Module 9
Why would a solo 401(k) likely be an inappropriate choice if a firm expanded by hiring additional employees?
If a one-person firm was to hire additional employees, a solo 401(k) plan would likely be viewed as far too expensive because of its generous employer nonelective contributions. Because a 401(k) plan must be nondiscriminatory, a solo 401(k) plan could not be offered to the owner and his or her spouse without including the other employees
Can the assets in a Keogh plan be rolled over into other tax-deferred retirement savings vehicles?
Tax-free rollovers from a Keogh plan to another Keogh plan, an employer-sponsored retirement plan, a 403(b) plan, a governmental 457(b) plan or an IRA are permitted.
Describe trustee administrative issues under a SIMPLE plan.
The SIMPLE plan trustee bears certain administrative requirements: (a) The trustee must annually provide the employer maintaining the plan with a summary description containing certain required information. (b) Each individual participant must be supplied with an account statement, detailing account activity and an account balance, within 30 days following the end of the calendar year. (c) Trustees must also file a report with the Secretary of the Treasury. Failure to file any of these documents can result in a financial penalty until the reporting failure is remedied.
What incentives for small employers to offer plans does EGTRRA provide in addition to liberalized plan provisions?
Under EGTRRA provisions, made permanent by the Pension Protection Act of 2006 (PPA), small employers with no more than 100 employees receive a tax credit for costs associated with establishing new retirement plans. The credit equals 50% of the costs in connection with creation or maintenance of a new plan. The credit is limited to $500 annually and may be claimed for qualified plan costs incurred in each of the three years beginning with the tax year in which the plan first becomes effective. Additionally, to encourage the introduction of small employer plans, EGTRRA enacted provisions that exempt a small employer from paying a user fee. The law exempts the small employer from fees for any determination letter request to the Internal Revenue Service, with respect to the qualified status of a retirement plan that the employer maintains if the request is made within certain time frames.
A Keogh plan can be designed as either a defined benefit or defined contribution plan. (a) Describe the limits that apply to benefits available under a defined benefit Keogh plan and (b) describe the maximum annual contribution allowed under a defined contribution Keogh plan.
(a) If a defined benefit Keogh plan is used, the same limit applies as for a defined benefit corporate pension plan; that is, the limit is the lesser of 100% of the average of the participant's highest three consecutive calendar years of earnings or $215,000 in 2017 (an indexed limit). (b) For defined contribution Keogh plans, the maximum annual contribution is the lesser of 100% of the participant's compensation or $54,000 in 2017 (an indexed limit). For the self-employed person, defined contribution plan "compensation" is the self-employed person's "earned income from self-employment" less onehalf of the self-employment tax (not to exceed $270,000 in 2017).
Explain (a) how much may be contributed to an IRA through a SEP and (b) how the answer changes in the case of a self-employed individual.
(a) The maximum contribution limit to a SEP is 25% of income up to $54,000 in 2017. If the employer contribution to the SEP in any year is less than the normal IRA limit applicable for that year, the employee may contribute the difference up to the allowable applicable annual limit. The employee contribution may be made either to the SEP or to one or more IRAs of the employee's choice. (b) In the case of self-employed individuals (proprietors and partners), the 25% contribution limitation will be on the basis of earned income since that term is defined in the law. This means that the contribution will be determined with reference to earned income after having subtracted the amount of the contribution and half of the self-employment tax. The result is that the 25% contribution limit, as it is applied to these individuals, is 20% of net income before subtracting the amount of the contribution but after subtracting half of the self-employment tax.
What is a solo 401(k) plan?
A solo 401(k) plan is simply a 401(k) plan that is offered to a one-person firm, or a two-person firm, usually composed of the owner and her or his spouse, that must comply with all of the administrative requirements for 401(k) plans except the filing of 5500 annual reports (provided the plan's assets are $250,000 or less).
Does an employer have wide discretion in terms of which employees it covers under a SEP plan?
An employer does not have wide discretion in terms of which employees it covers under a SEP plan. For an IRA funded by employer contributions to be treated as a SEP, the employer must contribute to the SEP of each eligible employee. As long as the employee satisfies the eligibility criteria mentioned earlier, the employer must make contributions on the employee's behalf.
Are plan loans from Keogh plans available to all self-employed individuals? Explain.
Because of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), loans from Keogh plans generally are permitted on the same basis as for qualified retirement plans. (However, both simplified employee pension (SEP) plans and Savings Incentive Match Plan for Employees (SIMPLE plans) individual retirement account (IRA) plans (discussed later) do not allow loans.)
Describe the nonrefundable tax credits that assist retirement savers directly rather than the small employers who are sponsoring some sort of retirement plan for their employees.
