Unit 11: Retirement Plans

Payroll Deduction Plans

- *Nonqualified* -allows employees to *authorize their employer to deduct a specified amount for retirement savings from their paychecks* -money is *deducted after taxes are paid* and can be invested in any number of retirement vehicles Tip: For the FINRA ex- ams, 401(k) plans are considered salary reduction plans, not payroll deduction plans. In exam questions, assume that payroll deduction plans are nonqualified. Also note that 401(k) plans are qualified plans, whereas payroll deduction plans are not.

Tax-Sheltered Annuities (TSAs)

- *Qualified plan* *available to employees of: >public educational institutions >tax-exempt organizations (501(c)(3) organizations) >religious organizations* Eligibility Criteria -must be at *least 21 years of age* -must have *completed one year of service* >> Written salary reduction agreement must be executed between the employer and the employee Contributions -funded by *elective employee deferrals from gross income* and *accumulate tax free until distribution* Distributions - *are 100% taxable, -10% penalty for dist before 59 1/2*

Simplified Employee Pensions (SEP IRA) Employer contribution reduce employee AGI

- *qualified individual retirement* plan that offer *self-employed persons and small businesses* easy-to-administer *pension plans* -allow an employer to contribute money to SEP Contributions - SEPs allow an *employer to contribute money to SEP IRAs that its employees set up* to receive employer contributions. - *Self-employed individuals and corporations may contribute up to a maximum amount* each year to a SEP IRA and an additional *catch-up contribution for those age 50 and older*. - Generally, an *employer can take an income tax deduction for contributions* made each year *to each employee's SEP*. - Also, the *amounts contributed* to a SEP *by an employer* on behalf of an employee are *excludable from the employee's gross income* From Investopedia: Because the funding vehicle for an SEP plan is a Traditional IRA, SEP contributions, once deposited, become Traditional IRA assets and are subject to many of the Traditional IRA rules, including the following: Distribution rules Investment rules Contribution and deduction rules for Traditional IRA contributions.

Keogh (HR-10) Plans

- *qualified plans* intended for *self-employed persons and owner-employees of unincorporated businesses or professional practices filing Schedule C with the IRS* - Keogh *planholder is permitted to make tax-deductible cash contributions each year up to a maximum amount.* - The plans can be set up as either defined-contribution plans or defined-benefit plans . With a defined-contribution plan, a contribution up to 25% of taxable income after the contribution is made is allowed . With a defined-benefit plan, contributions must be calibrated to ensure that the plan will be able to provide the benefit . This would generally require an actuary. - As with IRAs, a person may make *contributions to a Keogh until age 70. * - Employers must make contributions into the Keogh plans of eligible employees. To simplify, a *high-income employer making the maximum contribution to his own Keogh must contribute to the Keogh of an eligible employee at a rate of 25%.* Employees are eligible if they: >have worked at least 1,000 hours in the year >have completed one or more years of continuous employment >are at least 21 years old Testable: *Both IRAs and Keogh plans have maximum annual allowable contribution limits but they are significantly higher in a Keogh Plan.*

401(k) Plans Contrib excluded from AGI

-(thrift plans) considered *salary reduction plans* -type of *defined contribution plan* that *allows the employee to elect to contribute a percentage of salary to his retirement account* -*contributions are excluded from the employee's gross income and accumulate tax deferred * -*employers can make matching contributions upto a specific percentage of employee contribution* - permit hardship withdrawal

Deferred Compensation Plans

-*Nonqualified* -an *agreement between a company and an employee in which the employee agrees to defer receipt of current income in favor of payout at retirement* -assumed that *employee will be in lower tax bracket at retirement age* - risky bc *if the business fails, employee has no right to plan benefits* (become general creditor) -*at* employee's *retirement, taxable as ordinary income*

Nonqualified Plans

-*after-tax contributions -*only growth taxed on distribution -Contributions are not tax deductible -Plan does not need IRS approval -Plan can discriminate -Tax on accumulation is deferred -Excess over cost base taxed -Plan is not a trust

Corporate Retirement plan: Defined Contribution Plans

-*contribution amount is specified* by the plan (trust agreement) -the *benefit* that will be paid at retirement *is UNKNOWN* - are much easier to administer. - contribution formula might be expressed as a percentage of income. - *favors younger (less tenured) employees*

Profit-Sharing Plans

-*do not require a fixed contribution formula* and allow *contributions to be skipped during years of low profit* -easy and flexible

