entitled is the amount of the employee's account at retirement. Like a defined contribution plan, the plan participant assumes the investment risk. 2.) The age-based profit-sharing plan is a profit-sharing plan with an age-weighted factor in the allocation formula. a.) Older plan entrants are favored 3.) The new comparability plan represents an attempt to push age weighting to its maximum limit under the cross-testing provisions of the proposed nondiscrimi-nation regulations. 2. Application a. Age-weighted plans are appropriate in the following situations. 1.) There are older employees whose retirement benefits would be inadequate under a traditional defined contribution plan because of the relatively few years remaining for participation in the plan. 2.) An alternative to a defined benefit pension plan is needed to provide older employees adequate retirement benefits but with the lower cost and simplicity of a defined contribution plan. 3.) The employer wants to terminate an existing defined benefit pension plan to avoid the increasing cost and regulatory burdens associated with these plans. 4.) A closely held business or professional corporation has a relatively large number of key employees who are approximately age 50 or older. 3. Advantages a. Retirement benefits can be made adequate for employees who enter the plan at older ages. b. More of the total employer contributions in the age-weighted plan will likely be allocated to owners and key employees who are probably older. c. An age-weighted plan provides tax-deferred retirement savings d. The age-weighted plan is relatively simple and inexpensive to design, administer, and explain to employees. e. Qualifying lump-sum distributions may be eligible for the special 10-year forward-averaging tax computation available for certain qualified plans. f. Individual accounts for participants allow participants to benefit from good investment results. 4. Disadvantages a. A target benefit pension plan is subject to the minimum funding standards applicable to all pension plans. b. Employers are obligated to make minimum contributions each year under the plan's contribution formula or are subject to minimum funding penalties. c. An age-weighted profit-sharing plan is not subject to the minimum funding requirements but requires recurring and substantial contributions. 5. Design features a. The design of current age-weighted plans is dictated by the need to satisfy the proposed nondiscrimination requirements. 1.) Target benefit pension plan a.) The employer chooses a target level of retirement benefits as a percentage of annual compensation. b.) It requires an actuary when plan is implemented but not needed annually. c.) Employee bears the investment risk. d.) Participants have individual accounts. e.) PBGC insurance is not available. f.) Actual dollar benefit amount is not guaranteed. 6. Alternatives a. Defined benefit pension plans provide more benefit security because of the employer and government (PBGC) guarantee of benefit levels. 1.) They also allow greater tax-deductible employer contributions for older plan entrants who are highly compensated because the defined contribution plan annual additions limit does not apply. 2.) Defined benefit pension plans are more complex and costly to design and administer. b. Money purchase pension plans offer an alternative similar to target benefit pension plans but without the age-related contribution feature. c. Nonqualified deferred compensation plans can be provided exclusively for selected executives. The employer's tax deduction is generally deferred. d. Individual retirement savings are available as an alternative or supplement to an employer plan

PROFIT-SHARING PLANS

1. Description and characteristics a. The legal promise of a profit-sharing plan is to defer taxes. There are no mandatory funding requirements and in-service withdrawals may be permitted. b. A profit-sharing plan is a qualified defined contribution plan featuring a flexible employer contribution provision. 1.) Traditional profit-sharing plan 2.) Stock bonus plan 3.) ESOP and LESOP 4.) Savings/thrift plan 5.) 401(k) plan 6.) SIMPLE 401(k) plan (covered in Section XII, D) 7.) Age-based profit-sharing plan (Covered in Section VIII, C) 8.) New comparability plan (covered in Section VIII, D) c. The employer's contribution to the plan each year can be either a purely discretionary amount (or nothing at all if the employer wishes) or based on some type of formula usually relating to the employer's annual profits. d. Contributions are generally allocated to a participant's individual account on the basis of a nondiscriminatory formula. Age-weighted formulas can be used to determine contributions. e. Profit-sharing plans may permit in-service distributions (withdrawals) for a variety of reasons (e.g., medical expenses or home purchase). f. For a profit-sharing plan to remain viable, contributions must be substantial and recurring (IRS standard). 1.) Usually interpreted to mean a contribution must be made in three out of every five years 2. Tax deductibility a. The employer can deduct a maximum of 25% of total covered compensation. NOTE: Some individual plan participants may receive contributions in excess of 25%, as long as total company contributions do not exceed 25% of aggregate covered compensation and contributions do not violate the rules of discrimination. b. Excess contributions are subject to a 10% excise tax. 3. Employer contributions a. Discretionary contributions give the employer maximum flexibility to adjust contributions to match financial position and the employer's need for cash flow. b. Formula-based contributions 1.) Formula approach plans specify a method for determining contributions—generally, a percentage of profits but can be a percentage of compensation. 2.) A profit-based formula can define profits as either before tax or after tax and can be a flat percentage of profits or a sliding percentage. 3.) A compensation-based formula can define compensation as base pay or as base pay plus overtime and bonuses, or it can determine contributions on the basis of profit levels. 4.) The formula-based approach offers much less flexibility to the employer but may provide incentives for employees if contributions are tied to profits. c. Only the first $285,000 (2020) of an employee's compensation may be taken into account. d. The annual additions to an employee's account are limited to the lesser of 100% of the employee's compensation or $57,000 (2020) 4. Forfeitures a. Forfeitures can be used to reduce employer contributions. b. Alternatively, forfeitures can be reallocated to the accounts of remaining participants. 1.) If reallocated, forfeitures in a profit-sharing plan must be allocated in a nondiscriminatory manner. 2.) Forfeitures are usually reallocated in the same way contributions are allocated (e.g., relative compensation). 3.) If forfeitures are reallocated to participants, the amounts are included when applying the annual additions limit. 5. In-service withdrawals/distributions a. It is possible to design a profit-sharing plan allowing employees to withdraw all or part of their vested account balance before retirement if certain requirements are met. 6. Participant-directed investments a. The advantage of allowing participant-directed investments is that it limits the employer's fiduciary responsibility. b. ERISA requires that the plan have at least three investment choices (e.g., money market fund, bond fund, and stock fund) and that the employer provide education to the participants regarding investment choices. 7. Application a. A profit-sharing plan is appropriate when: 1.) an employer's profits or financial ability to contribute to the plan vary from year to year; 2.) a qualified pension plan is unsuitable, as the employer anticipates that there may be years in which no contribution can be made; 3.) the employer wants to adopt a qualified plan with an incentive feature by which employer contributions increase with the employer's profits; 4.) the employee group has certain characteristics, such as: a.) many of the employees are relatively young and have substantial time to accumulate retirement assets, or b.) the employees can and are willing to accept a degree of investment risk in their accounts; and 5.) the employer wants to supplement an existing defined benefit pension plan.

STOCK BONUS PLAN

1. Description and characteristics a. The major difference between a stock bonus plan and a traditional profit-sharing plan is that stock bonus plan benefits are generally distributed in the form of employer stock, not cash. 1.) The employer contributes either cash or employer securities to the plan. 2.) The contributions are determined in a variety of ways (a percentage of either profits or covered payroll), same as profit-sharing plans. b. A stock bonus plan may permit employee contributions but usually does not. c. Contributions to a stock bonus plan must be allocated to individual participant accounts. d. Stock bonus plans are subject to the same nondiscrimination requirements as traditional profit-sharing plans. e. The assets of a stock bonus plan can be invested primarily in employer stock or securities. f. Dividends from the employer stock in the plan can be either reinvested or distributed directly to participants. g. Only the first $285,000 (2020) of an employee's compensation may be taken into account. h. The annual additions to an employee's account are limited to the lesser of 100% of the employee's compensation or $57,000 (2020). 2. Distributions a. Generally, distributions are in the form of employer stock. b. For securities that cannot be easily traded on an established market, participants can request that the employer repurchase the securities at a fair price (the put option), and the employer must comply. c. Net unrealized appreciation (NUA) 1.) For a lump-sum distribution of employer stock, a participant has the ability to defer NUA on the employer securities. a.) NUA is (FMV - basis) at distribution. 2.) Upon distribution, the participant recognizes as ordinary income an amount equal to the value of the stock at the time of contribution to the plan. 3.) This ordinary income recognition establishes a tax basis in the employer stock for the employee-participant that is recovered tax free upon sale of the stock. 4.) The NUA is taxed as capital gain when the participant or beneficiary sells the stock. 5.) Any future appreciation of the stock (subsequent to the time of distribution) is then subject to capital gains tax rates (short term or long term depending on the holding period after the lump-sum distribution) in effect on the date of sale. NOTE: There is only a new holding period with respect to the appreciated value subsequent to the distribution. The NUA is not subject to any holding period limitations. 3. Voting rights a. Participants must be given the right to vote the shares of stock that have been allocated to their accounts. b. If the employer is closely held, plan participants need to be given only the right to vote on issues requiring more than a majority of outstanding common shares for passage. c. Major issues include mergers, consolidations, recapitalizations, liquidation, and corporate dissolution. 4. Valuation of stock a. If the stock of the employer is not publicly traded, an employer must hire an independent appraiser to value the stock as of each contribution (costly). 5. Disadvantages of investing in employer stock a. The employee has a concentrated (nondiversified) portfolio. 1.) Employers that sponsor qualified plans in which part of the plan accounts are invested in the employer's publicly traded stock must permit participants to immediately divest themselves of this stock and diversify the proceeds into other plan investments. 2.) This diversification rule is not applicable to ESOPs that do not hold employee contributions. b. Plans that invest in employer securities may have higher costs (because of appraisals). c. Employers with plans that invest in employer securities must worry about dilution of existing ownership (e.g., loss of control) 6. Tax implications a. Employer contributions to the plan are deductible when made, up to an annual limit of 25% of covered compensation. b. The regular annual additions limit for defined contribution plans applies to both ESOPs and stock bonus plans. c. Taxation to the employee on employer contributions is deferred, as with any qualified plan.

