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Material current through July 2020 exam cycle

Copyright © 2020 Brett Danko, LLC, USA - All rights reserved . Retirement Planning

Retirement Planning Table of Contents Lesson 1 Retirement needs analysis – HP calculations

– Assumptions for retirement planning – Financial needs

Lesson 2 Social Security / (Old Age, Survivor, and Disability Insurance OASDI) – Participation / Eligibility / Working after retirement Lesson 3 Types of retirement plans – Money purchase / target benefit / Profit-sharing / 401(k) / Stock bonus / ESOP – New comparability plan – Defined benefit / Cash balance / 412(i) Lesson 4 Qualified plan rules and options – Age and service / Coverage requirement/ HCEs / Vesting schedules

– ADP/ACP testing / controlled groups – Integration with Social Security for DB and DC plans

Lesson 5 Qualified plans rules and options – Deduction limits – Definition of compensation / Multiple plans – effective deferrals – Special rules for self-employed – Top heavy plans – key employees – Loans Lesson 6 Other tax-advantaged retirement plans – Traditional IRA / Roth IRA Lesson 7 Other tax-advantaged retirement plans – SEP / SARSEP – SIMPLE / SIMPLE 401(k) – 403(b) / 457 plan / Keogh Lesson 8 Regulatory considerations / Key factors affecting plan selection for business / Investment

considerations for retirement plans – ERISA – Investment consideration for retirement plans / Investment suitability Lesson 9 Distribution rules, alternatives, and taxation – Premature distribution / Hardships / QP penalties / Exceptions – Substantially equal payments – Lump sum distributions / Rollovers / required minimum distributions – Qualified domestic relations order (QDRO) – Net unrealized appreciation (NUA) Lesson 10 Employee stock options/ Stock Plans / Nonqualified deferred compensation – Unfunded / Section 162 / Rabbi trust / Secular trust – Constructive receipt / Substantially risk of forfeiture – Funded plans / Employee stock options/ Code section 83 and 83(b)


Copyright © 2020 Brett Danko, LLC, USA - All rights reserved Retirement 1-1

Retirement needs analysis Lesson 1 Retirement needs analysis Practical usage of the calculator in working with a client – retirement Retirement example How much does the client need in retirement funds to maintain his/her lifestyle considering inflation? 1st Inflate the annual need in today’s dollars to the first year of retirement (point R). 2nd Determine what lump sum is needed at the beginning of retirement (point R) to fund the presumed years of retirement (with inflation adjustment.) There are two distinct steps: Step 1.

Yearly income today Income needed for the $50,000 PV 20 years first year of retirement X-----------------------------------------------------------------------------X Solve for FV Inflation 4% Point R $109,556 Step 2.

Lump-sum needed at the beginning of the first year of retirement $109,556 PMT 25 years X------------------------------------------------------------------------------X (Death) Point R After tax return 8%, inflation 4% (3.8462%*) Solve for PV $1,806,577 Now, let's look at the second calculation. *Real Return (2nd step of retirement calculation) When the question expresses the annual retirement income need in "today's dollars," the

following formula must be used. It is the “inflation-adjusted” interest rate or “real rate of return.”

Inflation-adjusted = 1 - return x10011 inflation rate

after tax+ − + = 1.08 1x100 3.846%

1.04− =

10BII 12C 17BII+ 1.08, :, 1.04, -, 1, 1.08, enter, 1.04, : 1.08, :, 1.04, -, 1, x, 100, =, I/YR 1, -, 100, x, i x, 100 =, I%YR Solution: 3.8462% Examples If the client can earn a 9% after-tax investment return and inflation is 3%, what is the inflation-

adjusted interest rate? NOTE: Set the calculator for 4 decimal places. 10BII 12C 17BII+ 1.09, :, 1.03, -, 1, 1.09, enter, 1.03, : 1.09, :, 1.03, -, 1, x, 100, =, I/YR 1, -, 100, x, i x, 100 =, I%YR Solution: 5.8252



A client wants to receive the equivalent of $10,000 in "today's dollars" at the beginning of each year for the next 4 years. If he can earn 8% after tax on investments, how much must be invested today to fund this need if inflation is 5%? 10BII 12C 17BII+ 1.08, :, 1.05, -, 1 1.08, enter, 1.05, : 1.08, :, 1.05, -, 1 x, 100, =, I/YR 1, -, 100, x, i x, 100, =, I%YR 10,000, PMT 10,000, PMT 10,000, PMT 4, n 4, n 4, n Solve for: PV PV PV Correct solution: $38,363.98 (begin mode) / Incorrect solution: $37,298.32 (end mode) NOTE: Do not net the two returns. Doing so will produce a rate that supports a wrong answer on

the CFP® Exam. . Mini Case Milton Middleclass is age 51 and married. Milton and his wife Lynn (also age 51) expect to retire in 14 years at age 65. Due to unusual longevity in both families, either Milton or Lynn expects to live to at least age 95 (30 years) after retiring. They assume there will be no reduction in retirement needs after the death of one spouse. With the help of their financial planner, they determined that their annual retirement income need in today's dollars is $80,000. They feel confident that they can earn 6% after-tax on their investments and would like to assume that inflation will average 4% over the long term. 1. What amount will the Middleclass’ need at the beginning of the retirement period (age 65) to fund annual income that increases annually with inflation? A. $2,755,232 (+ $10) C. $3,135,730 (+ $10) B. $3,045,190 (+ $10) D. $3,196,045 (+ $10)

Answer: D The retirement need is $80,000 annually in today's dollars. 1st Inflate today's annual need to the first year of retirement (FV). $80,000 CHS PV, 4 i, 14 n = $138,534.11 FV (inflation only) 2nd Then, find the lump sum need at 65 to fund the 30 years of retirement factoring inflation. Inflation adjusted interest rate. 3rd The following shows the calculation time line in begin mode. NOTE: Answer C is incorrect because it used end mode. Retirement benefits are always

in begin mode unless the exam says to use end. age 51 14 years age 65 30 years 80,000 PV 4 i FV = $138,534 PMT [(1.06/1.04) – 1] x 100 = i (Begin Mode) (1.06 : 1.04 adjustment) i, $138,534 PMT, 30 n = $3,196,045 PV



2. Milton and Lynn review your figures and tell you that they feel they need at least $3,200,000 to feel comfortable. They now presume that their assets will grow to a value of $1,900,000 at the first year of retirement. What additional amouny must they set aside by the end of each year to meet their retirement goal?

A. $58,359 (+ $10) C. $80,259 (+ $10) B. $61,861 (+ $10) D. $81,802 (+ $10) Answer: B End mode $1,300,000 FV, 6 i, 14 n = $61,861 PMT

NOTE: Both the $3.2 million and $1.9 million have already factored inflation into the large future values. Simply solve for a payment based on future value of the difference (shortfall).

Applying the Facts 1. Toby Adams has determined that he needs to accumulate $350,000

by the time he retires in 12 years. He plans to start a level savings program making payments at the beginning of each month. He estimates his pension plan will have accumulated $150,000 in 12 years. He is a fairly aggressive investor and anticipates that he will earn an average 11% after-tax return and that inflation will average 5%. What amount of monthly payments should he make?

A. $668 C. $1,557 B. $901 D. $1,587

Answer: A Because the question never says in "today's dollars," inflation is not a factor in the calculation.

Begin mode 10BII/17BII+ 12 P/YR, $200,000 FV, 11 I/YR, 12 gold xP/YR, PMT = $667.66

12C $200,000 FV, 11 enter 12 ÷ i, 12 enter 12 x n, PMT = $667.66

2. Joe works at the local PM plant. He is 55 and plans to retire at age 65. He has been a union member but is about to accept a management position. He wants to retire on $2,000 per month (begin). The union estimates that his benefits will be $1,000 per month starting at age 65. PM provides a 401(k) with no company matching contribution. How much does Joe need to contribute to PM's 401(k) at the end of each month assuming a 10% return and presuming that he will live to age 95? [Joe has not started contributing to the 401(k).]

A. $561 B. $677 C. $771 D. $1,177

Answer: A First calculate the amount needed at 65 to pay $1,000 per month (begin). Why the beginning

mode? A retiree can’t wait until year end for benefits.

10BII/17BII+ (Begin) 12 P/YR, $1,000 PMT, 10 I/YR, 30 gold xP/YR, PV = $114,900 Then discount that value back to age 55. (End) $114,900 FV, 10 I/YR, 10 gold xP/YR,



PMT = $561 12C (Begin) $1,000 PMT, 10 enter 12 ÷ i, 30 enter 12 x n, PV = $114,900 Then discount that value back to age 55. (End) $114,900 FV, 10 enter 12 ÷ i, 10 enter 12 x n, PMT = $561

A. Assumptions for retirement planning 1) Inflation Inflation affects different people in different ways. The rate of personal inflation will vary from the actual "real" rate of inflation due to personal inflow and outflow factors.

Also, in the pre-retirement years, the employee's salary may not keep up with inflation. Retirees may be subject to more inflation concerns than younger wage earners because: – Medical insurance costs and expenses have been growing at a higher percentage than goods. – Retirees generally have a greater need for services, such as home maintenance. 2) Retirement period and life expectancy The expected starting date for retirement affects the amount of the lump-sum need at the

beginning of the period. This is compounded by the presumed longevity of the retiree and spouse, if married. In addition, persons in poor health may have to retire earlier. When a person needs to retire early combined with lengthening life expectancy, the retirement period can be 30-40 years or more. If the retiree is married, the average number of years until the second death of two persons is generally longer than the joint life expectancy the table shows. To compensate for underestimating the retirement period, a financial planner should add 5-10 years to the estimated life expectancy.

3) Lifestyle The key to successful planning is to accurately estimate the lifestyle and expenses of the

client in the retirement years. While some clients spend less in the post-retirement years, not all do. For example, healthy, young retirees many spend more on travel and hobbies. Using a guideline income ratio like 75% of current income needs may be reasonable. The client's retirement needs should be determined by thorough thoughtful analysis. This should be monitored periodically to reflect changes in goals and objectives. Many factors should be considered including:

– Where the client will live during retirement (metro area vs. small town) – Limited versus extensive travel – Long-term care (insured or out-of-pocket) – Full retirement or part-time work in the retirement years – Extra care for persons in poor health who retire early – Special needs for other family members 4) Total return The return assumption should be consistent with the client's risk tolerance. Most retirees prefer low-risk investments in their retirement years. These investments generally

produce relatively low returns. With a low returns and high inflation, it is possible to have zero or negative total "real" return.



B. Income sources Income sources that could be available to support the client's retirement needs include: – reverse mortgage on the family home – current investments – current retirement savings – future savings – Social Security benefits – potential inheritances – equity from sale of home if client rents rather than owns – downsizing Applying the Concept With regard to retirement planning versus estate planning, which of the following is true? A. To many clients retirement planning plays a secondary role to estate planning. B. When considering a surviving spouse, retirement planning must account for payment of estate taxes at the retiree's death. C. A gift at death of the remaining retirement assets to a charitable organization will be income and estate tax-free. D. Retirement assets are only subject to income taxes but not

estate taxes. They cannot be double taxed. E. The primary goal of retirement planning is to distribute assets whereas the primary goal of estate planning is to accumulate assets. Answer: C A gift of retirement account balances at death to a

charity has no exposure to either estate or income tax. Estate planning, wealth accumulation, and tax reduction normally play a secondary role to retirement planning. Due to the unlimited marital estate tax deduction, there is no estate tax at the death of the retiree when survived by a spouse. Retirement assets that are not transferred to charity(s) are subject to income tax and can be subject to estate taxes.

C. Financial needs 1) Living costs Factors beyond the retiree's lifestyle may affect retirement planning. 2) Charitable and beneficiary gifting objectives Retirement planning involves accumulation of wealth that likely will be expended during

the retirement years. If there is no surviving spouse and the accumulated wealth remains at the retiree's death qualified retirement plan benefits and IRAs paid to a charitable organization upon a retiree's death are not subject to income tax because the charitable beneficiary is exempt from tax.

3) Medical costs, including long-term need analysis One solution, other than buying effective health insurance and a LTC insurance, is to sell the personal residence and buy into a life-care community.



D. Straight-line returns vs. probability analysis During the long-term accumulation period, the planner must recognize the client's investment risk tolerance. Planning can be based on straight-line projections, such as 6% for all the years until retirement. It also could be based on probability analysis (Monte Carlo) to project future accumulations.

E. Pure annuity vs. capital preservation

An annuity payout means that a retiree's accrued benefits are distributed under one of the various annuity options. One option is a pure life (straight life) annuity. Life annuities

are normally used in defined benefit plan distributions. A pure life annuity provides the highest payout to the retiree for his or her lifetime but no benefits for the spouse. Payments stop when the retiree dies. If there is a need to provide retirement income to a spouse or other dependent, a joint and survivor annuity provides continuation of retirement income to other family members. Taking a lump sum distribution from an employer’s plan and rolling it into an IRA, can provide for not only the retiree but also other family members.

F. Alternatives to compensate for projected cash-flow shortfalls

The retirement planning process requires periodic monitoring. Some ways to address shortfalls include the following:

– saving more in each preretirement year – increasing investment risks to achieve higher returns – retiring later than expected or working part-time in the early retirement years

G. Pension maximization application Kyle, an engineer with Technosphere, Inc. plans to retire at age 65. He is a participant in the employer’s pension plan with only annuity payout options (no lump sum). Kyle asks the employee benefits department for his retirement payment options.

Kyle, age 65 -$5,000 per month pure life annuity Kyle, age 65, and his wife, age 50 -$3,375 per month joint and survivor annuity

The “pension max” application of a pure life annuity consists of electing a single life annuity (pure life) on Kyle and using part of the higher monthly benefit ($5,000) to purchase life insurance on Kyle. The life insurance death benefit can provide annuity benefits to Kyle’s wife if he predeceases her.



Applying the Facts 1. Jake, age 55, plans to retire in 10 years. He plans to convert

all of his retirement accounts to cash at that time. He has the following accounts.

$2,000,000 in profit sharing plan (currently 60% vested) $ 500,000 in a deductible traditional IRA $1,000,000 in a non-qualified variable annuity originally

purchased for $500,000 Presuming Jake can earn 5% on these accounts and he will be in a

50% combined federal, state, and local income tax brackets, what amount will he realize after paying the taxes? A. $2,340,508 C. $3,100,566 B. $2,600,566 D. $2,199,008

Answer: C 3,500,000 PV, 5i, 10n = $5,701,131 FV [$5,701,131 – 500,000*(basis)] x 50% = $2,600,566 $2,600,566 + $500,000* = $3,100,566

*Why subtract and then add back the $500,000? The annuity ($500,000) was purchased with after-tax dollars.

2. Larry and Roberta Young have been told that using a straight-

line calculation they will have to save $20,000 per year to meet their retirement income goal. Between paying off college debt, raising two children, and normal expenses, their budget indicates they can only save $10,000 today. However, they feel they can bring their college debt down and their employment earnings are increasing. What do you suggest they do?

I. Save the $10,000 and not worry about the projection II. Find another financial planner who can calculate a serial

payment III. Work more years before they retire IV. Increase the projected after-tax return of the projection

A. I C. III, IV B. II, III D. IV

Answer: B With a serial payment, the amount of savings increases each year based on an inflation projection. A serial payment would start smaller today*. Statement IV indicates an unrealistic assumption.

*For example, $10,000 today could be $10,800 next year then

$11,664 the 3rd year which means they will save 8% more each year. No calculation, concept question only.



3. Dan Morris works as an engineer for EEE, Inc. Five years ago, Dan divorced his wife. Under the divorce decree, she was awarded half of his pension. At age 55, Dan then married Lucy, age 45. Dan would like to retire in 5 years taking early Social Security retirement benefits. EEE, Inc. has a money purchase plan. Dan had to name Lucy as the beneficiary of his pension. Because of her age (10 years younger), his divorce, and market conditions, the projected joint and survivor annuity at age 64 will only be $4,000 per month. What should Dan do if he wants to retire in 5 years?

A. Work overtime or take a second job B. Work until to his Social Security full retirement age (FRA) C. Explore a pension max strategy D. Divorce Lucy

Answer: C With pension maximization, the pension payout can

be based on Dan’s life expectancy alone. Lucy, who is 10 years younger and female, is reducing the amount of the joint life payout. pulling the payout down. Answer C is only permitted if Lucy signs a consent to waive her rights. He also has to be insurable and take a policy out to cover her future needs.

NOTE: He is 59 now and in 5 years he will be 64. His NRA is age 67. This would increase his pension payout and Social Security payment.

4. Horace Jones consulted with a financial planner for a projection

based on a reasonable return but an exceptionally long retirement period. He also wants to leave a substantial legacy for his grandchildren when he dies. His concern is that both he and his wife have had family members who lived well beyond normal life expectancies. The result factoring inflation is a lump-sum dollar amount at normal retirement age that is way beyond what Horace can save annually. The financial planner showed Horace both level savings and a serial payment (increased savings each year) approach but neither could reach Horace’s goals. What else should the financial planner suggest?

A. Horace should invest more aggressively to achieve a higher rated return. B. Horace should plant to retirement at an older age. C. Horace should take a second job D. At retirement, Horace should buy a single life (pure life) annuity.



Answer: B If Horace waits until he is older to retire, he can save more. Then his years in retirement are fewer with more money available to fund his expenses. Answer A is not realistic. Answer C is debatable. Answer D will produce a level payment for his life but there is no inflation hedge or

residual value for his wife.

Applying the Facts: Behavioral Finance 1. Tim Owens, CFP®, works for a money management firm. The firm

has developed various financial products to fit its client’s needs. The firm has a quantitative method of matching products to specific client needs. The company has told Tim that he should follow the computer guidelines. What is the firm failing to consider? I. This method will not deal with particular investor biases or fears. II. This is not the appropriate way to meet client’s needs.

A. I C. Both I and II B. II D. Neither I or II

Answer: C Rather than products, self-determination is the

most important aspect of applied behavioral finances. It is optimal to build a decision making process to get people to make their own decisions.

2. Beverly’s grandfather lost all of his money when the bank

holding his deposits collapsed during the Great Depression. Her grandfather concluded that he would not make the same mistake again and keeps all of his money in a lockbox in the attic. Beverly’s investment attitude will probably reflect which of the following choices? A. Invest in quality blue chip stocks paying reasonable

dividends B. Invest in variable annuities C. Invest in Treasury securities D. Invest in bank-issued CDs and saving accounts

Answer: C Beverly will be very conservative. She will

likely avoid the stock market (Answers A and B) and perhaps banks. She may be very anxious about money.



Social Security (Old Age, Survivor, and Disability Insurance. OASDI) Lesson 2 Social Security (OASDI)

The following social insurance programs are covered by the Social Security Act. – Social Security (retirement, survivor, and disability insurance - OASDI) – Medicare – Federal Unemployment Insurance – Supplemental Security Income (SSI)

A. Paying into the system

A worker is fully insured if he/she has 40 quarters of coverage. You may also see the term "Social Security credit." A Social Security Credit is a given dollar amount of FICA-taxed earned income. There can be no more than four credits per calendar year. Once a covered worker has acquired 40 quarters or credits of coverage, he/she is fully insured for life. Fully insured workers are eligible for both survivor benefits and retirement benefits. NOTE: Do not expect any questions on currently insured (6 quarters of coverage) status.

Participating in Social Security Coverage - Nearly every worker is covered under OASDI. Employment categories not covered by Social Security include the following. – Federal employees who have been continuously employed since before 1984 unless

they elected to switch – Some Americans working abroad – Student nurses and students working for a college or college club – Railroad employees – A child, under age 18, who is employed by a parent in an unincorporated business – Ministers, members of religious orders, and Christian Science practitioners if they claim an exemption

– Members of tribal councils – Some state employees and teachers

NOTE: Members of the armed services are covered under OASDI.

Applying the Facts Mr. Axel is self-employed. He employs his 16-year-old daughter to enter customer data into the computer that is used in his business. He pays her approximately $5,000 per year ($10/hr.). Regarding this arrangement, which of the following statements is true? A. He must withhold federal income taxes. B. He must withhold FICA taxes. C. He must match her FICA taxes. D. He is not required to withhold any taxes. Answer: D Her earned income will be less than her standard deduction ($12,400). A child, under age 18 and

employed by a parent in an unincorporated business, does not have to pay self-employment or FICA taxes nor does the parent.



Railroad employees Railroad employees are excluded from Social Security coverage. Railroad employees have a special and separate retirement system administered by the Railroad Retirement Board. However, railroad employees and dependents are eligible for Medicare although

they are excluded from Social Security coverage. B. Eligibility and benefits To the Worker

- A retired fully insured worker age 62 or over is entitled to retirement benefits.

- A worker is entitled to disability benefits if he/she is under age 65 and has been disabled for 12 months, is expected to be disabled for at least 12 months, or has a disability which is expected to result in death and has completed a 5-month waiting period.

To the Spouse - The spouse of a retired or disabled worker qualifies for Social Security payments if he/she - is age 62 or over (see below) or at any age if the spouse -has a child in care under age 16 or -has a child age 16 and over and disabled before age 22. - The surviving spouse (including a surviving divorced spouse) of a deceased insured worker qualifies for Social Security payments if the widow(er) is age 60 or over. The divorced spouse must have been married to the worker for at least 10 years and

generally must not be remarried. A divorced spouse who is at least age 62 and has been divorced from the worker for at least two years can receive retirement benefits based on the worker's earnings even if the worker claims no retirement benefits.

- The surviving spouse of a deceased insured worker, regardless of age, qualifies for Social Security payments if caring for an entitled child of the deceased who is either under age 16 or became disabled before age 22. Dependent/child - The surviving dependent, unmarried child of a deceased, disabled or retired insured worker, qualifies for Social Security payments if the child is - under 19 and a full-time elementary or secondary school student or - age 18 or over but has a disability which began before age 22. Applying the Facts 1. Millie Martin (a fully insured worker) recently died. Mr.

Martin, age 50, has three children in his care, ages 17, 15, and 14 respectively. Is he entitled to any Social Security benefits? A. Yes, because he has a child in care under age 16, and

Millie was insured. B. No, because he is under age 60. C. Yes, because he has a child in care under age 18, and

Millie was currently insured.



Answer: A Although Mr. Martin is only 50-years old he has two children “in care” who are under age 16. Answer B refers to retirement benefits. Answer C refers to dependent benefits.

2. Which of the following dependents would be entitled to receive

Social Security benefits based on the FICA-taxed earnings of a deceased insured worker?

A. A 19 year old child in college B. A 19 year old child who is working C. A 19 year old child in high school D. A 19 year old child who is disabled

Answer: D The disability began before age 22. To qualify for survivor benefits, the child must be under age 19 and in high school.

Summary - benefit eligibility under Social Security A fully insured worker is eligible for certain retirement benefits (worker and spouse) plus

the lump-sum death benefit of $255. A currently insured worker is only eligible for the following.

– A lump-sum death benefit ($255) – A surviving spouse's benefits (if children are under age 16)

– A dependent benefit Who is eligible for the $255 lump-sum death benefit?

A spouse who was living in the same household as the deceased at the time of death or a dependent child (one or the other but not both)

C. How benefits are calculated

The primary insurance amount (PIA) is the basic unit used to determine the amount of each monthly benefit payable under Social Security. For example, a spouse/divorced spouse may be entitled to a PIA that is 50% or more of the worker's PIA.

Examples A spouse/divorced spouse is entitled to 50% of the spouses PIA unless his/her own benefit is

greater. Example: Sue had already worked part-time. Her PIA is $250. If her husband Sam's PIA is $1,000, then Meg's spousal benefit is $500 (50%). She will receive the greater of $250 or $500.

If a worker's PIA is $1,000, then the spouse's benefit is $500. The divorced spouse must have

been married to the worker for at least 10 years and must not be remarried. A divorced spouse who is at least age 62 and has been divorced from the worker for at least two years can receive retirement benefits.



Applying the Facts 1. Which of the following persons is eligible for retirement benefits under her first husband's retirement benefits provision? A. Helen, age 62, married 1986-1998, ex-husband employed 1973-2008, divorced, never remarried, ex-husband dies B. Jane, age 62, married 1989-2003, first husband employed 1973-2010, remarried, divorced, remarried C. Judith, age 63, married 1981-2000, first husband employed 1988-2011, remarried, second husband has died D. Emily, age 60, married 1986-2004, first husband employed 1984-2012, remarried 1993 E. Susan, age 68, married 1990-1998, first husband employed 1987-2018, remarried, divorced Answer: A Helen was married to her ex-husband for more than

10 years and has not since remarried. Answer B indicates that Jane is remarried. Answer C indicates that Judith can collect under her second husband. Answer D indicates that Emily is age 60 and remarried. Answer E indicates that Susan was married for fewer than 10 years.

2. Mr. Kidd is age 58. He is fully insured and is receiving Social Security disability benefits. His wife is age 53. He has three children. - Larry, age 30, disabled due to an accident at age 16 - Tim, age 18, still in high school - Ella, age 19, graduated from high school and is currently working full-time and living at home Which family members are entitled to Social Security benefits? I. Mr. Kidd IV. Ella II. Mrs. Kidd V. Larry III. Tim A. I, II, III, IV D. II, III B. I, II, III, V E. I, V C. I, III

Answer: B Mrs. Kidd is eligible because she has a child "in care." In care means (1) care of a child under age 16 or a mentally incompetent child 16 or over or (2) performs personal services for a disabled mentally competent child age 16 or over. Larry is entitled to benefits because his

disability began before he reached age 22. Tim is still in high school. Ella does not qualify for benefits because she is older than 18 and no longer a high school student.



Taking Social Security Benefits Before FRA When a person elects to start receiving a retirement benefit before Full Retirement Age (FRA), how is the benefit reduced?

A fully insured worker can start receiving retirement benefits as early as the month after

he reaches age 62 or any month thereafter. However, if the worker elects to start receiving benefits before FRA, the benefit is reduced. In making the reduction, the worker's PIA must first be determined. The PIA is then reduced by 5/9 of 1% (1/180)* for each of the first 36 months that the worker is under FRA when the benefits commence.

For example, if the worker's PIA is $1,000 and he elects to retire and then start receiving benefits 24 months before his FRA, his benefit will be reduced by $133.40 (24 x 1/180 x $1,000), resulting in a monthly benefit of $866.60. If the worker's benefits start 36

months before he reaches FRA, his benefit under this formula will equal 80% of his full PIA (36 x 1/180 x $1000) or a benefit of $800. There are no questions on the exam about

FRA increasing from 65 to 67; however, this is affecting everyone who is retiring now. NOTE: Questions will indicate the number of months before the FRA, not age 62 or age 65.

* 5 x 20 x .01 = 1 All you need to know is 1 9 x 20 180 180

D. Working after retirement

If a worker was were born January 2, 1943, through January 1, 1955, then his or her full retirement age for retirement benefits is 66. If someone works and is full retirement age or older, that worker may keep all benefits, no matter how much is earned.

If a worker is younger than full retirement age, there is a limit to how much that worker can earn and still receive full Social Security benefits. If the worker is younger than full retirement age during all of 2020, the government will deduct $1 from your benefits for each $2 earned above $18,240.

If the worker reaches full retirement age during 2020, the government deducts $1 from benefits for each $3 of earned income above $48,600 until the month you reach full retirement age.

Example $18,240 first rule Mary begins receiving Social Security retirement benefits at age 62 in January 2020 and

her payment is $600 per month ($7,200 for the year). During the year, she works and earn $23,240 ($5,000 above the $18,240 limit). Social Security would withhold $2,500 of her Social Security benefits ($1 for every $2 she earns over the limit).

Example $48,600 second rule Andy had not reached his full retirement age at the beginning of the year, but will reach it in November 2020. He earned $50,000 in the 10 months from January through October. During this period, Social Security would withhold $467 ($1 for every $3 he earns above the $48,600 limit).



E. Taxation of benefits If a person’s income plus half of his/her Social Security benefits is more than the following base amounts, up to 50% of his/her benefits will be included in his/her taxable income. The base amounts are $25,000 provisional income for a single taxpayer and $32,000 provisional income for married filing jointly. These numbers are not indexed.

If a person’s income plus half of his/her Social Security benefits is more than the following base amounts, up to 85% of his/her benefits will be included in his/her taxable income. The base amounts are $34,000 provisional income for a single taxpayer and $44,000 provisional income for married filing jointly. These numbers are not indexed.

Applying the Facts Which of the following is added to AGI when determining provisional income for the taxation of Social Security benefits? A. Workers’ compensation C. Gifts received B. Municipal bond interest D. Net passive losses

Answer: B Tax-exempt interest is added to AGI. Example #1 Mrs. A's income for the tax year consists of pension income of $15,000 plus Social Security

benefits of $12,000. Her husband died three years ago. Are her Social Security benefits taxable? Answer: No. The sum of her income ($15,000) plus one-half of her Social Security benefits

($6,000) is $21,000. (See Section E above) This is less than the base amount ($25,000), so no part of her Social Security benefits is included in her gross income. She is considered single.

Example #2

Mr. B is single. His only income is $3,000 per month from Social Security. What amount of his social security benefits is taxable?

Answer: $0; 1/2 of $36,000 is $18,000. This is less than $25,000.

Example #3 Patty's husband died last year. She received $250,000 in life insurance benefits. She has two

children, 12 and 10. She will receive a surviving spouse's benefit of $1,000 per month and a children's benefit of $1,200 per month. She invested the insurance money in growth mutual funds. She withdraws $2,000 per month. For the year, she received a 1099 for $14,000 (the taxable portion of the $24,000) from the mutual fund. Are the Social Security benefits taxable?

Answer: No, the same rule as Example 1 applies. $14,000 plus one-half of her benefits ($6,000) is less than $32,000. (She is treated as a qualifying widow for two more years (married filing jointly).

The person who has the legal right to receive the benefits must determine if the benefits are taxable. For example, if you and your child receive benefits but the check for your child is made out in your name, you must factor only your portion of the benefits in figuring if any part is taxable to you. The portion of the benefits that belongs to your child must be added to your child's other income (if any) to see if any amount of those benefits are taxable.



Example #4 Mr. Retired, age 65, and Mrs. Retired, age 62, are both collecting Social Security retirement benefits. He is receiving $1,000 per month, and she is receiving $500. He is also receiving

$3,000 monthly as a pension payout. They receive $12,000 of municipal bond interest yearly. Are the Social Security benefits taxable?

Answer: Yes, the sum of their income ($36,000 pension payout and $12,000 municipal bond interest) plus one-half of their Social Security benefits ($9,000) is $57,000. Therefore, 85% of the Retired’s Social Security benefits are taxable. NOTE: Municipal bond interest is

considered to be part of the Retired’s provisional income. NOTE: Provisional income is AGI plus tax exempt interest and ½ Social Security income. SUMMARY Rule 1: Working after retirement: If you take benefits and continue to earn income before FRA, then you can lose those benefits if your workplace earnings exceed a threshold. Rule 2: Income tax of benefits: If you take benefits, then you may have to pay income tax on those benefits if your provisional income exceeds a threshold. Don’t confuse the two rules. Social Security Disability Benefits A worker is entitled to disability benefits if he/she – is insured for disability benefits, is under age 65, – has been disabled for 12 months, is expected to be disabled for at least 12 months or suffered from a disability which is expected to result in death, – has filed for disability benefits, and has completed a 5-month waiting period. Applying the Facts Professor Einstein had been employed at State University. He earned $40,000 per year. The university funds a disability policy (180 day elimination period) to replace 60% of his income. The policy is coordinated with Social Security benefits. In addition, he has a financial consulting practice that produces $30,000 in net Schedule C income. He also purchased an individual disability policy (90 day wait) based on 60% of his consulting income (with no Social Security coordination). Assume that Professor Einstein is totally and permanently disabled and is awarded $800 per month disability payments from Social Security. What will be his gross benefit in the 5th, 6th, and 7th month from all three sources? A. $1,500; $1,500; $2,300 C. $2,300; $2,300; $3,500 B. $1,500; $2,300; $3,500 D. $2,300; $2,300; $4,300



Answer: B The professor’s payments are $1,500 from his individual policy for month 5, then an additional $800 from Social Security for month 6 ($2,300). The $2,000 benefit from the university is offset by Social Security payments in the 7th month or a net of $1,200 more ($3,500 total). There is a five-month waiting period under Social Security during which time no benefits are paid.

NOTE: The question says he is awarded $800 from Social Security. He has meet the 5-month waiting period.

Applying the Facts 1. Laura Peters, age 63, has been divorced for 12 years. She

earned $15,000 annually when she began working 20 years ago, and now makes $150,000. She is debating as to whether to retire now, wait until her FRA, or see if she can elect more coverage from Social Security because her ex-husband makes $1,000,000 per year. Which of the following approaches do you recommend?

A. Retire now and claim 50% of her ex-husband’s benefits. B. Retire at FRA and claim 50% of her ex-husband’s benefits. C. Retire now and collect 100% of her benefits. D. Wait until FRA and collect her benefits. Answer: D Waiting until full retirement age increases

benefits by 6-7% per year because she will have a higher 35 year average wage base. Her benefits are the greater of her own benefits or 50% of her ex-husband’s. Since she has been making well over the Social Security taxable wage base her own benefits should amount to more than 50% of his benefits (Answer B). If she retires now, it is 4 years before her FRA and she will lose 20% of her potential benefits (Answer C). Nothing indicates she must retire or start collecting benefits now. If she retires now (Answer A), she can no longer get 50% of his benefits and let her benefits grow. Then at FRA or age 70 she can take her benefits.

