Retirement Planning - Final Exam Study Guide | AAEC 4104, Exams of Agricultural engineering

Download Retirement Planning - Final Exam Study Guide | AAEC 4104 and more Exams Agricultural engineering in PDF only on Docsity! AAEC 4104 – Retirement Planning Final Exam Study Guide This is a fairly comprehensive list of concepts that could be tested on the Final Exam. a. Factors Affecting Retirement Planning—generally know what each is and be able to identify how each influences amount need to save for retirement, and be able to identify mitigating factors (Exhibit 2.21) i. Retirement Income Sources 1. Earnings (25%) 2. Pensions and annuities (20%) 3. Income and Assets (13%) 4. Social Security (40%) 5. Other (2%) ii. Work Life Expectancy (WLE) 1. Defined: The period of time a person is expected to be in the work force, generally 30-40 years iii. Remaining Work Life Expectancy (RWLE) 1. Defined: The work period that remains at a given point in time iv. Retirement Life Expectancy (RLE) 1. Defined: The time period beginning at retirement and extending until death; the RLE is the period of retirement that must be funded v. Savings 1. Defined: The Savings Rate identifies the average savings amount in the US based off consumption. Fell below 0 in 2005. The earlier one saves the less they need to save over their life (compounded periods). vi. Investment Returns 1. Defined: Risk versus return. vii. Inflation 1. Defined: Causes a loss in purchasing power. How the value of a dollar decreases over time. viii. Wage Replacement Ratio (WRR) 1. Defined: An estimate of the percent of income needed at retirement compared to earnings prior to retirement See table below: Factor Risk Mitigator Work Life Expectancy (WLE) Shortened due to untimely death, disability, health, or unemployment Life insurance, disability insurance, health insurance, education, training, experience Retirement Life Expectancy Lengthened Adequate capital accumulation 1 AAEC 4104 – Retirement Planning Final Exam Study Guide Savings rate, amount, and timing Too low and too late Save enough; start early Inflation Greater than expected Conservative estimate inflation and needs Retirement Needs Underestimated Use wage replacement estimators Investment Returns Inadequate to create necessary retirement capital Knowledge of and investments in broad portfolio of diversified investments and proper asset allocation Sources of retirement income Overestimation of social security benefits, private pension plans, or personal income (or adverse changes in taxation of such income) Conservatively estimate and plan for such income, as well as, monitor income projections and tax policy a. Look also at Exhibit 2.15 b. General definition of longevity risk i. Risk of outliving life expectancy. c. Capital Needs Analysis i. Defined: The process of calculating the amount of investment capital needed in retirement to maintain desired retirement lifestyle and protect against inflation. 1. Annuity Method a. Defined: Retiree meets assumptions, dies broke b. Steps to Compute: i. Calculate WRR ii. Determine gross dollar needs 1. Wage replacement amount in today’s dollars iii. Determine net dollar needs 1. Reduce gross needs by Social Security or other income benefits indexed to inflation iv. Inflate net dollar needs by inflation rate to retirement age v. Calculate capital needed at retirement age 1. Present value of the annuity due of preretirement needs 2 AAEC 4104 – Retirement Planning Final Exam Study Guide 2. Employer has to match payroll taxes paid by employee, creating a combined total payroll tax of 12.4% for OASDI up to $106,800 and 2.9% for Medicare. 3. Any contribution to retirement is not subject to payroll taxes by the employer and employee (saves them 15.3%). 4. Payroll exclusion does not pertain to employee elective pretax contributions (like 401(k) plans) 5. Social Security base wage is $106,800. Now, what does this mean? a. This means that they are only taxed UP to $106,800 in earnings. ii. ERISA protection 1. Anti-alienation, makes it very hard to get to assets, ERISA can only be seized to pay federal tax liens. a. Creditors cannot get these assets b. Once funds are distributed, they are no longer protected by ERISA. c. NOT PROTECTED if a Qualified Domestic Relations Order is processed by a court related to divorce, property settlement, or child support. b. Qualification Requirements i. Eligibility 1. Standard eligibility—one year service (1,000 hrs/yr) and age 21 2. 2 year election, 100% vesting rule 3. Educational institution—age 26, 100% vesting c. Coverage Test—receive any benefit/contribution to plan 2. Not every nonexcludable employee (qualified to participate in plan) is required to do so. The employer does not have to include all of the employees; they just have to pass certain tests to ensure they are nondiscrimatory. a. Nondiscrimination—reasonable (i.e. hourly/salaried, geographic) b. An employee is covered when he/she receives benefits from the plan. For instance, an employee is covered if he receives a contribution to the profit sharing plan at the end of the year. 3. Highly compensated employee Defined: 5% owner earns more than $110,000. Also defined as top 20% of employees ranked by compensation a. 5% means they own 5% of the company stock or capital. 