EMPLOYEE RETIREMENT INCOME SECURITY ACT (ERISA)

1. ERISA is the federal legislation that governs the nontax aspects of retirement plans and other employee benefits. a. ERISA is intended to protect retirement interests of plan participants. b. ERISA established equitable standards and curtailed potential plan abuse. 2. Qualified plans must meet ERISA requirements, including the following: a. Coverage b. Participation c. Vesting d. Reporting and disclosure e. Fiduciary requirements 3. ERISA includes four titles. a. Title I protects employees' right to collect benefits and imposes nondiscrimination and funding requirements. b. Title II establishes plan qualification requirements for special treatment under the Internal Revenue Code. c. Title III creates the regulatory and administrative framework for ongoing ERISA implementation. d. Title IV establishes the Pension Benefit Guaranty Corporation (PBCG) to insure defined benefit plan benefits. NOTE: One way to remember what each title deals with is to think of ERISA as a "way to replace pay:" ■ W—Workers' rights (collecting benefits, nondiscrimination, and funding requirements) ■ T—Tax Code treatment ■ R—Regulatory and administrative framework ■ P—PBGC 4. ERISA requires reporting and disclosure of plan information to the following: a. Internal Revenue Service b. Department of Labor (DOL) c. PBGC d. Plan participants 5. There is some overlap between ERISA and the Internal Revenue Code in the areas of plan participation, vesting, and prohibited transactions.

CHARACTERISTICS OF DEFINED CONTRIBUTION PLANS

1. Each employee has an individual account in the plan. 2. Plan benefit consists of the amount accumulated in the account at retirement or termination. a. Employee selection of investments will affect plan balance at retirement. b. Number of years in the plan will also affect the plan balance at retirement (favors younger participants who have time to accumulate retirement assets in the plan). c. Plan balance consists of contributions plus investment returns. 3. Tax-deferred retirement plan 4. The annual additions limit for all defined contribution plans sponsored by one employer cannot exceed the lesser of the following: a. 100% of the participant's annual covered compensation b. $57,000 (2020) 5. Employee bears investment risk. 6. Administrative costs are lower than for defined benefit pension plans. a. Employer costs are easily determinable. b. Plan costs can also be lower. 7. More easily understood by employees

[SIMPLE IRA AND SIMPLE 401(K)]- CONTRIBUTIONS—SIMPLE 401(K)

1. Employee elective deferrals are limited to $13,500 for 2020, with a catch-up amount for participants age 50 and over of $3,000, the same as a SIMPLE IRA. a. Elective deferral limits are less than those for a traditional 401(k) plan. 2. Employers may match elective deferrals up to 3% of compensation or alternatively make a 2% of compensation nonelective contribution on behalf of all eligible employees. a. The annual limit on employee compensation applies, limiting the maximum employer contribution to 3% × $285,000 (2020), or $8,550. b. For nonelective contributions, the maximum employer contribution is 2% × $285,000 (2020), or $5,700. 3. Employer contributions are always 100% vested. 4. Employers cannot (unlike a SIMPLE IRA) reduce matching percentage to below 3%. 5. The SIMPLE 401(k), like the safe harbor option, is exempt from the special nondiscrimination testing that applies to the traditional 401(k) plan.

[SIMPLIFIED EMPLOYEE PENSION (SEP) PLAN]- DISADVANTAGES

1. Employees cannot rely on a SEP plan alone to provide an adequate retirement benefit. 2. The benefits are not significant unless the employer makes substantial, regular contributions to the SEP plan. 3. The employee bears the investment risk under the plan.

(IRAs)- DESCRIPTION

1. There are two kinds of traditional IRAs: a. Individual retirement accounts (investment products) b. Individual retirement annuities (insurance products)

TAX AND OTHER IMPLICATIONS

1. Employer contributions to the plan are deductible for income tax when made. 2. Taxation to the employee is deferred until distribution. 3. The benefit paid from a defined benefit pension plan at normal retirement age cannot exceed the lesser of the following: a. 100% of the participant's compensation averaged over the three highest consecutive years of compensation b. $230,000 (2020) 4. Distribution from the plan must follow the rules for qualified plan distributions. 5. The plan is subject to the minimum funding rules of Section 412 of the IRC. 6. A defined benefit pension plan is generally subject to mandatory insurance coverage by the PBGC a. A defined benefit pension plan that is maintained by a professional service employer with 25 or fewer employees does not have to be covered by the PBGC. b. These professional individuals include the following, among others: 1.) Attorneys 2.) Accountants 3.) Architects 4.) Actuaries 5.) Engineers 6.) Doctors 7.) Dentists NOTE: One way to remember this group is ADD AAA Engineers. There are four professions that start with A.

(IRAs)- ADVANTAGES

1. For 2020, eligible individuals may contribute up to $6,000 to an IRA (spouses may each contribute $6,000 to their own IRA) and deduct this amount from their current taxable income (subject to phaseout rules). 2. Individuals who have attained age 50 may make an additional catch-up contribution of $1,000 (2020). 3. An income tax credit is allowed for certain taxpayers with respect to contributions to a traditional or Roth IRA. 4. Investment income earned on the assets held in an IRA is not subject to federal income tax until it is withdrawn from the account (tax-deferred growth). 5. Prior to 2020, contributions to traditional IRAs had to stop at age 701⁄2. However, the SECURE Act of 2019 eliminated this restriction. For 2020 and later, there is no age restriction on IRA contributions. Now anyone at any age can contribute to either type of IRA (traditional or Roth IRA) as long as the person has earned income or is married to someone with enough earned income to cover the contribution.

[SPECIAL RULES FOR SELF-EMPLOYED (KEOGH) PLANS]- BENEFIT PLANS FOR PROPRIETORSHIPS, PARTNERSHIPS, AND S CORPORATIONS

1. General characteristics a. Owners of these businesses are not technically employees of the business. b. Proprietorships, partnerships, and S corporations can have benefit plans for their employees that are exactly the same as those of regular C corporations. c. The deductibility of benefit costs is the same, and tax treatment to the regular employees is also the same as to C corporations. 2. Partnerships and proprietorships a. With the exception of health insurance premiums and contributions to qualified plans, most benefits and compensation paid to a proprietor are not deductible business expenses. b. Employee benefits for partners with qualified retirement plans are the following. 1.) Contributions are deductible by the partnership along with those for regular employees. 2.) Partners are taxed on qualified plan contributions and benefits much the same as regular employees. c. The effective percentage limits for contributions to qualified and tax-advantaged plans are lower for self-employed businessowners than for other employees because of the definition of compensation for these parti

COVERAGE TESTS

1. General rule (under Section 410(b)): The employer must cover at least 70% of all nonexcludable, nonhighly compensated employees. The general rule is commonly referred to as the safe harbor test. 2. Plans that do not meet the safe harbor test must satisfy one of the following two exceptions—the ratio percentage test or the average benefits percentage test. The plan must meet only one of the following three tests to pass the coverage requirement of ERISA (safe harbor [covers 70% of nonexcludable, nonhighly compensated employees], ratio percentage test, and the average benefits test). a. The ratio percentage test—the plan must cover a percentage of nonhighly compensated (NHC) employees that is at least 70% of the percentage of highly compensated (HC) employees covered ratio percentage test= % NHC covered/ % HC covered ≥70% b. The average benefits percentage test—has two components to satisfy annually 1.) The nondiscriminatory component a.) Classification is reasonable and based on objective business criteria (e.g., job categories, location, hours, or weeks). b.) The ratio percentage of the plan can be either ≥ 70% or be nondiscriminatory based on facts and circumstances. 2.) The average benefits percentage test—The average benefits percentage accrued for nonhighly compensated employees as a group must be ≥ 70% of the average benefits percentage accrued for the HC employees as a group. average benefits percentage test ⇒ average benefits % NHC/ average benefits % HC ≥70% 3. For purposes of the coverage test, being covered means an employee is benefiting under the plan. a. For example, a contribution to a defined contribution plan or an accrued benefit in a defined benefit plan b. For 401(k) plans, an employee is considered covered as long as he is eligible to make elective deferrals. Note the distinction that covered in a 401(k) plan means being eligible to contribute. The employee may or may not be making elective deferrals into the plan.

