Qualified Plans

Quiz

Question 1 Brian earned $100,000 this year and contributed $10,000 to his 401(k) plan account. His employer contributed an additional $2,000 on his behalf. All the following statements regarding this are correct, EXCEPT Brian's contributions to his 401(k) plan account are made with pre-tax dollars. Brian's taxable income will be reduced by the amount he contributed to his 401(k) plan account. Brian will not be taxed this year on the amount that his employer contributed to his account. -Brian's taxable income will be reduced by the amount that both he and his employer contributed to his 401(k) plan account. Because Brian's contributions to his 401(k) plan account are made with pre-tax dollars, his taxable income will be reduced by the amount he contributed. Question 2 With regard to qualified plans, the term "vesting" refers to which of the following points? No further contributions need to be made on behalf of a plan participant. -A plan participant achieves a nonforfeitable right to employer contributions made on his or her behalf. A plan participant's accrued benefit must be paid out. A plan participant can take distributions from the plan without penalty. Vesting does not refer to the time at which no further contributions need to be made on behalf of a plan participant. Question 3 Emily, age 48, withdrew $8,000 from her SIMPLE plan to buy a car. How much penalty tax will she owe? $0 $4000 -$800 $1600 Because Emily's withdrawal does not fall within any exceptions to the 10 percent premature distribution penalty tax, she will have to pay a penalty of $800. She will also owe regular income tax on the withdrawal. Question 4 All of the following distributions from a qualified plan are exempt from the 10 percent penalty tax on premature distributions, EXCEPT Distributions made because the participant dies. Distributions made because the participant has medical expenses that exceed 10 percent of his or her adjusted gross income. Distributions made because the participant becomes disabled. -Distributions made because the participant needs the funds to pay for homeowners insurance premiums. A distribution taken to pay homeowners insurance premiums would be subject to the 10 percent penalty tax on premature distributions, if taken before age 59 1/2. uestion 1 Which statement regarding defined contribution qualified plans is NOT correct? -The retirement benefit from defined contribution plans typically does not include contributions from the participant. The retirement benefit, when paid, is usually fully taxable. Participants can choose to receive the benefit at retirement as annuitized income. Participants can choose to receive the benefit at retirement as a lump-sum payment. When the retirement benefits from defined contribution plans are paid out, they are usually fully taxable. Question 2 Cindy, age 51, withdraws $15,000 from her 401(k) plan so that she can buy a new boat. All the following statements regarding this are correct, EXCEPT: Cindy may be pushed into a higher tax bracket due to the distribution. -Cindy can avoid taxation if she can demonstrate to the IRS that the boat was essential to her financial well-being. Cindy must pay tax on the distribution when she takes it. The distribution will be subject to a 10 percent premature distribution penalty. While there are several hardship rules that help to avoid penalty taxes, ordinary taxes cannot be avoided (nor would this qualify as a hardship purchase). Question 3 By offering tax incentives, the federal government encourages employees to participate in qualified retirement plans. Which of the following is NOT one of these incentives? The employee does not have to currently pay income tax on earnings that build within a qualified plan. -Benefits are taxed only if withdrawn at retirement. Employee contributions are made with pre-tax dollars. Employer contributions are not taxable to the employee when made. Employer contributions to a qualified retirement plan on behalf of an employee-participant are not taxable to the employee when they are made. Benefits are taxed only when they are withdrawn or otherwise distributed from the plan to the employee. Question 4 Which of the following statements is correct about earnings building within an individual's qualified plan account? The employee-participant must pay state income tax on the earnings. -The employee-participant pays no income tax on the earnings until they are withdrawn. The employee-participant must pay federal and state income tax on the earnings. The employee-participant must pay federal income tax on the earnings. Earnings that accumulate in qualified plans are exempt from income tax. Benefits are taxed only when they are withdrawn or otherwise distributed from the plan to the employee.

