Retirement Planning: Plan Selection for Businesses (Module 8)

We are using the word pension plan in the broad sense, but technically there are only four types of pension plans, what are they?

- Defined Benefit Pension Plan - Cash Balance Pension Plan - Target Benefit Pension Plan - Money Purchase Pension Plan

Target Benefit Pension Plan

A target benefit pension plan is similar to a money purchase plan. In a target plan the employer must make annual contributions to each participant's account under a formula based on compensation. In a target plan, however, the participant's age at plan entry is also taken into account in determining the contribution percentage. This is done on an actuarial basis so that older entrants can build up retirement accounts faster.

A simplified employee pension (SEP) does not have which of the following characteristics? a. Employer matching is not permitted. b. Social Security integration is not permitted. c. Loans and hardship withdrawals are not available. d. Age-weighting or cross-testing is not permitted.

B A SEP uses individual IRA accounts. Individual IRAs do not have hardship or loan provisions. SEPs cannot be age-weighted. SEPs can be integrated with Social Security. A one-person sole proprietorship can install a SEP. It does not have to be a stand-alone plan like a SIMPLE.

Which of the following retirement plans cannot have plan loans? a. 403(b) plan b. SIMPLE plan c. Defined benefit plan d. Stock bonus plan e. 401(k) plan

B Any type of qualified plan [or Section 403(b)] may permit loans (including DBs). Loans from IRA type plans are not permitted.

What is the unique feature of a Keogh plan as compared with qualified plans adopted by corporations? a. Keogh plans contribution on behalf of the owner is based on compensation b. Keogh plans contribution on behalf of the owner is based on earned income c. Keogh plans contribution on behalf of the owner is based on investment income d. Keogh plans contribution on behalf of the owner is based on contributions

B The unique feature of a Keogh plan, as compared with qualified plans adopted by corporations, is that the Keogh plan's contribution on behalf of the owner is based on earned income as opposed to compensation. Earned income is defined as the self-employed individual's net income from business after all deductions, including the deduction for the Keogh plan contributions

In a defined contribution plan, there is one main account where all participant money is invested. True or false? Why?

False In a defined contribution plan, the employer establishes and maintains an individual account for each participant. When the participant becomes eligible to receive benefit payments, the benefit is based on the total amount in the participants account

Why does the IRC require minimum funding requirements for defined benefit plans?

In the past, some companies under funded or took large loans from their DB plans. This caused major problems because employees were retiring and there was not enough money in the DB plan to pay out the benefits. This is why there are minimum funding requirements

Qualified plans for sole proprietorships and partnerships are called _______________

Keogh plans

The four R's of compensation policy (recruit, reward, retain and retire) are important objectives in designing pension plans. A well-designed plan use the four R's in what ways?

Recruit - employees by matching or bettering retirement benefit packages offered by competing employers, Reward - employees by linking benefits to compensation, Retain - employees by linking maximum retirement benefits to long service, and Retire - employees by allowing them to retire with dignity - without a drastic drop in living standard.

Lisa, age 35 and earning $50,000, wants to know how much money she will need to retire at age 65 with an income stream of 90% of her current earnings adjusted for inflation. Lisa is comfortable with the following assumptions: Inflation rate=4% Rate of return on investments at retirement=8% Life expectancy for Lisa at age 65=25 years

Step 1. Figure out the amount needed at age 65 in today's dollars. 90% of $50,000=$45,000 Step 2. Calculate the inflation-adjusted amount. $45,000=PV; 4%=I; 30=N: $145,953 Step 3. Calculate the capital needed to provide Lisa with $145,953 at age 65 for life while keeping pace with inflation and assuming the capital will be compounded at the assumed rate of return: 145,953=PMT; 25=N; (1.08/1.04)-1x100=I: $2,406,762.71 Note: Your calculator should be set to the "Begin" mode for this payment as your client will most likely anticipate receiving their retirement income payment at the beginning of the year rather than at the end.

Who assumes the investment risk with a Cash Balance Pension plan?

The EMPLOYER!

In order to design a pension plan for a business, three broad steps can be followed.

The first step consists of gathering the relevant facts. In this step the important factual information is gathered by conducting an employee census. In the census, a list of all employees with their compensation levels, ages and years of service for the employer is found. The existing and past pension programs maintained by the employer are studied. The second step consists of identification of employer objectives. In addition to factual information, the retirement planner must develop with the client a list of objectives that can be promoted by a retirement plan and their priorities to the employer. The third step is to choose plan features, which promote the employer objectives.