5 AAEC 4104 – Retirement Planning Final Exam Study Guide b. 20% can be manipulated for smaller companies; make it easier to pass tests 4. Three Coverage Tests (must meet one of three tests) a. General Safe Harbor i. Considers the number of non-highly compensated employees covered. Plan has to benefit 70% or more of the non-excludable, non-highly compensated employees. Nonexcludabl e Employees Covered Employees % Covered Employees NHC 75 55 73.3% HC 25 21 N/A Total 100 76 Passes test because > 70% b. Ratio Percentage Defined: Compares percentage of covered non-highly compensated employees to the percentage of covered highly compensated employees. i. > 70% ratio of NHC to HC Nonexcludabl e Employees Covered Employees (%) Covered Employees NHC 100 60 60 HC 50 40 80 Total 150 100 Ratio % Test: % of NHC Covered 60% % of HC Covered = 80% = 75%> 70%, PASS c. Average Benefits Defined: Determines whether the plan adequately benefits the NHC compared the benefits of the HC. Average benefit % ratio of NHC must be >70% Employ ee Statu s Salar y Bene fit $ Bene fit % Avg. Benefit % A HC $150,0 00 $15,00 0 10% 10% B HC $110,0 00 $11,00 0 10% 6 AAEC 4104 – Retirement Planning Final Exam Study Guide C NHC $50,00 0 $3,000 6% 5.33% D NHC $50,00 0 $5,000 10% E NHC $50,00 0 $0 0% NOTE: A benefit percentage is also determined for each non-excludable employee who does not benefit from the plan (thus, a benefit % of 0) Defined Benefit Plan must also satisfy the 50/40 Test a. 50 Employees/40% eligible test i. Plan must cover the lesser of 50 employees or 40% of employees. i. Vesting 1. Employee Contributions—100% vested 2. Employer Contributions a. DC plans—2 to 6 yr graded, or 3 yr cliff; unless 2- yr, 100% election b. DB plans—3 to 7 yr graded, or 5 yr cliff; unless 2- yr, 100% election ii. Top-Heavy Plans (>60% accrued benefits or >60% balances in DC to key employees) 1. Being top heavy influence generally requires vesting to be accelerated and funding to non-key employees to increase d. Plan Limitations on Benefits and Contributions i. Covered Compensation $245k in 2010--max. salary that can be used in plan funding formulas in qualified plans (both DB and DC plans) ii. DB Plans—max. annual benefit at retirement up to 100% of avg. 3 highest yrs salary (but not more than $195k) iii. DC Plans—max. total contribution (employer, employee, forfeitures) in plan year up to 100% salary (but not more than $49k; $54.5k if catch-up contributions > age 50) iv. Employer Contributions Limit 1. DC Plans—Employers can only deduct up to 25% of total covered compensation or payroll of all participants 2. DB Plans—25% rule does not apply, generally deduct whatever contribute III. Chapter 4: Qualified Pension Plans a. Pension Plan Requirements 7 AAEC 4104 – Retirement Planning Final Exam Study Guide 3. Unit credit formula; how do incentives for employees to stay at employer and increase salary change b/w these 3 methods? 4. Generally favors older participants—older receive larger % overall contribution to plan c. Cash Balance Pension Plans (DB plan) i. Guarantees both annual contribution rate and annual earnings ii. Generally favors younger participants--more potential years in plan, compounding d. Money Purchase Pension Plans (DC plan) i. Guarantees contribution (% of compensation each year) but not earnings ii. Generally favors younger participants--more potential years in plan, compounding e. Target Benefit Pension Plans (DC plan) i. Guarantees contribution based on schedule determined by actuary when plan set up ii. Earnings are not guaranteed similar to Money Purchase Pension Plans iii. Generally favors older participants-- receive larger % overall contribution to plan IV. Chapter 5: Profit Sharing Plans (all defined contribution plans) a. Contributions and Deductions i. When must contributions be made? Plan must be established by Dec 31 but contributions aren’t due til date of company’s income tax return 1. Are they mandatory? No, but plan risks disqualification if contributions aren’t made for an extended period of time ii. Total contributions (employer, employee, forfeitures) for each employee in 2010: $49k or $54k catch up if >50 (but never more than employee earned income) iii. Employer Deduction limited up to 25% of total employer covered compensation b. General diff. b/w allocation methods-Standard, Social Security Integration, Age-Based i. Standard Allocation - % of employee’s compensation; benefits the HC ii. Social Security Integration ("Excess" method only for profit sharing plans) 1. Excess rate is limited to the lesser of twice the base rate or 5.7% 10 AAEC 4104 – Retirement Planning Final Exam Study Guide a. Ex: $200k salary, 10% base rate, 15.7% excess rate. Results in a contribution of $25,312 [(10% x $106,800) + (15.7% x ($200k-$106,800))] iii. Age-Based – uses a combination of age and compensation for contribution allocation. Used when owners and key employees are older than most or all other employees and the company wants to tilt the contribution towards those older employees. 