2. Gus Gibson is approaching retirement age. He has paid enough FICA tax to qualify for $2,000 per month at FRA. Gus feels that his Social Security retirement benefits plus his retirement plan distribution ($1,000 per month) and municipal bond interest ($1,000 per month) will provide adequate retirement income. What amount, if any, of his Social Security retirement benefits will be included in his taxable income?

A. $0 at retirement age B. $1,000 C. $1,700 D. $2,000



Answer: C His provisional income is greater than $34,000 (single).

Social Security at 50% = $12,000 Retirement plan distribution 12,000 Muni bond interest 12,000

Provisional Income $36,000

$2,000 x 85% = $1,700 File and Suspend Repealed Prior to April 2016, a fully insured worker was able to implement the file and suspend arrangement to maximize Social Security retirement benefits. The worker could apply for benefits then suspend them choosing spousal benefits instead. S/he would then delay claiming her/his own retirement benefits until FRA or age 70. Under current rules, one may not file for one type of benefits then change to another. However, a fully insured worker has a one-time right to withdraw the application for benefits within 12 months of the initial claim. Benefits received prior to the withdrawal must be repaid (no interest applies). Example: Melissa made her initial claim for Social Security retirement benefits at age 62 because she needed extra cash. Six months later, a publisher offers her $500,000 advance for her novel, Fifty Shades of Financial Planning. Because twelve months have not elapsed since her initial claim, Melissa can withdraw her application, return her previously received benefits and delay her subsequent claim until her full retirement age (FRA) or until age 70. Her benefit amount would be substantially greater than it would have been with an initial claim at age 62.

3. Gale, single at 64, reaches FRA at age 66. She is deciding whether she should retire and take Social Security early or work until her FRA. She does not expect any major pay changes at work and her employer has asked her to stay on while they train someone to do her job. She is trying to determine her rate of return (the increase in benefits) by waiting. Everyone has told her to take her benefits now. What will the approximate rate of return in benefits be if she waits?

A. She is at maximum benefits now. B. 13.33% C. 16.67% D. 20.00% Answer: B She will retire 24 months early. 24 ÷ 180 =

13.33 loss of benefits. She will get 13.33% more at FRA.



4. Are Social Security benefits ever subject to tax if the taxpayer is full retirement age (FRA) or older? A. No, not unless the taxpayer continues to work then you can

keep your benefits tax-free. B. Yes, if the taxpayer’s taxable income is above certain base

amounts.

Answer: B Social Security benefits are subject to federal income tax if the taxpayer’s provisional income exceeds the applicable thresholds.



Types of retirement plans Lesson 3 Types of retirement plans A. Characteristics 1) Qualified plans Qualified plans are subject to Internal Revenue Code Section 401(a). 2) Nonqualified plans A nonqualified deferred compensation plan is any employer retirement, savings, or deferred compensation plan for employees that does not meet the tax and labor laws' (ERISA) requirements applicable to qualified pension and profit-sharing plans.

“Discrimination” means that the plans contributions and/or benefits are tipped toward the employer’s highly compensated employees. Major differences between nonqualified and qualified plans are shown below:

Nonqualified plan Qualified plan May discriminate May not discriminate Exempt from most ERISA requirements Many ERISA requirements No employer tax deductions for contributions Immediate tax deduction for until employee is taxed contribution (although employee may not be vested) Plan earnings are taxable to employer. Earnings accrue tax deferred until distribution. Distributions taxable at ordinary tax rates Distributions are taxable at ordinary tax rates (exception: 10-year averaging and NUA under Stock See Lesson 10 for more information Bonus, ESOPs and 401(k)s). B. Types and basic provisions of qualified plans 1) Defined contribution A defined contribution plan is a retirement plan that provides an individual account for each participant. Benefits are based solely upon amounts contributed to the participant's account, plus account earnings and forfeitures. Defined contribution plans and retirement plans include the following: Defined contribution plans (Qualified) Retirement plans (Not qualified) Money purchase SEP Target benefit SIMPLE Profit-sharing SARSEP Profit-sharing 401(k) Thrift or savings plans Stock bonus / ESOP 403 (b) Defined contribution plan and retirement plan benefits are based on the account balance at retirement.



2020 numbers Types of retirement plans Defined Benefit Pension (qualified plan / ERISA) (vesting schedule/administrative costs/exempt from creditors/can integrate with Social Security)

1. favors older employee/owner (age 50+) 2. specific retirement benefit

(can meet a set retirement objective) 3. requires a very stable cash flow 4. past service credits allowed

favors younger participants uncertain retirement benefits Cash Balance Pension Plan Defined Contribution (qualified plans/ERISA) Other retirement plans (vesting schedule / administrative (no vesting schedule / limited administrative costs) costs / exempt from creditors / integrated with social security) SIMPLE IRA keys Money-Purchase Pension keys 1. (SIMPLE 401(k) is exempt from creditors.) 1. up to 25% employer deduction 2. for small employers (100 or fewer employees) 2. fixed contributions 3. requires employer match (immediate vesting) 3. stable cash flow required 4. salary reduction limit up to $13,500 (FICA) 5. Company cannot have another plan. Target Benefit Pension keys 1. up to 25% employer deduction SEP IRA keys – No salary deferral 2. fixed contributions 1. up to 25% contribution for owner (W-2) 3. stable cash flow 2. account immediately vested 4. favors older employees 3. can be integrated with Social Security 4. special eligibility: 21+ years old, paid at least Profit Sharing keys $600, and worked 3 of the 5 prior years 1. up to 25% employer deduction 2. flexible contributions (must be recurring and substantial) SARSEP keys 3. 401(k) provisions (FICA) 1. may have up to 25 employees and 50% of the (hardship provisions) eligible employees must defer 4. SIMPLE 401(k) is exempt from 2. must have been in existence before 12/31/96 creditors. See SIMPLE for (grandfathered) additional information. 3. salary deduction limit $19,500 (FICA) Stock Bonus Plan keys 403(b) keys 1. up to 25% employer deduction 1. for 501(c)(3) organizations and public schools 2. flexible contributions 2. subject to ERISA only if employer contributes 3. 100% of the contribution can 3. salary reduction limit up to $19,500 (FICA) be invested in company stock. 4. Employer contributions may be subject to vesting schedule. 4. ESOP cannot be integrated with Social Security or cross-tested. NOTE: 457 plans operate as nonqualified deferred compensation (see Lesson 10). Keogh plans are qualified plans for the self-employed. They may be offered as either defined benefit or defined contribution plans.



a) Money purchase pension plan A money purchase plan follows a benefit formula requiring an annual employer

contribution that is a flat percentage of each eligible employee's compensation. Only the first $285,000 (2020) of each employee's compensation can be taken into account. The employer could contribute up to 100% of each employee’s compensation. However, the employer can only deduct up to 25% of total plan compensation (overall eligible payroll).

Maximum contribution – Section 415 Limit

The maximum annual contribution that an employee can receive is the lesser of 100% of salary or $57,000 (2020).

Example Mr. Owner’s salary is $300,000. The money-purchase plan contributes 25% of all participants’ eligible compensation. Mr. Owner may not receive a contribution to his retirement account of 25% of $285,000 = $71,250. It is limited to a $57,000 maximum contribution. (This works out to a contribution of 20% of $285,000.)

Applying the Facts Mac, the president of MAC, Inc., has a current salary of $300,000. The company provides a 15% money purchase plan. How much can the company contribute on his behalf? A. $19,500 C. $42,750 E. $71,250 B. $26,000 D. $57,000

Answer: C 15% of $285,000 (Salary cap is $285,000.)

When would a money purchase pension plan be appropriate? – The employer wants a stable work force (wants to retain key employees). – The employer wants a plan that is simple to administer and explain (pension stated

percentage contributed). – The employees are relatively young and well-paid.

Requirements to use a money purchase pension plan Employer must have a stable cash flow and profit to make the annual fixed contributions. Contributions are mandatory. Factors that affect the employee's retirement benefits (all defined contribution plans) – Years to retirement – Retirement benefits may be inadequate for employees who enter the plan at older ages. – Investment returns – Employees assume the investment risk under the plan. – Salary levels – Contributions are based on the participant's salary level for each working year rather than on the salary at retirement. – Employer contributions – The plan is subject to minimum funding standards, but employers may make contributions as low as 3%. – Forfeitures – Forfeitures can be reallocated to the participants or applied to reduce employer contributions. Example

Carol, age 45, is a shop supervisor. Her salary is $50,000 per year. Her employer contributes 5 percent of her salary. The plan is earning 7 percent. If she retires in 20 years, what amount would be in her account balance? $102,488.73 ($2,500 PMT, 7i, 20n) This is hardly adequate retirement income for Carol who is earning $50,000 in "today's dollars."



Applying the Facts Which of the following factors least affects a defined contribution plan participant's ultimate account balance? A. Investment return C. Employer contributions B. Inflation D. Life expectancy

Answer: D Inflation will affect salary levels and investment returns. At retirement, the employee receives the

account balance which may then be distributed as a pension annuity. Life expectancy affects defined benefit plans.

b) Target benefit pension plan A target benefit pension plan is a unique form of defined contribution plan because it also includes certain features associated with defined benefit plans. Provisions shared with defined contribution plans – Maximum contribution is the lesser of 100% of compensation or $57,000 (2020). – Retirement benefit is determined by account balance. – Employee assumes investment risk. – No annual actuarial determination is required. – Forfeitures may be reallocated to remaining participants or used to reduce employer

contribution. Provisions shared with defined benefit plans – Plan generally benefits older employees. – Actuary determines initial contribution level. – Fixed mandatory contributions Plan design An actuary initially determines the amount of funds needed for a level (base) annual

employer contribution using actuarial and interest assumptions in conjunction with a benefit formula. The level contribution will not change except to reflect new plan participants and increases in the compensation of plan participants.

Once the plan is established, the employer hopes to provide a specific benefit (the target) at retirement. However, the employer does not guarantee that the target benefit amount will be paid. Investment risk falls on the employee. Example Ron, age 40 is earning $100,000. He is told to expect a benefit of 25% of salary at age 65 ($25,000). Assuming an actuarial need of $310,000 in the account at age 65 and a 7% plan return, what amount does the employer need to contribute annually? $310,000 FV, 7i, 25n = $4,901 PMT (end) What happens if the plan generates a 10% rate of return? $4,901 PMT (end), 10i, 25n = $481,999 The higher account balance means that Ron

receives a higher pension payout. However, the contribution is still based on the 7% plan assumption.



NOTE: The calculations illustrated are not expected on the CFP exam. They were used to illustrate the following points:

– The account’s ending value is an actuarially “targeted” amount at retirement, – The employer’s contribution is limited to a maximum of 100% of compensation or $57,000, even if the actuarial determination is higher.

– The account balance at retirement may be lower or higher than the target due to the investment performance of the employee's account.

Applying the Facts 1. Ruth Watson is age 55. She earns $100,000 yearly as a human

resources manager. Her target benefit will be 50% of her salary ($50,000). The actuary determines that $660,000 will need to be in the account when she retires at age 65. Based on a 7% projected return, what is the required annual employer contribution?

A. $40,000 C. $51,000 E. $57,000 B. $47,769 D. $55,000

Answer: B $660,000 FV, 7i, 10n = $47,769 PMT (end) Remember, the maximum contribution is the lesser

of 100% of $100,000 or $57,000. $47,769 is less than $57,000 limit.

2. From question 1 above, what would be the correct answer if the actuarially determined that the account balance should be $870,000?

Answer: E $870,000 FV, 7i, 10n = $62,968 PMT (end) Although the target benefit formula requires an

annual contribution of $62,968, the most the employer may contribute is $57,000 (2020).

When would a target benefit plan be appropriate? A target benefit plan is an alternative to a defined benefit plan that provides adequate retirement benefits to older employees but has the lower cost and simplicity of a defined contribution plan. c) Profit-sharing plan A profit-sharing plan is a qualified defined contribution plan featuring flexible employer contribution provisions up to 25% of compensation. The 2001 Tax Act profit-

sharing plan contributions were limited to 15%. A tandem plan combined a 15% profit-sharing plan and a 10% money purchase plan. There is no need for a tandem after Tax Act 2001.

Features of profit-sharing plans

– The employer's contribution for each plan year can be a purely discretionary amount or nothing at all. The employer will not be saddled with mandatory contributions or a minimum funding requirement. However, the contributions must be “substantial and

recurring.” The IRS does not specify frequency or amount of contribution to satisfy the rule. Nevertheless, if too many years go by or too little dollars are contributed,

based on the facts and circumstances surrounding a particular plan, the IRS could retroactively disqualify the plan or consider it terminated.



– Each participant has an individual account. The account balance consists of employer contributions, investment returns, and forfeitures. Forfeitures are unvested terminated employee account balances. Forfeitures are normally reallocated to the plan participants.

When would a profit-sharing plan be appropriate? – When an employer's profit margin or financial stability varies from year to year – When an employer wants to adopt a qualified plan with an incentive feature to motivate employees to make a company profitable – When the employees are young, well-paid, and have substantial time to accumulate retirement savings Applying the Facts 1. Randy’s employer provides a profit-sharing plan. Which statement

below accurately reflects an advantage to Randy? A. Randy can expect a predictable level of funding under the

plan. B. Randy may receive forfeitures from terminated accounts. C. Randy bear no investment risk under the plan. D. Randy of all ages can expect to receive adequate levels

of retirement benefits.

Answer: B With a profit sharing plan, forfeitures are typically reallocated to the remaining participants. For a profit-sharing plan to remain viable, contributions must be substantial and recurring. Contributions are discretionary, not predictable. Contributions are generally pooled for investment purposes and then allocated to individual participant's accounts. The plan favors younger employees who have substantial time to accumulate retirement savings.

2. Which of the following is the most serious disadvantage to an employee when the employer offers a profit-sharing plan? A. Employee forfeitures can reduce employer contributions. B. Employer contributions are subject to FICA and FUTA. C. Contributions are purely discretionary amounts. D. The benefits at retirement are unpredictable.

Answer: C/D Because profit sharing plan contributions are discretionary and can occasionally be skipped, retirement benefits are uncertain. Answer D is also true. Although Answer A is true, forfeitures are normally allocated to the employee account balances. Answer B is false because employee deferrals are subject to FICA [see 401(k) below]. Employer contributions are not.



401(k) plan

A Section 401(k) plan (also known as a "cash or deferred arrangement" or CODA) is a provision that is added to a qualified profit-sharing or stock bonus plan. Under this provision plan participants have an option to put money in the plan or to receive the same amount as taxable cash compensation. If the employee elects to defer, the deferral is still subject to FICA and FUTA taxes but not federal withholding. The limit on elective deferrals is $19,500 in 2020. A catch-up contribution of $6,500 is also permitted if the participant’s age is 50 or older. When would a 401(k) plan be appropriate?

– When an employer wants to provide a qualified retirement plan for employees but can afford only minimal extra expense beyond existing salary and benefit costs

– When the employees want to increase their savings on a tax-deductible basis

Applying the Facts Omar, 40 years old, participates in his employer’s 401(k) program. Can he elect to defer more than $19,500 in 2020? A. No B. Yes

Answer: A The deferral is only $19,500. The deferral amount can also be supplemented by direct employer contributions up to the lesser of 100% of compensation or $57,000.

Solo 401(k) This is also known as the uni-401(k). The plan is not subject to coverage testing and nondiscrimination rules necessary for the typical 401(k) plan. The plan allows 2 different contributions: the elective deferral up to $19,500 plus the employer contribution

with a cap of $57,000. A catch-up contribution of $6,500 is also permitted if the participant's age is 50 or older. A uni(k) is generally permitted when the only participants are the owner and spouse or two partners. Keogh retirement plans and SEPs for self-employed individuals are subject to special rules (see Keogh). Corporate plan contributions are limited to 25% of the owner's compensation to a maximum of $57,000 (no catch up). The uni-401(k) deferral and contribution could be up to $63,500 ($57,000 + $6,500) which could be a larger dollar amount than the Keogh/SEP for the self-employed or some defined benefit plans allow. Safe Harbor 401(k) A safe harbor 401(k) plan automatically satisfies the nondiscrimination tests {involving highly compensated employees (HCEs)} with either an employer matching contribution or a non-elective contribution. The statutory safe harbor contribution using a match is $1/$1 on the first 3% employee deferral and $0.50/$1 on the next 2% employee deferral (4% if employee defers 5% of compensation). If the employer chooses the non-elective deferral method, the employer must contribute 3% of all eligible employees’ compensation regardless of whether the employee is deferring. Employer contributions must be immediately vested. Safe harbor plans are exempt from top heavy (key employees) rules if the only deposits are employee deferrals and employer contributions (3% non-elective or safe harbor match). Otherwise, top heavy employer contributions may be required.



Stock bonus plans (maximum 25% employer deductible contributions) and Employee stock ownership plans (ESOP) (25% employer contributions) Stock bonus plans and an ESOPs are variations of profit-sharing plans.

How are they different from traditional profit-sharing plans?

– A stock bonus plan may invest plan assets in employer stock; however, an ESOP must invest plan assets primarily in employer stock.

– Participants' accounts are stated in shares of employer stock. – Benefits are generally distributable in employer stock (certificates). – Employers may deduct dividends with respect to stock held in an ESOP. The deductible dividends must be: – paid in cash directly to participants or beneficiaries, or – paid to the plan and subsequently distributed in cash to participants or beneficiaries no later than 90 days after the close of the plan year, or – used to make payments (of principal and interest) on loans used to acquire employer securities, or – paid to the plan and reinvested in qualifying employer securities. When would a stock bonus plan or an ESOP be appropriate? – When a company wants to broaden ownership of its stock, to create a market for its stock, to provide liquidity for shareholders' estates, or to provide for business continuity

– When a company wants to provide its employees with a tax-advantaged means to acquire company stock – When an employer wants its workers to feel a sense of ownership In addition, the net unrealized appreciation (NUA) may not be taxed to the employee at the receipt of distributions from the plan (retirement). NOTE: See Lesson 9.

Employee stock ownership plan (ESOP) An ESOP is a stock bonus plan that the employer can use as a strategy for borrowing money from a bank or other financial institution. When an ESOP enables the employer

borrow money, it is known as a leveraged ESOP or a LESOP. Applying the Facts 1. Which of the following types of business is prohibited from

establishing an ESOP? A. S corporations C. Public traded corporations B. Partnerships (KEOGH) D. Closely held C corporations Answer: B Any business established as a corporation may

establish ESOPs. Partnerships cannot offer stock bonus or ESOP plans because partnerships do not issue stock. Partnerships may offer other types of retirement programs.

ESOP Diversification Participants age 55 or older having ten years of participation in the ESOP generally have the

right to diversify up to a total of 50% of their account balance. The ESOP must offer at least three investment alternatives or distribute cash or certificates to the participant.



2. In which of the following ways do ESOPs and stock bonus plans differ from traditional profit-sharing plans?

A. Stock bonus and ESOP plans typically invest plan assets mainly in the employer’s stock while profit-sharing plans cannot invest in the employer’s stock. B. Stock bonus and ESOP plans must base contributions on company profits while profit-sharing plan contributions

Are typically fixed. C. Stock bonus and ESOP plans are means to finance company

operations while profit-sharing plans are not viewed as a means to finance company operations.

D. Stock bonus and ESOP plans require participants to take distributions in the form of employer stock while profit- sharing plans generally distribute cash.

Answer: C Employer contributions in a stock bonus or ESOP plan are typically made with cash (not stock).

The plan then uses the cash to purchase shares from the company, thereby funding company operations. Answer A is wrong because profit-sharing plans can invest in a limited amount of employer stock, up to 10% of plan assets. Answer B is wrong because contributions to stock bonus and ESOP plans do not need to be based on company profits. Answer D is wrong because stock bonus and ESOP plans do not require participants to take distributions in employer stock. Under a “put option” participants may request cash distributions.

New comparability plan In a new comparability plan, the contribution percentage formula for one category of participants (such as managers) is greater than the contribution percentage for other

categories of participants. Like an age-based plan, new comparability plans are tested under cross-testing rules.

Cross-testing (except ESOPs) Cross-testing measures defined contribution plans for nondiscrimination on the basis of benefits, and defined benefit plans are tested on the basis of contributions. Since cross- testing generally results in higher contribution rates for older employees, cross-

tested plans are sometimes referred to as “age-weighted.” However, age weighting is also available without cross-testing.

A cross-tested plan does not apply a fixed age-weighted formula. Instead, the plan is designed to provide maximum benefits to highly compensated employees, while benefits for other employees are designed to provide the minimum required under nondiscrimination regulations. Cross-testing plans differentiate highly compensated employees (HCEs) from non-highly-compensated employees (NHCEs). A plan covering 10 employees might provide for a $57,000 annual contribution for the owner (HCE) and a flat percentage (the lesser of at least 1/3rd of the allocation rate of the



HCE with the highest allocation rate or 5% of the NHCE’s compensation) for the remaining employees (the NHCEs). Example

Bob Boss (HCE) has 4 eligible employees (NHCEs) working for the company ho owns. He wants a contribution of $57,000 for himself and the minimum contribution for the other employees.

Participant Compensation Contribution % Mr. Walters $285,000 $57,000 20% Employee #1 $ 50,000 $ 2,500 5% Employee #2 $ 40,000 $ 2,000 5% Employee #3 $ 40,000 $ 2,000 5% Employee #4 $ 30,000 $ 1,500 5%

The proposed plan provides a contribution of 5%. The NHCE gateway contribution percentage represents the lesser of 1/3rd of the highest percentage paid to an HCE’s (Mr. Walters) contribution percentage. (1/3rd of 20% = 6.67% or 5%.)

Under age-based (or age-weighted), the employee census scenario is important. If the NHCEs are substantially younger than the HCEs, age weighting is effective. Even one older employee can destroy the intended result. Optimally, the average of the NHCEs’

ages should be about 15 years younger than the average of the HCEs’ ages. Applying the Facts Which one of the following is a false statement about a cross- tested plan? A. Although the plan is a defined contribution plan, cross-testing

measures plan’s ultimate benefits for nondiscrimination. B. Contributions for NCES must satisfy a “gateway” requirement (the

lesser of at least 1/3rd of the allocation rate of the HCE with the highest allocation rate or 5% of the NHCE’s compensation).

C. Self-employed persons are permitted to adopt a money purchase cross-tested Keogh plan.

D. All defined contribution plans can apply cross-testing. Answer: D All makes Answer D wrong (false). ESOPs cannot be cross-tested. Self-employed persons who adopt Keogh

type plans can implement a cross-tested design. Keogh plans (HR-10 plans) are similar to qualified plans but for non-incorporated businesses.

C) Defined-benefit plan 1) Traditional A defined-benefit pension plan is a qualified employer pension plan that guarantees a specified benefit amount at retirement. DB and cash balance plans are required to carry

PBGC insurance.



When is a defined-benefit plan appropriate? – When an employer wants to maximize plan contributions to older employees – When an older controlling employee wants to maximize tax-deferred retirement savings for his/her (the older controlling employee) own benefit Section 415 limit Under Code Section 415, there is a maximum limit on the projected annual benefit (not

contribution) that a defined benefit plan can provide. For a benefit beginning at age 65, the maximum annual life annuity benefit is the lesser of (1) $230,000 (2020) or (2) 100% of the participant's compensation averaged over his/her three highest earning consecutive years. The plan is not required to reduce benefits to a participant who retires as early as age 62.

Plan - unit benefit formula The most frequently used defined benefit formula is the unit benefit formula (also known as the percentage-of-earnings-per-year-of-service formula). This formula factors both service and salary in determining the participant's pension benefit. Example The formula might provide 1.5 percent of earnings for each of the employee's years of service with the total percentage applied to the employee's average earnings. Under this formula, Dave a participant with an average annual compensation of $100,000 who retired after 30 years of service would receive an annual pension of $45,000.

45% (1.5% x 30 years) x $100,000 = $45,000

Final average method

The final average method, earnings are averaged over a number of years – usually 3 to 5 years prior to retirement. The final average method usually produces a retirement benefit that is better matched to the employee's income at retirement than would be

career averaged compensation. Only the first $285,000 (2020) of compensation is taken into consideration.

Example The annual defined benefit for an employee making $170,000, $245,000, and $300,000 the last

three years prior to retirement will be determined as follows: ($170,000 + $245,000 + $285,000) = $700,000. $700,000 ÷ 3 = $233,333. However, the maximum annual benefit is limited to $230,000. Past Service Credits

Past service is service with the employer prior to the inception of the plan. It is important to employers who are setting up a new plan for the benefit of long-service employees. For example, it can provide for 2% times the final 3 years' average salary times all years

of service with the employer (even those before the plan began). Defined benefit and cash balance plans may allow credits for past service.



Applying the Facts 1. If the XYZ pension plan provides a life annuity equal to 3% of

earnings per year up to 30 years of service, what amount of defined benefit will an employee with an average annual compensation of $300,000 receive as an annual pension after 30 years?

A. $57,000 C. $230,000 B. $63,500 D. $285,000

Answer: C 30 years times 3% is 90%. 90% x $285,000 (not 90% of $300,000) = $256,500 Remember: The salary cap is $285,000, but the annual benefit cap is $230,000.

2. Edwin Enderlee owned and operated E4, Inc. for 20 years. After low profit years, E4 has substantial retained earnings and

positive future earnings outlook. Mr. Enderlee wants to establish a defined benefit plan that will benefit him. E4 employs about 10 older workers (reasonably paid) and 15 younger employees (lower paid). Almost all of the employees would be eligible to participate, but most employees have been

employed by E4 for only a few years. Which type of benefit formula do you suggest? A. Unit-benefit formula B. Flat-percentage-of-earnings formula (also called fixed benefit formula) C. Flat-amount formula D. Final average method Answer: A The unit-benefit formula factors both service and salary in determining the participant’s ultimate pension benefits. The formula can credit Mr. Enderlee for prior service because he has been

with the company 20 years. In contrast, other employees have only been with the company for a few years. Answer B relates solely to salary. Answer C treats all employees alike. Answer D considers compensation at retirement.

3. Which is the most frequently used defined benefit formula? A. Flat-amount-per-year-of-service formula B. Percentage-of-earnings-per-year-of-service formula C. Flat-percentage-of-earnings formula D. Income-replacement formula



Answer: B Answer B is also known as the unit-benefit formula. It rewards long-service employees.

Answer A is related solely to service but does not reflect an employee’s salary. Answer C is related solely to salary and does not reflect the length of an employee’s service. Answer D is not a DB contribution formula; it represents the amount of an employee’s gross income that will be replaced under the benefit formula.

4. Which of the following is not a characteristic of defined

benefit plans? A. A specified retirement benefit is guaranteed B. The risk of pre-retirement inflation is assumed by the

participating employees C. Benefits based on past service may be provided D. Contributions are not attributed to specified employees

Answer: B All of the other answers reflect DB plan characteristics. The employer assumes the risk of

pre-retirement inflation in a DB plan. DB plan contributions are not earmarked to specified employees. Contributions are pooled.

5. Of the disadvantages to an employer that provides a defined- benefit plan, which is most worrisome? I. Annual employer contributions are required, and the employer’s future costs are not precisely known. II. They are more costly to administer than defined contribution plans, and the employee assumes responsibility for pre-retirement inflation and investment results. A. I only C. Both I and II B. II only D. Neither I nor II

Answer: A Annual contributions are mandatory and actuarially determined for each year. The amount is uncertain. The benefits to the employee are known. It is the employer rather than the employee who assumes responsibility for pre-retirement inflation and investment results. The employer makes up any deficiency.

6. Mark retires after 32 years of service with his employer. He will receive a monthly pension commencing at normal retirement date and paid as a life annuity equal to 2.2% of final-average

monthly salary ($10,000) multiplied by years of service. The plan bases benefits on 30 years of service. What is Mark’s income replacement ratio under this unit-benefit formula?

A. 64% C. 66% B. 60% D. Not enough information is

provided



Answer: C The ratio is 2.2% x 30 = 66%. Although most employers choose income replacement of between 40 and 60% of final-average salary for employees, higher income replacement ratios may be offered.

Contributions

From the employer’s point of view, the major disadvantage of a defined benefit plan is that the employer is subject to a potentially large annual funding obligation that must be paid whether or not the company made a profit. The actuarially determined annual contribution cannot be predetermined.

Factors that affect the amount of employer contributions to a DB plan

– Participant’s proximity to retirement age (older more, younger less) – Past service (service with the employer prior to the inception of the plan) – Forfeitures must be applied to reduce employer contributions because the actuarially

determined annual contribution must be made – not more and not less. – Investment return assumptions (lower assumptions more, higher assumptions less) – Salary scale assumptions (Older employees are paid more; new younger employees are paid less.)

Applying the Facts A. Increases company contributions B. Decreases company contributions C. No effect

What effects do the events below have on a defined benefit plan? _____1. The company hires older employees. _____2. Investment earnings are up significantly. _____3. New employees rarely stay one year. _____4. Inflation is lower than expected.

Answers: 1-A, 2-B, 3-C, 4-B Employees who stay fewer than one year never participate in the plan (one year for eligibility). If inflation is low, the stock market (investments) should rise. Increased earnings decrease company contributions.

If the plan uses an actuarial assumption of 6% and the plan actually makes 12%, the plan is “overfunded” and future contributions decrease. Lower inflation means salaries should remain constant rather than rise.

5. Which of the following is not a defined contribution plan characteristic? A. Defined employer contributions by set formula B. Benefits for past service are not provided. C. Employer assumes risk of pre-retirement inflation. D. Employee assumes risk of adequacy of retirement income.

Answer: C Contributions are designed by formula. Only defined benefit plans can provide a benefit that

considers past service. All of the other answers are DC plan characteristics.



2) Cash balance pension plan A cash balance pension plan is a qualified employer pension plan (a type of DB plan) that

provides for annual employer contributions at a specified rate to hypothetical individual accounts for each plan participant. The employer guarantees not only the contribution level but also a minimum rate of return on each participant's account. A cash balance plan works somewhat like a money purchase plan, but money purchase plans do not require employer guarantees of minimum rates of return.

Example Sam is entitled to a single-sum benefit that is based on a credit of 5% of compensation each year.

The credited amounts will accumulate with interest. Interest will be credited annually using a 30-year Treasury rate. Actual investment experience will not affect the value of the benefit. The

account balance at retirement will be annuitized to provide Sam’s retirement benefit.

When would a cash balance plan be appropriate? When cost savings for the employer and simple defined contribution make sense for the

company. NOTE: Many large companies have amended their defined benefit plans and adopted cash balance plans because guaranteeing specific benefits make some employers uncomfortable.

NOTE: All DB plans (including cash balance plans) may allow for past service credits. (Defined contribution plans cannot allow past service credits.) This means that a DB plan’s “benefit formula” may cover periods of employment prior to the plan’s inception date.

Applying the Facts 1. Which of the following is true about a cash balance plan? I. The minimum rate of interest credited to the account is

guaranteed by the employer. II. Investment discretion is offered to each participant. III. If the trust assets earn a higher return than guaranteed, future employer contributions are reduced. IV. If the trust assets earn a lower return than guaranteed, future employer contributions are increased. A. All of the above C. I, III, IV B. I, II D. II

Answer: C A cash balance plan provides a hypothetical individual account for each participant. These accounts are funded by the employer annually with "interest credits" (the guarantee). The actual return can, therefore, lower or increase employer contributions.



2. Which of the following statements is true about cash balance plans?

I. Past service credit may be available. II. They do not require that contributions earn a minimum rate

of return. III. The plan operates somewhat like a money purchase plan. IV. Forfeitures must be used to reduce employer contributions. A. All of the above D. II, III B. I, II, IV E. III, IV C. I, III, IV

Answer: C The plan requires that contributions are credited with a minimum rate of return, permits past service credits. Forfeitures must be allocated to reduce the next contribution.

What business would use a cash balance plan? A mid-size or large company that has a well-funded defined benefit plan and is looking to save on benefit costs (contributions) and avoid the PPA rules would install a cash balance plan. Who loses? Relatively speaking, older, long-service employees receive lower pension benefits when a

DB plan is converted to a cash balance plan. The disadvantage to older employees when a traditional DB plan is converted to a cash balance plan is that the lump sum payout at termination is generally considerably smaller.

Older employees also receive less with a cash balance plan rather than a traditional DB plan. The reason older employees lose benefits in later years is because cash balance plans base benefits on all of the working years while traditional DB plans base benefits on the highest paid three years. The cash balance plan generally features a fixed contribution. The contribution for that employee under a traditional DB plan may be higher.

Example Jane makes $100,000. Under a defined benefit plan, she will receive 50% of her salary at retirement. Based on a 25 year life expectancy and a return of 6%, this benefit has a PV equivalency at retirement of $677,518. Use begin mode, $50,000 payment, 25n, 6i = $677,518

Under a cash balance plan, the plan would contribute 5% of $100,000. If she worked for 20 years, she would have an account balance of $183,927 at retirement. End of the year contribution $5,000 payment, 20n, 6i = $183,927

The account balance would provide her with annual income of $13,573 per year. $183,927 PV, 25n, 6i = $13,573 PMT at the beginning of each year. $50,000 under defined benefit versus $13,573 under cash balance Jane would have to work 38 years with the employer to end up with the same benefit as the defined benefit plan. $677,518 FV, $5,000 + PMT (end), 6i = 38 years



c) 412(i) plan A 412(i) is a defined benefit plan funded entirely with insurance products such as life

insurance and annuities. The insurance company actuary's assumption determines the actual contribution due. This plan is exempt from the minimum funding standard; 412(i) is the Code section for fully insured plans.

Usage of 412(i)

This type of plan appeals to employers that have some need for life insurance. The plan allows for a large contribution, but the plan return would typically be lower than those of other DB plans. NOTE: Also known as a 412(e) 3 insurance contract plan.