Social Security Integration

The rules for this are very complicated, but in effect they allow a higher rate of qualified plan contributions or benefits for each employee with compensation above a specified level. This reduces employer costs for the qualified plan benefits for lower-paid employees and correspondingly allows greater benefits or contributions for higher-paid employees.

Is it possible to contribute the maximum limits for an employee under both a defined benefit plan and a defined contribution plan?

Under ERISA as originally enacted in 1974, the answer to this question was no. However, the combined plan formula of ERISA and Code Section 415(e) was repealed, effective after 1999. It is now possible to have a defined contribution plan and a defined benefit plan for a participant that provides the maximum benefit under both plans, subject to an overall limitation on employer deductions equal to 25% of covered payroll, with certain exceptions.

Money Purchase Plan

Under a money purchase plan, the employer is required to contribute a fixed and stated amount to the plan. The contribution may be up to 25% of covered compensation. The mandatory nature of the Money Purchase plan causes most employers to avoid these plans since they can contribute just as much to a Profit Sharing plan without the mandatory contribution requirement.

Cash balance plans

are a type of defined benefit plan that operates very much like a defined contribution plan of the money purchase type. The employer guarantees the principal and interest rate, so the employee assumes no investment risk. However, cash balance plans tend to provide greater benefits to younger employees and those with shorter service, as compared to other defined benefit plans.

The minimize-turnover objective can be met by adopting a:

- Defined Benefit Plan - Graduated Vesting

Many employers, particularly small closely held companies, view retirement plans as worthwhile only if they provide substantial, tax-sheltered retirement benefits for key employees. The following are the commonly used techniques for doing this?

- Defined Benefit Plans - Service-based Contribution or Benefit Formula - Age-weighting and Cross-testing - Combination of DB and DC Plans - 401(k) Plans - Social Security Integration

What are the steps in determining the Keogh deduction?

- Determine net income from Schedule C income, - Subtract one-half of the actual amount of the self-employment tax, and - Multiply the result by the net contribution rate calculated by: Plan Contribution Rate / 1 + Plan Contribution rate

There are three principal types of defined contribution plan formulas, what are they?

- Money purchase plan - Target benefit plan - Profit sharing plan

Maximizing employees' performance is a significant objective for employers. To maximize employee performance, the following plans can be considered:

- Profit sharing plans - ESOP/Stock bonus plan - DC or cash balance

Which statement is true concerning incidental safe harbor rules for death benefits in retirement plans? 1. They apply to qualified plans (defined contribution and defined benefit) and 403(b) plans. 2. They do not apply to SEPs; therefore, there is no limit to the amount of life insurance that can be held by a SEP.

1 The incidental rules for death benefits do not apply to SEPs (and SIMPLEs). However, the reason they do not apply is that SEPs (and SIMPLEs) cannot have life insurance. They are IRAs.

Which of the following statements are true regarding defined benefit plans? 1. a defined benefit plan makes it relatively easy to design a window plan to encourage early retirement 2. defined benefit plans are not subject to minimum funding rules 3. defined benefit plans do not allow companies to encourage early retirement by subsidizing benefits 4. a defined benefit plan can be designed to allow full benefits to accrue after a specified period with no further benefits accruing thereafter

1 & 4 A defined benefit plan can be designed to allow full benefits to accrue after a specified period with no further benefits accruing thereafter. In addition, a defined benefit plan makes it relatively easy to design a window plan to encourage early retirement

Which of the following are characteristics of employees who value immediate cash? 1. Short-term employees 2. Younger employees 3. Highly compensated employees 4. Long-term employees

1, 2 Employees who value immediate cash are usually younger employees who do not expect to stay with the employer long. In addition, they are often lower-paid employees as well

You are interested in working in the 403(b) market. Which of the following entities is eligible to do a 403(b) plan? 1. Private universities 2. Non-profit hospital 3. State of Florida 4. Church 5. Public school

1, 2, 4, 5 The State of Florida employees would be eligible for a 457 plan.

Sonia Appletree owns an upscale gift shop. Business varies so much that she cannot hire full-time employees and provide benefits. She has decided to limit the number of full time to two employees and the remainder of her employee needs can be met by numerous prior employees who only want to work part-time (500 hours per year at most). What kind of benefits could she offer to the full-time employees that would exclude the part-time employees. 1. Profit sharing plan 2. SEP 3. Group health insurance 4. SIMPLE 401(k)

1, 3, 4 Profit sharing and SIMPLE 401(k) are ERISA plans (1,000 hours per year requirement). Group health normally requires 30 hours per week. The SEP only requires the 3 year rule which many of the part-time employees may already qualify for.