1. Steps to Calc: a. PV of $1 @retirement b. Allocation Factor = Employee compensation x PV of $1 c. % of total Contribution = Allocation factor/Total Allocation d. Dollar Contribution = % of total contribution x $52,250 c. New Comparability Plans--generally what it is; why are these far less common? i. Profit sharing plan in which contributions are made to an employee’s account based on their respective classification in the company 1. Why are these far less common? Expensive, scrutinizes by IRS (borderline discriminatory) d. Cash or Deferred Arrangements (CODA)- also known as 401(k) plan i. Basics about a CODA or 401k plans 1. CODA= option to receive cash or defer taxation of compensation to future 2. How are elective deferrals and earnings on those deferrals taxed? a. Tax-deferred, not subject to tax til distributed 3. 401k= CODA attached to Profit Sharing (most frequent) or Stock Bonus Plan 4. Major advantages of 401k plans to employers? Can government establish? a. Minimal expense, no annual contributions commitment, owner employees may participate. Governments cannot establish a 401k ii. Contributions to CODA or 401(k) 1. Employee contributions (aka Elective Deferrals) may be made in--traditional 401k, Roth 401k (if offered in plan), after-tax contributions (Thrift plan) a. Know $16.5k 2010 deferral limit ($5.5k catch-up if 50 or older) b. Roth 401(k)--irrevocable, included in gross income (but not taxed when withdraw) 11 AAEC 4104 – Retirement Planning Final Exam Study Guide c. Individual 401(k) plan--basic understanding what they are, why used i. designed for self-employed individuals and owner-only businesses (5% ownership to be eligible) 2. Employer contributions--employer matching (be able to calculate example), employer profit sharing, or employer contrib. used to resolve ADP/ACP tests a. Ex: Employer matches 50% of employee’s deferral up to a maximum of 6% of compensation. 40k salary would result in employer contributions of $1,200 ($40k x 50% x 6%) iii. Nondiscrimination tests for CODAs/401ks--in addition to meeting coverage tests and being subject to top heavy rules (Ch 3), also meet both ADP and ACP tests (unless meet one of two safe harbor tests): 1. Actual Deferral Percentage (ADP) test--test to make sure average deferral % of NHC not too much below average deferral % of HC a. 1.25 requirement = ADP for HC employees is not more than the actual deferral % of all other eligible employees multiplied by 1.25 or the 200%/ 2% test = 1. the excess of ADP for the group of eligible HC employees/all other eligible employees. Cannot exceed 2% to pass test 2. ADP for HC employees is not more than the ADP of all other eligible employees multiplied by b. Be able to calculate example (Steps): i. Calc ADR by dividing Elected Deferral by Compensation ii. ADP is calculated by averaging the ADRs for the employees within each group (NH or NHC) iii. Apply Tests c. What happens if fail test? Must correct. How? i. Corrective distributions--return contrib. to HC ii. Recharacterization--change to after-tax contrib. 12 AAEC 4104 – Retirement Planning Final Exam Study Guide stock if the stock is not readily tradable on an established market. o If an employee dies, it could have a significant impact on the company’s cash flows o Recognize that Eligibility, Allocation (standard, age-weighted, SS integration), vesting requirements, deductible contribution limit same as profit sharing plans Chart Comparing Stock Bonus Plan to Profit Sharing Plan Stock Bonus Plan Profit Sharing Plans Plan Establishment December 31 December 31 Date of Contribution Due date of tax return plus extensions Due date of tax return plus extensions Type on Contributions Generally stock Generally cash Deductible Contribution Limit 25% of Covered Compensation 25% of Covered Compensation Valuation Generally needed ANNUALLY Generally unnecessary Eligibility Same as other Qualified Plan (age 21 and 1 year of service or 2 years with 100% vesting) Same as other Qualified Plan (age 21 and 1 year of service or 2 years with 100% vesting) Allocation Method % of compensation or formula based on age, service of classification % of compensation or formula based on age, service of classification Vesting Same as other Defined Contribution Plans (3 year cliff or 2-6 year graduated vesting) Same as other Defined Contribution Plans (3 year cliff or 2-6 year graduated vesting) Portfolio Diversification No Generally yes Voting Rights Generally yes Generally no Type of Distributions Generally in stock Generally in cash In-Service Withdrawals May be allowed after two years May be allowed after two years Loans May be allowed (but not usually) May be allowed (but not usually) Taxation of Deductions Lump sum distributions will qualify for NUA treatment. Other distributions are Generally full distribution is ordinary income 15 AAEC 4104 – Retirement Planning Final Exam Study Guide treated as ordinary income b. ESOPs i. What essentially is an ESOP and major ways different from Stock Bonus Plans  Qualified plan  DEFINED: A qualified plan that invests primarily in qualifying employer securities, typically shares of stock in the corporation creating the plan  Originally established to provide rank-and-file employees an ownership stake in the corporation for which they worked.  