Tax Incentives Encourage Qualified Plans

By offering tax incentives, the federal government encourages employers to set up qualified retirement plans for the benefit of their employees. Tax incentives are also provided to employees to participate in such plans. These tax incentives include the following: -A business can deduct the contributions it makes to a qualified plan as a business expense. -The earnings that build within a qualified plan are exempt from income tax until distributed. -Employer contributions to the plan on behalf of the employee-participants are not taxable to the employees when they are made. -Employee contributions to the plan are made with pre-tax dollars. That is, they are made directly into the plan before income taxes are assessed. This lowers the employee's taxable income. Benefits are taxed only when they are withdrawn or otherwise distributed from the plan to the employee.

Qualified Plan Distributions

The purpose of a qualified plan is to provide funds for an employee's retirement. Accordingly, tax laws strictly control how and when these funds can be accessed. They also control how they will be taxed. An important point is that funds that are not taxed when contributed are taxed when distributed. As noted, defined benefit pension plans typically pay their benefit in the form of monthly annuitized income payments. These payments begin when the participant reaches the age of retirement as specified in the plan (typically, age 65 or the Social Security full retirement age). At that point, the income payable to the plan participant is generally fully taxed. The main exception to that general rule is if the employee made any nondeductible contributions to the plan. Defined contribution plans allow participants to choose how to receive their benefit. Participants can choose to receive the benefit as a lump-sum payment or as annuitized income. The benefits from these types of plans are likely to include contributions the participant makes, which were previously not taxed. As such, the retirement benefit, when paid out, is usually fully taxable.

Required Minimum Distributions

The tax laws that apply to qualified employer plans are such that a plan cannot be used to endlessly shelter funds from tax. Distributions from a qualified employer plan must begin no later than April 1 of the year following the year the participant turns 70½ or upon retirement, whichever is later. These distributions must also be taken yearly in no less than minimum amounts prescribed by the tax laws. Fittingly, these distributions are known as required minimum distributions, or RMDs. Failure to take an RMD results in one of the stiffest penalties the IRS imposes. This penalty is 50 percent of the difference between the amount that was taken and the amount that should have been taken.

Overview

Retirement plans can be broadly categorized as either qualified or nonqualified. Qualified plans are those retirement plans that qualify for special federal income tax treatment. Nonqualified plans do not receive such favorable tax treatment. (A deferred compensation agreement for a key employee is an example of a nonqualified plan.) Qualified retirement plans are available for the following: -employers for the benefit of their employees -individuals -self-employed people This unit presents the various qualified plans that are available to businesses and to people. While its primary focus is on qualified plans for retirement, it also reviews plans that people can use to fund college tuition on a tax-favored basis.

Key Points

-To be deemed a qualified retirement plan (and thus eligible for favorable income tax treatment), a plan must adhere to the requirements of the Employee Retirement Income Security Act of 1974 (ERISA). -Employers are not restricted by ERISA's nondiscrimination rules when nonqualified plans are involved; they can pick and choose the employees to whom they offer these plans. -Distributions from a qualified employer plan must begin no later than April 1 of the year following the year the participant turns 70½ or upon retirement, whichever is later.

Distributions Before Age 59½

Qualified employer plans to which an employee contributes (such as a 401(k), 403(b), or SIMPLE plans) provide for immediate vesting of employee contributions. They also provide a vesting schedule for any employer contributions. To this extent, an employee controls the amounts in which he or she has vested. The employee can normally access vested amounts at any time. When taken, qualified plan funds are taxed. And if taken before the employee's age 59½, they may also be subject to a 10 percent tax penalty. For example, 47-year-old Linda has a 401(k) account with her employer. This account has accumulated to $75,000. She is fully vested in the account and decides to take a $20,000 distribution. Because the amounts that were directed into the 401(k) plan were never taxed, the $20,000, when withdrawn, is taxable to Linda. In addition, she will owe a tax penalty of $2,000. The tax laws do provide exceptions to the 10 percent premature distribution penalty. If a distribution is taken from a qualified plan before age 59½ for any of the following reasons, it is taxed but not penalized: -The participant dies. -The participant becomes disabled. -The participant has medical expenses that exceed 10 percent of his or her adjusted gross income. -The participant takes the distribution in substantially equal periodic payments over his or her life. If the plan is a SEP or SIMPLE plan, pre-59½ distributions can be taken without penalty for the previous reasons as well as -for a first-time home purchase; -to pay for qualifying higher education expenses; and -to pay health insurance premiums while unemployed.