Applying the Facts: Case / Evaluation 1. LLM, Inc. is considering installing a pension plan. They want

to make a reasonable annual contribution representing 10-15% of overall eligible compensation. They want the investment risk to fall on the participants. They would like the plan to be fairly easy to explain to the employees. Which plan should they adopt?

A. A cash balance pension B. A money purchase pension C. A target benefit pension D. A profit sharing plan E. A 401(k) SIMPLE plan

Answer: B A money purchase plan receives fixed employer contributions. Investment performance determines the amount of the retirement benefit. A fixed contribution is easy to explain and understand. In a cash balance plan LLM, Inc. must guarantee the return. In a target benefit plan contribution are based on age, compensation and other factors. It is not a straightforward level percentage for each employee and is not easy to explain. Profit sharing and 401(k) SIMPLE programs are not pension plans.

2. Twenty years ago, Claire joined Employee Outsourcing, Inc.

(EOI). EOI provides a target benefit plan that was designed to provide 30% of her salary at retirement. She is 62 and plans to retire early and take Social Security. What benefit can Claire expect from the target benefit plan at age 62? A. She will receive slightly less than 30% because she is

retiring early (62), the plan benefit was based on age 65. B. She will receive 30% of her salary. C. She will receive the account balance as a pension annuity. D. She will receive 30% of the salary that she was paid at age

42.



Answer: C Claire will receive the account balance which, when annuitized, could, when annuitized, provide more or less than 30% of her final salary.

3. Your client, Ralph Thompson, is confused. He worked for Trucker’s Unlimited, Inc. as a driver for 40 years. TUI offered a defined benefit plan for all 40 years. He was promised 1% of earnings for each year of service up to 30 years. During his last year of employment he earned $100,000. His first monthly check was for $2,500. He thought he should get more. What would you say to him?

A. The amount is correct. B. The amount is incorrect. You should have received $3,333.33 per month. C. Ralph, go back to the company and request an audit. D. Ralph, they are discounting your benefits because you retired early.

Answer: A The plan’s unit benefit formula specifies 1% for each of up to 30 (not 40) years of service. 30% of $100,000 is $30,000 per year or $2,500 per

month. Answer D could be true in some situations but Ralph’s age is not given. He should be 60 years old or older.

4. Alice is concerned about her retirement benefits. Some years

ago, her employer discontinued its defined benefit plan and rolled her account balance into a cash balance plan. Now she realizes that she will receive only the account balance at retirement. Unfortunately, Alice, due to a messy divorce and related health problems, does not have additional money for retirement except for what is in this plan. As the current year ends, she has seen the stock market lose 30% and bonds lose 15%. Should she be concerned about her employer’s contribution and her ultimate account balance? A. She should be concerned about the employer’s contribution

if the economy is doing poorly. B. She should be concerned about the account balance if the economy is doing poorly. C. She should be concerned about both the company contribution and the account balance if the economy is doing so poorly. D. Unless the company she works for is failing, (and even then) she should not be concerned.

Answer: D With a cash balance plan, the employer guarantees not only the contribution but also a minimum rate of return. If the company fails, the PBGC takes over the pension obligation.



Qualified plan rules and options Lesson 4 Overview of Lessons 4 through 9 In Lessons 4 through 9, you will be learning the rules for qualified plans. This overview will outline the differences between “qualified” retirement plans and retirement plans (e.g., SEPs, SIMPLEs, etc.). Understanding these differences will help you with many questions on the

exam. Qualified Plans (DB/DC) Retirement Plans (SIMPLE & SEP) 1. ERISA rules 1. No ERISA rules 2. Eligibility: age and service 2. SIMPLE – none / SEP – 3 out of 5/ $600 3. Top-heavy rules (key employee) 3. None – SEP automatically satisfied 4. Vesting schedule 4. None – SEP immediate

5. Coverage testing/ADP and ACP 5. None 6. Cross-testing (except for ESOP) 6. None 7. Integration with Social Security 7. SEP only (except for ESOP) 8. Multiple plan rules 8. Same as qualified plans

– Aggregate deferrals – Annual additions

9. Investment suitability 9. Investment suitability (UBTI/life insurance) (IRA rules/no life insurance) 10. Lump-sum distribution (10-year) 10. None 11. Rollover 11. Rollover – IRA rules 12. Distributions (20% withholding 12. Distributions (possible 10% penalty) and possible 10% penalty) (SIMPLE - 25% first two years) 13. QP penalty exceptions 13. IRA penalty exceptions 14. RBD (70 ½ or separation from service) 14. RBD (70 ½) 15. QJSA/QPRA/QDRO 15. None 16. Creditor protection (ERISA) 16. Varying creditor protection (state law) 17. Deductibility of contributions 17. Deductibility subject to phase out 18. Generally must establish in the tax year for 18. Establishment date varies by type of which the sponsor wishes to take the plan. deduction [exceptions: safe harbor and SIMPLE 401(k)] Qualified plan rules and options A. Nondiscrimination and eligibility requirements A qualified plan must cover a broad group of employees. Two types of requirements must be satisfied. The first is age and service. The second is coverage. 1) Age and service requirements – The maximum age and service for an employee to participate in a qualified plan are age 21

and one year of service (21-and-one rule). – A special provision allows up to a 2-year service requirement, but then the employee is immediately vested (2-year/100% rule). This election is not available with most 401(k)

plans.



An employee who meets the age and service requirement must be allowed to participate no later than the earlier of (1) the first day of the first plan year beginning after the date the employee first met the age and service requirement or (2) the date 6 months after these conditions are met. Year of service An employee who works 1,000 hours during the initial 12-month period after being employed will earn a year of service. Also, employees working 500 hours for at least 3

consecutive years will be eligible for the employer’s plan. Applying the Facts The one-year-of-service or two-year-of-service eligibility requirement is accurately illustrated in which of the following examples? (Hours shown include sick time, vacations, and holidays for the year 2020.) A. An employee is hired on 12/31/2019 and works three 8-hour days per

week through 12/31/2020. B. An employee is hired on 12/31/2019 and works two 8-hour days per

week through 12/31/2020. C. An employee is hired on 12/31/2019 and works 1,000 hours through

7/31/2020. D. An employee is hired on 1/3/2020 and works 1,000 hours through

12/31/2020

Answer: A Two requirements must be met: one “full” year of service and at least 1,000 hours worked during that year. Answer B is wrong because fewer than 1,000 hours were worked in a 12-month period. Answer C is wrong because only one of the two requirements has been met. This employee would become eligible to participate after completing 12 months of service. Answer D is wrong because the employee has not worked 12 full months (just a few days shy). 2) Coverage requirements In addition to rules addressing age and service for participation, qualified plan coverage is

further regulated through two alternative overall coverage tests. Ratio percentage test

The plan must cover a percentage of non-highly compensated employees (NHCEs) that is at least 70% of the percentage of highly compensated employees (HCEs) who are covered. If this test is failed, then the next test must be passed.

Average benefit test The average benefits for all non-highly compensated employees (NHCEs) must be at least 70% of those for highly compensated employees (HCEs).



Examples If Acme, Inc.’s plan covers 100% of the highly compensated employees (HCEs), then up to 30% of the non-highly compensated employees (NHCEs) can be excluded. 100% x 70% = 70%. If Harper, Inc.’s plan excludes 50% of the HCEs, up to 65% of the NHCEs could be excluded. 50% x 70% = 35% NHCE coverage required (100% - 35%).

If Nice Guy, Inc.’s plan excludes 10% of the HCEs, up to 37% of the NHCEs could be excluded. 90% x 70% = 63% NHCE coverage required (100% - 63%).

Applying the Facts 1. Which of the following statements is/are true? I. Under the percentage test, a plan will satisfy the coverage tests if it benefits at least 70% of the employees. II. The ratio test requires a plan to benefit a percentage of non-highly compensated employees equal to at least 70% of the percentage of highly compensated employees benefited under the plan. A. I C. I, II B. II D. Neither I or II

Answer: B Answer I would be correct if it added “who are non-highly compensated employees.”

2. If an employer wants to limit coverage, ERISA rules allow the exclusion of which of the following employees?

A. If a plan covers 100% of the highly compensated employees, up to 30% of the non-highly compensated employees can also be excluded.

B. All key employees can be excluded. C. If the plan excludes some of the highly compensated employees, more than 30% of the highly compensated employees

can be excluded. D. If the plan excludes 50% of the highly compensated employees

then more than 65% of the non-highly compensated employees may be excluded.

Answer: A Answer A is correct because 100% - 70% = 30%. Answer B is incorrect because key employee was

Substituted for “highly compensated.” Workers may not be excluded just because they are key employees. However, they could be excluded if they were highly compensated. Answer C is incorrect because highly was substituted for non-highly (30% of non-highly). Answer D is an incorrect answer because at least 35% of the non-highly compensated employees must be covered (70% of 50% - 35%). Then 100% - 35% = 65%, not more than 65%.



3) Minimum participation (defined benefit plans only) In addition to the coverage requirements, a minimum participation requirement must be met by defined benefit plans. A defined benefit plan must benefit at least the lesser of (1) 50 employees or (2) the greater of (a) 40% of all employees or (b) two employees (or if there is only one employee, that employee). Examples Medical Associates employs two doctors, Dr. L and Dr. M. LM has no other employees. Each doctor wants his own defined benefit plan. They can only participate in one plan (two

employee rule). Orthopedic Specialists, Inc. employees 10 doctors and 40 staff persons. The minimum participation requirement is the lesser of 50 employees or 40% of all 50 employees (20 employees). 4) Highly compensated employee (HCE) Highly compensated employee (HCE) affects ADP/ACP tests (2020). – a greater than 5% owner or – an employee earning in excess of $130,000 in the preceding year (2020) Key employee (affects top-heavy plans.) An individual is a key employee if at any time during the current year he/she has been one of the following. – a greater-than-5% owner or – an officer and compensation greater-than-$185,000 (indexed for inflation) (2020) or – greater-than-1% ownership and compensation greater-than-$150,000 (2020) Applying the Facts 1. Which of following individuals is classified as a highly

compensated employee (HCE)? A. John Smith, retired, who owns exactly 5% of the outstanding

Stock of ABC, Inc. B. Karen Jones, an officer with ABC, Inc., earned made $110,000 last year and will earn $130,000 this year. C. Tim Donaldson who owns exactly 10% of the outstanding stock of ABC, Inc. He will earn $250,000 this year. D. Jean Kellerman, a new employee of ABC, Inc., who will earn well over $130,000 this year.

Answer: C An HCE is an employee who earned more than $130,000 last year (2019) or an employee who was more than a 5% employee owner in the current or prior year. Someone who made exactly $130,000 last year is not an HCE. Answer A is wrong because John is retired. He is no longer “an employee.” Answer B is wrong because she would have had to earn over $130,000 last year to be classified as an HCE. Answer D is wrong because Jean did not work for ABC in the look-back year; therefore, her income for that year is deemed to be $0.



2. Whom among the following employees of Hotshoes, Inc. is not a key employee?

A. Don, who owns more than 5% of the company B. Ron, who received annual compensation in excess of $130,000

last year. C. John who is more than a 1% owner and had compensation in excess of $200,000 D. Lon who is an officer with annual compensation of $185,000

Answer: B Answer B identifies a HCE, not a key employee. 5) Permitted vesting schedules A plan is top-heavy if more than 60% of its aggregate accrued benefits or account balances are allocated to key employees. Example Tom and Sally make $400,000 each as co-owners of TS, Inc. TS, Inc. wants to establish a new money purchase plan. The other eligible employees salaries totaled $300,000. Is the plan top-heavy? Yes. $285,000 (T) + $285,000 (S) = $570,000 = .655 = 66% $570,000 (T/S) + $300,000 $870,000

What are the account balances of a new plan? The only “account balances” of a new plan are contributions (based on payroll). To determine balances for the new plan calculations are made based on payroll. The $285,000 is the salary cap for the key employees (Tom and Sally).

____________Faster – Vesting Schedules – Slower____ ________

Top-heavy DB plans Non-top-heavy All defined contribution plans defined benefit plans (only) 3-year cliff or 5-year cliff or 2- to 6-year graded or 3- to 7-year graded or 100% vested with 2-year eligibility 100% vested with 2-year eligibility

Applying the Facts Concerning the special top-heavy vesting requirement, which of the following vesting alternatives are acceptable? I. A top-heavy plan that formerly used a 7-year graded schedule must

now offer a 3-year-cliff schedule. II. A top-heavy plan that formerly used a 5-year cliff schedule must offer a 6-year graded schedule. A. I only C. Both I and II B. II only D. Neither I nor II

Answer: C The formerly allowed 7-year graded vesting schedule must be converted to either a 3-year cliff or a 2- through-6-year graded schedule. The once permitted 5-year cliff vesting schedule must be converted to either a 3-year cliff or a 2-through-6-year graded schedule.



Vesting schedule example (Based on Date of Hire) Using a 2- through-6-year graded vesting schedule, what percent of the account balance is an employee who has been with the company three full years vested using a one-year eligibility period? 40%

End of year Eligibility / Contribution Vesting % Year 1 Not eligible, one year needed N/A

Year 2 Contribution made to the plan 20% Year 3 Contribution made to the plan 40% Year 4 Contribution made to the plan 60% Year 5 Contribution made to the plan 80% Year 6 Contribution made to the plan 100%

Applying the Facts 1. Angela is a participant in her company's 7-1/2% money purchase

plan. The plan provides a 2-through-6-year graded vesting schedule with a one-year eligibility requirement. Angela has worked for this company 5 full years. What amount of her account balance is vested?

End of year Salary 1 $30,000 2 $32,000 3 $34,000 4 $36,000 5 $40,000 A. $6,390 C. $8,520 B. $8,250

Answer: C Ignore the first year of employment/service. No Contributions were made for Angela. To solve, add contributions for years 2, 3, 4, and 5 ($142,000). $142,000 at 7-1/2% is $10,650. She is 80% vested. ($10,650 x 80% = $8,520)

2. Martha is a participant in her company’s profit sharing 401(k)

plan. The plan provides a 2-through-6 year graded vesting schedule with a one-year eligibility requirement. Martha has now worked for the company 3 full years. What percentages of her deferrals and profit-sharing account balance is vested?

A. 0%/40% C. 100%/0% B. 40%/40% D. 100%/40% Answer: D Deferrals are always vested. They are the employees

own money. Martha is 40% vested in employer contributions.



3. While complying with ERISA pension plan participation rules, the employer also wants to adopt a plan using the most stringent service requirement. Which schedule should the client adopt?

A. 2-year/100 percent schedule D. 2-through-6-year graded B. 3-year cliff E. 3-through-7-year graded C. 5-year cliff

Answer: A The question is asking about the most stringent service requirement. All the other answers have a “one year (eligibility) or less” service

requirement. Only answer A can have a two-year service requirement. Do not confuse this with the most stringent vesting requirement.

4. Presume that the XYZ company plan is not considered top-heavy.

Which kind of vesting schedule can the company provide through its defined benefit plan to retain employees?

– Three eligible officers (more than 5% owners) make a total of $250,000 (not $250,000 each, $250,000 in total) – Six eligible employees make a total of $180,000.

I. The plan is top-heavy, it can use 3-year cliff. II. The plan is not top-heavy, it can use 5-year cliff. III. The plan is top-heavy, it can use 2- to 6-year graded. IV. The plan is not top-heavy, it can use 3- to 7-year graded. A. I, III C. II, IV B. I D. II

Answer: C Since this is a DB plan that is not top-heavy, it can use the slower vesting schedule. Answers I and III do not apply.

$250,000* = 58.14% $430,000

*The aggregate total of the 3 officers’ salaries is $250,000, not each making $250,000. Since benefit amounts are not given to perform the calculation, factor compensation. All employees would have the same percentage of salary contributed to the DB plan. NOTE: The calculation was not necessary. It justifies why the plan is not top heavy.

5. Mark wants to establish a pension plan for himself. He is age 55.

He’s considering a defined benefit plan. He knows the plan will be considered top-heavy. He wants a vesting schedule that will help his company retain employees. What is the most restrictive schedule the plan would be permitted to implement?

A. 3-year cliff C. 2- to 6-year graded B. 5-year cliff D. 3- to 7-year graded



Answer: C If the plan is top-heavy, it can only offer the 3- year cliff or the 2-6 year graded vesting schedule. Answer A or C. With Answer C, employees perceive that it is economically desirable to stay with Mark’s company until they become fully vested. When the word “retained” appears, select a graded schedule for the exam.

Mini case #1 Susan wants to establish a qualified plan to retain employees. Susan's, Inc. has the following employee census as of 12/31/2020. Employee DOB DOH Ownership Compensation 1 Susan 5/8/72 6/1/01 100% $300,000 2 Frost 2/16/60 6/1/01 -0- 120,000 3 Louis 9/12/68 8/1/06 -0- 48,000 4 Johnson 4/15/86 2/1/08 -0- 35,000 5 Ripley 12/7/90 10/1/09 -0- 32,000 6 Sidney 10/23/91 6/1/09 -0- 29,000 7 Hansen 5/17/93 4/1/09 -0- 25,000 8 Budd 6/12/01 12/1/18 -0- 18,000 9 Davidson 12/7/92 8/1/20 -0- 15,000 $622,000

1. Assume Susan's proposed plan will provide a graded vesting schedule. Which employees may be excluded because of the failure to satisfy statutory participation requirements?

A. All employees are excluded except for Susan and Frost. B. Only Davidson is excluded. C. Davidson and Budd are both excluded. D. Davidson, Budd, and Sidney are excluded.

E. No employees are excluded. Under non-discrimination rules, all employees must be eligible for a new plan.

Answer: C Budd is excluded due to his age and Davidson is excluded due to his service (less than one year).

2. Assume that a 10% money purchase plan was adopted and installed before 12/31/2020. Susan's Inc. makes its initial contribution to the plan. Will the qualified plan be considered top-heavy in the first year (2020)?

A. Yes, 43% of benefits accrue to the key employee. B. No, only 50% of benefits accrue to the key employee. C. Yes, 68% of benefits accrue to the key employee. D. Yes, the plan will not pass the ratio percentage test. E. Yes, the plan will not pass the average benefit test.

Answer: B Susan's comp. = ($285,000)* = 50% Eligible comp. $285,000 + 289,000**

* $300,000 is over the salary cap for 2020. ** Budd’s $18,000 and Davidson’s $15,000 are not included.



Note: Frost is not a key employee or HCE. NOTE: The account balances at year end would be 10% of the compensation. To simplify the calculation use compensation to determine whether (or not) the plan is top-heavy.

Assume for #3 that a money purchase (DC) plan was adopted. 3. Which of the following vesting schedules would Susan most likely

choose? A. 3-year cliff C. 2- to 6-year graded B. 5-year cliff D. 3- to 7-year graded

Answer: C Susan’s Inc. wants to retain employees. The graded schedule would motivate them to stay. Only non-top heavy defined benefit plans can use slower vesting schedules (Answers B and D).

Family Attribution rules Attribution rules can affect who is a key, or highly-compensated, employee (for the >5% ownership rule). An individual may be deemed to be a >5% owner because of relationship to an actual related >5% owner. (NOTE: If the business is not a corporation, similar principles apply.) If you are 1) an employee and 2) the spouse, parent, child, or grandparent of an individual who is a >5% owner, you are also deemed to be a >5% owner. (Only a

parent, not a grandparent, is deemed to own stock on behalf of children under age 21.)

Mini-case #2 ABC has a 401(k) plan with the following census as of 12/31/20. Emp. Officer DOB DOH Owner Compensation hrs. worked 1 Mr.A Yes 7/12/65 10/1/02 50% $ 80,000 2080 2 Mrs.A Yes 8/2/69 10/1/02 -0- 39,000 2080 3 Mr.B Yes 9/20/69 10/1/02 50% 80,000 2080 4 Mrs.B Yes 10/8/73 10/1/02 -0- 39,000 2080 5 Gus No 9/1/63 7/3/05 -0- 4,000 350 6 Mel No 11/7/61 2/1/07 -0- 6,000 425 7 Sally No 1/10/83 6/2/09 -0- 32,000 2080 8 Ray No 2/7/88 8/4/11 -0- 30,000 2080 9 Tim No 3/14/91 4/2/13 -0- 30,000 2080 10 Randy No 1/28/01 12/19/17 -0- 28,000 2081 11 Jane No 1/28/92 7/15/20 -0- 22,000 1120 $390,000

1. Using the 21-and-one rule for the year 2020, which of the following employees are ineligible to participate?

I. Gus III. Tim V. Jane II. Mel IV. Randy A. All of the above C. II, IV E. III, IV B. I, III, V D. I, II, IV, V



Answer: D Gus and Mel worked fewer than 1000 hours and/or less than 500 hours for three consecutive years. Randy is under 21, and Jane has less than one-half year of service.

2. Is the plan top-heavy? A. Yes B. No

Answer: A An individual is considered to own stock in a corporation owned directly or indirectly by his/her spouse (ownership attribution to the wives).

$80,000(A) + 80,000(B) + 78,000 (two wives) = 72% $330,000 (from $390,000 – 60,000*) *Gus, Mel, Randy, and Jane's salaries

3. What would be the most appropriate vesting schedule? A. 2- to 6-year graded C. 3-year cliff B. 3- to 7-year graded D. 2-year cliff

Answer: A For DC plans, only the faster schedules are available. Generally a graded schedule helps to keep employees.

Special NOTE: The CFP exam generally has no calculation questions on the non-

discrimination rules. ESOPs, 401(k)s, and matched 403(b)s are not tested on a benefits basis but must satisfy the ADP and ACP tests which are both focused on contributions. However, cross-tested profit-sharing plans are tested in terms of benefits.

6) ADP/ACP testing Because elective deferral programs are more likely to cover higher paid employees, elective

deferrals are subject to nondiscrimination testing under the "ADP" (actual deferral percentage) test, and employer matching and profit-sharing contributions are subject to nondiscrimination testing under the "ACP" (actual contribution percentage) test. The two tests are similar: both compare the percentages of highly compensated employees (HCEs) to those of the non-highly compensated employees (NHCEs). In both tests, the HCEs rate must be both of the following.

1. not more than 125% of the NHCE rate (ADP is 8% or greater) or 2. not more than 200% of the NHCE rate and not more than two percentage points greater than the NHCE rate (ADP is between 1% and 8%)

Shorthand method: 0 to 2% is “times 2,”and 2 to 8% is “plus 2.”

NHCE HCE Deferral 1% (x2) 2% Deferral 2% (+2 or x2) 4% Deferral 3% (+2%) 5% Deferral 4% _____ ____

Example If the ADP for non-highly compensated employees of company X for last year was 4%, the ADP for

highly compensated employees for this year can be as high as 6% (4% plus 2%). This meets test 2.



Applying the Facts Sturdy Steel, Inc. provides a 401(k) plan where the NHCE’s average deferral is 4%. Under ADP/ACP what is the maximum amount that Ray, age 49, the owner and only (HCE), can defer if he earns $300,000 in 2020? A. $13,500 C. $19,500 E. $26,000 B. $17,100 D. $23,600

Answer: B Using test #2, $285,000 x 6% = $17,100 (4% + 2% = 6%).

Catch-up deferral The act also provides special "catch-up" elective deferral amounts for individuals who have reached age 50 by the end of the current calendar year. The elective deferral limit is increased by the lesser of an applicable dollar amount ($6,500 in 2020) or the amount of the participant's compensation reduced by any other elective deferrals by the participant for the year.

Applying the Facts If Ray, from the question above, was age 50, what would have been the maximum amount that he may contribute in 2020? A. $13,500 C. $19,500 E. $26,000 B. $17,100 D. $23,600 Answer: D $17,100 plus $6,500 catch-up contribution Tax Relief Act of 2001 Elective deferrals under a 401(k) plan are not taken into account for purposes of the employer’s

deduction limits. The elective deferrals are not currently taxable to the plan participant. 7) Controlled group Common control must be taken into account in identifying the "employer." This applies to

contribution maximums and non-discrimination testing. The common control rules are as follows.

Parent-subsidiary – One entity (the parent company) owns at least 80% of one (or

more) of the other entities. Brother-sister – Five (or fewer) owners of two or more entities own 80% or more of each entity.

Affiliated service group – The affiliated service group (ASG) rules apply primarily to service organizations that provide professional services in the field of health, law, accounting, engineering, etc. Employee leasing – Provisions were adopted to reduce the discrimination potential from an employer's choosing to lease employees from an independent employee leasing organization rather than employ them directly.



Example Wonder Widget, Inc. engages Accountants on the Spot for its bookkeeping. Debbie Deb a common-

law employee of Accountants on the Spot. As a “worksite employee,” she works for Wonder Widget for over one year. She will then be treated as a “leased employee” of Wonder Widget. Debbie must be credited for eligibility and vesting under Wonder Widget’s qualified plans.

Why is it important to identify a controlled group? Annual additions to a participant's qualified plan account are limited to the lesser of 100% of compensation or $57,000. For purposes of this limit, an individual with multiple accounts applies the limit in the following ways.

– In the aggregate to all accounts when the plans are offered by a single employer or two or more related employers.

– Separately to each account in unrelated employer plans Related employers are controlled groups and may limit annual additions to $57,000.

Applying the Facts 1. Dr. Brainsurgeon and Dr. Heartsurgeon establish a medical practice

as equal partners. The partnership then forms a separate service organization to provide all support services for the medical practice. The service organization will employ all of the support employees. Each of the doctors would own 50% of the service organization. The doctors wish to adopt a qualifying plan covering only themselves and none of the regular employees. Which of the following rules would eliminate this type of planning? A. Personal service corporation (PSC) rules B. Affiliated service group rules C. Parent-subsidiary rules D. Leased employee rules

Answer: B This arrangement is an affiliated service group. It Is neither a parent-subsidiary nor a personal service corporation (no mention of a corporation).

2. Mr. Ryan owns Ryan, Inc. Ryan, Inc. provides a 25% money purchase plan. A $57,000 annual contribution is made for him. Ryan, Inc. recently purchased 90% of another corporation. Can Mr. Ryan install another defined contribution plan at the second corporation and participate in it?

A. No, because the new business is a subsidiary corporation. Mr. Ryan’s total annual additions are limited to $57,000.

B. No, because this is a brother-sister controlled group, and annual additions are limited to $57,000.

C. Yes, because this is an unrelated corporation, and Mr. Ryan can contribute to a second plan up to the annual additions based on his compensation from the second corporation.

Answer: A Ryan, Inc. (parent company) owns >80% of second company. This is a parent-subsidiary relationship.



B. Integration with Social Security/disparity limits The purpose of integration is to equalize the employer's contributions to retirement plans for higher and lower paid employees. Without plan integration, the employer contributes a higher percent of compensation for lower paid employees. The net result is to lower the cost for rank-and-file employees while maintaining the same level of contribution (cost) for relatively higher paid employees (typically owners). Example – 25% money purchase plan with no integration The owner's salary is $350,000; the maximum money purchase contribution is $57,000

(100% / $57,000 rule). Only a 20% contribution (20% of $285,000) can be made for the owner because 25% of $285,000 is more than $57,000. For a rank-and-file employee whose salary is $30,000, the maximum contribution would be $6,000. (The employee must also receive a 20% contribution.)

1) Defined benefit plans

There are two methods for integrating defined benefit formulas with Social Security: the "excess" method and the "offset" method. Only the excess has appeared on the CFP exam in recent years. The offset method makes employees feel mis-used.

Defined benefit plans – excess method Integration level - Level of compensation above which the excess

contribution is made. It can’t exceed the social security taxable wage base.

Base benefit percentage - Plan benefit for compensation below the integration level Excess benefit percentage - Plan benefit for compensation above the integration level Defined benefit plan integration excess plan – permitted disparity = lesser of the base benefit percentage or 26.25% (flat) Examples base percentage + permitted disparity = excess percentage 30% + 26.25% = 56.25% (26.25% / 56.25%) 20% + 20% = 40% (20% / 40%)

Applying the Facts If Excellent, Inc. installs a DB plan with a base contribution rate of 24.25%, how much will the excess percentage be? A. 24.25% C. 48.50% B. 26.25% D. 50.50%

Answer: C The permitted disparity is the lesser of the base benefit percentage or 26.25%. 24.25% + 24.25% = 48.50%



2) Defined contribution plans

Integration level - Any dollar amount up to Social Security wage base (2020: $137,700) Base contribution percentage - Contribution percentage for compensation below the integration level Excess contribution percentage - Contribution percentage for compensation above the integration level Permitted disparity - Lesser of the base contribution percentage or the 5.7% formula for determining components of integrated DC plan Examples If the base contribution percentage is 10%, then the permitted disparity is 5.7%, and the excess contribution percentage is 15.7%. Base percentage + permitted disparity = excess percentage 10% + 5.7% = 15.7% 16.77% + ____ = ____ (5.7%/22.47%) 4% + ____ = ____ (4%/8%) – If the base contribution percentage is 10%, what is the permitted disparity?

It is 5.7% (excess 15.7%). – If the base contribution percentage is 4%, what is the permitted disparity?

It is 4% (excess 8%). Example – illustrates how integration works

– The HCE top salary is $285,000. (The salary cap is $285,000.) – The base contribution percentage is 17%. – The excess contribution percentage is 22.7% (17% + 5.7%). – The permitted disparity is 5.7%.

HCE contribution First $137,700 @ 17% = $23,409 Remainder @ 22.7% = 33,437 Total contribution for HCE $ 56,846 ($154 below maximum)

NHCE contribution $30,000 x 17% = $5,100 Integration can be used in a target benefit pension plan, money purchase, profit-sharing,

stock bonus, and SEP (but not an ESOP or SIMPLE) plan to allow the highly compensated employees to maximize the company contributions ($57,000) and minimize the non-highly compensated employee contributions.



Applying the Facts 1. What is the permitted maximum disparity for an integrated money

purchase plan? A. 5.7% C. 7.65%

B. 6% D. 26.25%

Answer: A It is the lesser of the base or 5.7%. 2. What is the permitted disparity if the base contribution is 5%? A. 5% C. 7.65%

B. 5.7% D. 10.7%

Answer: A 5% + 5% = 10%

3. Which of the following is false concerning the profit-sharing allocation formula? A. It may allocate contributions on a pro-rata basis B. Contributions must be definite and predetermined C. It may discriminate in favor of highly compensated employees D. It may skew contributions to specific participants

Answer: B Answer B is false because the profit-sharing allocation is flexible and is not determined until year end. Contributions do not need to be allocated on a pro-rata basis and may be skewed to older

participants through Social Security integration, age-weighting, or cross-testing. Answer D is correct but ultimately, these methods must not be discriminatory.

Applying the Facts 1. Kathy Overachiever works for ABC, Inc. Her salary is $200,000. ABC

provides a money purchase plan that contributes 20% to her account each year. Kathy is age 50, and is single. She has a $440,000 current balance in her money purchase plan. She wants to retire in 10 years. She projects that there should be about $1 million in her account at age 60. It would provide about a $50,000 – 60,000 payout over her life expectancy. She feels that will not be enough. Another company (XYZ) approached her to work part-time(20 hours per week). They offered her $100 per hour or approximately $100,000 per year. If XYZ has a 20% profit sharing plan, can she participate? A. Yes, if ABC and XYZ are not a controlled group. She can

receive a contribution of $20,000. B. Yes, if ABC and XYZ are not a controlled group. She can

receive a contribution of $16,500 ($57,000 max). C. No, because she is not considered a full-time employee. D. No, because ABC and XYZ an affiliated service group.



Answer: A There is nothing to indicate that ABC and XYZ are a

controlled group. Under ERISA rules, 1,000 hours a year qualifies as a year of service.

2. Warren Workhard is upset. His employer provides a 401(k) profit sharing plan. Due to unprofitable years, the company discontinued making a profit sharing contribution. Then they stopped offering a 401(k) match. Now the company informed him that he can only defer 4% of his $200,000 salary (HC). Because he participates in this plan, he cannot make a deductible $6,000 IRA contribution. Also, due to AGI phaseout, he also cannot make a Roth IRA contribution. What happened to the plan? A. The company had to reduce the permitted deferral percentage

when they stopped the match. B. The number of NHCEs deferring has diminished to the point that the plan no longer meets coverage ADP/ACP requirements. C. The company decided to cap the percentage so employees would have more cash to spend. D. The company installed another plan that integrates with the 401(k) plan.

Answer: B When the NHCEs do not participate the plan generally does not meet the coverage percentage (ratio percentage). This is going to trigger ADP/ACP testing. Answers A, C and D are nonsense.

3. Four years ago, Rich joined Crane, Inc. After 3 months with the

company, he became eligible to participate in the 401(k) plan. Crane does not provide a matching contribution but does make a profit sharing contribution with a 1-through-5 year gradual vesting schedule. How much of his account is vested? (ignore earnings)

Deferral Company Contribution 1 $10,000 $15,000 2 $12,000 $20,000 3 $13,000 $12,500 4 $15,000 $22,500

A. $56,000 D. $106,000 B. $92,000 E. $120,000 C. $96,000

Answer: D The deferrals are never subject to vesting ($50,000 deferral total). They belong to Rich immediately. The company contribution ($70,000) are 80% vested: Year 1 20%; Year 2 40%; Year 3 60%; Year 4 80% $70,000 x 80% = $56,000 $50,000 + $56,000 = $106,000



4. Last month, Bert turned age 50. He is a participant in his company’s 401(k) profit sharing plan. He usually contributes the maximum elective deferral, $19,500 (2020), and the company’s usual contribution is 10% of his salary of $120,000 or $12,000. To accumulate more money in his plan, he is going to add the $6,500 catch-up contribution. How will this limit his deferral or the company contribution?