IRA Contributions

-*fully tax deductible*, regardless of income,* if* the investor is eligible to *participate in a qualified plan* -*if ineligible*, contributions are *deductible (or partially) if the taxpayer's AGI falls within established income guidelines* -*high-earning individuals* that are covered by a qualified plan may *not take a tax deduction*, but *can still make contributions* -contributions cannot exceed earned income for the year -the *dollar cap is increased by a catch-up amount for individuals age 50 and over* FYI: Contribution limit for Individuals (2013) $5500 Additional contribution for 50+ (2013): $1000

Qualified Plans

-*pre-tax contributions -Contributions tax deductible -Plan approved by the IRS -Plan cannot discriminate -Tax on accumulation is deferred -All withdrawals taxed as ordinary income -Plan is a trust

Health Savings Account

-*qualified employer sponsored plans that allow before-tax contributions to a savings account* to be used for medical expenses -IRS allows *one time funding distribution from an IRA to a qualified HSA without paying federal income taxes or penalties* on the IRA distribution

Ineligible Funding and Practices

-Ineligible Investments >collectibles >life insurance (Cunning Life Inspector) -Ineligible Investment Practices >short sales of stock >speculative option strategies >margin account trading (Strength - Of - Materials)

Appropriate IRA Investments

-Stocks -Bonds -Mutual funds -UITs -Government securities -US government-issued gold and silver coins -Annuities

Pension Liability

-a legal obligation to pay retirement benefits to future retirees

Self-Employed 401(k) Plan

-can be set up by a *business with no full-time employees (only owner, spouse and part-time employees)* -offer *higher contribution limits* -greater flexibility -penalty-free loans from the plan's funding, provided they paid back on time -business can be a *sole proprietorship, a partnership, or a C corporation, S corporation, or limited liability corporation*

The Employee Retirement Income Security Act of 1974 (ERISA)

-established to *prevent abuse and misuse of pension funds* -apply to *private sector (corporate) retirement plans and certain union plans* - NOT PUBLIC FIRMS Criteria: >Participation: identifies eligibility rules for employees and states that *all employees must be covered if they are 21 years or older and performed on year of full service* >Funding: requires that* funds contributed to the plan be segregated from other corporate assets* >Vesting: employees are *entitled to their entire retirement benefit within a certain number of years of service, even if they have left* the company >Communication: plan document *must be in writing and employees must be given annual statements of account* and updates of plan benefits >Nondiscrimination: *all eligible employees must be impartially treated* through a uniformly applied formula >*Beneficiaries: must be named to receive an employee's benefits* at his death People from Vegas (use) Citi National Bank

Earned Income

-income from work, such as wages, salaries, bonuses, commissions, tips, and so forth

IRA Rollovers

-individuals may move their investments from *one IRA to another IRA or from a qualified plan to an IRA* -can only do so *once a year* -must be *completed within 60 calendar days of withdrawal* -direct transfers have no withholding -if individual receives a *distribution of assets from an employer-sponsored qualified plan, the payor must retain 20% of the distribution as a withholding tax*

IRA *Distributions*

-may *begin without penalty after age 59 1/2 and must begin by April 1 of the year after the individual turns 70 1/2* -distributions *before* age *59 1/2* are subject to a: *10% penalty* as well as *regular income tax*, *except* in the event of: >death >disability >first-time homebuyer for purchase of principal residence >education expenses for the taxpayers, spouse, child, or grandchild >medical premiums for unemployed individuals >medical expenses in excess of defined adjusted gross income (AGI) limits Non compliance: -*if distributions do not begin by April 1 of the year* after the individual turns 70 1/2, a *50% insufficient distribution penalty applies* and (- This is applicable to the amount that should have been withdrawn on the basis of *IRS life expectancy tables*. These are known as the IRA holder's *annual "required minimum distribution" (RMD) and "required beginning date" (RBD) Ordinary income taxes also apply to the full amount*.

IRA Transfers

-occurs when the account assets are sent directly from one custodian to another, and the account owner never takes possession of the funds -*no limit on the amount of transfers*

Unfunded Pension Liability

-one where adequate reserves have not been set aside to meet this future obligation

Corporate Retirement plan: Defined Benefit Plan

-promises *a specific benefit at retirement* determined by *a formula involving retirement age, years of service, and compensation* (*advance your collection*) The amount of the contribution must be *determined by actuarial calculation because it involves complex assumptions* about investment returns, future interest rates, and other matters. - Used by firms who wish to *favor older key employees because a much greater amount may be contributed for those with only a short time until retirement*. Testable: In an employer-sponsored defined benefit plan, *the contribution amounts vary* according to the assumptions used. The *benefit amount, however, will be fixed per person based on a formula* combining age, years of service, salary, etc.