Special form of a SBP  Employees have significant tax advantages.  Employee ownership in the context of ESOPs refers to ownership in the stock of the corporation through an employee benefit plan by most or all of the corporation’s employees.  The trust may borrow money from a bank or other lender to purchase the employer stock.  Corporation generally repays the loan through tax deductible contributions to the ESOP. o Both the interest and the principal repayments for the loan are income tax deductible. o The ESOP can thus be “leveraged.” o ESOPs with borrowings are referenced as LESOPs, which stands for Leveraged Employee Stock Ownership Plans  To become eligible, an ESOP must satisfy various rules of the IRC and of ERISA. Comparison Chart of Stock Bonus Plans to ESOPs Stock Bonus Plans ESOPs Plan Establishment December 31 December 31 Date of Contribution Due date of tax return plus extensions Due date of tax return plus extensions Type of Contributions Generally stock Generally stock Deductible Contribution Limit 25% of covered compensation 25% of covered compensation plus interest paid on loans 16 AAEC 4104 – Retirement Planning Final Exam Study Guide Valuation Generally needed Generally needed plus dividends (in certain circumstances) Eligibility Same as other Qualified Plans (21 and 1 year of service or 2 years wth 100% vesting) Same as other Qualified Plans (21 and 1 year of service or 2 years wth 100% vesting) Allocation Method % of compensation or formula based on age, service or classification % of compensation or formula based on age, service or classification Integration with Social Security Yes No Vesting Same as other Defined Contribution Qualified Plans (3 year cliff or 2 to 6 year graduated vesting) Same as other Defined Contribution Qualified Plans (3 year cliff or 2 to 6 year graduated vesting) Portfolio Diversification No Yes, up to 50% if at least 55 years old and 10 years of participation in ESOP plan Voting Rights Generally yes Generally yes Distributions Generally stock Generally stock In-Service Withdrawals May be allowed after two years of participation May be allowed after two years of participation Loans May be allowed (but not usually) May be allowed (but not usually) Taxation of Distributions Ordinary income with NUA treatment available Ordinary income with NUA treatment available ii. What are the two general forms of ESOPs? Are they both controlled using a trust? 1. Basic—how do these generally work? 17 AAEC 4104 – Retirement Planning Final Exam Study Guide securities to ESOP in year of sale if meet certain requirements (sells > 30% securities (owned for 3 years) to ESOP, reinvest proceeds w/n 1 yr in new domestic securities (which hold onto for 3 years)? 1. Taxed at NUA. The company slowly becomes liquid and the owner can “sell” the company to its owners and have a better retirement. 2. Non recognition of gain treatment. a. Carry adjusted basis over into qualified retirement securities v. Can an LESOP deduct more than 25% of covered compensation? 1. Yes. Unlimited amount vi. Allocation methods—standard, age-based (but no SS integration allowed) vii. Distributions--similar to Stock Bonus Plans (i.e. NUA, distrib. before age 59 1/2) viii. Why, in general, is setting up an ESOP in a S-Corp a great planning strategy? 1. S Corp is equal to one employee – better for discrimination tests. 2. Distributions of S Corporation stock that constitutes qualifying employer securities held by the ESOP may be used to make interest and principal payment on loans utilized to acquire securities VI. Chapter 7: Distributions from Qualified Plans (QP) a. Pension Plans i. Generally Allow in-service withdrawals? 1. Not permitted to offer in-service withdrawals to participants UNLESS the participant is participating in a phased-in retirement. 2. Distributions are made because of participant’s termination of employment, early retirement, normal retirement, disability, or death. ii. Normal Retirement--usually paid as annuity, must generally offer QJSA & QPSA (or QOSA if plan participant waived QJSA); How are distributions generally taxed? 1. Distributions are generally subject to ordinary income tax iii. Are income taxes deferred? 1. Yes. b. What distribution options may a profit-sharing plan have? 20 AAEC 4104 – Retirement Planning Final Exam Study Guide i. At retirement or termination--lump sum, annuitize (if plan permits), rollover ii. QJSA and QPSA not required unless what? 1. Married couples 2. Can be waived by the nonparticipant spouse when the participant turns 35 until the participant dies. iii. In-service withdrawals permitted at any age (with taxes, penalties)? Loans allowed? 