A. It will not limit either the deferral or the company contribution. B. It will reduce his deferral by $6,500. C. It will reduce his salary by $6,500 and his profit sharing contribution to $118,500 at 10%. D. His annual addition will be capped by $57,000.

Answer: A Catch-up contributions do not affect deferrals, company contributions or the $57,000 maximum annual additions limit. They are permitted in

addition to the Section 415 limit of $57,000.



More qualified plan rules and options Lesson 5 Qualified plan rules and options (continued) C. Factors affecting contributions or benefits 1) Deduction limits [§404(c)]

The employer can only deduct a maximum of 25% of all participants' (aggregate) eligible compensation. Certain individual plan participants may receive contributions in excess of 25% as long as total company contributions do not exceed 25% and contributions do not violate the rules of discrimination.

2) Defined contribution limits The Section 415 "annual additions limit" applies to all defined contribution plans. It

limits annual additions (employer contributions, employee salary reductions, and plan forfeitures) to each participant's account to the lesser of $57,000 (2020) or 100% of compensation. Account earnings are not factored into the annual additions limit. NOTE: If an employee receives annual additions that exceed the 415 limit, the employer has several options. The excess:

– may be reallocated among other employees whose 415 limit has not been exceeded, – may be applied in a later year to the same employee (funds held in a suspense account), or – may be used to reduce future plan contributions.

Applying the Facts Darlene earned $140,000 as a computer programmer last year. She is employed by Computerland, Inc. Due to very high turnover last year (prompted by merger talks), Darlene should have received a forfeiture contribution that would have caused her annual additions to exceed the §415 limit. What are her employer’s options regarding the excess forfeiture amount? I. The excess may be reallocated to those participants who have not reached their §415 limit. II. The excess may be held in a suspense account and reallocated in a subsequent year to the participant who had the excess (Darlene). III. The excess may be used by employer to reduce future plan contributions. IV. The employer may remove the excess forfeiture amount from the plan and use the funds for operations. A. I, II, III C. II, III, IV B. I, III, IV D. All of the above

Answer: A Plan assets must be used for the exclusive benefit of

plan participants and their beneficiaries.



4) Annual compensation limit Only the first $285,000 (2020) of each employee's compensation is taken into account for purposes of this contribution limit.

Example of Section 415 limit - defined contribution plan Sid's salary is $285,000 annually. He defers the maximum amount ($19,500) into his employer’s

401(k) plan. The company matches up to 3% ($8,550). What amount can the company add as a profit-sharing contribution? $28,950 [$57,000 - ($19,500 + $8,550)] [maximum 415 limit - (deferrals + match)] What amount can the company add as a profit-sharing contribution if, due to

exceptionally heavy employee turnover, $3,000 of forfeitures is added to Sid's account? $25,950 [$57,000 - ($19,500 + $8,550 + $3,000)] [maximum 415 limit - (deferrals + match + forfeitures)]

Applying the Facts 1. Arnold’s current year compensation is $120,000. He is 45 years

old and neither an officer or owner. His employer makes a 10% money purchase contribution, a 10% profit-sharing contribution. Arnold also defers $19,500 into the 401(k) plan that matches $0.50/$1 up to 5% of compensation. In addition, he’ll receive $14,000 in reallocated forfeitures. What is the total amount that may be added to Arnold’s account this year? A. $19,500 C. $63,500 B. $57,000 D. $46,000 because he is not eligible

to receive any forfeitures

Answer: B He can receive up to the §415 annual addition limit ($57,000). However, the excess forfeiture ($4,000) cannot be applied to his account this year. MP – $12,000 PS – $12,000 Deferral – $19,500 120,000 x 5% x ½ – $ 3,000 Forfeitures – $10,500

$57,000

2. Spike Cool earns $160,000 as the young owner of a one-employee corporation. What amount is the total that he can defer (2020) to a solo 401(k) plan assuming the maximum profit-sharing contribution will also be made?

A. $17,000 C. $40,000 B. $19,500 D. $57,000



Answer A The maximum profit-sharing contribution for Spike is limited to 25% of $160,000 or $40,000. However, the maximum annual addition (the Sec. 415 limit) is $57,000; therefore, the maximum

deferral amount cannot exceed $17,000 ($57,000 minus $40,000 equals $17,000).

3. The owner of a company, age 30, earns $215,000 this year. How

large a deferral can be made to a 401(k) with no employer match and a 15% contribution to a profit-sharing plan for 2020?

A. $13,500 C. $24,750 E. $57,000 B. $19,500 D. $26,000

Answer: B The 2020 Section 415 limit is $57,000. If the Company contributes 15% of $215,000 ($32,250), the owner can defer a maximum of $19,500. $24,750 exceeds the 2020 elective deferral limit.

5) Definition of compensation Compensation Compensation is generally considered to include only taxable compensation paid or accrued during the tax year. The definition of compensation also includes elective

deferrals under Section 401(k) and Section 457 and generally includes salary reduction contributions to Section 125 cafeteria plans (FSAs). (Inclusion or exclusion is determined by the plan document.)

Example Howard's current year salary is $170,000. He defers $10,000 into his 401(k) plan and $7,500

into an FSA (Section 125) plan at work. If his employer provides a 20% profit-sharing plan, what amount will it contribute? $170,000 x 20% = $34,000. There is no compensation offset for deferrals.

Did this contribution violate any rules? No, the $34,000 plus the $10,000 deferral is $44,000. This is less than 100% of compensation or $57,000. The FSA reduction does not affect the calculations.

Applying the Facts 1. Matt's salary is $150,000. He defers $9,000 into his employer’s

401(k) plan and $6,000 into a Section 125 plan. If his employer makes a 10% profit-sharing plan contribution, how much would be contributed to his account?

A. $13,500 C. $19,500 B. $15,000 D. $26,000

Answer: B 10% of $150,000 (Contribution is based on pre- deferral salary.) His salary is not reduced by the deferrals ($9,000 and $6,000). Contributions

are made by the employer. Deferrals are made by the employee.



2. A defined contribution plan or defined benefit plan is prohibited from defining compensation to include or exclude which of the following?

A. Overtime B. Bonuses C. Compensation that exceeds $285,000 (2020) D. Nonrecurring compensation (e.g. one-time bonus, etc.)

Answer: C In 2020, compensation that exceeds $285,000 cannot be considered. It must be excluded. The rest may be included or excluded by the employer providing the definition of compensation is not discriminatory.

3. Victoria Sanderson, an outside director of a publicly traded

corporation, receives $75,000 for her services. It is reported on Form 1099. She wants to shelter as much of her director’s fees as possible. What do you recommend? I. As a director, she is not eligible to establish a qualified retirement plan because no employer/employee relationship

operates between her and the corporation. II. She is eligible to fund an IRA because director fees are

earned income. A. I C. I, II B. II D. Neither I or II Answer: C An outside director (who is not an employee of

the corporation for which she is a director) may establish an IRA or qualified plan on the basis of director fees. Board of Director fees qualify as compensation (earned income).

4. If Victoria opens a qualified plan, can she also contribute to a deductible IRA based on the information in the prior question?

A. Yes if she is single B. Yes if she is married C. Answers A and B are correct.

Answer: C The phaseout for deductible contributions for single taxpayers is $65,000 - $75,000 and $104,000 - $124,000 for married (2020). With only the director’s fees she can contribute up to 25% ($18,750). $75,000 – 18,750 results in an AGI that is less than $65,000 (phaseout).



6) Multiple plans (2020) Elective deferrals - more than one employer If there is more than one employer, Eeective deferrals to multiple plans are always

Aggregated. 401(k) / 403(b) / SIMPLE / SARSEP $19,500 maximum + $6,500 (catch-up)

SIMPLE and another SIMPLE $13,500 maximum + $3,000 (catch-up) Examples

1. Walter Workaholic works for two employers. At one employer, he defers $9,000 into a 401(k). How much can he defer into the second employer's 401(k)?

Answer: A maximum of $10,500 would max him out at $19,500.

2. Amy Ambitious has two employers. At one employer, she defers $6,500 into a SIMPLE.

How much can she defer into the second employer's 401(k)?

Answer: A maximum of $13,000 would max her out at $19,500.

NOTE: If no age is provided, do not assume the employee is over age 50. The question must indicate an age of 50 or older to use catch-up.

Annual additions Annual additions to a participant's qualified plan account are limited to the lesser of 100% of compensation or $57,000. For purposes of this limit, an individual with multiple accounts applies the limit as follows. – in the aggregate to all accounts when the plans are offered by a single employer or two or more related employers

– separately to each account in unrelated employer plans

Example Bill works for two unrelated employers, ABC (day job) and XYZ (night job). Each employer has a money purchase plan. ABC contributes $30,000 for Bill, and XYZ contributes $35,000 for Bill. What will be the result of these contributions? Both contributions are allowable. The two employers are unrelated.

7) Special rules for self-employed (non-corporations) A Keogh (HR-10) plan is a qualified retirement plan for sole proprietorships and

partnerships. Keogh plans may operate as defined benefit, money purchase or profit-sharing type plans for sole proprietor and partnerships. There are important distinctions between self-employed and corporate plans. – The owner-employee contribution or benefit is based on net earnings instead of salary. Net earned income is the owner-employee's net income from the business after all deductions, including the deduction for non-owner employee(s) only plan contributions (net Schedule C income).

– The IRS has ruled that the self-employment tax must be computed and a deduction of one-half of the self-employment tax must be taken before determining the deductible contribution [.9235 x (15.3% : 2)] or 92.35% x .0765.



– In addition if the employee* contribution is formula then the self-employed contribution is 15% .15 : 1.15 13.04% 25% .25 : 1.25 20% *non-owner employee

Example Ted's Schedule C income $ 70,000.00 1st subtract 1040 self-employment tax adjustment $70,000 x 92.35% x .0765 = - 4,945.34 2nd apply the following percentage $ 65,054.66 Profit-sharing 25% : 1.25 x 20% or Money purchase * $ 13,010.93 * This is the owner-employee's adjusted plan contribution. The formula for the percentage is

calculated as follows: [(plan contribution %) : (1 + plan contribution %)]. In this case, the maximum owner contribution for a profit-sharing or money purchase plan is

[25% : 1.25] = 20%. For a 25% profit-sharing or money purchase plan, the owner-employee would only receive a contribution of 18.59% ($13,010.93 : $70,000). Recommendation: Use the shortcut method below. Shortcut: Take the net schedule C income, then

-- multiply by 12.12% for 15% contribution for non-owner employees or -- multiply by 18.59% for 25% contribution for non-owner employees

Example Sol Soleproprietor maintains a 15% profit-sharing plan. His business will produce $50,000 of profit. Business profit/net income $50,000

less 1040 self-employment tax adjustment - 3,532 ($50,000 x .07065) $46,468

15% : 1.15 x 13.04% $6,059 maximum contribution Shortcut: (This calculation is also used for a self-employed SEP contribution.) 15% plan multiply business profit by 12.12% ($50,000 x 12.12% = $6,060) NOTE: The calculation, if it is on the exam, will use a wage base under the Social Security maximum ($137,700). There is no easy way to calculate the answer above the wage base. Applying the Facts 1. George is the sole proprietor of George's Plumbing. He has established a 25% money purchase plan. In the current year, his business will produce $50,000 of net Schedule C earnings. What

amount can he contribute to his Keogh plan? A. $9,235 +/- $1 C. $10,000 +/- $1 B. $9,294 +/- $1 D. $12,500 +/- $1

Answer: B $50,000 minus $3,532 ($50,000 x 92.35% x .0765) times 20% (owner-employee contribution) equals $9,294. Use the shortcut $50,000 x .1859 = $9,295



2. Which of the following statements is/are true about net

earnings? I. Net earnings are determined after claiming all allowable business deductions, including the deduction for the employee only retirement contribution.

II. The self-employed person’s contribution or benefit is based on net earnings.

A. I only C. Both I and II B. II only D. Neither I nor II

Answer: C Both statements are true. D. Top-heavy plans 1) Definition A defined contribution plan is top-heavy if more than 60% of the total amount in the accounts of all employees is allotted to key employees. 2) Key employee An individual is a key employee if at any time during the current year he/she has been one of the following. – was a greater-than-5% owner or – officer and compensation greater-than-$185,000 (indexed for inflation) (2020) – greater-than-1% ownership and compensation greater-than-$150,000 (2020) 3) Vesting A plan is top-heavy if more than 60% of its aggregate accrued benefits or account balances are allocated to key employees. 4) Effects on contributions or benefits Minimum benefits and contributions for non-key employees A top-heavy plan must provide minimum benefits or contributions for non-key employees. DB - The benefit must be at least 2% of compensation multiplied by the number of employee's years of service in which the plan is top-heavy up to a maximum of 10 years. NOTE: B is the second (2%) letter of the alphabet. Example Stan, a non-key employee, has been with the company 20 years. The plan has been top-heavy for 15 years. What is the minimum benefit the company must fund for Stan? 2% x 10 years = 20% benefit DC - The minimum employer contribution must be no less than 3% of each non-key employee's compensation. NOTE: C is the third (3%) letter of the alphabet.



E. Loans from qualified plans Qualified plan loans [includes TSA/403(b)] IRC Section 72(p) allows participants to borrow from their plans on a tax-free basis, provided the following requirements are satisfied:

- Loans are made under an enforceable agreement requiring repayment. - Total loans do not exceed the lesser of 50% of the participant's vested plan benefit or

$50,000. A special rule allows participants with small accounts to borrow up to $10,000 without regard to the percentage limitation.

- The loan is repaid over a period not exceeding five years unless the loan is used to acquire the participant's principal residence. The residence does not have to be pledged as security for the loan in order to qualify for a repayment period longer than five years. Another exception to the five-year loan repayment is a leave of absence (less than one year).

- Loan repayments to be made are in level installments at least quarterly. If a participant fails to make payments according to schedule, the entire balance due is deemed a taxable distribution. A deemed distribution is subject not only to ordinary income tax but also to the 10% penalty if made prior to age 59 1/2. Although a deemed distribution causes taxation to the participant, it doesn't disqualify the plan.

For income tax purposes, interest on a plan loan will be treated as consumer interest.

Generally, it will not be deductible by the employee as an itemized deduction unless the loan is secured by the principal residence. Principal residence loans are also allowed to key employees. However, the interest is not deductible (ever!) even when the loan is secured by the key employee’s principal residence. Interest is never deductible when a plan loan is secured by elective contributions made to a 401(k) or tax sheltered annuity. In other words, the only way a non-key participant can deduct interest paid on a plan loan is if the following two conditions are met: 1) The loan is for the participant’s primary residence. 2) The loan is secured by the primary residence.

The adequacy of the security will be determined based on that which would be required in the case of a normal commercial between two unrelated parties at arm’s length terms. A participant's vested accrued benefit under the plan may be used as security for the participant loan to the extent of the plan's ability to satisfy the participant's obligation in the event of a default.

NOTE: A qualified plan is not required to provide loans. Loans from IRAs, SEPs, SIMPLEs and

Roth accounts are not permitted.

Applying the Facts 1. Plan loans are not allowed in which of the following type of retirement plans? A. Target benefit plan C. SAR-SEP B. Defined benefit plan D. ESOP

Answer: C SEPs, SIMPLEs, and IRAs are prohibited from offering loan provisions. All qualified plans may have loan provisions although defined benefit, ESOP, and stock bonus plans seldom do.



2. Plan loans that are made available to plan participants must satisfy which of the following requirements? I. Available to all participants on a reasonably equivalent basis and must not be available to non-highly compensated employees in an amount greater than the amount made available to other employees

II. Adequately secured and bear a reasonable (market) rate of interest


Answer: B Loans must be available to all participants on a reasonably equivalent basis. They must not be

available to HIGHLY compensated employees (HCEs) in an amount greater than the amount made available to other employees.

3. Which of the following statements is true about loans from 403(b) plans?

A. They are not allowed because 403(b) plans are not technically “qualified” plans.

B. Loan balances do not have to be secured. C. Interest deductions are prohibited if the loan on the plan is secured by amounts attributable to salary reductions. D. There are no limits on the amount each participant can borrow (not a qualified plan).

Answer: C Plan loans from 403(b) plans are permitted; they

have to be adequately secured. Limits apply ($50,000, etc.). The loan can be secured by the plan assets. If the loan was used to purchase a home, then it may be secured by the home.

4. Mr. A owns AB, Inc. with Mr. B. Mrs. A also works for AB, Inc.

AB, Inc. provides a 401(k) profit-sharing plan for its employees. If Mr. A defers $19,500 and AB, Inc. contributes $37,500 to his profit sharing account, can Mrs. A also defer and receive a company contribution?

A. She can only defer but she cannot get a company contribution. B. She cannot defer because her husband has deferred the maximum, but she can get a company contribution. C. She can both defer and receive a company contribution. Answer: C The attribution rules only affect whether a plan is top heavy (or not). There are no limitations

to employer contributions as elective deferrals when both spouses work for the same company.



Applying the Facts 1. Tom Jones owns TJ, Inc. TJ, Inc. employs no other workers. He

has become successful at age 50 delivering specialized projects for large companies. Typically, his annual salary ranges between $300,000 to $500,000. TJ, Inc. normally retains $25,000 in excess earnings each year. TJ currently has accumulated $150,000 in retained earnings (in a money market account). What is the maximum the company can contribute for Tom if it adopts a profit sharing plan?

A. The 415 limit of 57,000 B. 25% of salary

C. 18.59% of salary D. 25% of excess earning E. $25,000

Answer: A The 2020 annual additions limit is $57,000.Tom is

not self-employed, he owns a corporation. He would need to reduce his salary or allocate part of the retained earnings to find his contribution.

2. Jerry owns Jerry’s Jerseys, an S corporation. He takes a salary

of $2,000 per month. Typically, the corporation has additional earnings of $200,000. His basis in the corporation is zero, so Jerry’s K-1 usually reflects an additional $200,000 of unearned income. He wants to establish a money purchase plan with maximum contributions. What is the maximum amount that Jerry’s Jerseys may contribute on his behalf?

A. $6,000 B. $26,000

C. $57,000 D. We do not know his age to determine if he can defer

$19,500 plus a $6,500 catch up contribution.

Answer: A Compensation means salary (rather than profits). The K-1 income is unearned income. Under Section

415 limits, the plan can contribute up to 100% of compensation. However, under Section 404 he can only receive a contribution of 25% of compensation or $6,000. Jerry’s Jerseys has no other employees (Answer B). Overall, the deductible plan contributions cannot exceed 25%.



3. Goode Knight works for two unrelated companies. Both need his specialized services. He works for one or the other 30 plus hours per week. He enrolled in both of their SIMPLE plans and defers the maximum. His annual salaries range between $130,000 to $150,000 in total for both companies. What amount can he defer to the SIMPLE plans?

A. $13,500 in total B. $13,500 plus catch-up of $3,000 in total

C. $13,500 plus 3% of salary in total D. $19,500 E. $57,000

Answer: A Deferrals are aggregated. Nothing indicates his age. When no age is provided a catch-up

contribution cannot be assumed. 4. Perry Persuasive is an insurance salesman. He is self-employed

with no other employees. He usually has gross income of $140,000 and necessary business expenses of $20,000. To generate sales he has joined various civic and social organizations. His meals expenses total another $40,000. If he installs a maximum profit sharing plan how much can he contribute to the plan?

A. $18,590 C. $40,000 B. $26,000 D. $57,000

Answer: A Calculate Perry’s net income.

Gross revenues $140,000 less business expenses -20,000 Less 50% meals -20,000

Net $100,000 Then apply the Keogh rules. For 25% plans use 18.59% of net income. NOTE: Expect a 15% or 25% plan (12.12% and 18.59%) scenario on

the exam.



Individual Retirement Accounts Lesson 6 Other tax-advantaged retirement plans A. Types and basic provisions 1) Traditional IRA Annual contributions

The maximum annual contribution for traditional and Roth IRAs for 2020 is $6,000. In future years, the $6,000 amount will be indexed for inflation in increments of $500. Also, the maximum annual contribution amount for taxable years beginning in 2006 and thereafter is increased by $1,000 for the “catch-up” contributions for individuals who have attained the age of 50 before the close of the taxable year. Note that the maximum annual contribution is still limited to the lesser of the increased dollar limit or 100% of compensation.

Example Mr. Green is retired. He has an AGI of $100,000. Can he contribute to a deductible or nondeductible IRA? No, he cannot do either. He has no compensation (earned income) because he is retired.

Compensation represents earnings from wages, salaries, tips, professional fees, and

bonuses. In addition, alimony and separate-maintenance payments are also considered compensation for IRA purposes (pre-2019 agreements). This remains true although the

payor spouse may no longer deduct the alimony payments. Applying the Facts Which of the following income sources can be used to determine the amount of deductible IRA contribution that is allowed? I. S corporation distributions II. Deferred compensation (informal funding) III. Professional fees IV. Board of director fees V. Alimony received under a divorce settlement A. All of the above C. III, IV, V E. IV B. II, III, IV D. III, IV

Answer: C For IRA deduction purposes, professional fees, Board of Directors fees and decreed alimony as well as separate maintenance payments are treated as compensation. S corporation distributions are unearned income (K-1 distributions). Informally funded deferred compensation is not constructively received. It is not income until it is constructively received.

Spousal IRA If a married person does not work or has limited compensation, he or she can contribute to a spousal IRA as long as the couple has compensation that equals or exceeds contributions to the IRA of both persons.



Who is eligible? Any person receiving “compensation” can contribute to an IRA. For some, the

contribution will be deductible; for others, the contribution will not be deductible, but the earnings will grow tax-deferred.

Keys to IRA deductibility – If neither spouse is an active participant or if a single person is not an active participant, then IRA contributions are deductible (not subject to AGI limits).

Plans that affect active participant status include participation in qualified plans, SIMPLE plans, SEPs, TSAs, and union plans (but not 457 governmental or nongovernmental plans).

Activity that results in active participant status includes annual additions to a defined contribution account or benefits accrued for the tax year to a defined benefit plan. Annual additions include employer contributions, employee contributions and forfeitures.

Applying the Facts Elliott, an employee of Smart, Inc., is concerned because he has not received an annual addition to the Smart profit-sharing plan for the past two years. He earns $100,000 per year, is age 40 and married. Which of the following statements are true? I. All defined contribution plans are subject to minimum annual

funding. II. He cannot contribute to an IRA because he is an "active participant" in an employer plan. III. He can make a deductible contribution of $6,000 to an IRA. IV. He can make a deductible contribution of up to $12,000 with a spousal IRA as well as his own. V. He can make a deductible IRA contribution because ABC hasn't made contributions to the profit-sharing plan. A. I, II C. III, IV, V E. II, III B. I, II D. III, IV

Answer: D If Smart, Inc. does not make a contribution to a profit-sharing plan in a given year, Elliott is not considered to be an active plan participant (although he is still covered under the plan). This is true as long as there were no "annual additions" made to the employee's account. Answer V says contributions not annual additions. Money purchase and defined benefit plans are subject to minimum funding requirements, but profit-sharing plans are not.

– If one spouse is an active participant and the other spouse is not an active participant, the non-active spouse can make a deductible IRA contribution if the couple’s combined adjusted gross income (AGI) is less than $196,000 (phased out at $206,000).*



– For active participants, deductible IRAs are phased out between the AGI limits shown.* Year Single taxpayers (active) Married filing jointly (active) 2020 $65,000 - $75,000 $104,000 - $124,000 *NOTE: In both of these cases, the spouses can contribute to a non-deductible IRAs if they are both above phaseout. Phaseout numbers are given. Matching Exercise (2020) Indicate whether each of the following taxpayers is entitled to a full (F), a partial (P), or a spousal only (S) deduction for a $6,000 contribution made to an IRA. NOTE: All individuals are under age 50. 1. _____A single individual, AGI $75,000, who is not an active

participant in an employer-sponsored qualified retirement plan

2. _____A single individual, AGI $72,000, who is an active participant in an employer-sponsored qualified retirement plan but not yet vested

3. _____A married couple filing jointly, combined AGI $216,000, neither spouse actively participating in an employer- sponsored qualified retirement plan 4. _____A married couple filing jointly, combined AGI $122,000,

Both spouses actively participating in an employer- sponsored qualified retirement plan

5. _____A married couple filing jointly, combined AGI $135,000, Spouse "H" is actively participating in an employer-

sponsored qualified retirement plan while spouse "W" is not covered by an employer-sponsored qualified retirement plan

Answers: Question 1 F (not participating) Question 2 P (in phaseout $65,000 - $75,000) Question 3 F (neither participating) Question 4 P (both spouses in phaseout) Question 5 S (spouse "W" only, spouse "H" phased out $104,000 - $124,000) NOTE: Spouse A

could contribute to a nondeductible IRA.

Early distributions before age 59-1/2 trigger the 10% penalty. Exceptions: death / substantially equal payments / total, permanent disability / first

home expense up to $10,000 / qualified education expenses / medical expense > 10% of AGI / distribution used to pay medical insurance premium after separation from employment subject to floor of 10% of AGI unless unemployment compensation has been received for at least 12 weeks and the withdrawal was made in year of unemployment or year immediately following unemployment / $5,000 for qualified birth/adoption.



Applying the Facts Which of the following IRA distributions is exempt from the 10% early withdrawal penalty? I. A hardship withdrawal II. First home acquisition cost of up to $10,000 III. Qualified loan of $10,000 for first home purchase IV. Qualified education cost for participant's child V. Separation from service at age 55 A. I, II, III, IV, V C. II, III E. II, IV B. II, III, IV D. III, IV Answer: E Distributions for (first time) home purchase and

qualified educational costs (college tuition and fees) are exempt. Hardship withdrawals are available with 401(k) plans. Loans and separation from service rules apply to qualified plans. Loans from IRAs are not allowed.

No loans permitted – If the owner borrows from an IRA account or uses it as security for a loan, that owner generally is considered to have received the entire interest. If all or part of the IRA is pledged as security for a loan, the portion that is pledged is treated as a distribution.

Applying the Facts Peter, who has an opportunity to make a quick 50% return on his money, needs cash fast. Today he has a $30,000 balance in his IRA. He doesn't feel the 60-day window is long enough, so he takes a $15,000 collateralized loan. He pledges his whole IRA account balance for the loan. Which of the following is true? A. As long as the term wasn't greater than 5 years and the amount less than ½ of the account, this is an allowable transaction. B. Peter faces a 10% penalty and income tax on the $15,000 collateralized loan. C. The loan, if made at a reasonable interest rate and adequately secured, would be an allowable transaction. D. This is a prohibited transaction, and it results in a loss of

IRA status on the whole account.

Answer: D Generally, a loan from an IRA is disqualified it and results in a “deemed distribution” of the account. Answer B would be correct if the question indicated that he only pledged $15,000 of the account balance.



2) Roth IRA (2020) Presuming that the taxpayer has earned income (or a spouse with earned income),

eligibility for a Roth IRA may then be restricted based on the amount of adjusted gross (AGI).

– For individuals phased out between $124,000 and $139,000 – For married filing jointly phased out between $196,000 and $206,000 – For married filing separately phased out between $0 and $10,000 Eligibility is not restricted by an individual's age. Contributions by individuals with earned income may continue at any age. Contributions are not deductible.

Eligibility is not affected by the individual's participation in an employer-sponsored retirement plan. Contributions are limited to $6,000 per year (or 100% of compensation, whichever is less). The $6,000 limit combines contributions made to both traditional IRAs and Roth IRAs. Investments grow tax-deferred, and QUALIFIED distributions are tax-free. A nonworking spouse may also contribute to a Roth IRA, as with a traditional IRA. There are no mandatory distributions at age 72. Contributions can even be made after age 72. The minimum distribution rules that require distributions from traditional IRAs beginning at age 72 do not apply.

Applying the Facts Ward and June, married filing jointly, have an AGI of $131,000. June participates in a 401(k) plan at work. Ward does not participate in any workplace retirement plan. Which of the following are true? I. Both Ward and June can contribute to Roth IRAs. II. Only Ward can contribute to a Roth IRA. III. Only June can contribute to a Roth IRA. IV. Only Ward can contribute to a deductible IRA. V. Both Ward and June can contribute to deductible IRAs. A. I, II, V C. I, IV B. II, IV D. III, V Answer: C Their AGI is below $196,000. Ward can fund a

deductible IRA; June can't deduct her contributions because she is an active participant in an employer’s plan and their AGI is above $124,000. Both Ward and June can fund Roth IRAs.

Conversions Prior to 2010, taxpayers with modified gross income of $100,000 or more were not permitted to make Roth conversions. The Tax Reconciliation Act permits all taxpayers to make Roth conversions, regardless of income level. Distributions (within 60 days) from a regular IRA (also including qualified plan, SEP, SIMPLE, 403(b) or governmental 457) to a Roth IRA are allowed.

Example Bob Smith, age 74, wants to convert his IRA to a Roth IRA. Does he need to take a minimum required distribution (RMD) before converting? Answer: Yes. Converting to a Roth IRA will not satisfy his RMD. He must take a RMD distribution before converting to a Roth IRA.



Non-spouse beneficiaries Any non-spouse beneficiary who inherits a qualified plan account balance is eligible to convert

that plan to an inherited Roth IRA, and the plan must allow this transfer. Please note: This conversion must be accomplished by a direct transfer because non-spouse

beneficiaries can never make a 60-day rollover. However, while a non-spouse beneficiary who inherits a qualified plan account balance can convert it to an inherited Roth IRA, if the same beneficiary inherits an IRA they cannot convert it to an inherited Roth IRA.

Applying the Facts Fay Fashion, a widow age 66, plans to retire soon from her position as head buyer for a retail chain. She currently earns $140,000 per year and has a current balance of approximately $800,000 in her account in the company's profit-sharing 401(k) plan. She also owns substantial non-qualified assets most of which were inherited from her late husband. She is concerned about RMDs in a few years. What should a CFP® professional suggest she do with her 401(k) account to avoid RMD requirements? A. Leave the money in the 401(k) plan after she retires B. After retirement, roll the 401(k) money into an IRA and then

consider cash flow and other tax matters before converting her traditional IRA into a Roth.

C. After retirement, roll the 401(k) money into an IRA and then immediately roll it into a Roth IRA D. After retirement, use distributions from the 401(k) to buy an annuity E. After retirement, roll the 401(k) money into a Roth IRA Answer: B The rollover (conversion) can be made directly from

the 401(k) to the Roth (Answer E). If she retires soon, she will have 6 years (age 72) to consider careful tax planning. Answer B is a better answer.

Contributory distributions Carl Contributor established a Roth IRA in 2010 with a $3,000 contribution and then contributed $3,000 in 2014 and $3,000 in 2015. In 2020 he withdraws $5,000; the full amount of this withdrawal will be tax-free because he contributed $9,000. Regular contributions are always distributed tax-free no matter when they are withdrawn. Any

excess withdrawals will fall under conversion and earning distributions.



Conversion and earnings distributions The road map below is for conversions only. Remember 2020 conversions are still subject to the following two charts:

Withdrawal of conversion assets

Meets five-year holding period

– no income taxes or early withdrawal penalty taxes

No income taxes or early withdrawal penalty taxes

No income taxes but 10% early withdrawal penalty tax

Withdrawal of conversion assets

SPECIAL PURPOSE

1. attainment of age 59 ½ 2. death 3. disability 4. first home purchase

(up to $10,000) 5. medical expenses 6. medical insurance premiums while unemployed 7. substantially equal periodic payments 8. higher education expenses

No Special Purpose

Fails to meet five-year holding period



Ordering rules for distributions

1. Where a Roth contains both conversion and contributory amounts, annual Roth contributions are considered to be withdrawn first. They are not taxable. 2. The converted amount(s) is (are) withdrawn second. 3. Earnings are considered to be withdrawn last.

Withdrawal of earnings from either a conversion Roth IRA or a contributory Roth IRA Meets five-year holding period Fails to meet five-year

holding period Triggering events

1. attainment of 59 ½ 2. death 3. disability 4. first home purchase (up to $10,000)

Remaining special purposes 5. medical expenses 6. medical insurance

premiums while unemployed

7. substantially equal periodic payments

8. higher education expenses

No triggering events or special purpose

No income tax or 10% early withdrawal penalty tax

Income tax and 10% early withdrawal penalty tax

Income tax but no 10% early withdrawal penalty tax

Special purposes 1. attainment of 59 ½ 2. death 3. disability 4. first home purchase (up to $10,000) 5. medical expenses 6. medical insurance

premiums while unemployed

7. substantially equal periodic payments

8. higher education expenses

No special purpose



Examples on conversions In 2010, Ramona deposited $2,000 in her Roth IRA. In 2010, she also converted her $10,000

IRA to her Roth IRA. In 2011, 2012, 2013, and 2014 she contributed $2,000 per year to the Roth, and in 2015 she contributed $3,000 (total $13,000). The account currently is worth $28,000. 1. What happens if she withdraws $13,000 this year? There is not a taxable event because

she contributed $13,000.

2. What happens if she withdraws $23,000 this year with no special purpose? A. The first $13,000 comes out tax-free (contributions). B. The extra $10,000 is conversion money. She meets the five-year holding period. Therefore, she incurs no income taxes or penalty. 3. What happens if she withdraws the whole $28,000? The conversion money rules of 2B (above) apply, but the earnings ($5,000) are subject to income tax and a 10% early withdrawal penalty (no special purpose). Unless it says Ramona is over 59½, you cannot assume she is over 59½. Examples for earnings 1. Alice deposits $2,000 per year into a Roth IRA. After four years, she closes the Roth account. What will be the tax effect? The earnings (only) will be subject to both income tax and a 10% early withdrawal penalty (fails to meet the five-year holding period and no special purpose). 2. What would be the tax result if the withdrawal were due to total disability? The earnings (only) will be subject to income tax (no 10% penalty). It fails to meet the five-year holding period. 3. Clifford needs to withdraw money from his Roth IRA for medical expenses. He

established the Roth in 2007 ($2,000). More than five years have passed since he established the account. What will be the tax effect?