Roth 401(k) Plan

-requires *(after-tax) contributions but allows tax-free withdrawals, provided the owner is 59 1/2 and occurs five years after first contribution* -*employer matching contributions* are eligible, but must be made *into a traditional 401(k) account* -would have *two 401(k) accounts - Roth and Traditional IRA* - but *cannot transfer money between the two accounts* Important differences from Roth IRA: unlike a Roth IRA: ■ there are *no income limitations* on who may have such a plan; and ■ the* account owner must begin withdrawals by age 70½.* - income lim/ 701/2 W

Savings Incentive Match Plans for Employees (SIMPLEs)

-retirement plan for *businesses with fewer than 100 employees that have no other retirement plan in place* - The *employee makes pretax contributions into a SIMPLE plan up to an annual contribution limit. The employer makes matching contributions.* - matching contribution requirements and limits for employers are specified by the IRS - Include catch-up contributions for those age 50 and olde

401(k) Plan Conversions

401(k) plan participants may convert funds held in their 401(k)s into Roth 401(k) plans. - this allows 401(k) account holders to pay the taxes on the funds when they are rolled over into the roth 401(k). - In the roth 401(k), the funds can grow tax free and they can be withdrawn without tax liability in the future.

Coverdell (Education IRA)

Contributions -allow *after-tax contributions* of up to *$2,000 per student per year* for children *younger than 18* - *Contributions* are *not deductible and must cease when the beneficiary reaches age 18*. Any unused balance must be rolled over or distributed by the time the beneficiary attains age 30. - Amounts *not used for one child may be rolled over tax free to the account of another child* of the *same family* only *once during any 12-month period*. -contribution limits may be *reduced or eliminated for high-income tax payers* Distributions -distributions are *tax free as long as used for qualified educational expenses* -*if* account is *not depleted* by age *30*, must be *distributed to the individual subject to income tax and 10% penalty or rolled into an education IRA* - *If a distribution* *exceeds education expenses*, a *portion* representing earnings will be *taxable to the beneficiary and may be subject to an additional 10% penalty tax*. Testable points Testable: Under Coverdell rules, an *eligible educational institution includes colleges as well as elementary or secondary schools*. In contrast, Distributions from Section 529 plans are limited to higher education only.

Spousal IRA

Contributions for nonworking spouses: -individuals with *nonworking spouses are allowed to contribute up to a total of 2 x $ 5,500 split between to accounts*

Roth IRA

Contributions: -allow *(after-tax) contributions* up to a *maximum annual allowable limit per individual per year* - Contributions to *other IRAs when combined with contributions to a Roth may not exceed the maximum annual allowable limit*. - Contributions to Roth IRAs are not deductible on one's tax return. Unique: Therefore, there is no phase-out schedule regarding a contribution being deductible as there is with a traditional IRA. however, there is a *phase-out schedule regarding the contribution that can be made to a Roth IRA*, and again the schedule is *tied to an individual's AGI*. The contribution limit is phased out from the low end of the phase-out scale until the *high end*, *above which no contribution to a Roth IRA would be allowed* Distributions: -*earnings are not taxed* as they accrue or when they are distributed from an account as long as the money has *been in an account for five taxable years* and the IRA owner has *reached age 59 1/2* -*(Imp)* minimum distributions at age 70 1/2 do NOT apply - *(Imp)*10 1/2 penalty for early distribution before 59 1/2 is waived for first time homebuyers - No 701/2 W - 10% penalty waived - new home Testable The maximum annual *contribution* to a Roth IRA* is 100% of earned income, not to exceed* a maximum allowable dollar limit.