1. Common in cash or deferred arrangement (CODA) plans, or 401(k)/403(b) 2. Loans are prohibited on other tax-sheltered retirement savings vehicles (IRAs, SEPs) 3. May not exceed $50,000 or one-half of the FMV of the participant’s vested accrued benefit under the plan c. How are distributions from Qualified Plans taxed? Typically as ordinary income, except for? i. After-tax contributions will have an adjusted basis. ii. Annuity payments iii. Lump-sum (10 year forwarding average) d. Rollovers i. What are advantages of rolling over from QP to another QP or IRA? But lose NUA, 10-yr forward avg, pre-1974 capital gains if roll over to IRA. 1. Used to continue the deferral of the recognition of income taxes until the ultimate distribution of the assets from the new plan. 2. Usually for people who have terminated employment, or who want more investment choices/control over his/her plan. ii. Direct Rollovers--what generally are they? Must they be offered and accepted by QP? 20% withholding? Can directly rollover now to Roth IRA? 1. Occurs when the plan trustee distributes the account balance directly to the trustee of the recipient account. 2. Not required to be offered and accepted by QP 3. Usually completed with a wire transfer from the old custodian to the new custodian or a check from the old custodian negotiable only by the custodian of the new account. 4. All qualified plans must offer rollovers of certain distributions 5. IF the participant elects a direct rollover, then the original plan custodian is not required to withhold 20% of the distribution for federal income tax purposes. 21 AAEC 4104 – Retirement Planning Final Exam Study Guide iii. Indirect Rollovers--what generally are they? 20% withholding? Must reinvest full amount (including 20% w/h) within 60 days. 1. A distribution to the participant with a subsequent transfer to another qualified account a. Original custodian issues a check to the participant in the amount of the full account balance reduced by the 20% mandatory withholding allowance. 2. Then, the participant must reinvest the full amount within 60 days. 3. The participant must reinvest the full amount, so the other 20% must come from other income sources in order to meet IRS standards. a. Then, the participant will receive a tax refund of the 20% difference. 4. Only one indirect rollover per participant per year. a. In CONTRAST, there can be an unlimited amount of DIRECT rollovers per year e. Lump-Sum Distributions (LSDs) i. Be able to recognize 4 general requirements—100% distribution; w/n 1 yr; death, disability, separation from service, at least 59 ½; participated in plan at least 5 years ii. Net Unrealized Appreciation (NUA)—LSD employer securities; know how to calculate example, how are subsequent gains/losses taxed? When generally not take advantage of NUA?  Most likely to occur from a stock bonus or employee stock ownership plan. Inherited securities do not take adv of NUA.  Taxpayers who receive a lump-sum distribution of employer securities (such as stock) has favorable captain gains rates, rather than ordinary income.  DEFINED as the excess of the fair market value of the employer securities of the fair market value of the employer securities at the data of the lump-sum distribution over the cost of the employer securities at the date the securities were contributed to the qualified plan FMV at Date of Distribution – Value of Securities Used at the Date of Employer Contribution = NUA 22 AAEC 4104 – Retirement Planning Final Exam Study Guide ons Funding nt Risk Stock % Integ ratio n Expert ra ll y F a v or e d ? QOSA/ QPSA Pension Plans Defined Benefit Pensio n Plan ER Yes ER ≤ 10% Yes Actuary and Pensio n Exper t Older A g e E nt ra nt s Yes Cash Balanc e Pensio n Plan ER Yes ER ≤ 10% Yes Actuary and Pensio n Exper t Youn g er P er so n s Yes Target Benefit Pensio n Plan ER Yes EE ≤ 10% Yes Actuary once and Pensio n Exper t Older A g e E nt ra nt s Yes Money Purcha se Pensio n Plan ER Yes EE ≤ 10% Yes None Youn g er P er so n s Yes Profit Sharing Plans Profit Sharin g Plan ER No EE ≤ 10 0% Yes None Highl y C o m p e n No 25 AAEC 4104 – Retirement Planning Final Exam Study Guide sa te d a n d Y o u n g er P er so n s Stock Bonus Plans ER No EE ≤ 10 0% Yes Valuation Specialist and Pension Expert Highl y C o m p e n sa te d a n d L o n g L e n gt h of S er vi c e No ESOP ER No EE ≤ 10 0% No Valuation Specialist and Pension Expert Highl y C o m p e n sa No 26 AAEC 4104 – Retirement Planning Final Exam Study Guide te d a n d L o n g L e n gt h of S er vi c e 401(k) Plan/R oth 401(k) Accoun t ER and EE No EE ≤ 10 0% No Pension Expert Saver s a n d Y o u n g er P er so n s No Thrift Plan EE No EE ≤ 10 0% Yes Pension Expert Saver s a n d Y o u n g er P er so n s No Age-Based Profit Sharin ER No EE ≤ 10 0% Yes Pension Expert Older H ig No 27 AAEC 4104 – Retirement Planning Final Exam Study Guide  No filing requirement for plan with one participant and assets >$250,000 i. Plan termination--Employees become 100% vested (all contributions) with termination VIII. Chapter 9: Individual Retirement Accounts (IRAs) and Simplified Employee Pensions (SEPs) a. Qualified Plans (QPs)--more admin./reporting, ERISA protection, Loans permitted, 10-yr avg, pre-74 cap gain treatment, NUA--while these not present in IRAs, SEPs, SIMPLE IRAs Characteristics Qualifi ed Plan s IRA s SEP I R A s SIMP LE IRA s** 403( b) Pla ns Provides for tax deferral for deposits and savings √ √ √ √ √ Provides shelter for current income √ √ √ √ √ Annual reporting – Form 5500 √ × × × Maybe *** Vesting Required √ × × × × Loans are permitted √ × × × √ Protection under ERISA √ ×** * * ×** ** ×**** Maybe * 10-year averaging permitted √ × × × × Pre-74 capital gain treatment √ × × × × Distributions eligible for NUA √ × × × × *Many 403(b) plans provide for ERISA protection; however, some do not. ** There are very few, if any, SIMPLE 401(k)s. ***Employer maintained 403(b) plans must file Form 5500. ****Although federal bankruptcy protection is available under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. 30 AAEC 4104 – Retirement Planning Final Exam Study Guide √ Yes × No b. General differences b/w Types of IRAs i. Traditional--1. Deductible (Distrib. taxable), 2. Non-Deductible (Distrib. not taxable) ii. Roth—Nondeductible contributions, Qualified distributions tax-free iii. SEP IRAs—IRAs provided by employers, greater funding limits than other IRAs  Small business retirement plan o SEP IRA accounts for employees including owner o Tax-deferred growth of contributions  NOT QP, but similar characterisitcs o More liberal coverage requirements o Established as late as extended due date of tax return o Unique contribution, vesting, and distribution rules  Contributions – discretionary, limited to lesser of 25% employee’s covered compensation or $49,000, and can integrate with Soc. Sec.  100% vested at all times  Withdrawals are ordinary income, with potential 10% early withdrawal penalty c. IRAs Contributions i. Limits generally lesser of $5k ($6k if 50 or older) or earned income (exception—Spousal IRA), may be subject to AGI limitations ii. Age > 70 1/2 can no longer make traditional IRA contrib. Apply to Roth IRAs? No, can continue to contribute after 70 ½ iii. Timing of IRA contributions—by due date of individual’s tax return (usually 4/15) iv. Nondeductible contributions—tax-deferred growth, adjusted basis (know how to calculate how distributions are taxed) d. Distributions from Traditional IRAs i. Generally taxed as ordinary income (unless non-deductible contributions made) ii. RMDs—same as for Qualified Plans (Chapter 7) iii. Distributions subject to 10% penalty if prior to age 59 ½ 1. Be able to identify general differences in exceptions to 10% penalty for QP vs. IRA (Exhibit 9.9, power point slides) 31 AAEC 4104 – Retirement Planning Final Exam Study Guide e. Roth IRAs i. Similarities and differences b/w Traditional vs. Roth IRAs Traditional IRA Roth IRA Earned Income √ √ Contributions Contributions cannot be made beyond 70 ½ Contributions can be made beyond 70 ½ Deductions √ N/A Investment Choices √ √ Minimum Distribution Rules During life and after death Only after death Prohibited Transactions √ √ ii. Contribution Limits--$5k (or $6k if 50 or older), know that a phase-out limit exists Contribution AGI Phaseout Limit (2010) Single $105,000 - $120,000 Married Filing Jointly $167,000 - $177,000 Married Filing Separate $0 - $10,000 Note: Under TIPRA 2005, the conversion AGI limit was eliminated for tax years after 2009. Further, in 2010, taxpayers can elect to defer payment of taxes due from traditional IRA to Roth IRA conversion over a 2-year period. iii. Roth IRA conversions—no AGI limit in 2010, taxpayers may elect to defer payment of taxes over 2 year period (in 2010, 2011) iv. Qualified Roth IRA Distributions are income-tax free and not subject to 10% penalty 32 AAEC 4104 – Retirement Planning Final Exam Study Guide v. Investing--employee assumes risk; only in mutual funds or annuity contracts vi. Roth 403b--similar to Roth 401ks (but not subject to AGI limitations) vii. Limit on Total Contributions (from employee and employer)--same as 401k viii. Loans--only allowed in ERISA 403b plans ix. Distributions--generally only be made after age 59½, Death, Separation from Service Disability, Hardship 1. Generally taxed as ordinary income (unless after-tax contributions or Roth 403b), and potential 10% penalty 2. Subject to RMD rules (even for Roth 403b) c. 457 Plans i. What are they basically? Generally Tax-exempt and governmental entities form. ii. Contributions (or elective deferrals) 1. Not combined with other plans--so can defer max $16,500 (2010) in 457 and max $16,500 (2010) for 403(b) or 401(k) 2. 3 Year Catch-up provision (457b)--additional $16,500 contribution/yr (in 3 years prior to normal retirement age) if previous unused deferrals. iii. 3 Types 1. 