In an effort to encourage lower-income and middle-income workers to save for their retirement, EGTRRA provided nonrefundable tax credits to individuals who are 18 years of age or over, unless they are full-time students or claimed as dependents on another taxpayer's tax return beginning in 2002. The credit could be claimed for tax years beginning in 2002 and was to end in 2006. PPA made these credits permanent in 2006. The credit is claimed on the taxpayer's tax return and applies to the first $2,000 in retirement plan contributions. Those retirement plan contributions eligible for the credit would include elective contributions to SEP, SIMPLE, 401(k), 403(b), and eligible governmental 457(b) plans, as well as contributions made to traditional and Roth IRAs.
How did PPA account for the possible adverse impact of wage inflation on the nonrefundable tax credits assisting retirement savers, and what mechanism was included in the legislation to make retirement saving with the tax credit more convenient for taxpayers?
In order to insure that wage inflation did not adversely erode the ability for individuals to make use of the nonrefundable tax credits, PPA indexed the adjusted gross income limits needed to qualify for these nonrefundable tax credits beginning in 2007. Additionally, for taxpayer convenience, PPA allowed taxpayers to direct the Internal Revenue Service, after 2006, to deposit any tax refund attributable to the saver's credit into a retirement plan or IRA.
Discuss the early withdrawal penalty in regard to withdrawals from a SIMPLE plan
Participants in a SIMPLE IRA who take a distribution before the age of 59½ are subject to the 10% penalty tax on early withdrawals. Employees withdrawing contributions during the two-year period beginning on the date of initial participation are subject to a 25% penalty tax. A distribution from a SIMPLE account may be rolled into an IRA without penalty if the individual has participated in the SIMPLE account for two years.
Explain how much an employer may deduct for contributions to a SEP.
The employer's deduction for a SEP contribution may not exceed the actual contribution made to the SEP to the extent that the contributions for each employee do not exceed the 25% and/or Section 415 limits. If the employer contributes more than the amount deductible, the employer can carry over the excess deduction to succeeding taxable years. A 10% excise tax is applied on nondeductible contributions.
What specific changes by EGTRRA made solo 401(k) plans more attractive for sole proprietors?
The following EGTRRA changes made solo 401(k) plans more attractive for sole proprietors: (a) Elective deferrals no longer reduced the payroll base for computing employer nonelective contributions. (b) Profit-sharing plans used as the underlying base plan in a 401(k) plan could receive an employer nonelective contribution of 25% rather than the prior allowable percentage of 15%. (c) Elective deferral limits were increased. (d) Employees aged 50 and over could make catch-up elective deferrals to their plans.
List the eligibility requirements for establishing a Keogh plan (also called HR-10 plan).
The following eligibility conditions must be met in order for a Keogh plan to be established: (a) Only a sole proprietor (not a common law employee) or a partnership (not an individual partner) may establish a Keogh plan. (b) If an owner-employee wishes to establish and participate in a Keogh plan, he or she must cover all employees who are at least 21 years of age and have one year of service with the employer. A two-year waiting period can be used if the plan provides 100% vesting after the two-year period. (c) Keogh plans must meet the same nondiscrimination coverage and participation requirements as other qualified plans. (If a plan is top-heavy, the special topheavy rules explained in another section of the textbook must be met.)
Describe the alternatives employers have for contributions under SIMPLE plans detailing alternatives for (a) matching contributions, (b) nonelective contributions and (c) employee notification requirements that accompany some of these choices.
(a) The required employer matching contribution is either made on a dollar-fordollar basis up to 3% of an employee's compensation for the year, or the employer could elect to match at a rate lower than 3% but not lower than 1%. (This option to match below 3% is available to SIMPLE IRAs but not to SIMPLE 401(k)s.) (b) Instead of making a matching contribution, an employer can opt to make a nonelective contribution of 2% of compensation for each eligible employee who earned at least $5,000 during the year. (c) To apply the lower matching percentage, employers must notify employees of their intent to apply the lower match within a reasonable time before the 60-day election period in which employees determine whether they will participate in the plan. If opting to make nonelective contributions, the employer is again required to advise eligible employees of its intention within a reasonable time before the 60-day election period during which employees decide whether to participate in the plan.
Explain the administrative issues employers avoid with a SIMPLE plan.
Employers avoid certain administrative requirements commonly associated with a qualified plan by offering a SIMPLE plan. The following administrative requirements are avoided by offering a SIMPLE plan: (a) Employers are not required to file annual reports. (b) A SIMPLE 401(k) plan is not subject to the nondiscrimination and top-heavy rules generally applicable to regular 401(k) plans. This exempts them from the actual deferral percentage (ADP) test and the actual contribution percentage (ACP) test where employer matching contributions are involved. (c) Employers also are relieved of fiduciary liability under the Employee Retirement Income Security Act of 1974 once a participant or beneficiary exercises control over account assets.
State the major employer administrative issues of SIMPLE plans.
Employers face the following administrative issues when maintaining a SIMPLE plan: (a) Employers are required to advise employees of their right to make salary reduction contributions under the plan and of the contribution alternative if elected by the employer. (b) Notification to employees must include a copy of the summary plan description prepared by the plan trustee for the employer. The summary plan description must be provided to the employees before the period in which an employee makes a plan election. (c) Employers must submit employee elective deferrals to their financial institution no later than 30 days after the last day of the month for which the contributions were made. (d) Employer matching contributions are due for deposit by the date that the employer's tax return is due, including extensions. (e) An employer makes contributions on behalf of employees to a designated trustee or issuer. (f) Plan participants must be notified that SIMPLE plan account balances may be transferred to another individual account or annuity.