PROHIBITED TRANSACTIONS

1. Generally, a prohibited transaction is the improper use of an IRA account or annuity by the individual or any disqualified person. 2. Examples of disqualified persons include the following: a. The account fiduciary b. Members of the individual's family (spouse, ancestor, lineal descendant, and spouse of a lineal descendant) 3. Examples of prohibited transactions with an IRA include the following: a. Borrowing money from it (IRAs do not permit loans b. Selling property to it c. Receiving unreasonable compensation for managing it d. Using it as security for a loan e. Buying property for personal use (present or future) with IRA funds 4. Prohibited transactions have the following effects on an IRA account and the owner: a. Generally, if an individual or the individual's beneficiary engages in a prohibited transaction with the individual's IRA account at any time during the year, it will not be treated as an IRA as of the first day of the year. b. If the individual (or beneficiary) engages in a prohibited transaction in connection with the IRA account at any time during the year, the individual (or beneficiary) must include the fair market value of all (or part, in certain cases) of the IRA assets in gross income for that year. c. The individual must use the fair market value of the assets as of the first day of the year he is engaged in the prohibited transaction. The individual also may have to pay the 10% tax on premature distributions. 5. Borrowing on an annuity contract a. If an individual borrows money against an IRA annuity contract, the individual must include in gross income the fair market value of the annuity contract as of the first day of the tax year. b. The individual also may have to pay the 10% additional tax on premature distributions. 6. Pledging an account as security a. If an individual uses a part of her IRA account as security for a loan, that part is treated as a distribution and is included in gross income. b. The individual may have to pay the 10% additional tax on premature distributions.

PARTICIPANT ELIGIBILITY

1. IRC Section 410 a. Plans are not permitted to require an employee to complete a period of service with the employer maintaining the plan extending beyond the later of the date on which the employee attains age 21 and the date on which the employee completes one year of service (21-and-1 rule). b. For eligibility purposes, a year of service means a 12-month period during which the employee has worked at least 1,000 hours. c. The service requirement period can be increased to two years if the plan provides immediate 100% vesting of employer contributions upon entry. 1.) 401(k) plans may not use the two-year service requirement. 2. Excludable employees a. Union employees whose retirement benefits were negotiated in a separate agreement b. Nonresident alien employees who have received no U.S. wages or compensation 3. Plan entrance dates a. Once an employee has met the eligibility requirements, plan entry occurs on the next available entrance date. Qualified plans may have a variety of entrance dates—monthly, quarterly, semiannual, and so forth. b. Because a qualified plan cannot make an employee wait more than six months to enter the plan after meeting the eligibility requirements, qualified plans generally have at least two entrance dates each plan year

TRANSFERS INCIDENT TO DIVORCE

1. If an interest in an IRA is transferred from a spouse or former spouse (transferor) to an individual (transferee) by reason of divorce or separate maintenance decree or a written document related to such a decree, starting from the date of the transfer, the interest in the IRA is treated as the individual's (transferee's) IRA. 2. The transfer is not taxable (or penalized) to the transferor spouse and the recipient spouse may roll over the interest to another IRA or IRAs.

STRETCH IRAS UNDER THE SECURE ACT

1. In general a. Traditionally, a stretch IRA extends the period of tax-deferred earnings of assets within an IRA beyond the lifetime of the person who established the IRA, sometimes over multiple generations. However, the SECURE Act of 2019 has reduced the amount of the stretch to 10 years for most, but not all, situations. The SECURE Act did this by establishing three types of beneficiaries: 1.) Eligible designated beneficiary (EDB): Mostly unchanged from the former rules. These people are still allowed to factor in their life expectancies when determining the RMD rules. There are five types of EDBs: surviving spouses, disabled people, chronically ill people, people no more than 10 years younger than the decedent owner (i.e., a sister who is two years older or a friend eight years younger), and a minor child of the decedent. A surviving spouse who is an EDB always has the option to move the decedent's money into an IRA in the spouse's own name and be subject to the IRA rules based on his own age. An EDB who is a minor child is only allowed to use his life expectancy until reaching the state set age of majority. At that time, the RMD requirements revert to the 10-year rule. The SECURE Act also established a new test. The test for being an EDB is taken on the date of death. However, the identity of a designated beneficiary is still determined on September 30 of the year follow-ing the year of death. For example, Mary died on June 27, 2020. Her daughter Sally was 35 at the time and healthy. Six months later, Sally was in a car wreck and became disabled. Since Sally was healthy on the day Mary died, Sally cannot be an EDB. On September 30 of the year following the year Mary died, Sally officially became the designated beneficiary. However, she is not an EDB. Thus, becoming an EDB is a two-step process. First, you must be in one of the five categories of EDBs on the date of death. Second, you must be a designated beneficiary on September 30 of the year following the year of death. 2.) Designated beneficiary: A designated beneficiary is a person or certain types of trusts for whom the IRS can calculate a life expectancy. The identity of any designated beneficiary and the second step in being an EDB is determined on September 30 of the year following the year of death. Being a designated beneficiary (only and not an EDB) means the person who inherits the employer retirement account or IRA is always under the 10-year rule regardless of when the decedent passed away relative to his required beginning date (RBD). The 10-year rule means the account must be completely emptied by December 31 of the year containing the 10th anniversary of the decedent owner's death. Notice that this is 11 tax years. Thus, a decedent's healthy adult child will always be under the 10-year rule whether the decedent passed away at 45 or 105. The SECURE Act greatly limited the options for someone who is only a designated beneficiary and not an EDB. 3.) Beneficiary: Being listed as a beneficiary allows the entity to receive the retirement assets, but only being a beneficiary (and not an EDB or even just a designated beneficiary) means the ability to stretch the retirement asset is the most limited. The most common beneficiaries in this category are estates and charities. Charities often want the money as soon as possible, so their options for stretching the account are less important. The estate is the most impor-tant type of beneficiary. The rules were not changed for this category by the SECURE Act. Often, when a family has young children they will list the spouse as the primary beneficiary and "my estate" as the contingent beneficiary. As a minimum, the secondary beneficiary should be updated to the children's names as they reach the age of majority. b. After the IRA owner's death, beneficiaries are allowed to take distributions under the rules for whichever type of beneficiary they are and (usually) when the original owner died relative to the required beginning date (RBD). (See XV(H): Required Minimum Distributions) c. By spreading out, or stretching, distributions over as long as allowed by law, the account has the best opportunity to grow, and taxes are deferred. IRS data shows that around 20% of people take withdrawals from inherited IRAs and employer retirement accounts according to the RMD rules. The other 80% withdraw the money faster than the RMD rules.

DEFINED BENEFIT PENSION PLANS- ADVANTAGES

1. In traditional defined benefit pension plans, employees are not taxed until benefits are received. 2. Retirement benefits, at adequate levels, can be provided to all employees regardless of age at plan entry. 3. The benefit levels are guaranteed, both by the employer and by the PBGC (may be limited). 4. For older, highly compensated employees, a traditional defined benefit pension plan generally allows the maximum amount of tax-deferred retirement savings. 5. Defined benefit pension plans may encourage early retirement, which may be advantageous to the employer if plan funding costs can be reduced as a result of older participants retiring.

[SIMPLIFIED EMPLOYEE PENSION (SEP) PLAN]- CHARACTERISTICS

1. It can be adopted by completing a simple IRS form (Form 5305-SEP). 2. The monetary benefits of a SEP plan are totally portable by employees because funding consists entirely of IRAs for each employee. 3. Employer contributions are always fully vested and are not forfeitable. 4. A SEP plan provides as much, or more, flexibility in the amount and timing of contributions as a qualified profit-sharing plan. a. The employer is free to make no contribution to the plan in any given year. b. The separate IRAs allow participants to benefit from selected investments. 5. The SARSEP plan salary reduction contribution limit for 2020 is $19,500 (the same as the limit for 401(k) plans). a. Individuals who have attained age 50 may make additional catch-up contributions. b. The additional catch-up amount is $6,500 (2020). 6. An income tax credit is allowed for certain taxpayers with respect to elective contributions to a SARSEP plan. See Section VII(G)(6) for a discussion of an income tax credit for elective deferral contributions. 7. A SEP plan, but not a SARSEP plan, can be integrated (permitted disparity) with Social Security. 8. SEP plans may be established by C corporations, S corporations, partnerships, LLCs, and sole proprietorships.

[SPECIAL RULES FOR SELF-EMPLOYED (KEOGH) PLANS]- HOW ARE SELF-EMPLOYED RETIREMENT PLANS DIFFERENT FROM OTHER QUALIFIED OR TAX-ADVANTAGED PLANS?