The earnings (only) will be subject to income tax (no 10% penalty). Why? Special purpose (medical expense) triggers income tax on earnings. The $2,000 contribution is not subject to tax.

Required minimum distributions Roth IRAs are not subject to the required minimum distribution rules. Roth IRAs have the following distributions rules due to the death of the original owner. The Roth IRA account balance must be: – Distributed within five years of the owner's death or – Distributed over the life expectancy of the designated beneficiary with distributions commencing prior to the end of the calendar year following the year of the owner's death, or – Where the sole beneficiary is the owner's surviving spouse, the spouse may delay distributions until the Roth owner would have reached age 72 or may treat the Roth as his or her own (roll it into his/her Roth). If the surviving spouse treats the inherited Roth as his or her own Roth, then no distributions are required by the surviving spouse.



Applying the Facts 1. Which of the following types of IRAs are not subject to required

minimum distribution rules? I. A Roth IRA

II. A Roth inherited by a spouse rolled into his/her own Roth IRA III. A Roth inherited by a child of the owner (death before RBD) IV. A Roth inherited by a child of the owner (death after RBD) A. I, II, III C. I, II B. I, II, IV D. III, IV

Answer: C Only a Roth and a Roth inherited by a spouse are not subject to the RMD rules. NOTE: RBD means

required beginning date 2. In 2004, Beth, then age 52, deposited $2,000 in her Roth IRA.

In 2004 she also converted her $20,000 IRA to her Roth IRA. In 2005 she contributed $2,000 to the Roth. The account is currently worth $40,000. What happens if she withdraws the entire $40,000 today?

A. $36,000 is subject to income tax and a 10% penalty. B. $16,000 is subject to income tax and a 10% penalty. C. $16,000 is subject a 10% penalty. D. The withdrawal is entirely tax-free.

Answer: D In January 2004 Beth was age 52. She has attained 59-1/2 and meets the five-year holding period. The contribution ($4,000), the conversion funds($20,000), and the earnings ($16,000) are tax-free distributions.



Mini case Charles, age 47, and his wife Pam, age 39, reported a current year AGI of $83,000. Charles works for Y2, Inc. The company has a 401(k) plan. Charles is contributing 6% (the maximum allowable) of $100,000 to the 401(k), and the company matches 50%. Charles and Pam have a traditional IRAs (contributing $6,000 each in 2020) with $100,000 in them. Pam is a stay-at-home mom, and they have two children (ages 9 and 7). They would like to retire by age 62. 1. If Charles wants to roll his traditional IRA into a Roth IRA, which of these statements is correct?

A. Charles cannot roll his traditional IRA into a Roth IRA because of his income and current 401(k) plan participation.

B. Charles can roll his traditional IRA into a Roth IRA, but he will have to pay a penalty and federal income tax. C. If Charles uses the converted Roth account balance for the

post-secondary education of his children, he will have to pay ordinary income tax from the distributions (on earnings only).

D. Charles must take distributions from the converted Roth after age 70-1/2 because he converted it before age 50.

Answer: C There are no longer income restrictions on conversions to Roth IRAs. Charles can roll his traditional IRA into a Roth. If he makes the rollover (Answer B), he will have to pay regular income tax (federal tax) but no penalty. Charles does not have to take distributions from the Roth at any age (Answer D). He may have to pay income tax on the earning he withdraws for educational needs, but the conversion distributions will be tax-free (already paid tax)(remaining special provisions).

2. Charles and Pam recognize that they should save an additional $2,000 per year for retirement. They would like to save in the most tax-advantaged way. What would a CFP® professional most likely advise them to do?

A. Charles and Pam should dollar cost average into a small cap growth fund over the next 18 years. B. Charles should increase his contribution to the Y2, Inc. 401(k) plan. C. Charles should purchase a variable annuity. D. Pam should open a traditional IRA.

Answer: C A variable annuity would give them tax-deferred growth until retirement. Then the distributions would be based on the annuity income distribution rules. The small-cap fund distributions at retirement would be subject to LTCG in excess of basis. The fund may pay a small dividend. Answer



B is wrong because he is contributing the maximum allowed. Answer D is wrong because they are already contributing $6,000 each to traditional IRAs.

The TCJA generally repealed the ability to recharacterize any Roth IRA conversions in 2018 through 2025. Recharacterization is still available for rolling out excess contributions to a Roth IRA. This is typically used when the taxpayer contributes early in the year to a Roth IRA, but then has an AGI over the phaseout limits, thereby disqualifying the Roth IRA contribution for that year. As a result, in 2018 and beyond, the taxpayer can still undo the contribution without being subject to an excess contribution penalty tax by recharacterizing the contribution to a traditional IRA. Applying the Facts Who among the following taxpayers may recharacterize a Roth contribution that was made (attributable) to the 2020 tax year? A. Lou, who recharacterized because the value of the converted

investments declined after the conversion was completed. B. Rue, a single taxpayer who received a substantial bonus that

raised her AGI to $200,000. C. Sue, who realized she would benefit more from a deductible

contribution to a traditional IRA instead. D. Stu, who realized that he didn’t have enough available cash to

pay the federal income tax generated by the conversion of his traditional IRA to a Roth.

Answer: B Under the TJCA and beginning in the 2018 tax

year, the only circumstance under which Roth recharacterization is permitted is when the taxpayer’s AGI exceeds the contribution threshold for that year. Taxpayers filing singly must have a modified adjusted gross income under $139,000 to contribute to a Roth IRA for the 2020 tax year, but contributions are reduced (phased out) starting at $124,000. For taxpayers who are married filing jointly, the combined AGI must be less than $206,000, with reductions beginning at $196,000. If Rue did not recharacterize, she would face a 6% penalty on the contribution.

The Roth owner who wishes to recharacterize would generally instruct the trustee (or custodian) holding the Roth IRA to transfer the amount to a traditional IRA (in a trustee-to-trustee or within the same trustee). Assuming this is completed by the deadline for the Roth owner’s tax return (including extensions, generally to October 15), the contribution will be treated as made to the traditional IRA for that year (as if the Roth contribution never occurred), the October due date operates even when the taxpayer did not request an extension in April.



Applying the Facts: 1. Which of the following rules correctly apply to Roth IRA

recharacterization and conversion? A. The taxpayer may not recharacterize a Roth IRA conversion

if his AGI exceeds certain annually-indexed AGI thresholds. B. The taxpayer may not convert from a traditional to a Roth

IRA if her AGI exceeds certain annually-indexed thresholds. C. Taxpayers whose AGI exceeds limits for Roth contributions

may recharacterize the Roth contribution to a traditional IRA contribution.

D. If a Roth IRA is reconverted, it automatically loses its potential for tax-free distributions.

Answer: C After the TCJA, only “corrective” recharacterizations are allowed.

Roth 401(k) Only 401(k) and 403(b) plans and governmental 457 plans may offer a "qualified Roth

contribution program.” The “Roth(k)” is an account for after-tax elective deferrals. Participants in plans that establish such a program are able to designate all or a portion of their elective deferrals as Roth contributions. The Roth contributions are included in the participant’s gross income in the year made and then held in a separate account with separate record keeping. Earnings allocable to the Roth contributions remain in the separate account. Employees may designate their contributions (deferrals) as Roth contributions. For 2020, the maximum elective deferral amount is $19,500 plus a $6,500 catch-up contribution (if age 50 by 12/31 of deferral year). All employer contributions (including matching contributions) are made into traditional 401(k) pre-tax accounts. There are no income limits associated with Roth 401(k), 403(b) accounts or 457(b). A qualified distribution from a Roth 401(k) account will not be includable in the participant’s gross income. Rollovers will be available only to another Roth account or Roth IRA. The tax-free status of a Roth 401(k) is subject to a 5-year term after the first contribution. There is no exception for first-time home purchases. To be tax-free, the distribution must be made after the 5-year period and after the participant has reached age 59½, died, or become disabled. The traditional 401(k) portion (for employer contributions) is subject to the normal ‘in-service” distribution rules. Roth 401(k) plans will require minimum distributions when the account holder reaches the required beginning date. The traditional 401(k) portion will also be subject to required minimum distributions at the required beginning date.

Employers are not obligated to offer Roth 401(k), 403(b) or 457(b) accounts. Some employers may decide against offering the new Roth 401(k) to avoid the administrative burdens associated with offering two separate plans (Roth and traditional).



Applying the Facts 1. A participant can roll over his/her Roth 401(k) account to which of the following?

I. A traditional IRA II. A 401(k) plan with Roth 401(k) option III. A governmental 457 plan with 457(b)option IV. A 403(b) plan with Roth 403(b) option V. Another qualified plan without Roth 401(k) option A. I, II, III, IV C. I, III, V B. II, III, IV D. II, IV

Answer: B A participant can roll over his/her Roth 401(k), Roth 403(b) or Roth 457(b) account only to another Roth IRA arrangement. A participant cannot roll over his/her Roth 401(k) account to a traditional IRA, a governmental 457, or any type of qualified plan without a Roth 401(k) type option. Answers II, III, and IV produce Roth 401(k) type options.

2. In 2020, Lauren is considering deferring some of her salary into

her employer’s 401(k) plan. She is 51 years old and expects to make $100,000 this year. Her employer’s plan will be adding a

Roth 401(k) feature to the current plan. She asks a CFP® professional for information and advice on contributing to a Roth 401(k) account. What can that CFP® professional accurately tell her? I. You can defer up to $26,000 into your regular 401(k)

account or her Roth 401(k) account but cannot contribute $26,000 to both.

II. You can contribute $7,000 to a Roth IRA although you will be an active participant in her employer’s Roth 401(k) plan.

III. Your employer can make an after-tax Roth matching contribution.

IV. Your active participation will prevent you from contributing to a Roth IRA and a deductible traditional IRA.

A. All of the above C. II, III B. I, II D. IV

Answer: B Lauren is 51. She can fund a $6,500 catch-up

contribution in her 401(k) – Roth or regular. Her non-employer provided Roth IRA contribution will begin to be phased out at $124,000. In 2020, the regular Roth contribution limit is $6,000 and the catch-up amount is $1,000. Employers may match Roth 401(k) deferrals, but the match must be made in pre-tax dollars. Lauren’s active participation will prevent her from contributing to a deductible IRA only. She can contribute to a non-employer provided a Roth IRA that makes Answer IV incorrect.



ABLE Accounts The ABLE (Achieving a Better Life Experience) Act, expands Code Section 529 to create tax-advantaged accounts for the disabled. Individuals may contribute up to $15,000 annually (the amount of the annual gift exclusion). Distributions, used for qualified disability expenses are not included in gross income if the beneficiary became disabled before age 26. The ABLE account is exempt from the $2,000 limit on personal assets for Medicaid and SSI.

Applying the Facts: Which of the following statements about the ABLE (Achieving a Better Life) Act is correct? A. ABLE contribution limits are similar to those permitted for

Coverdell Education Savings Accounts (ESAs). B. Contributions to ABLE accounts (up to limits) may generally be

claimed as an above the line deduction. C. Distributions used for qualified disability expenses may be

excluded from gross income until the beneficiary attains age 18. D. A disabled individual may be the beneficiary of only one ABLE

account. Answer: D A disabled individual may be the beneficiary of only

one ABLE account. The maximum contribution to an ABLE account reflects the annual gift tax exclusion (which is considerably higher than the $2,000 maximum annual deposit to Coverdell ESAs.) ABLE account contributions are not deductible. Distributions from an ABLE account may be permitted without regard to the age of the beneficiary provided that beneficiary became blind or disabled before age 26.

Applying the Facts 1. Les Leisure, age 65, is single. He is retired and goes fishing

mot days. He wants to make a simple investment of $6,000. You find out his AGI is $80,000. What would a CFP® professional tell him about his available options? I. He can contribute to a deductible IRA II. He can contribute to a non-deductible IRA III. He can contribute to a Roth IRA IV. He can purchase a mutual fund A. I, III, IV D. II, III B. I, III E. IV C. II, III, IV

Answer: E Les is retired and does not appear to have “compensation.” AGI is not compensation. He must have compensation to contribute to any IRA.



2. Tom Terrific owns T2, Inc. and will earn $1,000,000 this year.

T2 typically employs about 100 employees. Tom is divorced and age 53. How much can he contribute to a deductible IRA?

A. $0 D. $12,000 B. $6,000 E. $14,000 C. $7,000

Answer: C Nothing indicates that T2 offers a retirement plan. If Tom is not a participant in a workplace

retirement plan, no AGI phaseout applies. He is over 50, so he may take advantage of the

$1,000 catch-up contribution plus $6,000.

3. Lorne Lovemyjob, age 72, continues to work for XYZ, Inc. His annual salary is $100,000. XYZ has a profit sharing 401(k) and he is still a participant. Lorne’s wife died 3 years ago, at age 69. He has started taking distributions from her IRA. His AGI is $150,000. Which of the following is an allowable contribution for Lorne?

A. A deductible IRA B. A non-deductible IRA

C. A Roth IRA D. A Contribution to his wife’s IRA E. None of the above

Answer: B His single taxpayer AGI rules out any deductible IRA/Roth IRA contribution. He cannot contribute to his wife’s IRA because she died.

4. Sue, age 55, is doing everything she can to save for retirement.

Sue went through a messy divorce in which attorney fees and court costs consumed most of the marital assets. Her employer provides a Roth 401(k) and she is contributing $26,000 annually. If the company provides a 3% match on her $250,000 salary. To which of the following accounts may she contribute?

A. $6,000 deductible IRA B. $7,000 deductible IRA

C. $7,000 non-deductible IRA D. $6,000 to a Roth IRA

E. $7,000 to a Roth IRA

Answer: C Sue is a participant in a worksite retirement plan and is subject to the deductible IRA phaseout (Answer A and B). Her AGI even after subtracting $26,000 from her salary is above the phaseout limit for a no-employer provided Roth.



Other tax-advantaged retirement plans

Lesson 7 Other tax-advantaged retirement plans (continue) 3) SEP (Simplified Employee Pension)

A SEP is an employer-sponsored plan under which contributions are made to each participating employee's IRA. A SEP permits for employer contributions only. SEPs are easy to adopt. A SEP can be easily adopted by completing a Form 5305-SEP.

Employer contributions

Annual SEP contributions are limited to the lesser of 25% (not 100%) of compensation ($285,000 maximum) or $57,000 (2020). For self-employed owners only, contribution is limited under Keogh rules. The employer contributions are flexible. Like a profit-sharing plan, there is no requirement to make a contribution. All contributions are 100% vested immediately.

When would a SEP plan be appropriate? A SEP is appropriate when the employer wants an alternative to a qualified profit-sharing plan that is easy and inexpensive to install. SEP requirements

The employer who provides a SEP gains simplicity but loses flexibility with regard to participation requirements. SEPs are subject to different participation requirements than those for qualified retirement plans. Contributions for employees must be the same percentage as the owners contribution percentage. But, the "recurring and substantial"

contributions requirement does not apply to SEPs. The major SEP requirements include the following: – A SEP must cover all employees who are at least 21 years of age and who have worked for the employer during 3 out of the preceding 5 calendar years. Part-time employment counts in determining years of service. – Contributions need not be made on behalf of employees whose compensation for the calendar year is less than $600 (2020).

The employer can therefore exclude employees with fewer than 3 years of service but must cover all employees who have 3 or more years of service and earn more than $600. For the employer with numerous short-term employees, this permissible exclusion can be an advantage. But for the employer with numerous long-term, part-time employees, this can be a disadvantage.

Salary reduction SEP (SARSEP) Employers can no longer establish salary reduction SEPs. If the plan was adopted before January 1, 1997, and maintained by the employer, the plan is grandfathered. The limitations are the following: – The employer can have no more than 25 employees at any time during the year.

– At least 50% of all eligible employees must participate (that is, make a salary deferral) in the SARSEP. – The limit on the deferral is $19,500 (2020). It is adjusted for inflation. The additional

$6,500 over 50 catch-up contribution is allowed. – Newly hired employees may join the grandfathered plan.



Applying the Facts 1. Which of the following statements about a SEP is false?

A. SEP contributions cannot exceed the lesser of 25% of each participant's eligible compensation or $57,000 (corporations only).

B. Contributions to a SEP plan cannot exceed 20% of the self- employee's eligible net earned income less the self- employment tax (like a Keogh). C. A SEP is available only to a company with up to 25 eligible employees.

D. Most employers use Form 5305-SEP to install a SEP plan.

E. Employer contributions to the employee's account must be immediately vested.

Answer: C Answer C refers to a SARSEP not a SEP. A SARSEP is only available to a company with up to 25 eligible employees if established prior to 1997. A corporation can contribute up to 25% of $285,000 of compensation for each employee ($57,000). Sole proprietors and partners can contribute up to 20% of net earned income less self-employment tax like a Keogh. (see Lesson 5)

2. Years ago, Cora age 54 contributed $7,500 to her employer’s SARSEP. The employer also made a $2,500 matching contribution.

She now works for a hospital. What should she do with the old SARSEP? A. Take a tax-free distribution. B. Roll it into a current IRA, a new IRA, or her current

employer’s qualified plan. C. Roll over $7,500 into an IRA and take a distribution of

$2,500 free of penalty and ordinary income tax. D. Take a full distribution and pay ordinary income tax.

Answer: B Answers A and C are wrong because SARSEP distributions taxable because they had been made with non-taxed dollars. Answer D is wrong because she’d also have to pay a 10% early distribution penalty. (She is still subject to the age 59 1/2 rules.)

3. When is an employee generally eligible to participate in a SEP? A. In the current year if he/she attains age 21 by December 31st B. If the employee performed services for the employer in at least 3 of any 5 preceding years

C. If the eligible employee received a minimum of $600 in the current year of employment and worked for the employer during 3 out of the 5 preceding calendar years

D. If all of the above are met



Answer: C Answer A is wrong because the employee must have attained age 21 to be a participant. Answer B is

wrong because the employee must have worked there for at least 3 of the immediately preceding 5 years.

4. A simplified employee pension (SEP) does not feature which of the following characteristics?

A. Loans and hardship withdrawals are not available. B. Age-weighting or cross-testing is not permitted. C. Social Security integration is not permitted. D. Employer matching is not permitted.

Answer: C A SEP make contributions into individual IRA accounts. Individual IRAs may not offer hardship withdrawal 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).

4) SIMPLE Savings incentive match plan for employees (SIMPLE) refers to a SIMPLE IRA plan. SIMPLE IRA (2020) A SIMPLE IRA is an employer-sponsored plan under which contributions are made to a participating employee's IRA. In a SIMPLE, all eligible employees have the opportunity to make elective pretax contributions of up to $13,500 (2020). The limit is indexed for inflation in $500

increments. Unlike a 401(k), there is no nondiscrimination testing. This is a noteworthy advantage to the SIMPLE IRA Salary deferrals are subject to FICA and FUTA.

*Technically, it is $10,000 as indexed, currently it is $13,500. See practice question #1. Employer contribution A SIMPLE IRA requires mandatory employer contributions. – Employer contributions represent dollar-for-dollar matching contribution up to 3% of

the employee's compensation. However, an employer can elect a lower percentage, not less than 1%, in no more than 2 out of the 5 years ending with the current year. NOTE: The match depends on the participant deferrals (no deferral – no match) or

– Nonelective contribution of 2% of compensation for all eligible employees The contribution cannot be more or less than 2% and is not dependent on participant deferrals. (Employee receives the 2% employer contribution even if not deferring.)

What employers can offer a SIMPLE plan? An employer with 100 or fewer employees that wants an easy-to-administer plan funded

through employee salary reductions and an employer match A SIMPLE can be adopted by completing IRS form 5304- or 5305-SIMPLE (rather than by the complex procedure required for qualified plans). The form is given to eligible employees; it is not filed with the IRS.



NOTE: A SIMPLE plan can be terminated, but only prospectively, terminating no earlier than the next calendar year. Contribution opportunities must be available until then.

Limitation The sponsoring employer cannot maintain any other qualified plan, 403(b), or SEP at the same time it maintains a SIMPLE. Eligibility requirements The plan must cover any employee who earned $5,000 in any two previous years and is reasonably expected to earn $5,000 in the current year. The sponsoring employer must notify participants that they have a 60-day election period just prior to the calendar year to make a salary deferral election or modify a previous election from the following year.

Employers of household workers may make SIMPLE IRA contributions on behalf of domestic employees. The contribution is nondeductible, but it is no longer subject to a 10% penalty. The contribution for domestics cannot be made in connection with a trade or business.

Example You and your spouse work. You hire Amy to clean your house and take care of your children.

You make a contribution to Amy’s SIMPLE IRA. You cannot deduct the contribution on Amy’s behalf because you are not a business.

Vesting / distributions Participants are fully vested at all times. All the restrictions on traditional IRA distributions apply, and distributions are taxed the same; however, the 10% distribution penalty is increased to 25% during the first 2 years of participation. This discourages participants from spending their SIMPLE account. SIMPLE 401(k)

A SIMPLE 401(k) is a plan in which a traditional 401(k) adopts SIMPLE provisions. A 401(k) plan that adopts SIMPLE provisions is exempt from both ADP and ACP tests. Such a plan is also exempt from the top-heavy requirements. This is an advantage but it

comes at the cost of having an extremely rigid plan design. Most employers interested in a SIMPLE would choose a SIMPLE IRA.

NOTE: A SIMPLE 401(k) is still a 401(k). As an ERISA plan, it is exempt from creditors.

The SIMPLE 401(k) may not choose the special 1% match election. Both the SIMPLE and SIMPLE 401(k) have a special catch-up provision of $3,000. Applying the Facts 1. What is the maximum amount that Roy, a 35-year-old employee, can

defer into his employer’s SIMPLE plan? A. $ 9,000 as indexed C. $10,500 B. $10,000 as indexed D. $11,500

Answer: B $10,000 as indexed ($13,500 in 2020)



2. Because a SIMPLE plan operates through individual retirement accounts, which of the following is true? A. Assets can be invested in collectibles or annuities. B. Participant loans are allowed. C. Participants can invest in U.S. government issued gold

coins. D. An employee is fully vested after one year of service. Answer: C Annuities may be used as a funding vehicle, but life insurance is not allowed in any IRA type

arrangement. Collectibles cannot be used as a funding vehicle, but U.S. government minted gold coins are acceptable. Participant loans are never allowed. For any IRA-like plan, vesting is immediate.

3. Which of the following statements is true about a SIMPLE plan? A. The employer can have more than 100 employees who earn $5,000 or more. B. A SIMPLE can operate in tandem with a money purchase plan. C. A SIMPLE plan can be arranged as an IRA or a 401(k). D. An employer must match employee contributions.

Answer: C Certain employers may sponsor either a SIMPLE IRA or a SIMPLE 401(k). D is wrong because the employer has the option of making a (non-matching) 2% nonelective contribution to all eligible employees. The 2% contribution is not dependent on deferrals. In other words, anyone who is eligible to participate in the plan would receive the 2% contribution even if he/she were not deferring.

4. What is the maximum deferral limit for a SIMPLE in 2020? I. $13,500 II. Answer I can be exceeded by those who have attained age 50 (catch-up provision) A. I C. Both I and II B. II D. Neither I or II

Answer: C A participant can be 49 and still make a catch-up deferral providing the participant will attain age 50 by December 31st of the current plan year.



5. When using a 3% match formula, the maximum possible contribution (employer and employee combined) that can be made this year to a SIMPLE or a SIMPLE 401(k) for a 49-year-old participant earning $450,000 is which of the following?

I. $27,000 for a SIMPLE IRA II. $22,050 for a SIMPLE 401(k) when using the formula (3%)


Answer: C Under a SIMPLE IRA using the maximum match formula, an employee under age 50 earning $450,000 is eligible to receive an employer match of $13,500 (3% x $450,000 plus another $13,500 from her own deferral). Regarding SIMPLE 401(k)s, the $285,000 compensation cap applies regardless of which method of employer contribution is used – match or nonelective. Under a SIMPLE 401(k), the answer is $13,500 plus 3% of $285,000 ($8,550) for a total of $22,050.

5) §403(b) plans Tax-deferred annuity (TDA) plan / Tax-sheltered annuity (TSA) plan [also referred to as a Section 403(b) plan] is a tax-deferred employee retirement plan that can be adopted only by certain tax-exempt organizations and certain public school systems. Employees have accounts to which they contribute through elective salary reductions and to which employers can match [like a 401(k) plan]. Salary reductions are subject to FICA and FUTA. Qualifications – tax-exempt organizations In order to qualify to offer 403(b) plan, a tax-exempt organization must be a 501(c)(3) organization. These are non-profits organized for religious, charitable, scientific, literary, or educational purposes. Most familiar nonprofit institutions such as churches, hospitals, private schools, colleges, and charitable institutions are eligible to adopt a 403(b) plan. In order to be a qualified public school, an organization must include: – A regular faculty and curriculum – A regularly enrolled student body Tax Relief Act of 2001

The limit on elective deferrals to 403(b) plans is $19,500 for 2020. The limit is indexed for inflation.

Contribution limits The process of determining the maximum excludable amount now generally entails the two steps shown below: 1. For salary reduction contributions, determine whether the intended contribution exceeds the elective deferral limit for the tax year ($19,500 in 2020) and

2. Determine whether the intended contribution amount (including any employer matching contributions) exceeds the Section 415(c) limit ($57,000 or 100% of compensation, whichever is less)



If the entire contribution comes from salary reduction, only the salary reduction limit may be excluded from participant’s gross income. However, if the contribution is partially salary reduction and partly employer contribution, the salary reduction portion is limited to the salary reduction limit, and the total excludable contribution may not exceed the Section 415 limit (1 and 2 above).

"Catch-up contribution"

1. The otherwise applicable dollar limit on elective deferrals under a Section 403(b) annuity can be increased for individuals who have attained age 50 by the end of the plan year. ($6,500 catch-up)

2. The employee with 15 years of service with the same eligible employer can exclude up to an additional $3,000 if the requirements are met.

Important Note: If the employee qualifies under both 1) and 2) above, both catch-up contributions can be made by the employee in the same year (see example below). Example

Eva Evolution, a 54-year-old biology teacher (salary of $50,000) has been working for the Lincolnwood school system for 15 years. Because she is over 50 and has been working for the same employer (same school system counts as same employer), for 2020 she can defer $19,500 plus $6,500 (normal age 50 catch-up) plus another $3,000 (special 15-year catch-up).

Applying the Facts Adam, age 45, participates in his tax-exempt employer's 403(b) plan. This year will be Adam's sixth year of service as a zookeeper with that not-for-profit employer. His salary will be $49,000. He has contributed $50,000 over the past five years. How much can he defer this year? A. He can defer 20% of his compensation or $9,800. B. He can defer the annual exclusion allowance of (20% of $49,000 x 6) – $50,000 = $8,800. C. He can defer 25% of his compensation or $12,250. D. He can defer $19,500.

Answer: D Adam can defer the lesser of $19,500 or 100% of compensation.

Funding

403(b) investments are limited to annuity contracts or mutual funds. "Incidental life insurance" protection under annuity contracts is also permitted. Individual securities are

not. Applying the Facts 1. Which of the following types of funding vehicles is not approved for 403(b) plans? A. Mutual fund C. Cash value life insurance B. Variable annuity contract D. Unit investment trust



Answer: D UITs, closed-end funds, or individual securities are NOT permissible investments for 403(b) plans. Cash value life insurance must be an incidental

benefit. Only open-end mutual funds are allowed.

2. Which of the following entities generally may not sponsor a 403(b) program?

A. The State of Florida B. 501(c)(3) organizations C. Educational institutions operated by a state or political subdivision of a state D. A state or local government with regard to employees who perform service, directly or indirectly, for an educational organization

Answer: A A state or local government can be a qualified employer but only with regard to employees who perform service, directly or indirectly, for an educational organization (Answer C).

3. Which of the following plans does not provide the same dollar amount of maximum deferral limit (disregard any allowable catch-up) as the others?

A. SARSEP B. Stock bonus 401(k) C. SIMPLE 401(k) D. Profit sharing 401(k)

Answer: C A SIMPLE 401(k) has a deferral limit of $13,500 (2020) plus an applicable catch-up contribution ($3,000 for age 50).The deferral limit for Answers A, B, and D is $19,500 (2020) plus applicable catch-up ($6,500 for age 50).

4. Which of the following contributions are always 100% vested to the employee? I. Matching contributions for SIMPLE/SIMPLE 401(k) II. Employer contributions for SARSEP and SEP


Answer: C SIMPLE, SIMPLE 401(k), SEP, and SARSEP employer contributions are always 100% vested. Employee deferrals in any type of plan also are always 100% vested (It is the employee’s own money).



5. A CFP® professional is seeking sales opportunities in the 403(b) market. Which of the following entities is eligible to adopt a 403(b) plan?

I. Private universities II. Non-profit hospitals

III. State of New Jersey IV. Churches V. Public schools

A. All of the above D. II, IV B. I, II, IV, V E. III, IV C. I, V

Answer: B The State of New Jersey employees would generally be eligible for a Section 457 plan rather than a 403(b) plan.

6) §Section 457 plan

Section 457 of the Code provides rules governing all nonqualified deferred compensation plans of governmental units, governmental agencies, and also certain non-church controlled tax-exempt organizations.

Deferral Limits The dollar limit on deferrals to an eligible Section 457 plan is the lesser of (1) $19,500 in

2020 or (2) 100% of compensation. Example

Karen’s 2020 compensation is $30,000. She works for a not-for-profit organization. She wishes to defer the maximum amount permitted. Her deferral is now limited to the lesser of $19,500 or 100% of her compensation. She can defer $19,500.

Special "Catch-up" contribution provision A special catch-up contribution provision applies during the participant's final three years of participation before Normal Retirement Age (typically age 65). The special catch-up cannot be used in the final year of employment. For such eligible years, the limit on

deferrals is increased to the lesser of (1) 2 times the normal limit ($19,500 x 2 for 2020) or (2) the sum of (a) the otherwise applicable limit for the year, plus (b) the amount by which the applicable limit in preceding years exceeded the participant's actual deferral for those years. Doubtful this will be tested.

Age 50 “Catch-up” provision Participants in a plan provided by a governmental employer who are age 50 and over

are eligible for an additional deferral (catch-up) of $6,500. NOTE: Only the greater of the age 50 catch-up or the special catch-up may be used in the three years preceding normal retirement age (not both). The exam will most likely test the age 50 catch-up.

No coordination with elective deferrals

Old rules stating that the contribution limits under Section 457 must be coordinated with the contribution limits of a 401(k), a 403(b), and a SARSEP were repealed.



Example Madison is the executive director of a not-for-profit organization (non-governmental). She

makes $50,000 and contributes the maximum to a Section 457 plan. She also works for her own corporation and receives a salary of $50,000. If she installs a 401(k) plan in her corporation, what amount can she defer? Sally can defer $19,500 under the Section 457 plan and an additional $19,500 under the 401(k) plan. If she were age 50 or older, Sally could defer $19,500 (no catch-up) –she is not a governmental employee- under the Section 457 plan and $26,000 ($19,500 + $6,500 catch-up) under the 401(k) plan.

Inclusion of income

Distributions from an eligible governmental Section 457 plan must include deferred compensation in gross income for the tax year in which such deferred compensation is paid.

Distributions from an eligible nongovernmental tax-exempt plan are required to include deferred compensation for the tax year in which such deferred compensation is paid or otherwise made available. (Substantial risk of forfeiture is removed.)

Required minimum distribution Section 457 governmental plans are subject to qualified plan required minimum distributions and can be rolled into a Roth IRA. Such rollovers are not allowed for non-

governmental 457s. Qualified domestic relations orders (QDROs) Section 457 plans are subject to QDROs. Applying the Facts Which of the following employers is permitted to adopt a 457 plan? I. A public accounting firm II. A state government III. A municipal government IV The United Way V. A church A. All of the above C. II, III, V E. IV, V B. II, III, IV D. II, IV

Answer: B A state, city, and any agency of a state or political subdivision of a state( for example, a school system or the water authority)are eligible. Any organization that is exempt from federal income tax, except a church, mosque or synagogue, is eligible.

Withholding / Social security (FICA) taxes Amounts deferred under nonqualified plans are not subject to Social Security taxes until the year in which the employee has constructive receipt or no longer has a substantial risk of forfeiture. Then the deferred compensation is subject to withholding and Social Security taxes. 7) Keogh (HR-10) plan

A Keogh functions much like any qualified plan. It can operate as a defined benefit, money purchase, or profit-sharing plan (see retirement Lesson 5 for more information).



Applying the Facts 1. Enrique Enterprising is self-employed. He wants to start a

retirement plan. His Schedule C annual net income is usually $200,000. He is 45 years old and has no employees. What type of plan is a CFP® professional most likely to suggest? A. Keogh profit sharing plan B. Keogh defined benefit plan C. SEP D. SIMPLE IRA Answer: C Enrique can contribute $37,180 to a SEP based on

18.59% of his net Schedule C income (Keogh rules). The SEP is easier to install and maintain than any qualified plan. The Keogh profit sharing plan is subject to numerous ERISA filings and requirements. The Keogh DB plan does not suit Enrique’s income or age. The SIMPLE is a combination of deferral $13,500 plus 3% of salary $6,000 for a total of $19,500.