Acronyms

ERISA The Employee Retirement Income Security Act of 1974 (ERISA) People from Vegas (use) Citi National Bank Part, Funding, Vesting, Communication, non discrimination, Beneficiaries Defined benefit plan advance your collection retirement age, years of service, and compensation IRA Ineligible Investments >collectibles >life insurance (Cunning Life Inspector) Ineligible Funding >short sales of stock >speculative option strategies >margin account trading (Strength - Of - Materials)

Section 529 Plans

Eligibility based on domicile -*prepaid tuition plans* for *state residents* or *college savings plans* for *residents and nonresidents* Purpose: - prepaid plans allow resident donors to lock in current tuition rates Contributions: - college savings plans allow donors to save money to be used later for college tuition -*any adult can open account* for future college student (*should not be related*) -allows *lump sum or periodic payments* -contributions are considered gifts and *made with after-tax dollars* and *earnings accumulate on a tax-deferred basis* Impt: >>>> > Contributions may be made in the form of periodic payments but follow the gift tax rule. Therefore, to *avoid gift tax, contributions are limited to the maximum allowable amount per year per donor (double for spouses)*. > donor may *aggregate contributions for up to five years* but then make *no further contributions for those years without being* subject to *tax*. Impt: >>>> -overall *contributions levels* *vary from state to state* Distributions: -most states permit *tax-free withdrawals* as long as the donor has *opened an in-state plan* (may be taxable if you got out-of-state) -*assets in the account remain under the donor's control* even after the student becomes of legal age -there are *no income limitations on making contributions* to a 529 plan -plans allow for monthly payments if desired by the account owner -account *balances may be transferred to a related beneficiary* Testable: 529: - Eligibility for the plans is state specific. - Monies distributed from the plan may be used to pay for *tuition in a 'state funded institution' in that state or you can use those monies to pay for a portion of an in-state private school or any out of state school*. - There are few restrictions on who may be the first beneficiary of a Section 529 plan. However, *if the beneficiary is redesignated, the new beneficiary must be a close family member of the first*

Individual Retirement Account (IRA)

Purpose: -created to encourage people to save for retirement in addition to any other retirement plans Contributions (Individuals) -anyone who has earned income may make an *annual contribution of up to $5,500 or 100% of earned income*, whichever is less -contributions to IRAs *must be made by April 15 of the year following the tax year* -may contribute *until age 70 1/2*, *provided* they have *earn*ed income -*if contribution is exceeded, a 6% excess contribution penalty applies* to the amount over the allowable portion - -the *dollar cap is increased by a catch-up amount for individuals age 50 and over*

Comparing Keogh and Traditional IRA

Source of contributions K: Employer; employee may also make nondeductible contributions I: Employee Permissible investments K: Most equity and debt securities, US government- minted precious metal coins, annuities, *cash-value life insurance* I: Most equity and debt securities, US government-minted pre- cious metal coins, annuities Nonpermissible investments K; Term insurance, collectibles I: Term insurance, col- lectibles, cash-value life insurance (Cunning Life-Inspector) Change of employer K: *Lump-sum distribution may be rolled over into an IRA within 60 days* I: Does not apply Penalty for excess contribution K: *10% penalty* I: *6% penalty* Taxation of distributions Both are Taxed as ordinary income

Conversion IRA to Roth IRA

The IRS, during specified periods of time, has allowed investors to convert one type of IRA to another. In addition, the IRS has allowed, under current tax code, investors the opportunity to treat a contribution allocated to one type of IRA as if it had been made to a different type of IRA. It is known as re-characterizing the contribution. The most common case of re-characterization is when a traditional IRA has been converted into a Roth IRA, and the participant wishes to go back to the traditional IRA instead of remaining in the roth. This would be accomplished by having the contribution transferred from the Roth IRA back to the traditional IRA in a trustee-to-trustee transfer. If the transfer is made by the due date (including extensions) for the individual's tax return for the year during which the contribution is made, the individual can treat the original conversion as if it never happened. There are several reasons why an individual might choose to re-characterize their contri- butions, but here are two of the most common (I) *Exceeding the earnings limitation on contributing to a Roth IRA*: A Roth contribution might have been made early in the year. Due to larger than expected earnings by year end, the investor's adjusted gross income exceeds the allowable limit. Re-character- ization is a way to "undo" the Roth IRA contribution and put the money into a traditional IRA. (II) *A significant decrease in the value of the account since the original conversion*. E.g. A conversion of $100,000 in a traditional IRA to a Roth IRA takes place. The investor has until April 15, or any available extension time for filing, to decide what to do. If on that date, the value of the Roth is less than the original amount converted, the investor will still owe ordinary income taxes on the $100,000 converted. But, if the individual were to re-characterize the entire account (worth less than the amount originally converted), the funds would be back in a traditional IRA, and no taxes would be due until the money is withdrawn. - Impt You *cannot convert and reconvert an amount during the same tax year or, if later, during the 30-day period following a re-characterization*. If you reconvert during either of these periods, it will be a failed conversion