1. Keogh plans cover self-employed individuals who are not considered employees 2. Earned income a. The most important special rule is the definition of earned income. Earned income takes the place of compensation in applying the qualified plan rules. 1.) Income is defined as the self-employed individual's net income from the busi-ness after all deductions, including the deduction for Keogh plan contributions. 2.) In addition, the IRS has ruled that the self-employment tax must be calculated and a deduction for the employer share (above-the-line deductible amount) of the self-employment tax must be taken before determining the Keogh deduction. b. Steps in determining the deduction for the self-employed businessowner are as follows: 1.) Determine net income from Schedule C (or Schedule K-1) 2.) Subtract above-the-line deductible amount of the self-employment tax (applicable to that income) 3.) Multiply the result by the net contribution rate from the rate table (see Appendix 4: Self-Employed Person's Retirement Plan Contribution Rate Table) NOTE: The special calculation is required for the owner only; it is not required for employees of the owner 3. Life insurance a. Life insurance can be used as an incidental benefit in a qualified plan covering self-employed individuals, but the tax treatment for the self-employed individuals is different from that applicable to regular employees in a qualified plan. b. The entire cost of life insurance for regular employees is deductible as a plan contribution. Employees then include the value of the pure life insurance element as taxable compensation. c. For a self-employed individual, the following applies. 1.) The pure life insurance element of an insurance premium is not deductible. 2.) Only the portion of the premium that exceeds the pure protection value of the insurance is deductible. 3.) The pure protection value of the insurance is determined using Table 2001. d. For regular employees, the following applies. 1.) They have a cost basis (a nontaxable recovery element) in a plan equal to any Table 2001 costs if the plan distribution is made from the same life insurance contract on which the Table 2001 costs were paid. 2.) For a self-employed individual, however, the Table 2001 costs, although effec-tively included in income because they were nondeductible, are not includable in the cost basis.

PROHIBITED TRANSACTIONS

1. Many transactions are considered to be contrary to the interest of plan participants and are therefore prohibited. 2. Prohibited transactions include the following: a. Sale, exchange, or lease of property between the plan and a party in interest b. Loan between the plan and any party in interest c. Transfer of plan assets to or use of plan assets for the benefit of a party in interest d. Acquisition of employer securities or real property in excess of legal limits e. Self-dealing

FIDUCIARIES AND THEIR OBLIGATIONS

1. Named fiduciary a. The plan document must specifically designate a named fiduciary or fiduciaries that will be responsible for the administration and management of the plan. b. The fiduciary must manage plan assets solely in the interests of the plan participants and beneficiaries. 2. Other fiduciaries a. Other individuals beyond the named fiduciary may acquire fiduciary obligations with respect to the plan. b. A fiduciary is defined as a person who controls plan management, assets, or administration or who renders investment advice for a fee or other compensation. c. Generally, corporate officers and directors, plan administrators, bank trustees, members of a plan sponsor's investment committee, investment advisors, and any persons who select the fiduciaries take on fiduciary obligations 3. ERISA-imposed obligations of fiduciaries a. The fiduciary must exercise the care, skill, and diligence of a prudent person acting solely in the interest of plan participants and beneficiaries. b. The fiduciary has an obligation to diversify the plan's assets to reduce the risk of loss. c. The fiduciary also must act in accordance with the plan's provisions and must refrain from acts forbidden under the law. d. A fiduciary may not do the following: 1.) Be paid for services if already receiving full-time pay from an employer or union whose employees or members are participants 2.) Act in a transaction involving the plan on behalf of a party whose interests are adverse to those of the plan or its participants or beneficiaries 3.) Receive consideration for his own personal account from any party dealing with the plan in connection with a transaction involving the assets of the plan 4.) Cause a plan to engage in certain transactions with parties in interest 5.) Permit more than 10% of plan assets to be invested in employer securities or real property, except in the case of certain profit-sharing plans (such as ESOPs or stock bonus plans) 4. Parties in interest a. Parties in interest are limited in or excluded from transactions with qualified plans b. These parties include: 1.) any administrator, officer, trustee, custodian, counsel, or employee of a plan; 2.) a fiduciary; 3.) a person providing services to the plan; 4.) the employer or employee union; 5.) a 50% or greater owner of the company; 6.) certain relatives of parties of interest; and 7.) certain other related corporations, employees, officers, directors, partners, and joint ventures.c. Prohibited transactions 1.) Sale, exchange, or lease of any property between the plan and a party in interest 2.) Loan between the plan and any party in interest 3.) Transfer of plan assets to or use of plan assets for the benefit of a party in interest 4.) Acquisition of employer securities or real property in excess of legal limits 5. Scope of fiduciary's responsibilities a. One fiduciary may become responsible for the acts or omissions of another if the fiduciary participated in the breach of duty, knowingly concealed it, or imprudently allowed it to occur. b. ERISA provides a procedural, not a performance, standard for assessing the behavior of fiduciaries. A fiduciary is not required to be successful in managing the plan's assets. c. In smaller firms, the firm's owner also may be the plan's administrator and principal decision-maker and, as a result, the only fiduciary. 6. Prohibited transaction exemption for investment advisors a. A prohibited transaction exemption is available for a fiduciary that renders investment advice to a plan participant or beneficiary for a fee. b. Exemption applies only if the fiduciary is one of the following: 1.) A person registered as an investment advisor under the 1940 Act or under the laws of the state in which it maintains its principal office and place of business 2.) A financial institution 3.) An insurance company 4.) A person registered as a broker or dealer under the 1934 Act 5.) An affiliate of one of the previous or an employee, agent, or registered represen-tative of a person described previously who satisfies certain requirements c. The exemption covers the following transactions: 1.) Providing investment advice to a participant or beneficiary under the plan as to any security or property available as an investment under the plan 2.) Acquiring, holding, or selling a security or other property available as an invest-ment under the plan pursuant to such investment advice 3.) Receiving fees or other compensation, directly or indirectly, in connection with any of the previously listed transactions d. The exemption is available only if the fiduciary advisor provides the investment advice under an eligible investment advice arrangement 7. Investment advice a. Retirement plan service providers that offer investments to participant-directed plans can provide investment advice and, if narrated, recommend their own products without violating fiduciary rules. b. In general, there is an exemption from the prohibited transaction rules for advice provided under an eligible investment advice arrangement. To be eligible, an investment advice arrangement has to meet one of the following criteria: 1.) Make the advisor's fees neutral (meaning that the fees do not change based on which products are chosen) 2.) Use an unbiased computer model certified by an independent expert to create a recommended portfolio for a participant's consideration

myRA RETIREMENT SAVINGS ACCOUNT

1. New type of Roth IRA developed by the U.S. Treasury Department 2. Available to employees through employers, allowing contributions via payroll deduction on an after-tax contribution basis 3. Targeted for low-to middle-income workers who may not have access to an employer-sponsored retirement plan 4. May be established with any payroll deduction amount and are subject to regular Roth IRA contribution limits and rules 5. Earns interest at the same rate as the Government Securities Investment Fund in the Thrift Savings Plan for federal employees 6. Participation is subject to income thresholds 7. Must be transferred to a regular Roth IRA when a participant's account balance has reached $15,000, or after 30 years 8. Stopped accepting new contributions on Dec 4, 2017. a. The federal government is encouraging myRA owners to roll the assets into a Roth IRA

NONQUALIFIED PLANS

1. Nonqualified plans are not subject to the same ERISA rules as qualified plans. 2. Nonqualified plans do not benefit from all of the tax advantages that apply to qualified plans or other tax-advantaged plans. 3. Nonqualified plans are generally discriminatory in favor of highly compensated employees. 4. Nonqualified plans may supplement qualified plans and may defer taxes for the employee-participants. a. These are used to provide benefits to key employees beyond the qualified plan IRC Section 415 limits. b. Employer only promises to pay the employee the benefits. c. Benefits must be subject to a substantial risk of forfeiture (i.e., subject to the claims of general creditors) or they will be considered as constructively received and currently taxable to the employee. d. Benefits payments are not deductible by the employer until paid and are includable in the employee's taxable income at the time of receipt. 5. Types of nonqualified plans (covered in detail in Book 2 - Risk Management, Insurance, and Employee Benefits Planning) a. Deferred compensation (top-hat)—salary reduction plans b. Executive employee benefit plans 1.) Excess benefit plans—provide salary continuation through excess benefits or contributions that exceed qualified plan annual additions limits 2.) Supplemental executive retirement plan (SERP)—may be used to provide contributions and benefits in excess of IRC limits for key executives 3.) Phantom stock plans—an accounting entry without actual stock ownership 4.) Restricted stock—actual company stock provided to executives when certain conditions have been met 5.) Stock options—incentive stock options (ISOs) and nonqualified stock options (NQSOs) 6.) Employee stock purchase plans (ESPPs)—permit employees to purchase company stock, often at a discount 7.) Junior class shares—a separate class of common stock typically convertible into common shares upon certain specified events 8.) Stock appreciation rights—gives the right to the monetary equivalent of the increase in the value of shares of stock over a specified period

PBGC-INSURED BENEFITS

1. PBGC insurance may not cover all plan benefits. 2. PBGC insurance does not cover benefits added to a plan less than five years before a distress termination.