2. Laurence Harris just retired at age 70 in January of the current

year. He worked for the State of New Jersey for 40 years. He is receiving distributions from his 457 plan. The State of New Jersey wants to hire him as an independent contractor and pay him $84,000 annually ($7,000 a month). To perform this job, he will incur little or no expenses. He plans to file a Schedule C for this 1099 income. Which of the following can he do? I. Make contributions of 25% ($21,000 to a SEP) II. Make contributions of $57,000 to a SEP III. Make non-deductible contributions to an IRA IV. Make contributions of $15,615.60 to a Keogh money purchase plan V. Make a $13,500 deferral and contribute $2,520 (employer) to a SIMPLE A. I, III, IV, V D. III, IV, V B. I, IV E. None of the above C. I, V

Answer: D For self-employed individuals, contributions must

follow the rules for Keogh plans (18.59%). He cannot contribute 100% of compensation for a SEP. He can contribute 18.59% of his net Schedule C income and V (the SIMPLE) based on $84,000.



3. Bill Richblood owns Richblood, Inc. For years, although the

business was profitable, Bill resisted providing a retirement plan. He did not want his business to assume all the paperwork and mandatory employer contributions. Now the employees are leaving to work for competitors. Bill 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 gives the best advice. Which of the following planner’s advice is the best for Bill? A. #1 FP – install a SEP because it can be integrated with

Social Security. This means a bigger percentage of the company contribution will be made for Bill. In addition, the plan is simple to install.

B. #2 FP – install a defined benefit plan because the largest contribution will be made for Bill. C. #3 FP – install a SIMPLE because of the relatively small

mandatory employer contributions. D. #4 FP – install a cash-less ESOP because the company can contribute stock rather than cash.

Answer: A With a SEP there are no mandatory contributions

and it is easy to install. A defined benefit plan is complicated and can require large, unpredictable mandatory contributions. An ESOP means that Bill has to share stock with his employees. There is no indication he is willing do so. There is no indication that the employees would want to contribute to a SIMPLE. Employer contributions are very limited to 3% of compensation. The SEP will allow for higher employer contribution.

4. Gloria Goodtaste owns and operates an upscale gift shop.

Revenue varies so much that she cannot hire many full-time employees or provide benefits. The gift shop employs only two full-time workers. The remainder of her needs are met by several prior employees who only want to work part-time (400 hours per year at most). What kind of benefits should Gloria offer to the full-time employees that may exclude the part-time employees? I. Profit-sharing plan II. SEP III. Group health insurance IV. SIMPLE 401(k) A. I, III, IV D. II, III B. I, III E. IV C. I, IV



Answer: A Profit sharing and SIMPLE 401(k)s are ERISA plans with the 500/1,000 hours per year service eligibility requirement. Group health insurance plan participation normally requires 30 hours per week. SEP eligibility requires the 3 year rule for which many of the part-time employees may already qualify.

5. Harry Stonewall owns HS, Inc. HS is a small manufacturer of

parts sold to larger manufacturers. The profits of HS, Inc. vary from month-to-month. Harry feels he can train an employee to run a piece of equipment in an hour. Harry fires employees for various legitimate reasons. Most employees only last a month or two due to firing and layoffs. Harry wants to adopt a retirement plan for his company what a CFP® professional be most likely to recommend? A. Defined benefit pension plan B. Profit sharing plan C. SEP D. SIMPLE E. SIMPLE 401(k)

Answer: C With a SEP, it is doubtful that HS, Inc’s short-

lived employees would meet the 3-year service requirement. In addition, the company is permitted to contribute the maximum of 25% or $57,000 for Harry who, obviously, will remain with his company.



Regulatory considerations / Key factors affecting plan selection for businesses / Investment considerations for retirement plans Lesson 8 NOTE: This is under review by the DOL.

Regulatory considerations A. Employee Retirement Income Security Act (ERISA) ERISA imposes various duties, standards, and prohibitions on plan fiduciaries. In addition, there are specific rules relating to prohibited transactions. Prohibited transaction

rules specify that plan fiduciaries and parties in interest must not engage in certain activities unless there is an available exemption. Fiduciaries and parties in interest (defined below) may also be subject to excise taxes or other penalties on prohibited transactions under the Internal Revenue Code.

B. Department of Labor (DOL) regulations ERISA defines "fiduciary" as a person who "renders investment advice for a fee or other

compensation, directly or indirectly, with respect to any monies or other property of a qualified plan, or has the authority or responsibility to do so." The DOL regulations further define "investment advice," focusing on two essential elements:

– The value of, or the advisability of, investing in, purchasing, or selling securities, or other property – Whether the advisor, either directly or indirectly (e.g., through or together with any affiliate), entails either of the following. 1. Has discretionary authority or control with respect to purchasing or selling

securities or other property for the plan

2. Regularly renders any advice described above to the plan based on a mutual agreement, written or otherwise, in which the advice will serve as a primary basis for investment decisions with respect to the plan assets and that the advisor will render individualized investment advice to the plan based on its needs regarding such matters as, among other things, investment policies or strategy, overall portfolio composition, or diversification of plan investments

The DOL recognizes that broker/dealers regularly provide research, information, and advice concerning securities in the ordinary course of their business. Nevertheless, the

DOL position is that the provision of such research or recommendations is not itself the rendering of "investment advice" unless done pursuant to a mutual agreement, written or otherwise, to provide regular individualized advice that serves as the primary reason for plan investment decisions.

C. Fiduciary liability issues The general standards of conduct under ERISA require that a fiduciary discharge its duties with respect to a plan: – Solely in the interest of the plan participants and beneficiaries – For the exclusive purpose of providing benefits to the participants and their beneficiaries and defraying reasonable plan expenses – With the care, skill, prudence, and diligence under the circumstances then prevailing, that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims



– By diversifying investments of the plan so as to minimize the risk of large losses unless, under the circumstances, it is clearly prudent not to do so Potential liabilities for breach of fiduciary duties under ERISA The fiduciary standards of ERISA that apply to the investment advisory service include

the prudence and diversification requirements. Under the prudence standard, a fiduciary is required to act with the care, skill, prudence, and diligence that would be exercised by a prudent person familiar with the matter and acting under similar circumstances. The test for evaluating a fiduciary's prudence in investing plan assets "is one of conduct and not a test of the result of performance of the investment (i.e. profits)." The diversification requirement does not set a specific percentage limit on any one investment.

D. Prohibited transactions In addition, ERISA prohibits certain transactions between a plan and a "party in interest" or a fiduciary. A party in interest includes a fiduciary and a person providing services to a

plan. ERISA provides that a fiduciary shall not cause a plan to engage in a transaction if it knows or should know that the transaction constitutes a direct or indirect conflict of interest, as follows.

– furnishing of goods or services or facilitates between the plan and the party in interest with respect to the plan or – transfer to, or use by or for the benefit of, a party in interest, of any assets of the plan. ERISA prohibits a plan fiduciary from dealing with the assets of the plan in its own interest or for its own account (the anti-self-dealing rule) or from receiving any consideration for its own personal account from any party dealing with the plan in connection with a transaction involving plan assets (the anti-kickback rule). Applying the Facts 1. The XYZ Corporation maintains a profit-sharing plan. The plan

invests in money market mutual funds, T-bills, T-bonds, and corporate bonds. Relative to the investment manager’s choices which option do the employees in the plan have?

A. Sue the investment manager for lack of diversification B. Report the investment manager to the Department of Labor C. Sue the investment manager because the investments are not

an inflation hedge D. Do nothing

Answer: D Because this is a profit-sharing plan (and not a 401(k)), participants can’t argue that the investment manager was negligent. The plan calls for prudent investments, and a fiduciary is not required to be successful in managing the plan's assets. NOTE: This plan is funded solely with employer funds, rather than employee deferrals.



2. Universal Technical Solutions, Inc. provides a 401(k) plan where the participants may choose to allocate their elective deferrals among several funds in accordance with DOL Reg. 2550. Funds range from money market mutual funds to aggressive, highly volatile growth funds. Several of the participants lost substantial amounts of their elective deferrals in the highly volatile funds. Considering the prudent person (prudence) rule, what is the employer’s liability?

A. No liability B. A 5% penalty and replacement of lost funds C. The employer is relieved of fiduciary responsibility for any investment directed by the participant. D. The company is responsible to pool employee accounts; therefore, the company must replace lost funds.

E. The fiduciary may be liable under the prudent person rule.

Answer: E As long as the company (the fiduciary) contracts for the investment management advisory services,

it may be liable. Small plans typically offer a "family of funds." Highly volatile growth funds may not be considered to be “prudent.” If the portfolio of investments available to the employees only included four non-equity investments, the correct answer would reflect that the fiduciary is responsible because there was no diversification.

E. ERISA and Other Qualified Plan Regulators

ERISA is not the only body of legislation that regulates qualified plans. The Internal Revenue Code and the PBGC also control the operation of qualified plans. One of the PBGC’s primary obligations is to “insure” the payment of guaranteed benefits. PBGC is funded with annual premiums paid by defined benefit plan sponsors. The Internal Revenue Code (IRC) dispenses favorable tax treatment to those plans that “qualify” and denies favorable tax treatment to formerly “qualified” plans committing serious rule violations. Certain retirement and employee benefit plans do not qualify under the code and therefore are not afforded favorable tax treatment (example, a non-qualified deferred compensation plan). The Treasury department interprets and administers tax laws. The Treasury dispenses its requirements through revenue procedures, revenue rulings, private letter rulings, etc.

ERISA (rather than the IRC) protects the interest of participants. The Department of

Labor (DOL), enforces ERISA – not the IRS. The DOL and PBGC issue interpretive guidelines (i.e., regulations) on ERISA provisions. The DOL also issues advisory opinions on specific situations. Advisory opinions explain situations affected by ERISA. Additionally, DOL issues prohibited transaction exemptions (PTE) to specific entities (or persons). Occasionally, a PTE may apply to qualified plans generally.



Benefits guaranteed by the PBGC (Only defined benefit and cash balance plans) Only for plans lacking sufficient assets to pay benefits, the PBGC guarantees a monthly benefit (no lump sums) that is adjusted annually based on PBGC regulations and ERISA formulas. The PBGC guarantees only cover nonforfeitable benefits (prior to termination) and pension benefits (i.e., monthly payments). Furthermore, the PBGC only covers participants who are entitled to the benefit (i.e., service, vesting), or the benefit is in pay status. Several other restrictions apply. Defined benefit plan terminations DB plans may be voluntarily terminated by an employer or involuntarily terminated by the PBGC (part of DOL). A voluntary termination, also called a standard termination, occurs when there are sufficient assets to fund accrued benefits. A distress termination

occurs when there are insufficient assets to fund accrued benefits. Distress terminations are only allowed in the following situations:

– The employer is in a bankruptcy liquidation proceeding. – The employer is in a bankruptcy reorganization proceeding. – The employer can prove to the PBGC that plan termination is necessary to pay debts.

Only the PBGC can initiate an involuntary termination of a DB plan. Applying the Facts 1. Under ERISA rules, which organization is charged with the administration of defined benefit plan termination rules? A. ERISA C. DOL E. IRS B. PBGC D. PWBA

Answer: B The PBGC insures against loss of benefits and also oversees plan terminations. The Department of Labor (DOL), through the Pension and Welfare

Benefits Administration (PWBA), is charged with the enforcement of reporting, disclosure, and fiduciary provisions of ERISA. 2. The Pension Benefit Guaranty Corporation’s (PBGC) main responsibility is to insure benefit payments to participants in, and beneficiaries of, most of the following types of employee benefit plans except which of the following? A. Defined benefit plans C. Cash balance plans B. Target benefit plans D. Integrated DB plans

Answer: B A target benefit plan is not covered by PBGC because it is a defined contribution plan. Defined benefit plans (which include cash

balance plans) are generally eligible for coverage under PBGC.



3. The PBGC may not require a plan to be involuntarily terminated for which of the following reasons? A. The plan isn’t funded per applicable legal standards. B. The plan is not able to meet its benefit payments. C. The plan has a long-run portfolio loss that may get significantly worse over time. D. The plan sponsor has not paid its compulsory PBGC premiums.

Answer: D The PBGC may terminate a pension plan because of problems with benefits or contributions. Failing to pay PBGC premiums would not trigger termination of the plan.

4. Cash balance plans have which of the following significant

advantages over defined contribution plans? A. PBGC insurance coverage is provided. B. Benefits are fully funded at all times and beyond the reach of the employer’s creditors. C. Cash balance plan participants will be better off because they are credited with a guaranteed, steady rate of return. D. Cash balance plans require past service credits.

Answer: A The cash balance plan must maintain coverage under the PBGC. Assets already paid into either plan are beyond the reach of the employer’s creditors, but if the company fails, the defined contribution plan may not have sufficient assets to meet it’s obligations. This would not be covered by the PBGC. Like defined contribution plans, poor investment returns will result in lower retirement benefits. Cash balance plans can allow past service credits, but they are not required to do so.

Key factors affecting plan selection for businesses A. Owner's personal objectives

Each type of plan meets certain planning objectives better than others. Plan design involves finding the right match between employer objectives and employee objectives. Some objectives that could influence the type of plan selected by the owner could include the following:

– maximizing the proportion of plan contributions that benefit owners, highly compensated or older employees

– maximizing or minimizing employer contributions – maximizing employer contribution flexibility – vesting to minimize turnover – allowing employees to make before-tax salary deferrals



Tax considerations Investment income in retirement plans is tax-deferred. If the business owner is in a personal 37% income tax bracket, the owner can pursue active management to structure a portfolio attempting to outperform the market. In a retirement plan, this will not cause

any tax effect until retirement. At retirement, the owner may be in a lower income tax bracket.

Establishing a qualified plan The plan document must be executed within the tax year for which the employer wishes to take the tax deduction (DB and DC) for its contribution. However, safe-harbor 401(k)

plans must generally be adopted before the beginning of the plan year. Standard 401(k) plans (with deferrals) must be established before the first deferral can be made. New SIMPLE 401(k) plans may be adopted anytime on or after January 1 but not later than October 1 of the year in which it is adopted.

Example

To reduce corporate taxes and to retain employees, Flower Power, Inc. (using a calendar tax year) wants to establish a qualified cash or deferred arrangement before the end of the calendar year. In late October, its owner, Petunia Flowers, is considering a standard 401(k) or a safe-harbor 401(k). What type of plan can she establish before the end of the current year that will allow a tax deduction for this year? Only a standard 401(k) – why? A 401(k) needs to be established by the end of the employer’s tax year, but in order for deferrals to be made in the current tax year, the plan must be established before the last day of the year. Safe-harbor plans generally need to be established before the beginning of the plan year. If a safe-harbor plan is adopted this year, the plan would be able to receive contributions and deferrals beginning next year. A SIMPLE 401(k) could not be adopted for the current year because it’s past October 1st.

Applying the Facts 1. Sharp Shoelaces, Inc. is a small company. It reports under the

cash method of accounting. It currently provides a profit sharing plan. At year end, although profitable, it does not have enough cash to contribute to the plan. If Sharp, Inc. can make a contribution to the plan, it can save 21% on taxes. What should the company do? A. Pay the IRS the 21% in taxes on its profits and hope it can

have the cash available to fund the plan. B. Make the contribution by the corporation’s filing due date. C. File for an extension and try to obtain the cash to fund the

plan. D. Since the funding is not completed by year end, the company

cannot contribute for the current tax year.

Answer: C They only have to come up with 79% because taxes will virtually fund 21%. Answer C makes more sense

than Answer B. An extension gives Sharp Shoelaces, Inc. more time. The contribution has to be made before the tax filing, but not by year end. Corporations have a special make-up rule.



2. Terrific Toys, Inc. reports under the accrual method of accounting. At year end (Christmas)they typically sell substantial amounts of inventory. The concern is that although they “book” a lot of sales, they may not get the cash until the following year. They have problems funding the company’s profit sharing plan. What should the company do if it is reasonably profitable?

A. Change their accounting method from accrual to cash. B. If they cannot fund the plan by their tax filing date,

borrow the necessary funds from a bank. C. Wait until next year and pay the corporate taxes due. D. File the corporate tax form showing an amount owed to the profit sharing plan as a deduction. Answer: B The company cannot change to a cash accounting

system. They can wait another year, but why not save 21% in taxes? Answer D is not allowed, the cash must be contributed to the plan.

Establishing a SIMPLE A SIMPLE may be established by an employer up to the due date of the employer’s tax return.

Establishing a SEP A SEP may be established after an employer’s fiscal year-end. An employer has until the due date of the business tax return, including extensions, to establish and make contributions to a SEP for the taxable year (a noteworthy advantage). Investment considerations for retirement plans

A. Suitability B. Time horizon Money market account Liquid - suitable for cash flow situations (low risk but provides low returns) (participant loans or withdrawals on

retirement distributions) Fixed income bonds Semi-liquid depending on maturity (may lose value and has a fixed return) Common stock Long-term (generates income and capital growth but has price volatility) Mutual funds Long-term (similar to common stock but offers more diversification than individual stocks) Real estate Long-term (may generate above-average returns in inflationary times) GICs Generally have a 2-7 year maturity (have a fixed return)

Pension Protection Act of 2006

The tax code previously prevented LTC policies from being included as part of individual annuities. In addition to changing the tax code to allow LTC-annuity combinations, the PPA directs the Department of Labor to clarify regulations for including annuities in 401(k) plans. Currently, the annuity must meet "safest available annuity" standards.



C. Diversification The diversification requirement means the trustees have the duty to diversify the

investments to minimize the risk of large losses. A DC plan that holds publicly-traded employer securities must allow participants to

"diversify" employer contributions after 3 years of service. Participant investment, model-driven, and "flat fee" advice is permitted.

Under automatic investments - unless the employee makes other choices, the participant’s account balance may be invested in a balanced account with stocks and bonds.

D. Fiduciary considerations According to ERISA , the fiduciary could be sued for failing to diversify investments.

Fiduciaries are required to operate the plan in accordance with the plan document. E. Unrelated business taxable income (UBTI) If UBTI exceeds $1,000, the qualified plan’s UBTI is subject to income tax in the current

year. Income from a limited partnership or dividends from a margined account are considered UBTI income.

Applying the Facts An S corporation holds the following investments in its ESOP. Which of the investments shown below is subject to UBTI? A. Dividends from S corporation stock B. Annuities C. Apartment complex using 80% debt financing D. Equipment leasing limited partnership

Answer: D Income from a limited partnership interests (except real estate) are considered UBTI income.

F. Life insurance According to Treasury Regulations, life insurance benefits must be merely "incidental" to

the primary purpose of the plan, namely to provide retirement benefits. If the amount of insurance meets either of the following tests, it is considered incidental.

1. The aggregate premiums paid for a participant's insured death benefit are at all times less than the following percentages of the plan benefit for that participant. Ordinary life insurance/whole life 50% Term insurance 25% Universal life 25% 2. The participant's insured death benefit must be no more than 100 times the expected monthly benefit. Defined contribution plans normally use the percentage limits (25% / 50%), and defined benefit plans normally use the "100 times" limit. Example

If the monthly defined benefit is $4,000, then the life insurance death benefits can be up to $400,000 (100 times).



Why life insurance? Using life insurance in a qualified plan satisfies the need for life insurance protection for the owner of a small business and provides a tax deduction to the business. The pure

insurance protection is generally taxed to the participant at the Table 2001 cost. If the death benefit is payable from the proceeds of a life insurance policy, the difference between the face amount and the cash surrender value is treated as death proceeds (the pure death benefit) and is excluded from income. This assumes the insurance cost under Table 2001 was paid.

Example

Mrs. Widow receives a $40,000 lump sum life insurance benefit from her deceased husband's pension plan. The cash value of the policy is $10,000. The pure death benefit will be tax-free ($40,000 - 10,000), but the cash value ($10,000) will be subject to ordinary income tax. Applying the Facts 1. Which of the following plans cannot provide for death benefits paid from life insurance? A. ESOP C. Profit-sharing – 401(k) B. 403(b) D. SIMPLE

Answer: D IRA plans such as SIMPLEs cannot provide life insurance. The only plans that are allowed to purchase life insurance are the qualified plans (answers A and C) and the 403(b).

2. Success, Inc. has been informed by its plan administrator that its defined benefit plan is overfunded. The plan administrator indicates that it may be a long time before additional employer contributions can be added to the plan. What can Success, Inc. do to continue to contribute and deduct) new money to the plan?

A. Nothing. B. Select life insurance and annuities to fully fund the plan C. Continue to make contributions until the IRS sends a notice D. Find a new plan administrator who will allow them to make

new contributions

Answer: B With a fully funded whole life DB plan, the employer can use the actuarial assumptions of the whole life contract. The actuarial assumptions of the cash value insurance policy are normally lower than most other plan assumptions, allowing for additional contributions.



3. Under incidental rules for death benefits, there are actually two separate tests: a 25% test and a 50% test. Regarding these tests, which of the following statements is (are) true?

I. If term insurance is used, the aggregate premiums paid for the policy cannot exceed 25% of the participant’s total plan cost. II. If whole life or universal life is used, the aggregate premiums paid for the policy cannot exceed 50% of the participant’s total benefit because about half of the premiums paid under cash value policies represents pure insurance protection and the other half represents the investment element of the policy. A. I only C. Both I and II B. II only D. Neither I nor II Answer: A Universal life and term insurance must follow the

25% rule. The 50% rule only applies to Whole life (not universal or term).

4. When life insurance is purchased in a qualified plan to provide death benefits, the current cost of the “pure insurance” protection is subject to taxation. The cost attributable to this pure life protection will be the lower of which of the following?

A. PS 58 cost and Table 2001 B. Table 2001 and the employee’s cost basis C. Actual cost as provided by the carrier and Table 2001 D. PS 58 and the employee’s cost basis

Answer: C The PS 58 Table is no longer used.

5. Which statement is true concerning incidental safe harbor rules for death benefits in retirement plans? I. They apply to qualified plans (defined contribution and defined benefit) and 403(b) plans. II. They do not apply to SEPs; therefore, there is no limit to the amount of life insurance that can be held by a SEP. A. I only C. Both I and II B. II only D. Neither I nor II

Answer: A 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.



6. Business owners may choose to use qualified plan assets to purchase life insurance for estate planning purposes. (The most available assets to pay the premiums may be in the qualified

plan). A popular planning strategy is to purchase a second-to-die insurance policy in a qualified plan. Which of the following qualified plan(s) can hold second-to-die insurance?

A. Cash-balance plan C. Money purchase plan B. Profit-sharing plan D. All of the above

Answer: B Only profit-sharing plans can hold second-to-die insurance. Pension plans cannot. Cash balance plans and money purchase plans are pension plans.

7. Which of the following types of qualified plans can offer disability insurance?

A. DB pension plan C. 401(k)/profit-sharing plan B. ESOP D. All of the above

Answer: D Qualified plans are eligible to hold disability insurance.

Applying the Facts 1. Mr. Stressed was recently divorced. The messy divorce significantly

reduced his net worth due to attorney fees and the settlement. Now at age 55, he is in poor health but does a procedure that should earn him a $1 million annually after business expenses. He proposed to his girlfriend, Kathy age 50, but she is concerned about his lack of financial assets. Her own contested divorce left her with minimal assets. Money is a source of tension between them. What kind of retirement plan would maximize benefits for both for him and Kathy if he should die prematurely?

A. Target benefit plan contracting with an aggressive money manager

B. 412(i) plan funded with whole life insurance C. Profit sharing 401(k) plan with catch-up contributions

invested in commodity ETFs D. Cash balance pension plan guaranteeing 20% contribution and

generating a 10% return from a well-diversified portfolio.

Answer: B The 412(i) is a fully funded insurance plan. This would allow for large contributions. Even if he was rated, the life insurance would be charged to him at standard rate (based on Table 2001). It would build upon a tax-free basis until retirement. In addition should he die before retirement Kathy would receive the pure death benefit income tax-free (see 412(i) – Lesson 3). At retirement, he could buy this policy from the plan and keep it in his retirement years. However, if he dies within the next few years, there is not much in the plan. D is a possible answer but generating a 10% return is not likely.



2. Before he died, Mr. Adams, age 68, had been considering

retiring. He had discussed his retirement options with his wife. As a participant in a generous profit sharing 401(k) plan, he had accumulated $1.5 million. Mr. and Mrs. Adams had very little money invested outside the plan. Other assets were their home and personal property. He had not claimed Social Security benefits. Mrs. Adams, age 65, also had not claimed Social Security retirement benefits. Mrs. Adams has no investment knowledge and has trouble making decisions. If she applies for benefits under Social Security, what do you suggest she do with her late husband’s retirement plan account?

A. Roll it into an IRA in her name and hire a competent money manager.

B. Leave it in his 401(k) account until she needs the income. C. Roll it into an IRA and take a guaranteed lifetime income

option. D. Roll it into a Roth IRA in her name and use the money manager who was handling the 401(k).

Answer: C By taking the guaranteed lifetime income, she will not be forced to make a decision. His Social Security benefits may not be enough to support her lifestyle. While living, Mr. Adams never saved money. Answer A and B do not address her needs for money now. Answer D would be subject to income tax.

3. Mr. Platte owns a small appliance repair business. The business

hires a variety of part-time employees who work either daily or hourly. Some work once or twice a month and some only work during peak times. These part-time employees are mainly semi-retired. They have worked for Mr. Smithton for years. Mr. Smithton wants to fund a retirement plan with last year’s profits. He wants the business to be able to deduct the contribution. At year end, he found out that his business made too much money and would pay too much in taxes. Is there anything he can do?

A. Establish a profit sharing plan and fund it this year but claim the deduction for last year.

B. Establish a SIMPLE plan and fund it this year but take a deduction for last year. C. Establish a SEP and fund it this year but take a deduction for last year

D. Nothing

Answer: C The business can establish the SEP until it files its prior year tax return. This would include extending the filing time. However, the business will have to make contributions for those part-time

employees who qualify. Mr. Platte wishes to install a retirement plan.



Distribution rules, alternatives, and taxation Lesson 9 Distribution rules, alternatives, and taxation A. Premature distributions

In-service distributions (meaning distributions from a qualified plan while the participant is still working for the employer) may be allowed in any of three situations (providing the plan document allows these types of distribution). 1. Attainment of specific age or years of service. [Important Note: Distribution must

generally occur after attainment of Normal Retirement Age (NRA) in the case of a Money Purchase pension plan or age 59½ for 401(k) deferrals]. There is no hardship requirement for this type of distribution.

2. Hardship. A hardship withdrawal is allowed at any age in any type of profit- sharing plan. The two hardship tests are as follows.

– Financial needs test (due to immediate and heavy financial need) – Resources test (the amount of the withdrawal cannot exceed amount needed to

satisfy need and participant has no other sources to satisfy need) 3. The Pension Protection Act is now allowing for in-service distributions as early as age

62 from DB plans. The PPA also clarifies that this distribution will be treated as retirement income.

Hardship withdrawals from Profit Sharing and Stock Bonus plans Section 401(k) plans can allow participants to make in-service withdrawals for hardship at

any time before termination of employment. A financial hardship is "immediate and heavy," and presumes no other resources can be reasonably available to meet this need.

The hardship withdrawal is subject to ordinary income tax and often the 10% early

withdrawal penalty. The 10% will not apply if the distribution qualifies under the 59 1/2 rule or disability qualified plan exemptions.

A hardship distribution is considered a “Safe Harbor” distribution if the distribution is for any of the following:

– Medical expenses for the participant, the participant’s spouse, or dependents – Tuition, room and board, and other educational expenses for the next 12 months for the post-secondary education for the participant, the participant’s spouse, or dependents – The purchase of the participant’s principal residence – To prevent eviction from or foreclosure of mortgage of the participant’s principal residence – Funeral expenses – Certain expenses relating to the repair of damage to the employee’s principal residence

– The distribution cannot be in excess of the immediate need. Rules: Under the 2017 TCJA, the plan cannot: – Force participant to first take any allowable loans from plan. – Limit participant from making deferrals for 6 months after the hardship distribution.

NOTE: Hardship withdrawals are limited to deferral amounts and vested matching and profit sharing contributions as well as earnings on 401(k) elective deferral contributions. They may not include unvested amounts and earnings.



Applying the Facts 1. The 401(k) salary deferral element of a profit-sharing plan is

not subject to which of the following special rules? A. In-service withdrawals can only be made by participants who

have reached age 55 or have a financial hardship. B. 401(k) salary reductions are immediately vested. C. 401(k) salary reductions cannot be forfeited. D. Salary deferrals are subject to the Actual Deferral Percentage (ADP) test – a type of nondiscrimination test.

Answer: A In-service withdrawals can only be made by those who have reached age 59½. They can also be made

by participants who have a financial hardship regardless of age.

2. Under the safe harbor rules for hardship distributions, which of the following circumstances constitute a hardship? A. Purchase of a vacation residence for the participant B. Payment of K-8, secondary, and postsecondary tuition for education for a participant, his or her spouse, children, or dependents C. Medical expenses for the participant, spouse, or dependents D. Payment of amounts necessary to prevent the eviction of the participant from his or her vacation residence or from

foreclosure on his or her mortgage

Answer: C Only payment of “postsecondary” (college)tuition is included under the safe harbor rules. Answers A and D are wrong because they do not specify “principal” residence. Withdrawals used to purchase second homes, vacation homes, or rental property owned by the participant do not qualify under the hardship rules. Answer B is wrong because it included K-8 and secondary tuition.

3. Which of the following characteristics is not associated with a profit-sharing plan? A. It can allow in-service distributions. B. It cannot invest the plan’s assets in the sponsoring company’s stock. C. The employee assumes the risk of preretirement inflation, investment performance, and adequacy of retirement income. D. The employer can deduct up to 25% of the compensation of all eligible participants.



Answer: B A plan subject to ERISA generally may not acquire or hold employer securities if the total fair market value of such assets exceeds 10% of the plan’s portfolio at the time of acquisition. The plan can invest up to 100% of the plan’s assets in the sponsoring company’s stock only if the plan document allows it. This would be the case with an ESOP stock bonus plan.

1) Penalties Penalties and requirements that apply to qualified plans and TSA distributions The Tax Relief Act of 2001 provides that amounts distributed from an eligible 457 plan that are attributable to an amount transferred from a qualified plan or IRA will be subject to the 10% tax penalty. 2) Exceptions . Early (age 59½) – 10% tax penalty exceptions – Death – Disability – Substantially equal periodic payments following separation from service – Distribution following separation from service at age 55 or later – Distribution in accordance with a QDRO (to any alternative payee)

– Medical expenses in excess of 10% of AGI or health insurance costs while unemployed (must file for unemployment) – $5,000 distribution for qualified birth/adoption

Applying the Facts Which of the following qualified plan distributions is exempt from the 10% early withdrawal penalty? A. First home acquisition cost B. Qualified education cost for participant's child C. Substantially equal periodic payments D. Death

Answer: D Distributions due to the death of a participant in a qualified plan are exempt from the 10% early withdrawal penalty. The first two answers are for IRA distributions, not qualified plan distributions. Substantially equal periodic payments from qualified plans must be due to separation from service. With IRA distributions, A, B, C, and D would be true.

3) Substantially equal payments (§72t) In general, a premature distribution is a distribution prior to age 59-1/2. Section 72(t) provides for a number of exceptions to the 10% additional tax. Among these exceptions is that the 10% additional tax will not apply to a distribution which is "part of a series of substantially equal periodic payments." "Substantially equal payments" must be as follows. – paid not less frequently than annually



– paid without changing the amount for the longer of 5 years or until the payee reaches age 59-1/2 – based upon the life expectancies of the recipient or recipients – based upon a reasonable rate of interest – if applicable, based upon reasonable mortality assumptions Generally, No Modification

Once payments begin, they may not be increased, decreased, or changed in any way prior to age 59-1/2 or before the end of 5 years, if longer. For example, payments which begin at age 52 must continue to age 59-1/2, while payments which begin at age 58 must continue to age 63. If payments are modified in any way, the 10% additional tax is applied retroactively to all payments received before 59 ½. For example, an individual who began using IRC 72(t) at age 52 would have to continue receiving the same amount of payments up to age 59-1/2. If the individual changed the payment amount at age 58, the 10% tax would be retroactively applied to all payments received since age 52.

In an important exception, a one-time election allows participants to switch from the

annuity or amortization method to the RMD method (with no penalty). The effect of this election will be to reduce the 72(t) payout amounts and thus associated tax liability. While this change could go a long way to preserve retirement funds, it also sharply reduces payout levels.

Annuity distribution options – Life annuity - payments for the participant’s lifetime

– Joint and Survivor - payments to the participant for his or her lifetime If at the participant's death the beneficiary is still living, a specified percentage of the participant's benefit continues to be paid to the beneficiary for the remainder of his or her lifetime. The beneficiary is typically the participant’s spouse.

– Life annuity with guaranteed payments - Payments are made for the longer of the life of the participant or for some specified guaranteed period. – Annuity certain - a specified amount of monthly guaranteed payments after which all payments stop Note: Under certain circumstances, a lump sum distribution may also be available. Qualified joint and survivor annuity and qualified preretirement survivor annuity

A qualified joint and survivor annuity (QJSA) is a post-retirement death benefit for the plan participant's spouse. Qualified pension plans are required to provide a QJSA. Currently, the survivorship annuity must be not less than 50% of nor greater than 100% of the annuity payable during the joint lives of the participant and spouse.

The PPA requires a second joint and survivor annuity option in pension plans. It is called a Qualified Optional Survivor Annuity (QOSA).

QOSA

At a minimum, the QOSA must be a 50% joint and survivor annuity. Many plans specify a 75% joint and survivor annuity. The participant can elect out of this benefit only with written spousal consent. The election out must be made during a 180-day period prior to the annuity's starting date. In addition, the participant must receive notice explaining his/her right to defer and explaining the consequences.