Which of the following are ways savings are encouraged through the tax system? 1. deferral on tax savings accounts 2. tax free accumulation of interest on corporate bonds 3. deferral of tax on capital gains until realized 4. potential exclusion of a base amount of the capital gain of the sale of residence 5. deferral of tax and other benefits for qualified retirement and tax advantaged plans

3, 4, 5

Who benefits when the plan contribution formula is based on an employee's years of service? 1. Part-time employees 2. Contractors 3. Owners 4. Seasonal Employees 5. Key employees

3, 5 Plan contributions base don an employee's years of service generally benefit the owners and key employees who typically have longer service

For a given set of actuarial assumptions, there is a crossover age at which the defined benefit plan is more favorable to adopt. The crossover age is somewhere between ______ and ____ approximately, depending on the actuarial method and assumptions used in the defined benefit plan.

45 and 50

What is the longest waiting period permitted for full vesting for matching employer contributions?

6 years Under current law, the longest wait permitted for full vesting of matching employer contributions is six years under the graduated two to six year vesting schedule

Larry Jones, self-employed, wants to start a retirement plan. His Schedule C net income is usually $200,000. He is 45 years old and has no employees. What do you suggest? a. SEP b. Keogh defined benefit plan c. Keogh profit sharing plan d. SIMPLE

A The Keogh profit sharing plan is subject to all The ERISA filings and requirements. The Keogh DB does not fit for his income or age. The SEP has the same contribution limits (18.59%) (see page 5-8), but is simple to install. He could contribute $37,180. The SIMPLE is a combination of deferral $13,000 plus 3% of salary $6,000 for a total of $19,000. For simplicity and contribution limits, SEP is the best answer.

Which retirement plan is best for a woman who is a consultant (self-employed) and makes $150,000? She wants to put away 10%. a. SEP b. IRA c. Roth IRA d. Keogh

A The SEP allows for up to 18.59% (self-employed). It is simple. A Keogh answer by itself isn't enough of an answer. It should say Keogh DB, MP or PS.

Matt Williams owns MT, Inc. Matt has had a SEP for himself and his employees for years. Matt is turning 70 early next year. A financial advisor told him he should stop the SEP. The financial advisor said he should start a profit sharing plan. Then he would not have to take required minimum distributions on any of the money until he retires. Matt is seriously considering that. What would you respond? a. He cannot move the SEP money to the profit sharing plan. b. He can wait until he is 70½ to take required minimum distributions. c. He will have to take required minimum distributions next year, but can delay them until April 1st of the following year. d. The financial advisor is correct.

A Unfortunately he is a greater than 5% owner. He will be both 70 and 70½ this year. Although "He can wait until he is 70½ to take required minimum distributions." is a correct answer, he will be both 70 and 70½ next year. "He cannot move the SEP money to the profit sharing plan." is false. The funds could have been moved.

Bill Richblood owns Richblood, Inc. For years, although very profitable, Bill has resisted doing a retirement plan because of all the paperwork and mandatory employer contributions. But employees are leaving to work for competitors and he feels he has to offer some kind of retirement plan to retain key employees. He has consulted various financial planners and he wants to know which one has the best advice? a. #1 FP - do a SEP because it can be integrated with Social Security. This means a bigger percentage of the company contribution will go to Bill. In addition, the plan is simple to install. b. #4 FP - do a cash-less ESOP because the company can contribute stock rather than cash. c. #2 FP - do a defined benefit plan because the largest contribution will go to Bill. d. #3 FP - do a SIMPLE because of small mandatory employer Contributions.

A You should be able to eliminate two answers right away. A defined benefit plan is not simple and can require large mandatory contributions. An ESOP means Bill has to share stock with his employees. There is no indication he is will do so. With a SEP there is no mandatory contributions and it is simple to install. There is no indication that the employees would want to contribute to a SIMPLE and employer contributions are very limited (3%). The SEP will allow for higher employer contribution. Debatable question/answer.

Window Plan

A window plan provides additional retirement benefits, often in the form of deemed additional years of service that provide additional benefit accruals. These benefits are available to specified employees who retire early during a specified window period. Window arrangements are also possible with defined contribution plans, but they generally can take the form only of additional cash bonuses or severance pay. Defined benefit plans are much more flexible in this regard.

How can qualified plans discourage unionizing?