PENSION BENEFIT GUARANTY CORPORATION (PBGC)

1. PBGC is a federal corporation created by the Employee Retirement Income Security Act of 1974 (ERISA) to insure plan participants against loss of benefits due to the termination of a pension plan (traditional defined benefits plans and cash balance plans only). a. It only insures defined benefit plans, not defined contribution plans. b. It only provides protection of pension benefits up to a maximum level of $69,750 ($5,812.50) for a 65-year-old in 2020. c. Professional service employers with 25 or fewer active participants are exempt from PBGC insurance requirements. 2. The PBGC can terminate a defined benefit plan for the following reasons: a. Minimum funding standards are not met. b. Benefits cannot be paid when due. c. The long-run liability of the company to the PBGC is expected to increase unreasonably.

[SPECIAL RULES FOR SELF-EMPLOYED (KEOGH) PLANS]- ADVANTAGES

1. Plan contributions are deducted from the businessowner's taxable income. 2. Income tax on investment earnings is deferred until funds are withdrawn from the plan. 3. From the viewpoint of an employee of an unincorporated business, plans for the self-employed businessowner are advantageous because employees of the business must be permitted to participate in the plan if certain conditions are met.

QUALIFIED PLAN REQUIREMENTS

1. Plan requirements a. Must be in writing b. Must be communicated to employees 1.) SPD c. Must be permanent d. Must not allow or have prohibited transactions

[SPECIAL RULES FOR SELF-EMPLOYED (KEOGH) PLANS]- DISADVANTAGES

1. Plans for the self-employed businessowner involve all the costs and complexity associated with qualified plans. For a small plan, however, it is relatively easy to minimize these costs by using prototype plans offered by various financial institutions. 2. Employers must comply with nondiscriminatory plan coverage requirements. 3. Life insurance in a qualified plan for a self-employed person is treated less favorably than for regular employees

MATCHING EMPLOYER OBJECTIVES TO THE RIGHT PLAN DESIGN

1. Proper plan design consists of achieving the right match between employer objectives and the available qualified plans. a. The usual objective is to maximize the proportion of plan contributions that benefit the owners and top management. b. Many employers, particularly small, closely held companies, view retirement plans as beneficial only when they provide substantial tax-sheltered retirement benefits for owners and high-ranking employees (those in a position to decide to implement a plan). c. Commonly used techniques for accomplishing objectives are as follows: 1.) Defined benefit pension plans were widely used by large employers, but that trend has been reversing for decades due mainly to high costs. 2.) Service-based contribution or benefit formulas can be based on an employee's years of service with the employer. 3.) Use of a target benefit pension plan that uses age and compensation weighting 4.) Use of age-based profit-sharing plans 5.) Integrate (permitted disparity) their plan with Social Security benefits (with some exceptions) 6.) Implement a prototype plan, which is a standardized plan that has received IRS approval as a qualified plan and is the easiest type for an employer to use d. Various objectives and the types of plans that accomplish each objective follow: 1.) Objective: To provide a savings medium that employees perceive as valuable, plans include the following: ■ ESOP/stock bonus plan ■ Money purchase pension plan ■ Profit-sharing plan ■ Thrift plan ■ 401(k) plan ■ SEP plan ■ Target benefit pension plan 2.) Objective: To provide adequate replacement income for each employee's retire-ment, the defined benefit pension plan is the best vehicle for the following reasons: ■ It can provide a benefit based on final average compensation, regardless of the employee's years of service. ■ There is no investment risk assumed by the employee. ■ Employer funding of the benefit is mandatory, subject to underfunding penalties, even if the employer's profits decline. 3.) Objective: To weight the allocation of plan contributions to older employees, options include the following: ■ Defined benefit pension plans ■ Age-based profit-sharing plans and target benefit pension plans are designed to steer benefits toward older employees. 4.) Objective: To create an incentive for employees to maximize performance of the company. Some options include the following: ■ Profit-sharing plan ■ ESOP/stock bonus plan 5.) Objective: To minimize turnover, defined benefit pension plans that use a graduated vesting schedule are the best option. 6.) Objective: To encourage early retirement, a defined benefit pension plan can do the following: ■ Allow benefits to fully accrue after a specified period (e.g., 25 years) ■ Relatively easy to design, a subsidized early retirement benefit provides a benefit at age 62 that is more than the actuarial equivalent of what the retiree would receive at normal retirement age. 7.) Objective: To provide employer with maximum contribution flexibility, the most flexible plans from a contribution standpoint are traditional profit-sharing plans and SEP plans. Amounts contributed each year can be entirely at the employer's discretion.

[TAX-SHELTERED ANNUITY (TSA)/403(B) PLANS]- ADVANTAGES

1. Provide a tax-deferred retirement savings opportunity for employees 2. Allow employees a choice in the amount or rate of savings that is equal to that of 401(k) plans 3. Generally permit in-service withdrawals

RETIREMENT NEEDS ANALYSIS MODELS

1. Pure annuity model 2. Capital preservation model 3. Purchasing power preservation model

INTEGRATION WITH SOCIAL SECURITY (PERMITTED DISPARITY)

1. Qualified plan benefit or contribution formulas can be integrated (permitted disparity) with Social Security (with some exceptions). 2. Retirement benefits are provided under the OASDI portion of Social Security. Employee and employer each contribute 6.2% of compensation up to the Social Security wage base ($137,700 for 2020) 3. Earnings above the wage base are effectively not counted for purposes of retirement benefits under the Social Security system. a. For example, employee A earns $60,000 per year and employee B earns $150,000 per year. If the Social Security wage base is $137,700, the employer is paying 6.2% on 100% of employee A's salary and only 92% ($137,700 / $150,000) of employee B's salary. Because there is this disparity in the Social Security system, most qualified plans and SEPs are generally allowed to integrate with Social Security. 4. Defined benefit pension plans have two methods by which they can be integrated with Social Security—the excess method and the offset method. a. Excess method—The plan defines a level of compensation, called the integration level, and then provides a higher rate of contribution and benefits for compensation above the integration level. b. Offset method—A fixed amount or a formula amount that is designed to represent the existence of Social Security benefits reduces the plan formula. c. Maximum permitted disparity 1.) The maximum difference between the benefit percentage below and above the covered compensation level is 3⁄4 of 1% multiplied by years of service, up to 35 years. 2.) This applies for both the excess and offset methods of integration. 3.) The maximum increase in benefits for earnings above the covered compensation level is 26.25% (3⁄4 × 0.01 × 35). 5. Defined contribution plans can be integrated with Social Security using only the excess method. 6. Excess method a. The excess method provides higher contributions above the integration level than below the integration level. 1.) The benefit level below the integration level is called the base percentage; the benefit level above the integration level is called the excess percentage. 2.) The excess percentage is limited to the lesser of (1) two times the base percent-age or (2) the base percentage plus 5.7%. [The 5.7% comes from the fact that of the 15.3% total Social Security taxes (FICA), 5.7% (over a third) is used to fund the Social Security retirement benefit.] 3.) This difference between the base percentage and the excess percentage, which is referred to as the maximum permitted disparity, can be illustrated with the following chart. (page 31) b. Integration level 1.) The integration level is generally equal to the Social Security taxable wage base (TWB), which is $137,700 (2020). a.) The integration level cannot exceed the Social Security wage base. 2.) The integration level can be lower than the Social Security TWB, which allows more income to be considered for the excess contribution level. a.) As the integration level is lowered, so is the maximum permitted disparity between the base percentage and the excess percentage. b.) It may be beneficial for employers to adjust the integration level to some-thing other than the Social Security TWB. 3.) Generally, the integration level will be set on the basis of the employee census. 7. Plans that may not integrate with Social Security a. ESOPs, SIMPLEs, and SARSEP plans (SARSEPs that are still in existence) are not permitted to integrate with Social Security. b. In addition, employee elective deferrals and employer-matching contributions to 401(k) plans cannot be integrated with Social Security. c. The profit-sharing contribution by the employer to a 401(k) plan can be integrated.

[SIMPLE IRA AND SIMPLE 401(K)]- CHARACTERISTICS

1. They can be established as either an IRA or a 401(k) plan (most are established as an IRA). 2. SIMPLE IRAs are not subject to nondiscrimination rules generally applicable to qualified plans (including top-heavy rules). 3. SIMPLE 401(k) plans do not have to meet special ADP tests and are not subject to top-heavy rules; other qualified plan rules apply.