QPSA A qualified preretirement survivor annuity (QPSA) is a preretirement death benefit for the

plan participant’s spouse payable upon the death of the participant who dies before the starting date of the QJSA. The survivorship annuity must be not less than what would be payable under the plan’s QJSA.

Applying the Facts The QPSA and QJSA death benefits are not required by which of the following types of qualified retirement plans? A. Money purchase pension plan B. Target benefit pension plan C. Money purchase pension plan that has been merged into a profit- sharing plan D. Profit-sharing plan

Answer: D Profit-sharing type plans do not have to offer the QPSA or QJSA distributions (although they can). Profit-sharing plans are not pension plans. Pension plans are subject to QPSA and QJSA rules.

Rollover The purpose of rollovers is to defer taxation and avoid the early distribution penalty. Plans that can be rolled over (into IRAs or successor plans) include all defined benefit,

defined contribution, 403(b), and governmental 457 plans. Permissible rollovers are as follows.

– A distribution from a qualified plan may be rolled over to another qualified plan or to an IRA. – A QDRO distribution to a spouse, former spouse, or alternate payee may be rolled over to an IRA or to another qualified plan. – A distribution to a surviving beneficiary may be rolled to an IRA or a qualified plan. –A distribution from a 403(b) may be rolled over to a qualified plan or to an IRA. – A distribution from a SIMPLE IRA may be rolled over to any eligible retirement plan after two years of participation; during the first two years of participation, a distribution may only be rolled over to another SIMPLE IRA. – After-tax contributions can be rolled over from a qualified plan to a traditional IRA, or can be transferred in a direct trustee-to-trustee transfer to a defined

contribution account (separate account for after-tax contributions). – Pretax contributions (deductible) from an IRA may be rolled over from a traditional IRA into a qualified plan (if the qualified plan document allows it). NOTE: After-tax contributions (nondeductible) from an IRA may not be rolled

over from a traditional IRA into a qualified plan. – A distribution from a 457 governmental plan can be rolled over to a qualified plan or to an IRA. Transfers to another 457 plan remain the only option for nongovernmental tax-exempt organizations. – Hardship distributions from any retirement plan cannot be rolled into any other qualified plan.



SIMPLE IRA Rollover A participant in a qualified plan, 403(b) plan or 457 plan may now roll over their distribution from that plan to a SIMPLE. However, the receiving SIMPLE had to have been established at least two years prior to receiving funds from the non-SIMPLE plan. Tax and penalty-free distributions from SIMPLES may now be rolled into qualified plans, etc, but only if the SIMPLE had been maintained for two years from its start date. Before this change, a SIMPLE could only accept distributions from another SIMPLE.

Applying the Facts Susan headed public relations for the Burnlee Association for the past three years and had been participating in their SIMPLE plan for the past year (after satisfying Burnlee’s two-year participation rule). She feels that she does not fit the culture at Burnlee and has just accepted a position as public relations director for Wonder Waffles, Inc. She would like to roll the balance in her SIMPLE account established through Burnlee into an account in the 401(k) plan maintained by Wonder Waffles. Susan is in the 24% marginal income tax bracket. What can a CFP® professional accurately tell Susan relative to her objective?

A. “Susan, unfortunately, you can’t roll your SIMPLE balance into the profit sharing plan without incurring considerable tax because you had not been in the SIMPLE for at least two years from the SIMPLE start date.”

B. “Susan, SIMPLE plan account balances may only be rolled into other SIMPLE accounts.”

C. “While you can’t make a distribution from your SIMPLE into a qualified plan now, you can make a tax-free transfer of your current SIMPLE account balance into a traditional IRA that you can then self-direct.”

D. “Susan, if you transfer your SIMPLE account balance into your new employer’s 401(k) plan, you will face a 38% tax rate on the distribution.”

ANSWER: A Unfortunately, Susan has NOT been participating in

the SIMPLE plan for two years (from start date). If she transfers her SIMPLE balance into Wonder Waffle’s 401(k) program she will incur tax and penalty. Given her marginal tax bracket, and the whopping 25% penalty tax on premature SIMPLE distribution, Susan’s effective tax break would be 49%! The 2015 Tax act does permit rollovers from SIMPLE accounts into qualified plans, but only after the SIMPLE account was maintained for at least two years. The same two-year rule also applies if Susan rolls her SIMPLE into a traditional IRA.



IRA 60 day rule An IRA owner can withdraw all or part of the balance in the account and reinvest it within 60 days in another IRA. This can occur only once each year (one-year period) per taxpayer (not per IRA). This allows the person to continue to defer any income tax due.

Direct transfer If the participant receives a direct distribution from a qualified plan, the distributing plan must withhold 20% of the distribution. In a direct distribution, the check is payable to the

participant. The 20% is paid to the IRS. The initial transfer from the qualified plan is tax-deferred if the direct distribution is transferred into another qualified plan or rollover IRA no later than the 60th day after the distribution from the plan.

To ensure tax-deferred treatment on the entire rollover amount (no 20% withholding), rollovers must be completed by means of a "direct transfer" ("direct rollover," trustee-to- trustee transfer). The plan's trustee must convey the funds directly from the qualified plan to the rollover account (another qualified plan or an IRA). In a direct transfer, the

employee cannot take a direct distribution (a check made out to him/her).

Applying the Facts Irving quit his job at Chocolate, Inc. He received a distribution check from his 401(k). In less than 60 days, he invested 100% of that distribution in an IRA money market fund account. Which of the following can he do? I. Move from the money market account to one of the other funds

available with his IRA account II. Take a distribution check to move the account balance to another

family of funds III. Make a trustee-to-trustee transfer to another family of funds IV. Make a direct transfer to another family of funds A. All of the above C. II, IV B. I, III, IV D. III, IV

Answer: A The first distribution comes from the 401(k) plan distribution (a “qualified 60 day”). It doesn’t count as a 60-day IRA distribution. Therefore, Brad can also make a 60-day IRA distribution within the next year.

Conduit IRA

Amounts received from an employer's qualified plan may later be moved to another qualified plan by using a conduit IRA. The conduit IRA holds the funds that have been

distributed from the qualified plan for the subsequent transfer to a new/different qualified plan. After 1999, there are few differences between the taxation of distributions from IRAs and qualified plans. (Five-year averaging expired 12/31/99.)



Applying the Facts Debbie participates in a qualified plan at Company A. She wants to quit her job at Company A and plans to join Company B. Company B also provides a qualified plan, but she will not be able to enter the plan for one year. What is the best advice you can give her? A. Roll the qualified plan assets from Company A into her existing contributory IRA. B. Roll the qualified plans assets from Company A into her existing nondeductible IRA. C. Take the distribution from Company A in cash. D. Roll the qualified plan assets from Company A into a conduit IRA. Answer: D Debbie can roll the qualified plan distribution from

Company A in anticipation of later rolling it into company B’s qualified plan. Rollovers are generally permitted between one traditional IRA and another or in some cases, between a traditional IRA and a qualified plan.

C. Required minimum distributions 1) Rules For IRAs / SEPs / SARSEPs / SIMPLEs, the required beginning date (RBD) is April 1st of

the year following the year in which the covered individual attained age 72. Subsequent distributions must be made by December 31st of each year thereafter. Owners of 5% or more of the equity of a corporation sponsoring a qualified plan are also subject to this rule.

Required beginning date (RBD) for distributions – Qualified plans [including 401(k)] / governmental 457 plans / 403(b)s The required beginning date, with the exception of 5% or greater owners, is the later of April 1st following the year in which the individual attained age 72 or retired. NOTE: The more-than-5% owner must take RMDs like IRA owners but still can contribute to the qualified plan. Applying the Facts Bill age 59 has worked for the State of New Jersey for 40 years. He has been contributing to its Section 457 plan and wants to receive a full distribution of the $400,000 balance in his account. Which of the following is true with regard to the $400,000 distribution? A. He can roll over the distribution into an IRA. B. He will be eligible for 10-year averaging. NOTE: Had to attain

age 60 by 1/1/96. C. There will be a 20% mandatory withholding on the distribution but it will not be subject to the 10% early withdrawal penalty. D. He can't receive any distributions until age 59-1/2. E. None of the above.



Answer: E Bill is still employed. Therefore, he cannot take an in-service withdrawal until he reaches age 70-1/2. He is currently 59. Once he separates from service, he can take a distribution. A governmental 457 account balance can be rolled into an IRA but not until age 70-1/2 or separation from service. 457s do not qualify for 10-year averaging. 10-year averaging is a special tax treatment. Doubtful it will be tested. Bill would not qualify for 10-year averaging because he was not 60 by 1/1/1996. 457s are not qualified plans. They are not subject to mandatory withholding rules.

2) Calculations Each year the required minimum distribution is calculated by dividing the previous year's

ending balance by a life expectancy number. The calculation's complexity lies in determining the correct life expectancy number.

Uniform Lifetime Table This table is the life expectancy table to be used by IRA owners to calculate lifetime distributions unless the beneficiary is the owner’s spouse who is more than 10 years

younger than the IRA owner. In the latter case, one would not use this table. Instead, use the actual joint life expectancy of the owner and spouse based on the regular joint life expectancy table. The following table will be given. For those IRA owners turning 70½ after 1/1/2020, the required RBD is now age 72.

Age of the employee Distribution period 72 25.6 73 24.7 74 23.8 114 2.1 115 and older 1.9

Applying the Facts 1. Bradley Burton will turn age 72 in the fall of the current year.

He has a $1,000,000 balance in his IRA at the beginning of this year and estimates it will have $1,050,000 at the beginning of next year. His wife is age 67. What amount is the required minimum distribution he must take by April of next year based on the "Uniform Lifetime Table"?

A. $36,496.35 B. $39,062.50 Answer: B $1,000,000 = $39,062.50 25.6



2. Kevin turns 72 on December 15th of 2020. What will be the RBD for his IRA account?

A. By April 1st of next year (2021) using age 72 B. By April 1st of next year (2021) using age 73 C. By April 1st of the following year (2022) using age 72 D. By April 1st of the following year (2022) using age 73 E. By April 1st of the following year (2022) using age 74

Answer: A Kevin will attain age 72 in 2020. Use age 72 for RMD.

Exception for Joint Life Distributions

An exception is available if the employee's sole beneficiary is the employee's spouse and the spouse is more than 10 years younger than the employee. In that case, the employee is permitted to elect the longer distribution period measured by the joint life and the last survivor life expectancy of the employee and spouse.

Applying the Facts Mr. Carter turns age 72 in June. He has a $1,000,000 IRA balance. If Mrs. Carter is 50 years old, what is the minimum distribution he must take by April 1, of next year based on the spousal table below?

$1,000,000 : 33.8 = $29,585.79 This would allow for more "stretch out” of payments versus $39,062.50 if single.

Applying the Facts 1. In the fall of this year, James will turn 72. He named his

wife Betty age 45 the beneficiary of his IRA. For the current distribution year, which life expectancy factor (divisor) is James entitled to elect?

A. 25.6 C. 38.2 B. 27.4 D. 38.3 Answer: C The exception to the new uniform lifetime table

applies if the sole primary beneficiary is the spouse and he or she is more than 10 years younger.

Betty is more than 10 years younger than James.



2. Archie will celebrate his 72nd birthday this June. He names his daughter Sandy age 45 the beneficiary of his IRA. In the current distribution year, which life expectancy factor may Archie be entitled to use? A. 25.6 C. 38.2

B. 27.4 D. 38.3

Answer: A The exception to the new uniform lifetime table only applies if the sole beneficiary is the spouse. 3) Penalties A 50% excise tax is imposed on the amount by which a distribution in a given year falls short of the minimum required distributions. Applying the Facts 1. Phil and his four brothers are equal owners of Brothers, Inc. Although he just turned age 72, Phil does not want to retire.

His account balance in the Brothers, Inc. money purchase plan is $1,000,000. (Uniform Lifetime Table factor is 25.6.) Is he exposed to an underpayment penalty this year?

A. No, because he hasn't retired yet. B. Yes, he will have to pay an excise tax of $36,496.35. C. No, but he has to take a distribution by April 1st of the year following the year in which he attained age 72.

Answer: C Phil is more than a 5% owner. He just turned 70. He must take a distribution (per Answer C). If he fails to take the required minimum distribution, the penalty will be $39,062.50* times 50% or

$19,531.25. *(1,000,000÷25.6)

2. Alice, a widow, loves her job as a librarian for a small, private elementary school. She continues to work past age 72. She continues to add to her employer’s SIMPLE plan. She has a current balance of $200,000 in her IRA and $20,000 in her SIMPLE plan. Does Alice have to take minimum distributions?

A. Yes, from her IRA only (She isn't retired.) B. Yes, from both the IRA and the SIMPLE C. No D. Yes, from her SIMPLE only

Answer: B For IRA plans, the required beginning date (RBD) is April 1 of the year following the year when the taxpayer turns age 72.

3. Mr. Bloom will turn 72 on June 1st. His IRA has a value of $500,000 at the beginning of this year. If he only takes a $9,000 distribution by April 1st of next year (for this year), what, if any, will be the amount of his penalty? A. $ -0- C. $5,265.63 B. $4,500 D. $19,531.25



Answer: C $500,000 : 25.6 (age 72) = $19,531.25

$19,531.25 – 9,000 = $10,531.25 $10,531.25 x 50% = $5,265.63

Charitable IRA Rollover Made Permanent The 2015 PATH Act made permanent the opportunity for individuals, age 70½ (not 72) or older to exclude from gross income up to $100,000 annually in IRA distribution that is contributed to a qualified charity. The amount satisfies RMD requirements without causing the dollars to be taxed although no charitable income tax deduction is available.

D. Beneficiary considerations/Stretch IRAs

The stretch has been eliminated by the 2019 Secure Act. Non-spouse individuals must liquidate the inherited IRA within 10 years.

Example

Derrick Young names his son Tyler as the beneficiary of his IRA. Derrick doesn't expect to need more than RMD from the IRA when he reaches 72. When Derrick dies, his son Tyler has 10 years to distribute the inherited IRA.

Required Minimum Distributions Owner dies before RBD Owner dies beyond RBD Spouse only beneficiary Spouse only beneficiary - Roll over IRA assets to his/her - Roll over IRA assets to his/her IRA and take distributions based on IRA and take distributions based on his/her own required beginning date his/her own required beginning date - Keep the assets in the owner’s IRA - Keep the assets in the owner’s IRA and take distributions (starting when and take distributions based on the owner would have reached 72) longer of: based on the spouse’s life expectancy 1. Spouse’s single life expectancy

2. No beneficiaries (see below) Non-spouse individuals Non-spouse individuals [child(ren), grandchild(ren) [child(ren), grandchild(ren) other individuals, qualified trust] other individuals, qualified trust]

- Take distributions within 10 years 1. Take distributions over 10 years (stretch eliminated) 2. No beneficiaries (see below) Non-individual No beneficiary (estate, charity, non-qualified trust) (estate, charity, non-qualified trust) - Fully deplete the IRA within 10 - Take payment over 10 years years of the owner’s death NOTE: Portions of the above chart are crossed out because it is unlikely that they will be tested.



Owner dies with the spouse as beneficiary - rollover (top of the chart both sides) In the year of death, the minimum required (beneficiary) distribution is zero. When the

owner dies and the account named a spousal beneficiary, the spouse enjoys special treatment. The distributions are based on the spouse's single life expectancy recalculated each year after the owner's death (top of chart – both sides). Top left side of the chart/non-rollover

If the owner dies prior to the calendar year in which he would have reached the RBD, the spouse does not have to start taking distributions until that year. Upon the spouse's death, the distributions become term certain, with the term based on the spouse's age in the year of death.

Applying the Facts 1. Will is age 70. His wife, Lisa, is age 62. Presuming that he

died, what is her best option for his IRA if she wants to delay distributions for as long as possible?

A. Roll over his IRA into her name and take distributions based on her own required beginning date

B. Keep the assets in his IRA (inherited IRA) and take distributions when Will would have reached 70-1/2

C. Fully deplete the IRA within five years of Will's death D. Disclaim the IRA proceeds

Answer: A Lisa is younger than Will. She can delay the distributions until her own RBD.

2. Mark is age 70. His wife, Anne, is age 62. If she dies, what is his best option relative to her IRA if he wants to delay her distributions for as long as possible? A. Roll over her IRA into his IRA and take distributions based on his own required beginning date B. Keep the assets in her IRA and take distributions when Anne would have reached her RBD C. Fully deplete the IRA within five years of Anne's death D. Disclaim the proceeds

Answer: B Anne is younger than Mark. He can delay distributions until she would have reached her

RBD. The disclaimed IRA must be distributed to another party.

Owner dies with non-spousal beneficiary (middle left of the chart) Example

Mom dies in 2020 owning an IRA account having a $1,000,000 year-end balance. Her son, Nick, is its only beneficiary. He does not need the money. Under the 10-year rule, he must liquidate the entire account balance no later than December 31 of 2030.



May a surviving spouse make a rollover contribution? (top of the chart) Since the surviving spouse of an owner of a traditional IRA is not subject to the inherited account rules (top of the chart), he or she may make rollovers to and from the plan. Generally, this applies whether the spouse is the beneficiary designated under the plan or inherited the account as sole beneficiary of the owner's estate. The regulations clarify that if a surviving spouse receives a distribution from a deceased spouse's IRA, "the spouse is permitted to roll that distribution over within 60 days into an IRA in the spouse's own name to the extent that the distribution is not a required distribution, regardless of whether or not the spouse is the sole beneficiary of the IRA." Owner dies with no specified beneficiary (bottom left of the chart) In the year of death, the minimum distribution is still calculated according to the Uniform Lifetime Table. In the years after the owner's death if the owner died before the required

beginning date (72) and there is no living beneficiary as of the owner's death, the five-year rule applies. The entire account balance must be distributed at any time up until 12/31 of the fifth year after the year in which the account holder died (bottom left of the chart).

Example Dad dies in 2020 owning an IRA account having a $1,000,000 year-end balance. His daughter, Lourdes, is its only beneficiary. She wants to take her time to plan for the distributions. Under the 10-year rule, she must liquidate the entire account balance no later than December 31 of 2030.

Applying the Facts Cindy and Mindy (twin sisters) died within months of each other at age 70. Both were divorced, and each left her entire estate, including IRAs, to their sons. Cindy’s is Clark (age 45), and Mindy's son is Simon (age 48). Cindy named Clark as her "designated beneficiary." Because Mindy never got around to naming a beneficiary her estate becomes the beneficiary. From an income tax standpoint, what will happen to the IRAs? I. Payments for each sister must be taken based on that sister's life expectancy (the uniform table) for this year (of death). II. Clark must take all distributions within 10 years. III. Simon must take all distributions within 10 years. IV. Clark must withdraw all the money from Cindy's IRA within five years of her death. V. Simon has to withdraw all the money from Mindy's IRA within five years of her death. A. I, II, III C. II, III E. III, IV B. I, II, V D. II, V

Answer: D No distributions were required in the year of death. (Neither sister was 72.) Clark was a named beneficiary (Answer II), but Simon was not named. The assumption here is that Simon inherited the IRA.



Pension protection Act of 2006 All non-spouse beneficiaries can transfer 401(k) proceeds to an IRA and withdraw the

funds either over a five-year period or over their life expectancies. The change will also apply to inherited 403(b) and 457 retirement savings accounts but for government workers only. If the non-spousal beneficiary wishes to continue deferring taxes, s/he should:

-- Arrange for a direct transfer of money – The money must be sent to the inherited IRA custodian. If the plan administrator sends the money to the non-spouse, the non-spouse will owe tax even if the non-spouse quickly deposits the money in an IRA.

-- Set up an inherited IRA – If the money is transferred to an existing IRA, the non-spouse will have to pay taxes on the entire 401(k). Non-spouse beneficiaries may now tap into 401(k) funds for qualifying medical and financial emergencies.

Retiring early – leaving funds in the 401(k) If the participant retires between ages 55 and 59-1/2 the participant can take withdrawals directly from his/her 401(k) without paying a 10% early withdrawal penalty. The age 55 “early retirement provision” is not available for IRAs

Example Garrett retires at age 55. He has a $400,000 account balance in his 401(k) account. If he rolls the

whole $400,000 into an IRA, he will have to wait until age 59-1/2 to avoid the 10% penalty. But if he takes a direct distribution of $50,000, he can avoid the 10% penalty on that amount. He can roll the remaining $350,000 into an IRA. He will then have $50,000 to use now without a 10% penalty. E. Qualified domestic relations order (QDRO) The general rule is that a qualified plan must provide that retirement benefits not be

assigned, alienated, or subject to garnishment. The two exceptions are as follows: – may not prevent the collection of federal taxes – may be attached by a spouse or former spouse through a QDRO

– QDROs typically operate in conjunction with a divorce decree Distributions due to a QDRO If under the plan the participant has no right to an immediate cash payment from the plan,

a QDRO cannot require the trustees to make such a cash payment to the alternate payee named under a QDRO. If compensating cash payments is not possible, QDROs can require that plan assets be segregated for the benefit of the spouse making the claim, with cash distributions made at the earliest time permitted under plan provisions.

Example

Pleasing Product, Inc.’s plan provides benefits at age 55 (or later) for a plan participant, then the QDRO distributions to a former spouse can be scheduled to begin at the ex-spouse's (the participant) age 55, whether or not the ex-spouse (participant) is retiring at that date. Special penalty waiver rule for public service employees The 10% early withdrawal penalty is generally waived if a distribution from a qualified plan (NOT IRA) is made to certain employees after separation of service at age 55 or older. However, penalty-free distributions from governmental plans (NOT 457 plans) for qualified public safety employees are available at age 50 and older. Public safety employees include law enforcement, customs and border patrol officers as well as firefighters.



F. Taxation of distributions 1) Tax management techniques

Distributions from retirement accounts are subject to ordinary income (except for NUA distributions) and, if the participant is under certain ages, a 10% penalty. The first tax management technique is to avoid the 10% penalty taking substantially equal payments (Section 72(t)). The second tax management technique is to spread distributions out to take advantage of possible lower tax brackets during the retirement years. The third is to use after-tax investments for retirement needs. The basis would be recovered tax-free and capital gains rates are lower than ordinary rates that apply to most retirement plan distributions. A combination of distributions from retirement and after-tax accounts should address potential income taxes.

2) Net unrealized appreciation (NUA) Net unrealized appreciation (the difference between the employer cost basis and market value at lump-sum distribution to the employee) is not subject to taxation until employee sells the stock. The net unrealized appreciation is always taxed at long-term capital gain rates, regardless of holding period. If the stock appreciates after the distribution, the gain not attributable to NUA will be taxed at favorable capital gains rate if the stock is held long-term. Example Sturdy Stockings, Inc. contributed stock with a basis of $20,000 to Jeff’s ESOP account. The

stock is distributed to Jeff at retirement with a market value of $200,000. The difference, $180,000, is not taxable until he sells the stock, but the $20,000 (basis) is taxable now (at time of distribution) as ordinary income. It is phantom income. If Jeff sells the stock 6 months after distribution for $250,000, then $180,000 is taxed at long-term capital gains rates, and $50,000 is taxed at short-term capital gains rates.

Applying the Facts 1. Rebecca is a participant in her employer's ESOP. Over the years,

the company has transferred stock with a cost basis of $100,000. Rebecca is now retiring. The stock has a current value of $300,000. She is planning to sell the stock in a few years. If, upon retirement, Rebecca takes a lump-sum distribution, what are her income tax implications?

A. $300,000 as ordinary income now. B. $100,000 as ordinary income now, $200,000 as a long-term

capital gain when she sells the stock later. C. $200,000 as ordinary income now, $100,000 as a long-term

capital gain when she sells the stock later.

Answer: B Rebecca will recognize $100,000 as ordinary income. The remaining $200,000 is deemed to be long-term capital gain when Rebecca sells the stock.

2. Continuing with the question above, what happens if Rebecca sells the stock for $330,000 six months later?

A. $30,000 is short-term gain, and $200,000 is long-term gain. B. $230,000 is short-term gain.



C. $230,000 is long-term gain. D. $30,000 is short-term gain.

Answer: A The extra $30,000 is either short-term or long-

term depending on the holding period after distribution.

3. Ellen’s husband Dale died recently. He was 53 years old. He was still working at the time of his death. After you, A CFP® professional, review Dale’s retirement plan information, you determine that the plan is an ESOP and that neither Dale nor Ellen (age 51) has taken any distributions from the plan. What advice is best for Ellen? I. If you take the securities as part of a lump-sum

distribution, all of the net unrealized appreciation (NUA) will be non-taxable at the time of distribution.

II. The NUA constitutes income in respect of a decedent (IRD). III. When you sell the stock after receiving it as part of a

lump-sum distribution, the NUA portion of the proceeds is a long-term capital gain.

A. I, II, III C. I, III E. III B. I, II D. II

Answer: A The NUA becomes IRD even when it involves a beneficiary receiving a distribution from an ESOP. In Answer II, there is an income tax deduction for

estate taxes paid on the NUA (if any). Due to the marital estate tax deduction, there will be none.

4. Linda Myers, married, is about to retire at age 68. She plans to

directly rollover her profit sharing 401(k) to a personal IRA. Who can be the beneficiary of the IRA?

I. Robert Myers, her husband II. Susan, her daughter III. Phillip, her son

IV. The American Heart Association A. All of the above C. I, IV B. I, II, III D. II, III, IV Answer: A An IRA owner can specify an individual or other

party to be the beneficiary of the account. Only pension plans require the husband to be the beneficiary.

5. Quincy owns 100% of Q Inc. He is turning 72 at the end of the current year. He participates in Q, Inc.’s profit sharing 401(k). What is his federal income tax situation for this year and next year in regards to the plan distributions and contributions? (Presume that he plans to continue to work next year.)



I. He will not have to take a distribution for the current year. II. He will have to take a distribution for the current year. III. He can continue to defer and receive profit sharing contributions next year.

IV. He cannot defer or receive profit sharing contributions next year. A. I, II C. II, III B. I, IV D. II, IV Answer: C Quincy is more than a 5% owner. He can wait until April 1st to take the distribution, but it is for

the current (this) year. He is both 70 and 70 ½ this year. He can still participate in the plan next year.

Applying the Facts 1. Dan turned 72 at the beginning of the current year. He invented

a marketable product that could be outsourced (produced by a separate manufacturer). By year end, the business produced a $500,000 profit in addition to his salary of $120,000. If the business operates as an S corporation, which of the following is/are true?

I. If he starts a profit sharing plan, the business can contribute $57,000 to his account if he has other employees. II. If he installs a SEP, the business could only contribute 18.59% of $120,000.

III. If he adopts a retirement plan he will have to take a required minimum distribution at year end.

IV. He should take more salary to maximize the company contribution. V. He cannot do anything because he will be 72 this year.

A. I, IV D. III, IV B. II, III, IV E. V C. II, V

Answer: A Because Dan is still limited by the 25% rule answer I is only true if he has other employees. Remember 415 limits annual contributions to 100% of compensation or $57,000. He is 72 this year. Answer II is false. The business is an S Corporation. It can contribute up to 25% of overall compensation. Answer III is false. The contribution will not go into the plan until next year (for this year). The required distribution (72) is based on the account balance as of the end of the prior year. It was zero. The account balance is the contribution for the current year although the corporation actually deposited it next year. Answer IV is true. Answer V is false. IRA contributions are now allowed after 72 as well as SEP and qualified plan contributions.



2. Kent Kelly is single. He has decided to retire. His employer never provided a retirement plan. For years he has contributed to a deductible IRA. With successful investment management he has accumulated $1.1 million in the account. He is going to split the IRA into two IRAs. One, now worth $800,000, will continue to grow and one for $300,000 will be distributed in substantial equal payments to avoid the 10% early withdrawal penalty. What happens if Kent ceases receiving payments at age 62 after four annual payments?

A. Nothing, because he will have attained age 59½ B. Nothing, because the remaining funds are still in the IRA C. The penalty will be 10% of the total annual payments received by Sam before he attained 59½ plus interest

D. The penalty recapture will be 10% of the total annual payments received by Sam plus interest

Answer: C Recapture will apply because Kent ceased receiving payments before the end of the five year period. The recapture will be for only those payments before he turned 59½. He turned 62 after four payments. 3. A new client asks you a question. He is turning age 72 in May of

this year. In the prior year, he rolled over $2,000,000 from his previous employer’s profit sharing 401(k) plan into an IRA. At year end it was worth $2,100,000. He wants to know how much will he have to take as a distribution this year, if any? Refer to uniform lifetime table.

A. $76,624.34 by April 1st of next year but for this year’s RMD B. $82,031.25 by April 1st of next year but for this year’s RMD C. No distribution is required for this year D. No distribution is required because he is still an active participant in the company’s profit sharing 401(k) plan

Answer: B The distribution period is 25.6 of the value of The account at the end of the prior year. $2,100,000 / 25.6 = $82,031.25



4. Norton owns Norton Notions (NN), Inc. NN established a SEP for Norton and his employees for years. Norton is turning 72 early next year. A financial advisor told him to close the SEP. The financial advisor said that NN, Inc. should start a profit sharing plan. Then he would not have to take required minimum distributions until he formally retires. Norton wants to delay his distribution for as long as he can. Norton is seriously considering the recommendation. What would a CFP® professional be most likely to tell Norton?

A. You will have to take a required minimum distribution next year, but you can delay it until April 1st of the following year. B. The financial advisor is correct. C. You can wait until he is 72 to take required minimum distributions next year. D. You cannot move the SEP money to the profit sharing plan. Answer: A Norton is a greater than 5% owner of NN, Inc. He

will be both 70 and 70½ this year. Answer D is false. The funds could have been moved.



Employee stock options / Stock plans / Nonqualified deferred compensation Lesson 10 Nonqualified deferred compensation A. Basic provisions and differences from qualified plans A nonqualified deferred compensation plan is any employer retirement, savings, or deferred compensation plan for employees that does not meet the tax and labor law (ERISA) requirements applicable to qualified. Major differences between nonqualified

and qualified plans are as follows: Nonqualified plan Qualified plan May discriminate May not discriminate Exempt from most ERISA requirements Many ERISA requirements No employer tax deductions for contributions Immediate employer tax deduction until employee is taxed for contribution (even though employee may not be vested) Fund's earnings may be taxable to employer. Earnings accrue tax deferred until (depends on investments) distributions. Distributions are taxable at ordinary tax rates Distributions are taxable at ordinary (exception: incentive stock options). tax rates (exception: 10-year averaging and NUA under a Stock Bonus and ESOPs). When is it appropriate? A non-qualified deferral compensation arrangement is indicated when an employer wants

to provide additional benefits to an executive who is already receiving the maximum benefits or contributions under the employer's qualified retirement plan(s). Without an additional incentive, the employer may not be able to recruit (new employees) or retain (current employees).

B. Types of plans and applications 1) Salary reduction plans The plan (also called a pure deferred compensation arrangement) uses some portion of the employee's current compensation to fund the ultimate compensation benefit. 2) Salary continuation plans The plan uses employer contributions to fund the ultimate compensation benefit. Example As a successful CFP® professional, you are offered employment with Mega Money, Inc. to

manage its financial planning division. Your annual practice income is typically $500,000 with SEP contributions. The new position will pay $750,000 and a 401(k) plan (6% with 3% match) and a pure deferred compensation arrangement of up to $250,000. The $250,000 to fund the deferred compensation arrangement will come from your $750,000 salary. Your counter offer could be $750,000 with a 401(k) plan (6% with 3% match) and a $250,000 salary continuation plan. You receive the entire $750,000 salary, and the firm will fund the $250,000 in your deferred compensation plan. This is a better arrangement for you.

NOTE: Under nonqualified deferred compensation, the firm (above) can design a plan exclusively for one particular executive. They can discriminate without regard to other

employees of the firm.



Applying the Facts Which of the following statements is true about a nonqualified deferred compensation plan? I. The contribution may be structured as additional compensation to the employee. II. The contribution may be paid from the executive’s current

compensation. III. The plan may provide for benefits in excess of qualified plan limits. IV. The plan may not discriminate. A. I, II, III, IV C. II, III B. I, II, III D. IV

Answer: B I correctly describes a salary continuation plan. II correctly describes a pure deferred compensation plan.

III is correct because that is the purpose of nonqualified deferred compensation.

The following reflect requirements for unfunded deferred compensation plans and nonqualified stock-based compensation/bonus plans. To maintain the deferral, a plan must be unfunded. The term "unfunded" can be misunderstood because the plan may consist of a mere promise (also called naked promise) to pay or be informally funded with life insurance, annuities, mutual funds, or other investments. Both methods are considered unfunded. Informal funding is considered unfunded because the assets are owned by the company and are subject to the company’s creditors (like other corporate assets). The employee has no access to the compensation that has been deferred. As a result, there are no tax deductions for contributions until the employee is ultimately taxed. The employee is taxed when he/she has constructive receipt or an economic benefit. Applying the Facts Which statements below accurately describe the characteristics of funded and unfunded non-qualified deferred compensation plans? I. An unfunded plan must have its assets held by a third-party

custodian or trustee. II. A funded plan can be a naked promise to pay; but, the deferred

compensation must be guaranteed by the employer. III. Unfunded plan assets are beyond the reach of the employer’s

creditors in the event of a hostile takeover. IV. A funded plan is beyond the reach of an employer’s insolvency and bankruptcy creditors. A. I, II C. IV E. II, IV B. III, IV D. I, IV

Answer: C An unfunded plan can be a “naked promise” to pay, but a funded plan cannot be. Certain unfunded plans (also known as informally funded) are within the reach of the employer’s insolvency or bankruptcy creditors. Answer IV is the only correct answer.



Life insurance and Section 162 Life insurance policies are often used as an informal funding vehicle because their cash

value buildup is not currently taxed. In conjunction with a non-qualified deferred compensation program, the premiums and benefits of life insurance contracts usually taxed as follows:

– The employer will own the policy and be its beneficiary. – Premiums are not currently deductible.