457(b) Governmental Entities--$5,500 catch up (50 or older), assets protected in a trust 2. 457(b) Tax-Exempt Entities--no catch up and assets not protected in trust 3. 457(f) Ineligible Entitities-- no catch up and assets not protected in trust; unlimited deferrals, but subject to "substantial risk of forfeiture" X. Chapter 11 Social Security a. How is it funded? FICA--7.65% (6.2% SS up $106,800, 1.45% Medicare on all salary), Self-employed: 12.4% up to 106,800, 2.9% Medicare --> but deduction 1/2 S/E taxes paid Example: If an employee earns $109,300 in 2010, the first $106,800 is taxed at a rate of 7.65%; while the remaining $2,500 will be subject to a tax of only 1.45% with a total tax of $8,206.45 b. Social Security Retirement Benefits i. Status 1. Fully Insured = 40 quarters (1 quarter ~ $1k/earnings), max. 4 quarters/year [Thus, those that earn ~4,000$ within one year earn 4 credits; max cap of earning 4 credits per year] 35 AAEC 4104 – Retirement Planning Final Exam Study Guide 2. Currently Insured=6 quarters (out of last 13); under this designation, the employee is entitled to only survivorship benefits ii. Normal Retirement Age (full benefits PIA available)--ages 65 up to 67 (Our current retirement age is 67). iii. Know how to calculate a participant's monthly benefit given: AIME, bend points, COLA adjustments Example AIME: When calculating the AIME, the highest 35 years of indexed earnings are used in the benefit computation. Sum these 35 years, and then divide the total by 420 months. This will result in your AIME. Look at Page 522 for an example Example of Bend Points: The PIA is the sum of three separate percentages of portions of the AIME. These portions are known as bend points. The points are calculated as such: 90% of the first $761 of their AIME, plus 32% of their AIME over $761 up to $4,586, plus 15% of the AIME that exceeds $4,586 NOTICE: the maximum PIA for 2010 is $2,346, or an AIME of $7,500) To increase the PIA for COLA, simply multiply the current year PIA by the COLA time frame. Example: PIA is $1,840.30 and PIA must increase from years 2006 through 2008; Simply multiple $1,840.30 by 1.033 (3.3%) 1.023 (2.3% COLA) and 1.058 (5.8% COLA) 1. What happens to benefit if... retire early and not working (20% 3 years early, 25% 4 years early, 30% 5 years early) or....retire later (8% increase/year those age > 67) 2. Do benefits increase or decrease, in general, for early retirees still working? They are usually reduced for early retirees still working. Calculations are as follows: Early Retirement may begin at age 62; 1/180 for each month of early retirement up to 36 months. An additional 1/240 reduction for each month of early retirement greater than 36 months up to 24 months. Thus, maximum total percent reduction is 30%. You make these reductions from your PIA. Late Retirement: If you begin taking retirement distributions after normal retirement age, you are still involved with a permanently increased benefit. The benefit increases by 3%-8% for each year of delayed retirement to age 70. Those born from 1943 and on use the factor of 8%. Note, there could be a 36 AAEC 4104 – Retirement Planning Final Exam Study Guide possibility of calculating the PV of earnings. Use TVM for this, the only ‘change’ is calculating the decrease or increase of payments, and then you just use basic TVM functions. iv. Taxation of Social Security benefits—what is max. % of SS benefits are taxable? What is the min. % of benefits that are taxable? Up to 85% of the Social Security benefits may be taxable. The minimum is 50%. MAGI is AGI + Certain Non-taxable Items (i.e. tax-exempt interest, Foreign Earned Income) Hurdles are: 1st hurdle: MFJ is $35,000; Single is $25,000 2nd hurdle: MFJ is $44,000; Single is $34,000 If 1st Hurdle < MAGI + ½ of SS benefits < 2nd Hurdle, Then the taxable amount of SS Retirement Benefits is the lesser of: 50% of SS benefits, or 50% [MAGI + .50 (Social Security Benefits) less Hurdle 1 value] Example: Calculation of benefits (single): Foreign earned income of $15,000 and SS of $30,000. MAGI + ½ of SS benefits > Second Hurdle, the taxable amount of the SS benefits is the lesser of: 85% of SS benefits, or 85% [MAGI + .5[ SS benefits] less Hurdle 2], plus the lesser of: $6,000 for MFJ, or $4,500 for all other taxpayers, or The taxable amount calculated based on the 50% formula and only considering Hurdle 1. Look at page 534 for more information. c. Disability Benefits Benefits payable to workers with: Severe physical or mental impairments which prevents them from performing “substantial work” for a year or more, or who have a condition that is expected to result in death. Generally fully insured with 20 quarters coverage (in last 40) d. General Beneficiaries of SS Retirement and Disability Benefits Worker, spouse ( >62, caring for child <16, caring for disabled child), children (<18, 18+student, disabled), dependent parents (age 62+), divorced spouse (>62, generally 10+ years of marriage) e. Survivor Benefits—what are they basically? Benefits payable to family members of deceased individuals who were entitled to benefits i. Who benefits? 