NONDISCRIMINATION IN BENEFITS AND CONTRIBUTIONS

1. Qualified plans may not discriminate in favor of highly compensated employees either in terms of benefits or in terms of employer contributions to the plan. (Discrimination is defined as either benefits or contributions for HCEs exceeding allowed limits. Nondiscrimination testing does not require all employees to receive exactly the same benefits for qualified retirement plans.) 2. Either the contributions or the benefits must be nondiscriminating in amount. a. Benefits, rights, and features provided under the plan must be available to participants in a nondiscriminatory manner (distribution options, loans, and so forth). b. Plan amendments must be nondiscriminating. 3. Noncontributory versus contributory plans a. Noncontributory plan (employer pays all) 1.) Most pension and profit-sharing plans b. Contributory plan (employee makes some contribution) 1.) 401(k) provision (cash or deferred arrangement, or CODA) 2.) Thrift plan (an after-tax savings plan) 4. Employer deduction limit a. Limited to 25% of covered payroll (participant covered payroll) 1.) The limit on the employer income tax deduction is determined with reference to the aggregate covered payroll of the company. 2.) The limit on contributions regarding an individual employee is subject to a limit of the lesser of the annual additions limit or 100% of employee covered compensation. 3.) It is possible that the employer contribution on behalf of one employee can exceed 25% of the employee's covered compensation. The contribution must be offset by another employee's percentage contribution that is less than the overall maximum. b. Defined benefit pension plans 1.) Contributions to a defined benefit pension plan are limited to an amount deter-mined actuarially under standards included in Section 404(a) of the IRC, or the amount required to meet minimum funding standards, if greater. 2.) The 25%-of-covered-payroll limit does not apply to the funding of a defined benefit pension plan, and the deduction is restricted only to that actuarial amount necessary to fund the promised benefit for the participants. c. Defined contribution, 403(b), 457, SEP, and SIMPLE plans 1.) Payroll amount upon which the 25% limit is based includes employee salary deferrals, resulting in a higher deduction limit for employer plan contributions. 2.) Unlike the limitation on contributions (where elective deferrals count towards the annual additions limit), for purposes of calculating the employer deduction limit, elective deferrals are not included.

QUALIFIED PLANS

1. Qualified plans must meet the following ERISA requirements: a. Coverage b. Participation c. Vesting d. Reporting and disclosure e. Fiduciary requirements 2. Qualified retirement plans must meet a number of requirements as specified in Internal Revenue Code (IRC) Section 401(a) (and immediately subsequent sections). 3. Employer and employee receive tax advantages. a. Employer receives immediate deductibility of all contributions made to the plan. b. Employee is not taxed on plan contributions or the earnings attributed to plan contributions as long as a plan distribution does not occur.

REPORTING REQUIREMENTS

1. Qualified plans must satisfy reporting and disclosure requirements of ERISA. 2. ERISA reporting requirements include the filing of an annual report. a. Form 5500 1.) Includes detailed financial information 2.) Includes actuarial information (for defined benefit plan) 3.) Consolidates annual report forms of IRS, DOL, and PBGC a.) Filed with the Employee Benefits Security Administration (EBSA) b. Form 5500-SF 1.) Available to plans that meet all of the following criteria: a.) Have fewer than 25 participants b.) Are eligible for the small plan audit waiver c.) Hold no employer securities d.) Have 100% of assets in investments that have a readily determinable fair market value c. Form 5500-EZ for small plans 1.) Consists of individual and/or spouse or two partners and/or their spouses 2.) Satisfies minimum coverage requirements without being combined with any other plan maintained by the employer 3.) Does not cover a business that is part of a controlled group 4.) Does not cover a business for which leased employees perform services 5.) If plan does not meet the previously listed conditions, Form 5500 must be used. 6.) If all conditions are met but the plan has total assets of $250,000 or less at the close of the plan year, filing Form 5500-EZ is not required. 7.) Form 5500-EZ should be filed for the final plan year even if there was no requirement to file for prior years. 3. The plan administrator is responsible for the following additional paperwork: a. Summary plan description (SPD) 1.) Explains how the plan works, what benefits are available, and how to get the benefits 2.) Must be provided to all plan participants 3.) Must note limitations, exceptions, reductions, and other restrictions on plan benefits 4.) Must be issued at least every 10 years b. Summary annual report (SAR) 1.) Is a summary of the information on the annual report, Form 5500 2.) Must be provided to plan participants each year c. Summary of material modification (SMM) 1.) Explains changes that occurred to the SPD within the last year 2.) Issued as needed 3.) Only summarizes major changes, including changes in vesting provisions d. Individual accrued benefit statement 1.) Must generally be provided to a plan participant within 30 days of a request 2.) Defined contribution plans must provide benefit statements at least quarterly to participants who direct their own investments and annually to those who cannot.

ADVANTAGES OF QUALIFIED PLANS

1. Qualified plans receive tax benefits not available to nonqualified plans. a. Employer contributions (and employee elective deferral contributions) are deductible by the employer (and excluded from the employee's gross income) in the year the contributions are made. b. Employer contributions are not subject to payroll taxes. c. Employees are not taxed on employer contributions in the year the employer contributes to the plan. d. Qualifying lump-sum distributions may be eligible for favorable tax treatment using 10-year forward averaging, pre-1974 capital gain treatment, and net unrealized appreciation (NUA) tax treatment. 1.) See Section XV: Distributions from Qualified Plans and IRAs for additional information e. The qualified plan trust is tax-exempt. 1.) Earnings on plan investments are not currently taxed to the employer or employee but rather accumulate tax deferred until distributed. 2.) Funds are taxed only when withdrawn as distributions. 3.) Rollovers to IRAs are permitted. 4.) If loans are permitted, they are not considered currently taxable distributions. 2. Qualified plans are protected from creditors by ERISA. 3. Establishing an employer-sponsored qualified plan a. Employer-sponsor must legally establish and adopt a qualified plan during the employer's tax year for which the plan will take effect. b. If the plan will use a tax-exempt trust for funding (the usual case), the trust must also be established by the end of the year of adoption and must be valid under the law of the state in which it is established. 1.) Certain small employers are eligible for a tax credit of up to $500 in start-up costs or employee education expenses incurred in connection with the adoption of a qualified plan. c. Advance determination letter 1.) A favorable ruling requested from the IRS that the proposed qualified retirement plan provisions meet Tax Code requirements 2.) Issued by the District Director of the IRS district in which the employer is located d. Adoption of a master or prototype plan is an alternative to the time and cost of requesting an advance determination. 1.) Standardized plans of various plan types (for example, a profit-sharing plan) that use standardized language approved by the IRS 2.) A master plan is distinguished from a prototype plan in that a master plan uses only a single financial institution for funding, while a prototype plan usually allows for more funding possibilities. 4. Organizations that can provide plan services include trust companies, commercial banks, investments firms, asset management groups, and insurance companies.

[SIMPLE IRA AND SIMPLE 401(K)]- SPECIAL RULES FOR SIMPLES

1. SIMPLE IRA withdrawals made within two years of initial participation are subject to a 25% premature distribution penalty tax (rather than 10%). a. However, certain exceptions to the penalty apply under IRC Section 72(t). See Section XV(D): Early Distribution Penalty for a list of exceptions to the early withdrawal penalty. 2. Distributions from a SIMPLE may be rolled over to another SIMPLE, but may not be rolled over to any other type of plan during the first two years of participation. Other plans, except Roth accounts, may not be rolled over to SIMPLEs until the participant's first two years have passed. 3. After-tax contributions are not allowed in a SIMPLE.

[SIMPLE IRA AND SIMPLE 401(K)]- ELIGIBILITY

1. This is a savings incentive match plan for employees (SIMPLE). 2. Employers with 100 or fewer employees who earned at least $5,000 during the preceding year and who do not maintain another employer-sponsored retirement plan (there is a two-year grace period to continue to maintain plan when number of employees exceeds 100) are eligible. 3. Employees who earned $5,000 during any two preceding years and are reasonably expected to receive at least $5,000 during the current year are eligible participants. 4. A self-employed person can establish a SIMPLE. 5. Employers cannot maintain another qualified plan, SEP, SARSEP, or 403(b) plan; however, qualified employers can maintain a 457 plan and also have a SIMPLE. 6. The prohibited investment rules for individual retirement accounts also apply to SIMPLE IRAs and SEP plans.

(SECURE ACT)

3. The SECURE Act extended the deadline for adopting a new retirement plan to the due date for filing that year's tax return including extensions. Now all retirement plans are like SEPs in that they can be established after the year has started and even after the year has ended. Of course, this limits the effectiveness for the first year if the employees are expected to be contributing, like a 401(k), but it helps employer contribution plans.