Plan Qualification Requirements

For an employer plan to be deemed qualified and to receive favorable tax treatment, it must meet very specific standards and requirements. These requirements were designed to ensure that the plan is set up, maintained, and operated for the benefit of the employee-participant. They also ensure that the employee's rights in and to the plan are protected. Though it is beyond the scope of this course to provide an in-depth look at these requirements, basic ERISA-mandated plan qualification requirements include: -The plan must be in writing and communicated to employees. -The employer must set up the plan for the sole benefit of the employees. -The employer, the employees, or both must make contributions consistently to the plan. -The plan cannot discriminate in coverage (that is, the employer cannot set up the plan mainly for the benefit of key employees or the business owners). -The plan must comply with set limits on contributions and benefits. -The plan must meet minimum funding levels. The plan must provide for comprehensive vesting schedules. (That is, the plan must provide a way for employee-participants to achieve full rights to the contributions the employer makes on their behalf. The same applies for the benefits that accrue to the employee-participants over time.)

Vesting Schedules

Generally speaking, there are two common vesting schedules that conform to IRS requirements: -cliff vesting -graded vesting Under a cliff vesting schedule, the participant is 0 percent vested in a plan's contributions or benefits for the first four years of participation. Then, in the fifth year, he or she is 100 percent vested. Year of Participation Vested Percentage 1yr 0% 2yr 0% 3yr 0% 4yr 0% 5yr 100% If the plan includes employer-matching contributions (as is common with 401(k) plans), cliff vesting is reduced to a three-year schedule. In other words, a participant is 0 percent vested in the employer's matching contributions for the first two years of participation. He or she becomes 100 percent vested in the third year. Year of Participation Vested Percentage 1yr 0% 2yr 0% 3 yr 100% Under a graded vesting schedule, the participant gradually becomes vested over the first seven years of participation, as shown in the table. Year of Participation Vested Percentage 1yr 0% 2yr 0% 3yr 20% 4yr 40% 5yr 60% 6yr 80% 7yr 100% Under a plan that provides for matching employer contributions, a graded vesting schedule is reduced to six years: at the end of the second year, the employee is 20 percent vested and then vests in 20 percent increments over the next few years, becoming 100 percent vested in six years. Year of Participation Vested Percentage 1yr 0% 2yr 20% 3yr 40% 4yr 60% 5yr 80% 6yr 100% A plan that provides for employee contributions, such as a 401(k) plan, cannot impose a vesting schedule on employee contributions. At all times, an employee is fully vested in amounts he or she contributed or deferred into the plan.

Qualified vs. Nonqualified Employer Retirement Plans

To be deemed a qualified retirement plan (and thus eligible for favorable income tax treatment), a plan must adhere to the requirements of the Employee Retirement Income Security Act of 1974 (ERISA). ERISA protects the rights of employees covered under an employer-sponsored plan by stipulating minimum participation and funding requirements. It is explained more fully later in this lesson. A retirement plan that does not meet ERISA's requirements does not qualify for favorable tax treatment. Under a nonqualified employer retirement plan, an employer cannot deduct as a business expense its contributions to the plan. Also, funds that the employer contributes to a nonqualified plan may be taxed as income to the employees in the year in which the funds are contributed. Though lacking the tax benefits of a qualified plan, nonqualified plans (e.g., deferred compensation plans) remain popular with key executives. Employers are not restricted by ERISA's nondiscrimination rules when nonqualified plans are involved; they can pick and choose the employees to whom they offer these plans.