– Death proceeds paid to the employers are not taxable as income to the employer. This is because the premiums paid were not deductible. Therefore, the proceeds remain tax- free death benefits. – Benefits paid to the covered employee (or to surviving dependents) are a deductible expense to the employer as paid. At this point, the employee has constructive receipt, or the surviving dependents receive an economic benefit. This payment is deferred compensation, not a death benefit. Either way, it is income taxable. – The present value of payments to the surviving beneficiaries is included in the employee's gross estate for estate tax purposes. This is because under the deferred compensation plan, the employee had a right to name the beneficiaries (incident of

ownership).

Applying the Facts 1. A CFP® professional required an extra incentive to join FP, Inc.

FP gave the CFP® a $10 million variable life insurance policy. FP paid the premium. Which of the following is true? A. This is a funded nonqualified deferred compensation

program. B. This is an unfunded nonqualified deferred compensation

program. C. The program is informally funded. D. The premiums are taxable to you. E. The premiums are nondeductible by FP.

Answer: D This is a Section 162 insurance plan. Section 162 insurance represents a direct cash bonus made to an insurance company to pay the premium on a policy that is owned by the employee. A 162 double bonus is an additional cash bonus to the employee to pay the tax on the insurance-based bonus. This is not a funded nonqualified deferred compensation plan.

2. In the prior question, if FP was the owner and beneficiary of

the variable life insurance policy, then which answers would have been correct?

Answers: B, C and E are correct. This would be an

informally funded deferred compensation arrangement.



3) Rabbi trust This trust is called a rabbi trust from an early IRS letter ruling involving an arrangement

between a rabbi and his employing congregation. Requirements include the following: – The assets in a rabbi trust must be available to all general creditors of the employer if it files for bankruptcy or becomes insolvent. – The participant must not have greater rights than other unsecured creditors. – The plan must provide clear rules describing when the benefits will be paid. – The company must notify the trustee of any bankruptcy or financial hardship the company is undergoing. When a bankruptcy or financial hardship occurs, the trustee must suspend payment to the trust beneficiary and hold assets for the employer's general creditors.

The main factors indicating the use of a rabbi trust are the following:

– Fear that the ownership or management might change before the deferred compensation benefits are paid (takeover/acquisition) – A situation where new management might be hostile to the key employee in the future and fail to honor the compensation agreement – A situation where litigation to enforce payment of deferred compensation in the future would likely be too costly to be practical

Applying the Facts In which of the following circumstances would a rabbi trust be an appropriate choice as a planning tool? I. Hostile takeover III. Acquisitions II. Mergers IV. Bankruptcy A. All of the above C. II, III B. I, II, III D. IV

Answer: B The rabbi trust provides no benefit security for an executive should the employer file bankruptcy. The executive assumes the status of the other creditors. 4) Secular trusts The secular trust (in contrast with a rabbi trust) is an arrangement that addresses two current problems associated with nonqualified deferred compensation plans: the lack

of security in relying on an informally "funded" plan and the fear that the tax savings will disappear because tax rates after retirement may be higher.

A secular trust is an irrevocable trust that is established for the exclusive benefit of the employee. Its funds are placed beyond the reach of the employer's creditors. Taxation occurs in the year in which the assets are placed in the trust with a corresponding deduction to the employer in that year or when a substantial risk of forfeiture no longer exists. The secular trust is considered a "funded" nonqualified deferred compensation arrangement. The trade-off for creditor protection is taxation of the compensation in the year it is transferred to the trust.



Applying the Facts An employer establishes a secular trust for its National Marketing Manager, Len. Which of the following statements is true? A. Len will be able to defer a portion of his current income. B. The benefits will be subject to the creditors of the employer. C. The plan is an informally funded plan. D. Because there is no substantial risk of forfeiture, taxation

will occur at the time the contribution is made. Answer: D Because the assets in a secular trust are beyond the reach of the employer’s bankruptcy or insolvency creditors, taxation will occur at the later of the following two dates: 1) when the funds are deposited into the plan or 2) when there is no longer a substantial risk of forfeiture. (Normally there is not

substantial risk of forfeiture with a secular trust.)

C. Income tax implications Informal funding creates taxation to the employer in two ways. First, the funds set aside to fund the plan must be taxed at the corporate level (as accumulated earnings). Second, earnings on the funds set aside (reserve) may create an additional tax. If an

annuity contract is held by an entity who is not a natural person (for example a corporation), the annuity rules change. The income on the contract must be treated as ordinary income received or accrued by the holder during that year.

Example A corporation offers a nonqualified deferred compensation plan for Wendy. The employer purchases and owns a variable annuity ($100,000 initial deposit). If the accrued gain for the year is 10% or $10,000, the gain must be reported as ordinary income. 1) Constructive receipt Income is taxable to a cash basis taxpayer in the year during which it is paid or made available to the taxpayer. Income is not treated as constructively received if the taxpayer's control of its receipt is subject to substantial risk of forfeiture or other

restrictions. 2) Substantial risk of forfeiture Substantial risk of forfeiture exists if the employee's rights to the enjoyment of the property are conditioned upon the performance of services for a period of time (based on the nonqualified deferred compensation arrangement). The tests to determine if a

substantial risk of forfeiture actually exists are the following: – The employee's relationship to other stockholders and the degree of their potential control – The employee's relationship to corporate officers



Applying the Facts Peter recently joined his grandfather's firm. (His grandfather is the CEO and his father is the President). Peter has extensive experience as sales manager for a competitor and has been made V.P. of sales. The firm has established a nonqualified restricted stock grant plan for Peter. He will qualify if he stays with the firm for ten years. Are the benefits taxable income now or in the future? A. Because there is a substantial risk of forfeiture; the stock

grants will be taxable in the future. B. This is an informally funded plan; the stock grant will be taxable when exercised. C. This is an unfunded plan. Forfeiture provisions are unnecessary.

The stock grant will be taxable in the future. D. This is a funded plan and stock grant is taxable now. E. Because there is no substantial risk of forfeiture; the stock

grant is taxable now.

Answer: E There is not substantial risk of forfeiture. Because Peter’s grandfather and father own and operate the firm, there is no substantial risk of forfeiture. Informally funded plans mainly hold life insurance, rather than stock grants or options. Stock grant plans (Restricted stock grants) normally have provisions for substantial risk of forfeiture and as grants only are not taxable under normal circumstances.

3) Economic benefit doctrine If any economic or financial benefit is conferred on an individual by an employer as

compensation in a taxable year, it is taxable to the individual in that year. Example Corporation X created a trust for an employee. The trustee was directed to invest the money and

pay half of it to the employee next year and the other half the following year. The court considered the doctrine of constructive receipt but determined that it didn't apply because the employee was not able to actually possess any of the money that year. The court did find, however, that the creation of the trust provided an economic or financial benefit that year.



Applying the Facts 1. Director of Product Development, Ira Inventive, and his employer

executed an agreement to defer a portion of future compensation under a deferred compensation plan. The plan provides for contributions based on corporate profits that would otherwise be paid in bonuses to Ira at the end of the corporation's fiscal year. Contributed amounts remain an asset of the employer at all times although the plan is credited with investment earnings on Ira’s behalf. At age 60 or his date of retirement, whichever occurs first, Ira will be entitled to distributions from the plan. Which statement correctly identifies the income tax implication of this deferred compensation plan for Ira? A. This is a funded salary continuation plan. Contributed

amounts remain an asset of the employer; thus, the employee has no current taxation.

B. Contributions are based on bonuses paid at the end of the fiscal year; therefore, they are immediately taxed to Ira.

C. The employer takes a deduction for the plan contributions and earnings only at the time Ira includes them in his income (i.e., age 60 or date of retirement).

D. This type of funded plan can use life insurance as an investment vehicle to avoid taxation of the cash value growth to Ira until he attains age 60 or retires.

Answer: C The employer may claim the deduction only at the time when the employee recognizes the income. A, B, and D are wrong because this is an unfunded

plan (not a funded plan). The investment remains an asset of the employer at all times. 2. Of the following entities, which can effectively implement a deferred compensation plan for its executives? A. Limited Liability Partnership D. General Partnership B. Corporation E. S-corporation C. LLC

Answer: B All of these entities may offer a deferred compensation plan. However, with pass-through

entities (A, C, D, and E) contributions to nonqualified plans are nondeductible at the time of contribution. The owners will have to

report the amount contributed to the deferred compensation plan on their personal tax returns. Regular corporations do not have this requirement because they are separate tax entities.



Employee stock options A. Basic provisions Employee stock options enable employees to buy shares of the employer’s stock at a

specified price. They operate somewhat like long calls.

Funded vs. Informally Funded (Unfunded) Plans If a deferred compensation plan is not a naked promise to pay (nor is informally funded) for income tax purposes, it may be said to be “funded." The two major determinants of taxation are the following: – the free transferability of the employee's interest and – the presence of a "substantial risk of forfeiture" at the time the contribution to the plan is made by the employer

1) Company restrictions Stock plans generally may be designed to benefit any employee. Stock options are

generally not offered by small, closely held corporations. They generally do not want to share ownership of the business. Such plans are most often used where ownership is broad or the company stock is publicly traded.

2) Transferability The options are not freely transferable. 3) Exercise price The stated price to purchase shares of the company stock. 4) Vesting Many options are not exercisable for a period of time after the options are granted. Vesting can also be subject to satisfying specific performance goals. Example 1 The employee's options will vest when corporate profits double. Example 2

An employer granted 10,000 options that become exercisable in 5 years from the date of grant as long as the participant is still employed on that date. In addition, the plan could implement a yearly schedule: 20% vested after one year, 40% after 2 years, and so on.

5) Expiration If an option is "out of the money" at the end of the exercise period, the option holder ordinarily would let the option expire without exercising it. The term of the exercise period is most often 10 years, but it can be shorter. 6) Cashless exercise

A cashless exercise involves selling some (or all) of the acquired shares to cover the cost of the options and the taxes due. Often all shares are sold when using this technique. Not all companies allow this type of exercise and sale. Cashless exercise may work for both NSOs and ISOs. However, if ISOs are exercised and sold in this manner, a nonqualifying disposition will have occurred, triggering ordinary income tax.



Incentive stock options (ISOs) / Nonqualified stock options (NSOs) An ISO plan is a tax-favored plan for compensating executives by granting options

to buy company stock. Only the first $100,000 worth of ISOs granted to any employee that vest in one calendar year is entitled to favorable ISO treatment. Options granted which exceed that amount are non-qualified. The excess is treated as a regular nonqualified stock option (for tax purposes). In addition, the corporation granting an ISO does not receive a tax deduction for it at any time with the exception of a disqualifying disposition. NOTE: An ISO program may be called a “qualified” employer stock option plan, but it is certainly not a qualified plan.

A nonqualified stock option is the right to purchase a specified number of shares of the employer's stock at a given time and a given price. The following events are important for both ISOs and NSOs 1) Income tax implications (regular, AMT, basis) a) Grant b) Exercise c) Sale

2) Holding period requirements For ISOs (qualified options) holding periods must be observed from grant to exercise and

from exercise to sale.

3) Disqualifying dispositions ISOs and NSOs are different. ISOs must satisfy numerous conditions in the Internal

Revenue Code. In return, the IRS levies no income tax when the options are granted or exercised to obtain shares. Employees are taxed only when they sell the acquired stock - at the 15% or 20% capital gains rate if they've held the shares long term. “Nonquals” needn't adhere to any holding periods. Upon exercise, income tax is due on any gains (the difference between the strike price and the shares' current market price). And if “nonqual” recipients hold on to the shares they acquire, they are subject to tax again when they sell the stock, on the difference between the share price at acquisition and the sale price. The major difference relates to taxation at the date of exercise. Whereas ISOs are not subject to regular tax when exercised, NSOs are.

Why ISOs? ISOs reward certain employees. They are most often granted to key employees to

motivate productivity. However, the employer receives no tax deduction when the shares are exercised.



Example (comparing ISOs and NSOs) Ed’s employer offers him a choice between a nonqualified stock option plan or an incentive

stock option plan. The option price is $20/share, and the share price at the time of exercise is $100/share. He feels that he will keep the stock until it is priced at $200/share. Then he will sell it. How will taxation occur in each situation?

Taxation ISOs NSOs Option granted No tax event No tax event Vesting period Per plan document, normal None required vesting is 1 year (see next page). Exercise at $100 No regular tax but bargain Difference taxable at element is AMT add-back ordinary income tax rates item ($80). Basis is $20. $100 - 20 = $80 Basis $100 Holding period 1 year from exercise date >1 year for LTCG treatment (see example 1) and 2 years from grant (see example 2) Sale at $200 Excess above basis is a Excess above basis is a capital gain ($180) (see capital gain ($100). example 3). There are two ISO holding-period rules, both of which must be satisfied to prevent a disqualifying disposition. The first holding-period rule is that the grantee must hold the

exercised ISO shares at least one year from the date of exercise before selling them. The second holding-period rule is the taxpayer must hold the shares from an ISO exercise at least two years from the grant (issue) date before selling them. Violating either rule results in a disqualifying disposition. For tax purposes, the ISO becomes an NSO. Almost all ISO grants require at least a one-year vesting period before the ISO can be exercised. If an ISO granted by an employer allows for a shorter vesting period, the ISO can be exercised without triggering a disqualifying disposition. The event that triggers a disqualifying disposition is most often not the date of exercise (providing the terms of the ISO plan document are met). It is the sale date! If the sale occurs within two years of the grant (issue) date or one year of the exercise date, it creates a disqualifying disposition.

Example 1 (exercise to sale holding period violated) Ed is granted an ISO in March 2017 for $20 per share. In January 2019, Ed exercises the

option when the fair market value is $100 per share. In December 2019, he sells the shares at $200 per share.

Result: $80 is compensation ($100 - $20); $100 is short-term capital gain ($200 - $100) (held 1 year or less since exercise: short-term capital gain above basis). Answer: The excess of the fair market value over the exercise price (the bargain element

– $80) is treated as compensation (taxed as wages) and subject to FICA and FUTA in the year the stock is sold. It loses its ISO status (for tax purposes) and is treated like a nonqualified stock option because the shares were sold within one year of exercise. The additional $100 is short-term capital gain.



Example 2 (grant to sale holding period violated) Ed is granted an ISO in March 2017 for $20 per share. In December 2017, Ed exercises the

option when the fair market value is $100 per share. In February 2019, he sells the shares at $200 per share.

Result: $80 ($100 - $20) is ordinary income (but not taxed as wages). $100 is long-term

capital gain ($200 - $100) (held more than 1 year since exercise: long-term capital gain above basis).

Answer: The excess ($80) of the fair market value over the exercise price is treated as ordinary income in the year the stock is sold. It loses its ISO status (for tax

purposes) and is treated like a nonqualified stock option because the shares were sold within two years of the grant (issue) date. The $100 is long-term capital gain.

Example 3 (no rules violated)

Ed is granted an ISO in March 2017 for $20 per share. In January 2019, Ed exercises the option when the fair market value is $100 per share. In February 2020, he sells the shares at $200 per share.

Result: $80 is an AMT add-back item ($100 - $20); $180 is long-term capital gain ($200 - $20) (greater than 1 year: long-term capital gain above basis). Answer: The excess ($80) of the fair market value over the exercise price is treated as as an AMT add-back item. It maintains its ISO status because the shares were sold more than two years after the grant (issue) date and more than one year after the exercise date. The $180 is a long-term capital gain. Disqualifying disposition note: If ISOs are sold in the same calendar year as the ISOs were exercised, the bargain element is taxable compensation subject to FICA. If the ISOs are

sold within 12 months of exercise (but in the following calendar year), the bargain element is ordinary income (not subject to FICA). If a non-qualifying disposition is triggered by a violation of the 2-year rule but the sale occurs in a different calendar year than the exercise occurred, the bargain element is ordinary income (not subject to FICA). If both the 1-year and the 2-year rule are violated, the bargain element is taxable compensation (subject to FICA).

Applying the Facts Dad was granted ISO options with a $15 strike price. He transfers (gifts) the options one year later to his daughter when the market price is $19. What is (are) the income ramification(s) if she exercises them at $25 two years later? A. $4 ordinary income to Dad / $6 ordinary income to the daughter B. $10 ordinary income to Dad C. $10 ordinary income to the daughter D. $6 ordinary income to Dad / $4 ordinary income to the daughter E. $10 capital gains to the daughter



Answer: B A gift of the ISOs to the daughter before exercise is a disqualifying disposition. (The ISO becomes an NSO.) Dad is charged with the resulting income. The only exception to the transfer before exercise is if Dad dies before he can exercise the options. If that occurs, the rights maintains ISO status when his daughter exercises.

The ISO cannot be transferable by the optionee. During the optionee's lifetime, the option may be exercised only by the optionee. If before death Dad (in the prior question) exercised the options and transferred them to his daughter, then the gift tax valuation would be based on the stock's FMV as of the date of transfer. For income tax purposes, the basis would be Dad’s basis, not FMV.

D. Planning strategies for employees with both incentive stock options and nonqualified stock options The participant should understand tax-timing issues. With NSOs, the regular tax (plus the possibility of FICA) must be paid at the time of exercise. If the employee holds the shares for future appreciation, the participant not only has to have paid the tax at exercise

but also have the cash necessary to purchase the shares. With ISOs, there is no regular tax due. However, the excess of the stock's FMV at the time of exercise over the option

exercise price is an AMT add-back item. In 2018 through 2025 very few taxpayers will be subject to the AMT. The participant should watch the timing of the exercise and avoid any disqualifying disposition.

Applying the Facts 1. Fred receives 10,000 ISOs to purchase Acme Corporation stock at $10 per share. Within two years of the grant date, he exercises them when the stock is $25 per share. Several years later, he sells the 10,000 shares of Acme for $100 per share. Regarding

the income tax consequences of this arrangement, which of the following statements are true? I. There is no taxable event on the grant of the options.

II. Upon exercise, he’ll have $150,000 of additional income for regular tax purposes.

III. He’ll have a long-term capital gain of $900,000 when he sells the stock. IV. He’ll have a long-term capital gain of $750,000 when he sells the stock.

A. I, II, III C. I, III B. I, II, IV D. I, IV

Answer: C Before selling the exercised ISO shares, Fred held them at least one year from the date of exercise and two years from the grant date. This is a "qualified" disposition. The bargain element (an AMT add-back item) is $15 per share. It is relatively unlikely that Fred has AMT exposure. The gain (long-term) at the time of the sale is $90 per share.



2. Innovation, Inc. (II) rewards its employees for constructive recommendations by granting them ISOs. Jack, its new Director of Products, was granted a $50,000 option for company stock some years ago. At the time of exercise, the market value of the stock was $100,000. Jack exercised the option and sold the stock for $200,000 thirteen months later. What were the tax implications to Jack? A. $50,000 was subject to ordinary income tax at exercise,

$100,000 was treated as capital gain at sale. B. $150,000 was subject to ordinary income tax at exercise, $0

at sale. C. $0 was subject to ordinary income tax at exercise, $150,000

was treated as capital gain at sale. D. $100,000 was subject to ordinary income tax at exercise,

$50,000 capital gain occurred at sale.

Answer: C There is no ordinary income tax at exercise. The basis is $50,000, and the difference is a capital gain. The grant was some years ago (more than 2).

3. When Jack (Question 2) exercised the option, what amount would be treated as an add-back item for purposes of the AMT?

A. $0 C. $100,000 B. $50,000 D. $200,000

Answer: B The bargain element is the excess of the fair market value of the stock at the exercise date over the option (exercise) price. The stock's

market value at the time of exercise is $100,000, and the exercise price is $50,000.This is an add-back item.

4. Elmer Executive was granted 10,000 ISOs to purchase Acme

Corporation stock at $10 per share. Once vested, he exercises the options when the market price of Acme is $25 per share. Several years later, he sells the 10,000 shares of Acme for $100 per share. Which of the following is/are true?

I. There is no taxable event on the grant of the option. II. Elmer will have no additional income for regular tax purposes upon exercise. III. Elmer will have a long-term capital gain of $900,000 when he sells the stock. IV. The AMT bargain element is $25 per share. A. All of the above C. II, IV B. I, II, III D. III

Answer: B The bargain element is the difference between the market price at exercise ($25) and the option price ($10). The $100,000 ISO limit does not apply to the amount of gain. It applies only to the amount of options that become exercisable

(vest) in any given year.



5. On January 1, 2018, Harry (an employee of Zebra) was granted 1000 ISOs to purchase Zebra stock at fair market value on the

date of grant ($20). On June 30, 2020 he exercised all of the ISOs when the market price of Zebra was $35, and he sold the stock for $35 the next day. Which of the following is true?

A. There is no taxable event on the exercise of the options. B. Harry will have to recognize $15 per share as compensation (ordinary income) on the date of exercise. There will be no gain or loss at the time of sale.

C. Harry will have to recognize $15 per share as short-term capital gain on the date of the sale.

D. Harry will have an AMT adjustment of $15 on the exercise date.

Answer: B When the time between the exercise to sale is less than 1 year a disqualifying event occurs. The ISOs became NSOs. Answers A and D are false. He will realize no gain or loss on the date of sale since his basis ($35) is the same as the sale price ($35). If he had sold them for a gain, the gain would have been short-term. If he sold them for a loss, the loss would have been short-term.

6. On January 1, 2019, Sally (a managerial employee of Classy Corp.) is granted 1,000 ISOs to purchase shares of Classy at the fair market value of the stock on the date of grant ($20). On June 30, 2019, Sally exercises all the ISOs when the stock's fair market value is $40. On December 30, 2020, she sells 500 shares for $50 per share. Which of the following are true?

I. This is a disqualifying disposition. II. Sally will recognize ordinary income of $20,000. III. Sally will recognize ordinary income of $10,000. IV. Sally will also recognize short-term capital gains of $5,000 when she sells the shares. V. Sally will also recognize long-term capital gains of $5,000 when she sells the shares. A. I, II C. I, II, IV E. II, V B. I, III D. I, III, V

Answer: D The ISOs are disqualified. They become NSOs. Sally is required to recognize the bargain element or $20,000. That added to the exercise price creates an adjusted basis of $40 per share. She held the exercised shares for over one year.

E. Election to include in gross income in the year of transfer [83(b) election]

Under an 83(b) election, the employee elects to recognize, at the time of the award, the excess of the fair market value of the stock awarded (granted) over the employee's cost as ordinary compensation income. This accelerates the taxable event to the award (grant) date. Any appreciation in the stock after the date of the award (grant) will not be taxed to employee until he or she sells the stock. All the gain will be taxed at favorable capital gains rates.



Example Doris Department-Manager is granted 1,000 shares of stock (at no cost) when the company's

stock is at $10 per share. Any restriction lapses two years later when the stock price is $30 (vested). The employee sells it a year later for $60 per share.

83 election - $30,000 ordinary income in two years and $30,000 capital gains in the third year 83(b) election - $10,000 ordinary income tax immediately and $50,000 capital gains in the third year Section 83 Section 83(b) Grant $ -0- taxable $10,000 ordinary income tax Restriction lapses $30,000 ordinary income tax $ -0- taxable 3+ years later sells $30,000 capital gains $50,000 capital gains NOTE: Section 83 and 83(b) apply to NSOs and restricted stock. The advantage is in the

$50,000 of capital gains treatment of Section 83(b) versus $30,000 of ordinary income and $30,000 of capital gains in the 83 election. The disadvantage is the $10,000 immediate income tax on grant.

When should the grantee elect to use 83(b)? When the stock is expected to substantially

appreciate over time. Stock plans - Types and basic provisions 1) Restricted stock A restricted stock plan normally involves a sale of stock (not options) to an employee at a bargain price. No taxation occurs if a substantial risk of forfeiture exists. 2) Stock appreciation rights (SARs) SARs are rights to be paid an amount of money equal to the difference between the value

of a specified number of shares of stock on the date the SARs are granted and the value of the stock on the date the SARs are exercised.

3) Phantom stock Phantom stock is a right to a cash (generally) bonus based on the performance of

phantom shares of a corporation's common stock over a specified period of time. Similarities between SARs and phantom stock The amount is paid in cash, stock, a combination of cash and stock, or any other form of consideration. Differences between SARs and phantom stock – The holder of phantom stock usually does not have a choice with respect to the

specified date of exercise. – Phantom stock is not granted in tandem with options. – Phantom stock typically carries dividend equivalent rights.



Example

A closely held financial services firm wishes to hire you, a CFP® professional, to run its financial planning division. You ask for nonqualified stock options based on your performance and the growth of company stock. However, the owners do not want to dilute their ownership position. They may be comfortable to provide you with SARs or phantom stock option. The taxation (ordinary income) occurs at the time of cash distribution because of constructive receipt.

There are a number of situations where SARS and phantom stock are appropriate:

- The company’s owners want to share the economic value of equity, but not equity itself. - The company is a division of another company, but it can create a measurement of its equity

value and wants employees to have a share in that. - The company is not a company; it is a nonprofit or government entity. - The company cannot offer conventional kinds of ownership because of restrictions such as

would be the case with an S corporation concerned about the 100 owner rule. Junior class shares (JCS) A JCS is a junior stock plan. After expiration of a substantial risk of forfeiture, the junior class shares (B) are converted into regular shares (A).

A. Employee stock purchase plan (ESPP) This is a Section 423 stock purchase plan. Under this plan the employer is allowed to

discount the price of stock up to 15% (charge 85%) of the market value. B. Income tax implications At the time stock is purchased under an ESPP, there are no tax consequences. Taxes are paid at the time of the sale of stock. The tax treatment applicable to both the corporation and the employee with respect to the ESPP is similar to the tax treatment of ISOs. C. Employee benefit analysis and application

The options must be made available to all employees. The ESPP eligibility typically is broader based than under an ISO plan.

Applying the Facts Ellen Executive was granted ISOs valued at $75,000 (1,000 shares) in March 2019. This grant of ISOs vests in two years. In June 2020 she was granted another $85,000 of ISOs (1,000 shares) that vest in one year. Eileen exercises the options as they vest. (Stock price at time of exercise is $100.) What are the tax implications upon exercise? (Assume the stock has not been sold.) A. There are no tax implications until the stock is sold. B. There is no income tax implication, but the bargain element is

an add-back item for the AMT. C. There is an income tax liability on the NSO portion

(taxable wages) and a bargain element on the ISO portion (add-back item).

D. There is only an income tax liability because more than $100,000 of ISOs were exercised in the same year.



Answer: C Answer D is wrong because when more than $100,000 worth of ISOs are vested in the same calendar year, only the first $100,000 will be treated as ISOs. The balance of options that are vested in the same year will be treated as NSOs (regardless of when they are exercised). The value of ISOs granted in a given calendar year does not cause any of the ISOs to be treated as NSOs so long as the value of ISOs vested in a

For this type of problem just look for an answer that includes both an income tax liability and an AMT bargain element (preference item).

Tom and Cindy Howell – Mini Case Tom and Cindy have engaged you, A CFP® professional, to develop and implement a financial plan. Tom, age 40 is self-employed as an anesthesiologist who earns $300,000. Cindy, age 40, currently owns a catering company with a salary of $105,000. Both are in excellent health. Tom and Cindy plan to retire at age 60. They will live on 50% of their current gross salaries as expressed in today’s dollars at the beginning of each year during retirement. They believe they can earn an overall average of 9% on all of their investments/retirement/CD accounts leading up to and during retirement. Both of their families have experienced longevity. Also, they want their income to last to age 90 with a balance left over of $200,000 for legacy purposes in today’s dollars. Tom and Cindy assume a 3% average inflation rate for life. Tom and Cindy have one daughter, Mary, age 9. They currently own a 529 plan with a balance of $40,000 and foresee an average rate of return of 8%. They would like to be able to provide $50,000 in today’s dollars per year of undergraduate education (4 year). They assume college costs will rise 6% annually.



Tom and Cindy Howell Financial Statement December 31, 20xx

Assets Liabilities Checking (JT) 5,000 Residence mortgage (JT) 350,000 Money Market (JT) 10,000 15,000 Total 350,000 Invested CDs (JT)(1) 40,000 Stock Portfolio 200,000 529 Plan (T)(2) 40,000 280,000 Retirement Plan SEP IRA (T)

250,000 Net Worth 985,000

Cindy’s Catering (C) 50,000 Use Assets Residence (JT) 550,000 Mountain house (C)(3) 140,000 Automobiles (JT) 50,000 740,000 Total Assets 1,355,000 Liabilities + Net Worth 1,355,000

T - Tom C – Cindy JT - JTWROS 1. CDs: Two $20K CDs with 2 and 3 years left to maturity yielding average 3% 2. 529 Plan: Started 3 years ago average 8% return 3. Mountain house; paid for (100K basis)

1. Tom has been working as an independent contractor for the past 8 years. Prior to that job, he was an employee of the local

hospital. The hospital provided a 403(b) plan with no matching contribution. Due to Tom’s tight budget he never deferred into the 403(b) plan. His contributions to the SEP are always less than the maximum allowed. How much can he contribute?

A. $52,981.50 B. $57,000 C. $0, he does not operate as a business D. $63,500



2. Tom has been offered a position by a different public hospital (not-for-profit). If he joins the hospital, he will become an employee. His salary would start at $300,000 per year. The hospital offers a 403(b) plan. What amount can Tom defer?

A. $19,500 B. $26,000 C. $57,000 D. $63,500 3. Tom feels that the public hospital offer is interesting but

wants more benefits. Which of the following could he request that would be permitted? I. Nonqualified deferred compensation funded by that life

insurance II. A section 162 plan providing life insurance III. A phantom stock plan IV. Incentive stock options

A. All of the above D. II, III B. I, III, IV E. IV C. I, IV 4. If Tom either continues to work as an independent contractor or

joins the public hospital and participates in its 403(b) plan, to which of the following can he contribute?

A. A deductible IRA B. A non-deductible IRA C. A Roth IRA D. He cannot contribute an IRA or a Roth IRA, but Cindy can do

a deductible IRA. Cindy’s Catering Company is an S Corporation (as of 12/31/20) Employee list (census) Name DOH DOB Salary Cindy 6/3/12 8/27/74 105,000 Joe 7/5/12 2/2/90 35,000 Martha 8/9/12 3/3/92 24,000 Jennifer 9/1/13 2/9/96 40,000 June 8/3/18 1/6/93 12,000 Alice 1/14/18 1/1/56 16,500



5. Cindy wants to install a retirement plan for her business. It is now profitable ($60,000 last year). In the early years of business, it broke even. All the employees are full-time except June and Alice. Which of the following plans would a CFP® professional be comfortable to recommend? I. SEP integrated with Social Security II. SIMPLE with 3% match III. Target Benefit Plan – age weighted IV. ESOP

A. All of the above D. II, IV B. I, II E. IV C. II, III 6. If Cindy does not adopt a retirement plan, what can she do? A. Deductible IRA B. Nondeductible IRA C. Roth IRA D. Nothing 7. Alice, an employee, is single. She wants to earn more income

next year as she turns 65. However, she wants to take Social Security retirement benefits (FRA age 66) to pay for Medicare. What would you suggest?

A. Don’t earn anymore income B. Earn more income but keep it under $35,000 C. Don’t take any earned income, retire now because 85% of the benefits will be taxed.

D. Presume that her Social Security retirement benefits will not be subject to federal income tax.

8. If Tom does not make a SEP contribution this year, then what can

Cindy do to save for retirement? A. Contribute to a deductible IRA B. Contribute to a nondeductible IRA C. Contribute to a Roth IRA D. Nothing 9. If Tom dies tomorrow, who will be entitled to receive Social

Security survivor benefits? I. Cindy II. Their daughter

A. I C. I and II B. II D. Neither I or II



Howell – Mini Case Answers 1. A Because Tom is an independent contractor, his SEP

contribution is limited to 18.59% with earned income of $285,000. He files on a Schedule C. He is self-employed. SEPs do not allows a 100% compensation. $285,000 x 18.59% = $52,981.50

2. A Tom’s contribution deferral is limited to $19,500. He is

age 40. There is no mention of a match. 3. D Since the new hospital organization is a not-for-profit it

cannot offer nonqualified deferred compensation. The premium cannot be deducted as a business expense. Under Section 162, the premium is charged to the employee and deductible by the business. Phantom Stock will work in this situation. ISOs cannot be offered because there is no stock to be issued.

4. B Due to active participation, he may only contribute to a

non-deductible IRA. She is also subject to spousal IRA phaseout due to his participation. He is subject to Roth IRA phaseout.

5. B A Target Benefit plan would not benefit Cindy that much

because she is only 40, and could take up most of her profit ($60,000). Nothing indicates Cindy wants to share equity in her company. Yes, the SEP can be integrated with Social Security and would benefit her because the integration level can be less than $137,700. It could be $40,000. Then the permitted disparity could increase her contribution.

6. B Due to the spousal rules, Cindy is subject to phaseout but

she can contribute to a non-deductible IRA. 7. A If Alice’s earned income stays at $16,000 her benefits will

not be reduced. Her FRA is not 65, it is 66+. Even if she earns $18,240, that plus ½ of her Social Security benefits may be less than the threshold for taxation ($25,000); she is single.

8. A Cindy may deduct her IRA contribution. She will no longer

be subject to spousal IRA phaseout because Tom does not make a SEP contribution.

9. C Cindy and her daughter will receive Social Security

survivor benefits. Her daughter is under 16. The daughter would be entitled to survivor benefits until at least age 18.

Documents

Retirement Planning Table of Contents - Brett Danko › sites › default › files › ... · Applying the Facts 1. Toby Adams has determined that he needs to accumulate $350,000