[SIMPLE IRA AND SIMPLE 401(K)]- CONTRIBUTIONS—SIMPLE IRAS

1. SIMPLE IRAs allow employees to make elective contributions as a percentage of compensation up to $13,500 (2020). 2. In addition, individuals who have attained age 50 may make additional catch-up contributions. The additional catch-up amount is $3,000 (2020). 3. An income tax credit is allowed for certain taxpayers with respect to elective contributions to a SIMPLE plan. [See Section VII(G)(6) for a discussion of an income tax credit for elective deferral contributions] 4. Employers must make contributions to the SIMPLE based on one of the following options: a. Match dollar for dollar up to 3% of employee's compensation b. Unlike qualified plans, the covered compensation limit of $285,000 (2020) is not considered in the matching contribution formula. Alternatively, employers can match as little as 1% of compensation in no more than two out of five years. c. Make a 2% of compensation nonelective contribution for each eligible employee 5. All contributions are immediately and fully vested to the employee. 6. No more than $285,000 (2020) of compensation can be taken into account for purposes of the 2% nonelective contribution. 7. After-tax contributions are not allowed. 8. Contributions made by employees are excludable from the employee's gross income for income tax purposes and are subject to payroll taxes. 9. Because a SIMPLE IRA is a form of IRA, it may not purchase life insurance as a funding vehicle. 10. An employee (under age 50) who earns $13,500 in 2020 could have contributions to the SIMPLE up to $13,405 [$13,000 + (0.03 × $13,000)], which is more than would be permitted by a SEP or qualified plan

DEPARTMENT OF LABOR REGULATORY RESPONSIBILITIES

1. The DOL is involved in retirement plans through its Office of Pension and Welfare Benefit Plans. 2. Duties of the DOL include the following: a. Reporting and disclosure—The DOL ensures compliance with the plan reporting and disclosure rules. 1.) A summary plan description is the most significant disclosure requirement. 2.) Failure to comply with reporting and disclosure requirements can lead to fines and, in some cases, imprisonment. b. Defining prohibited transactions—The DOL ensures that no self-dealing or conflicts of interest occur. 1.) ERISA prescribes certain prohibited transactions. 2.) The goal of the prohibited transaction rules is to keep the interests of the plan separate from the sponsoring entity. 3.) The DOL issues prohibited transactions exemptions (PTEs). c. Fiduciary—The DOL governs the actions of the plan fiduciaries, which are individuals or corporations meeting any of the following characteristics: 1.) Exercises discretionary authority or control over management of the plan or assets of the plan 2.) Renders investment advice for a fee 3.) Has discretionary responsibility or authority in administration of the plan d. Interpretation—The DOL issues communications that explain existing laws.

(SECURE ACT)

1. The SECURE Act tries to advance lifetime income options for retirees as an alternative (look-alike) to defined benefit plans. The act provides for portability of lifetime income options for defined contribution plans, 403(b) plans, and governmental 457 plans (457(b) plans). There are also safe harbor rules for plan fiduciaries selecting lifetime income providers as long as the fiduciary engaged in an objective, thorough, and analytical approach involving the financial capacity of the insurer to satisfy the guaranteed income contracts and considers the costs and benefits of the insurance company offerings. If the fiduciary concludes that the insurance company at the time of selection is financially capable of meeting its obligations and the relative cost and benefits of the guaranteed retirement income contracts are reasonable, then the fiduciary safe harbor is met and the fiduciary is not liable for the initial selection of the retirement income provider. On the other hand, fiduciaries certainly need to monitor the financial state of the lifetime income providers. Thus, the SECURE Act really only offers fiduciary liability relief for the initial selection. In truth, even this liability protection is only as good as the thoroughness of the documentation because the lawsuit will allege that the fiduciary was not thorough enough. Still, at least the bar has been set. One thing the lifetime income rules have in common is that they allow employees to have a better feel for how much income their current situation would provide in retirement. For example, most people would not know how much monthly income could reasonably be expected from a retirement account worth $100,000 at retirement. For most Americans, this sounds like a lot of money. However, the lifetime monthly benefit should be somewhere between $300 per month and $600 per month. If this $100,000 is 20-30 years in the future, then the purchasing power of the amount is roughly cut in half. A lifetime income option would be somewhere near that range, and hopefully the individual will be motivated to increase contributions. The DOL has until December 2020 to come up with model lifetime income disclosure language. This will not be easy.

[TAX-SHELTERED ANNUITY (TSA)/403(B) PLANS]

1. The employer organization must be one of the following: a. A tax-exempt employer described in Section 501(c)(3) of the IRC 1.) The employer must be organized and operated exclusively for religious, chari-table, scientific, public safety testing, literary, or educational purposes; to foster national or international amateur sport competition; or for the prevention of cruelty to children or animals. 2.) The organization must benefit the public rather than a private shareholder or individual. 3.) The organization must refrain from political campaigning or propaganda intended to influence legislation. 4.) Most familiar nonprofit institutions such as churches, hospitals, private schools and colleges, and charitable institutions are eligible to adopt a 403(b)/TSA. b. An educational organization with: 1.) a regular faculty and curriculum; and 2.) a resident student body operated by a state or municipal agency a.) Most public schools and colleges may adopt a 403(b)/TSA plan. b.) 501(c)(3) private educational organizations may also adopt a 403(b)/ TSA plan. 2. When a TSA plan is appropriate a. The employer wants to provide a self-reliant or tax-deferred retirement plan for employees but can afford only minimal extra expense beyond existing salary and benefit costs. b. A TSA plan can be funded entirely from employee salary reductions (elective deferrals). c. The employee group has one or more of the following characteristics: 1.) Employees want a choice as to the amount or rate of savings (i.e., a choice between various levels of current cash compensation and tax-deferred savings). 2.) A younger workforce often prefers this type of plan because it is similar to a defined contribution plan. 3.) Employees are willing to accept the investment risk in their plan accounts. d. A qualifying employer wants a savings supplement to its existing retirement plans. 1.) A qualifying employer is either a public or private tax-exempt organization. 3. Plan must meet at least one of three coverage tests for 403(b)/TSA plans: a. The ratio test, in which the percentage of nonhighly compensated employees who benefit under the plan must be at least 70% of the percentage of highly compensated employees b. The percentage test, in which the plan must benefit a minimum of 70% of nonhighly compensated employees c. The average benefits test, under which the average benefit percentage for nonhighly compensated employees must be at least 70% of the average benefit percentage for highly compensated employees

DEFINED BENEFIT PENSION PLANS - GENERAL OBJECTIVES

1. The plan objective is to provide a defined level of retirement income to each employee regardless of age at plan entry. 2. The employer wants to allocate plan contributions to the maximum extent for the benefit of older employees. 3. The older controlling employees in a small business want to maximize tax-deferred retirement savings for key employees. 4. The organization must have stable cash flow to be able to meet annual mandatory funding requirements and bear the risk of plan investment returns.

LIMITATIONS ON BENEFITS AND CONTRIBUTIONS

1. To prevent a qualified plan from being used primarily as a tax shelter for highly compensated employees, there is a limitation on plan benefits and employer contributions 2. Defined benefit pension plan limits a. The benefit paid from a defined benefit plan at retirement or the Social Security retirement age, if later, cannot exceed the lesser of: 1.) 100% of the participant's covered compensation averaged over the three high-est consecutive years of compensation (covered compensation is compensation up to $285,000 in 2020); or 2.) $230,000 (2020). 3. Defined contribution plan limits a. The annual additions limit for all defined contribution plans sponsored by one employer cannot exceed the lesser of: 1.) 100% of the participant's annual compensation; or 2.) $57,000 (2020). b. Annual additions include the following: 1.) Employer contributions 2.) Employee contributions (both pretax and after tax) 3.) Forfeitures reallocated to the employee's account a.) A forfeiture is created when a plan participant separates from service with the employer prior to reaching 100% vested status. The nonvested portion returns to the plan. In defined contribution plans, forfeitures may be reallocated among the remaining participants or used to fund the employer contribution. 4.) Annual additions limit does not include catch-up contributions. c. Multiple annual additions limits 1.) If a taxpayer has two separate sources of income (but not from a controlled group), he may be eligible to have two annual additions limits, one for each source of income

VESTING

1. Traditional defined benefit pension plans must vest at least as rapidly as one of the following two schedules (assuming the plan is not top heavy): a. Five-year cliff vesting—No vesting is required before five years of service; 100% vesting is required after five years of service. b. 3-7-year graduated (or graded) vesting—The plan must provide vesting that is at least as fast as the following schedule. c. Cash balance pension plans require three-year cliff vesting. 2. Defined contribution plans must vest at least as rapidly as one of the following two schedules for all employer nonelective contributions and matching contributions: a. Three-year cliff vesting—No vesting is required before three years of service; 100% vesting is required upon the completion of three years of service. b. 2-6-year graduated (or graded) vesting—The plan must provide vesting that is at least as fast as the following schedule. NOTE: These are the same vesting schedules used for top-heavy defined benefit plans. 3. The employer may choose a vesting schedule that is more favorable to the employee but not less favorable than the cliff. a. Cliff vesting is administratively easier. However, graded vesting will often mean higher forfeitures. Graded vesting requires employees to remain longer for full vesting. It is important to look at the employer's actual turnover to decide which vesting schedule is better. 4. If a qualified plan provides for employee contributions, the portion of the benefit or account balance attributable to employee contributions (and earnings attributed to those contributions) must be 100% vested at all times (nonforfeitable). 5. Years of service for purposes of vesting a. A year of service for purposes of vesting is considered 1,000 hours within a 12-month period. All years of service must be counted with few exceptions. Two of the more common exceptions are as follows: 1.) Years before the implementation of the plan 2.) Years before age 18 b. Both years before the implementation of the plan and years before age 18 may be considered at the choice of the employer (must be in the plan document). c. Service time with a subsidiary of the employer-sponsor must be included for determining vesting eligibility. d. It is important to recognize that, for vesting purposes, an employee's years of service typically begin on the hire date, not the date on which the employee becomes eligible to participate in the plan. 6. Situations in which employer contributions are 100% vested are as follows: a. Plan termination—Benefits become 100% vested in the event of a plan termination. b. SEP plans, SARSEP plans, and SIMPLEs—All contributions to these plans are fully vested. c. Attainment of normal retirement age—An employee attaining normal retirement age is automatically fully vested. d. Under a 401(k) plan, elective deferrals, qualified nonelective contributions, and qualified matching contributions are 100% vested at all times. e. Safe harbor contributions to a safe harbor 401(k) plan f. Plan requires two years of service for eligibility

OTHER TAX-ADVANTAGED RETIREMENT PLANS

1. Types a. Simplified employee pension plans (SEPs) b. Traditional individual retirement annuities and accounts (traditional IRAs) c. Roth IRAs d. Savings incentive match plan for employees (SIMPLE IRA) e. 403(b) plans [supplementary retirement annuities and tax-sheltered annuities (TSAs)] 2. Promise to pay the balance of the individual account at retirement 3. Distribution rules are essentially the same as those for qualified plans.