An attractive retirement package that is as good as or better than labor-union-sponsored plans in the area, can help to keep employees from organizing into a collective bargaining unit. Collective bargaining often poses major business problems for some employers.

Apex, Inc. wants to reward its employees but does not have cash to contribute for year-end 2019. The company feels it will be in a very profitable position during the year 2020. What would you suggest Apex do? a. Adopt a profit-sharing plan and, in lieu of a cash contribution, give the plan a promissory note. b. Adopt a profit-sharing plan and borrow the necessary contribution from a bank. c. Adopt an ESOP and fund the contribution with company stock. d. Do not start the plan until 2020

B This option allows Apex to put money in the plan now and get a tax deduction now. Adopting an ESOP and fund the contribution with company stock is a good answer, but there is no indication in the question that Apex is interested in using company stock. This is the best answer.

Which of the following plans does not provide the same maximum deferral limit (disregard allowable catch-up)? a. Profit sharing 401(k) b. SARSEP c. SIMPLE 401(k) d. Stock bonus 401(k)

C The deferral limit for all answers except the SIMPLE 401(k) is $19,000 (2019) plus applicable catch-up ($6,000 for age 50). A SIMPLE 401(k) has a deferral limit of $13,000 (2019) plus applicable catch-up ($3,000 for age 50).

Part of the process of implementing a 401(k) plan is to "sell" the plan to the employees. A. True B. False

Correct Answer: A. True Explanation: Part of the process of implementing a 401(k) is to "sell" the plan to the employees so that all employees, including highly compensated employees, can fully benefit from the plan. If the nonhighly compensated employees are not participating, it limits the amount of participation of highly compensated employees.

A qualified plan receives tax benefits that are not available for a nonqualified deferred compensation plan. Which of the following is NOT one of the tax features of a qualified plan? A. Vested employees are taxed on employer contributions in the year contributions are made to the plan. B. Employer contributions are deductible by the employer in the year paid. C. The plan itself is a tax-exempt fund. D. Earnings on plan investments accumulate tax-free to both the employee and the employer.

Correct Answer: A. Vested employees are taxed on employer contributions in the year contributions are made to the plan. Explanation: Vested employees do not pay tax on the employer contributions until they are withdrawn from the plan.

Each type of qualified plan meets certain employer objectives better than others. Which of the following is NOT an accurate description of plan features that meet specific objectives? A. The savings account feature of defined contribution plans is more popular with younger employees. B. A defined benefit plan works well to encourage retirement. C. A defined contribution plan is most likely to meet the objective of assuring adequate retirement income. D. An ESOP or profit sharing plan will tend to create an incentive for employees to maximize performance.

Correct Answer: C. A defined contribution plan is most likely to meet the objective of assuring adequate retirement income. Explanation: The savings account feature of defined contribution plans attracts younger employers. A defined benefits plan will work well to encourage retirement. It may not meet the objective of assuring adequate income. An ESOP or profit sharing plan tries to create an incentive for employees to maximize performance.

Even if the earned income is not used for consumption, the federal income tax system imposes tax on income from savings. What are the three major exceptions when taxes can be avoided? 1. Unrealized capital gains 2. Capital gains on sale of personal residence 3. Tax deferral for qualified retirement plans and IRAs 4. Interest on Savings

Correct Answers: 1, 2, 3 Explanation: The federal income tax system imposes tax on income from savings even if it is not used for consumption, with only three major exceptions: deferral of tax on capital gains until realized, exclusion of gain on the sale of a personal residence, and deferral of tax and other benefits for qualified retirement plans and IRAs.

ABC, Inc. is an accrual based firm. At year end (Christmas) they sell a lot of inventory. The concern is that although they "book" a lot of sales, they may not get the cash until sometime next year. They always have problems funding the company's existing profit sharing plan. What should the company do if the company is reasonably profitable (39%)? a. Change their accounting method to cash from accrual. b. Let the year go by and pay the corporate taxes due. c. File the corporate tax form showing an amount owed to the profit sharing plan as a deduction. d. If they cannot fund the plan by their tax filing date, borrow the necessary funds from a bank if they want to fund the plan.

D The company cannot change into a cash type accounting system. They can let the year go by and pay the corporate taxes due, but why not save on 39% taxes? Filing the corporate tax form showing an amount owed to the profit sharing plan as a deduction is not allowed, the cash must be contributed to the plan.

In what situation can a 401(k) plans be favorable to highly compensated employees?

when there is maximum participation by the nonhighly compensated employees, this allows for highly compensated employees to maximize their contribution levels