Describe the general requirements that must be met for an employer to establish a SEP
Internal Revenue Code (IRC) Sections 408(j) and (k), which provide the general authority for SEPs, provide for an increase in the normal IRA limit if certain requirements are met. A SEP is treated under the law as an IRA with higher limits. The employer establishing a SEP can be an incorporated entity or a self-employed individual. For the employer, a SEP is a plan that utilizes IRAs to provide retirement benefits for employees. The employer must notify the employees of the plan. The program must be defined contribution in nature; the defined benefit approach is not permitted for these plans. The SEP must be a formally adopted program with the following characteristics: (a) It must be in writing and must specify the requirements for employee participation. Further, it must specify when the employee makes contributions and how each eligible employee's contribution will be computed. (b) The employer must make contributions to the SEP for any employee who is at least 21 years of age, has worked for the employer during at least three of the last five years and has received at least $600 in 2017, indexed for cost-of-living increases, in compensation from the employer for the year (c) Employer contributions may not discriminate in favor of any highly compensated employee (HCE). (d) Employer contributions may be discretionary from year to year. However, the plan document must specify a definite allocation formula. (e) Each employee must be fully vested in his or her account balance at all times. (f) The program may not restrict the employee's rights to withdraw funds contributed to his or her SEP at any time (i.e., the program must give unrestricted withdrawal rights to the employees). (g) The employer may not require that an employee leave some or all of the contributions in the SEP as a condition for receiving future employer contributions. (h) EGTRRA increased the percentage of compensation allowance for SEPs from 15% of compensation to 25% of compensation beginning in 2002. The Section 415 limit was changed by EGTRRA to the lesser of 100% of compensation or $40,000 for 2002. The limit on includable compensation was increased to $200,000 in 2002. Also, the amount allocated or contributed in total by the employer for the employee under a SEP and other qualified pension or profitsharing plans may not exceed the Section 415 limits. (In 2017 the Section 415 limit had increased to $54,000 and the limit on includable compensation to $270,000.) In addition, an employee may make a regular contribution to an IRA, and this is not aggregated with the SEP contributions for purposes of the 25% or Section 415 limits. (i) The top-heavy provisions of the law apply to SEP programs; however, a special provision allows employers to elect to measure aggregate employer contributions, instead of aggregate account balances, to test if the SEP has exceeded the 60% limit. (j) SEPs cannot permit employees to make loans, since the plans are IRAs.
The legislative intent of the Small Business Job Protection Act of 1996 when it instituted SIMPLE plans was to create a retirement savings vehicle for small employers that was not subject to the complex rules associated with qualified plans, such as the nondiscrimination requirements and top-heavy rules. List the major characteristics of SIMPLE plans.
The following list details the major characteristics of SIMPLE plans. (a) These plans may be created by employers with 100 or fewer employees who received at least $5,000 in compensation from the employer in the preceding year. (b) A SIMPLE plan may be established either as an IRA or as a 401(k) plan (c) Employees can make elective contributions of up to $12,500 per year in 2017 (indexed). Catch-up provisions are available for employees aged 50 and older. (d) Employers make matching contributions or nonelective contributions to a SIMPLE plan. (e) Employers have certain notification requirements to employees. (f) Nonelective contributions are subject to the $270,000 compensation cap in 2017 (indexed) prescribed by Section 401(a)(17) of IRC, whereas matching contributions are not subject to this limitation. (g) An employer electing to create a SIMPLE plan may not maintain another qualified plan in which contributions were made or benefits accrued for service in the period beginning with the year the SIMPLE plan was created. (h) All contributions to a SIMPLE account are fully vested and nonforfeitable. (i) To participate in a SIMPLE plan, an employee must have received at least $5,000 in compensation in any two prior years from the employer, and the employee must be reasonably expected to receive $5,000 in compensation from the employer during the year. (j) There is no stipulation that a certain number of employees participate in a SIMPLE plan in order for an employer to offer such a plan. (k) Employers eligible to offer SIMPLE plans are determined on a controlled group basis, taking businesses under common control and affliated service groups into consideration. (l) Self-employed individuals may participate in a SIMPLE plan. (m) Certain nonresident aliens and employees covered under a collective bargaining agreement may be excluded from participation.
What are the deduction limits for the owner under a Keogh plan?
The owner's deduction for contributions for himself or herself is based on the owner's earned income from self-employment, which takes into account the deduction for one-half the self-employment tax and the deduction for contributions to the plan on the owner's own behalf. In a profit-sharing plan, for example, the maximum deductible contribution for the self-employed individual is 20% of earned income, less one-half the self-employment tax, before subtracting the amount of the contribution.