TERMINATIONS

1. Upon termination of a qualified plan, all employees of the plan become fully vested in their benefits as of the date of termination. a. Sponsors that terminate a qualified plan must discontinue all contributions and benefit accruals and must distribute all plan assets within a reasonable period after the termination of the plan. b. An involuntary plan termination may be initiated by the PBGC for a plan that is unable to pay benefits.

[SPECIAL RULES FOR SELF-EMPLOYED (KEOGH) PLANS]

1. When long-term capital accumulation, particularly for retirement purposes, is an important objective of a self-employed businessowner 2. When an owner of an unincorporated business wishes to adopt a plan providing retirement benefits for regular employees as an incentive and employee benefit as well as retirement savings for the businessowner a. The types of entities that may adopt self-employed retirement plans include the following: 1.) Sole proprietorships 2.) Partnerships 3.) LLPs 4.) LLCs taxed as sole proprietorships or partnerships b. S corporations do not have self-employed owners and therefore do not have self-employed retirement plans 3. When a self-employed person has a need to shelter some current earnings from federal income tax 4. When an individual has self-employment income as well as income from other employment and wishes to invest as much of the self-employment income as possible and defer taxes on i

(IRAs)- APPROPRIATE APPLICATION

1. When there is a need to shelter current compensation or earned income from taxation 2. When it is desirable to defer taxes on investment income (as IRA earnings are tax deferred) 3. When long-term accumulation, especially for retirement purposes, is an important objective 4. When a supplement or alternative to a qualified pension or profit-sharing plan is needed

(IRAs)- DISADVANTAGES

1. Withdrawals may be subject to a 10% penalty (see Section XV: Distributions from Qualified Plans and IRAs). a. Loans are not permitted. b. All withdrawals are considered distributions from the IRA and are subject to the rules for such distributions. 1.) Early distribution penalty may apply 2. Distributions are not eligible for 10-year forward averaging, capital gains treatment, or NUA that applies to certain lump-sum distributions from qualified plans. 3. Withdrawals from the account are required by April 1 of the year following the year the individual reaches age 72 except in the case of a Roth IRA. 4. All distributions from IRAs are ordinary income to the extent taxable (see exceptions for Roth IRA under Roth IRAs, Section XI(F)).

(SECURE ACT)

2. The credit for certain small employers starting an employer retirement account has been increased. The old credit was $500 per year for three years for eligible employers with no more than 100 employees making $5,000 per year or more. The new credit is the lesser of 50% of the qualified plan start-up costs or the greater of $500 or $250 times the number of non-highly compensated employees eligible to participate in the plan

(SECURE ACT)

4. Starting in 2021, multiple employers can join together under one plan document even if they are completely unrelated. Congress hopes this will encourage more employers to offer retirement plans to their employees. Multi-employer plans have been available for a long time; however, there had to be a nexus between the employers (meaning the employers were related in some manner like in the same industry) and if one employer failed the plan requirements then all employers in the plan also failed. Starting in 2021, the need for a nexus is eliminated, and if one of the employers fails the plan requirements, then the other employers are safe as long as they actually meet the plan requirements. The hope is that multi-employer plans will lower administrative costs for the various employers. This could be especially true with the use of the internet. It is possible to accommodate many plan participants with a broader use of the internet for things like enrollment and contribution changes.

(SECURE ACT)

5. The SECURE Act started the process to allow long-term part-time employees to be part of cash or deferred arrangements (CODAs like 401(k) plans). Starting in 2023, employees who are at least age 21 and have three consecutive years of service with more than 500 hours but less than 1,000 per year will be eligible for the retirement plan. However, they can be denied matching funds and non-elective employer contributions. Also, they will not count for nondiscrimination testing or top-heavy testing. In othewords, they will be allowed to save using the employer plan, but the employer is not really required to count them for most tests. Also, these employees get a year of vesting for every 1,000 hours of work. If they work 1,000 hours in a year, they are no longer in this category. Finally, the first year that will count towards the three-year rule is 2021. Thus, no one will be helped by this law until 2024

ERISA REQUIREMENTS

Defined benefit pension plans are subject to all the ERISA requirements for qualified plans for participation, funding, vesting, and so forth (See Section II, "Regulatory Considerations for Retirement Planning," in this volume).

THE 50/40 TEST

NOTE: Additional coverage test for defined benefit plans only 1. All defined benefit pension plans must benefit no fewer than the lesser of the following: a. 50 employees b. 40% or more of all nonexcludable employees 1.) For purposes of the 40% test, the plan does not have to consider employees who are not eligible for the plan. 2.) Noneligible employees include the following: a.) Employees who do not meet age and service requirements (typically, age 21 and one year of service) b.) Excluded employees, such as union employees, certain airline pilots, and nonresident aliens NOTE: If the employer has five or fewer employees, two employees must be covered. In the case of a single employee, that person is required to be covered. Below is an example of the 50/40 test "lesser of" rule. ■ A company sponsoring a defined benefit pension plan with 1,000 nonexcludable employees must benefit at least 50 employees. ■ A company sponsoring a defined benefit pension plan with 100 nonexcludable employees must benefit at least 40 employees. 2. In addition, defined benefit pension plans also must meet one of the safe harbor, ratio percentage, or average benefits percentage tests

1. Pure annuity model

a. Basic capital needs analysis b. Most common model used for retirement needs analysis c. Capital depleted over the life expectancy of retiree d. Determined on a pretax basis e. Steps: 1.) Determine the wage replacement ratio (WRR) a.) Adjust for any Social Security benefits if the client wishes to include them in the analysis 2.) Adjust the preretirement need for inflation 3.) Calculate the present value at retirement of an annuity due (BEGIN mode on calculator) for an annual payment equal to the result from Step 2 over the full retirement life expectancy (estimate life expectancy conservatively at 90-95) and use the inflation-adjusted earnings rate 4.) Determine the amount to save during the work life expectancy—discount the capital needed at retirement using the savings rate and investment earnings rate, being mindful as to whether the client is expected to save annually or more frequently, and whether the client is expected to save under an annuity due or an ordinary annuity scheme

ERISA requirements for qualified plans

a. Eligibility (age and service) b. Coverage c. Vesting d. Reporting and disclosure e. Fiduciary

Compensation limit

a. For purposes of qualified plans, covered compensation is capped at $285,000 (2020). 1.) Thus, in 2020, only the first $285,000 of each employee's compensation may be used to calculate contributions and benefits for any qualified plan.

2. Capital preservation model

a. Maintains the original balance needed at retirement under the pure annuity model for the entire retirement life expectance

Retirement planning is often among a client's top goals. Therefore, it is critical that a financial planner know sources of retirement income.

a. Social Security b. Employer-sponsored plans c. Personal savings and investments d. Earnings (e.g., part-time employment)

The employer and the participant

a. The employer has the right to control the plan subject to the terms of the plan document and usually retains the right to amend the terms of the plan or terminate the plan. b. The participants are usually the passive beneficiaries of the plan.

Four elements of a qualified plan

a. The plan document provides the terms and benefit amounts provided by the plan. b. Once adopted, the plan is recognized as a separate legal entity (must be in writing). c. The trust holds the plan assets. The trustee is usually selected by the employer. d. The funds, once contributed, become the plan funds and, except in unusual circumstances, cannot be returned to the employer.

Financial planning and the retirement needs analysis...

a. This is the starting point in most retirement planning engagements. b. These calculations "set the stage" for discussion and prioritization of actions needed to obtain goals. c. CFP Board Job Task Domains—primarily related to Domains 1-3 1.) Establishing and defining the client-planner relationship a.) Client may be the employer who wishes to implement an employer-spon-sored plan or who is interested in new management of an existing plan. b.) Client may be the participant in an employer-sponsored plan or indi-vidual seeking advice about individual plans for retirement 2.) Gathering information necessary to fulfill the engagement a.) Key component in retirement planning b.) Must gather information pertaining to all available sources of retirement income: ■ Employer-sponsored plans ■ Individual savings plans ■ Social Security benefits information ■ Earnings/employment income 3.) Analyzing and evaluating the client's current financial status a.) Retirement needs analysis establishes the financial snapshot of where the client is currently in relation to where the client wants to be at retirement. b.) Analysis helps to establish necessary savings objectives and identifies variables for consideration. c.) Participation in available plans and respective performance of the plans can be analyzed.