37 AAEC 4104 – Retirement Planning Final Exam Study Guide The executive or individual defers receipt of salary to the future; Must elect to defer compensation before earning. f. Nonqualified deferred compensation plan (NQDC)—basically what is this? A contractual arrangement between an employer and an executive whereby the employer promises to pay the executive a predetermined amount of money sometime in the future. i. What basically is a phantom stock plan and when might they typically be used? A nonqualified deferred compensation arrangement whereby the employer gives fictional shares of stock to a key employee. At a later time, the stock is valued and executive will receive the increase in value as compensation. No actual stock is issued. The executive has taxable income and employer has deduction at time payment is made to the executive. When ideal to use? When you want to align incentives of executive to company without dilution of earnings. ii. What basically are Supplemental Retirement Plans (SERPs)? Also known as ‘Top-Hat’ plans, they provide additional benefits to select ‘top- hat’ group. “Excess benefit plans” provide benefits in excess of benefits in Qualified Plans. They’re designed to provide additional benefits to an executive during retirement. iii. Major Differences b/w Unfunded Promise to Pay, Rabbit Trust, Secular Trust Unfunded Promise to Pay Rabbi Trust Secular Trust Funded with assets? No Yes Yes Employer has access? Yes No No General Creditors have Yes, claim below Yes, claim below No 40 AAEC 4104 – Retirement Planning Final Exam Study Guide access? gen creditors gen creditors When is income taxable to executive? Actually or "constructively” received Actually or "constructively” received Immediately as funded by employer (or vesting) When is the payment deductible to employer? When payment is made When payment is made Immediately as funded + "constructively received" g. Employer Stock Options i. Basically what are stock options? What are the 3 types? Stock options are the right to buy stock at a specified price for a specified period of time. The agreement must be in writing and the holder has no obligation to exercise. The 3 types are: ISO’s; Non-Qualified Stock Options (NQSO’s); and Stock Appreciation Rights (SARs) ii. Incentive Stock Options (ISOs) 1. ISOs— better tax treatment (if sell stock after 2 years from grant and 1 year from exercise date), but are more restrictive: May only be granted to employees, and the total FMV of ISO grants must be <$100,000/yr per executive. 2. ISO Disposition a. Know how to calculate tax consequences (W-2 Income, AMT adj., capital gains, employer deduct.) related to Grant, Exercise, Sale date 3. Disqualifying ISO Disposition (sell stock before 2 yrs from grant date, 1 year from exercise date) a. Know how to calculate tax consequences (W-2 Income, AMT adj., capital gains, employer deduct.) related to Grant, Exercise, Sale date. MUST PERFORM THESE ON THE PRACTICE PROBLEMS 4. Cashless Exercise— Exercise ISO option without cash (3rd party lends cash to executive to exercise option, executive repays lender almost immediately through proceeds from sale of stock) This tactic is very common. A cashless exercise is a disqualifying disposition. a. Know how to calculate tax consequences (W-2 Income, AMT adj., capital gains, employer deduct.) related to Grant, Exercise, Sale date 41 AAEC 4104 – Retirement Planning Final Exam Study Guide iii. Nonqualified Stock Options (NQSOs)— Ties and employee benefit to the performance of the company stock. Option that does not meet requirements of an ISO. not as many restrictions (i.e. no >$100k/yr per executive limit), but less favorable tax treatment 1. Know how to calculate tax consequences (W-2 Income, AMT adj., capital gains, employer deduct.) related to Grant, Exercise, Sale date iv. Stock Appreciation Rights—basically what are these? Rights that grant the holder cash = Excess of FMV of stock above exercise price; Ties employee benefit to the value of the employer stock; essentially cashless exercise without right to purchase stock. No taxation at grant date, unless employee elects IRC Section 83(b). Employee—W-2 income for excess value over exercise prices (income and payroll taxes). Employer—Tax deduction for W-2 amount. 1. Know how to calculate tax consequences (W-2 Income, AMT adj., capital gains, employer deduct.) related to Grant, Exercise, Sale date v. Restricted Stock Plans—what basically are they? Why are they used?’ Plan which pays executives with shares of employer stock; Executive does not pay any amount towards the stock; stock has restrictions preventing executive from selling or transferring usually via a vesting schedule which creates a substantial risk of forfeiture. They are used to increase executive retention, align executive and shareholder interests, and compensate without use of company cash flow. 1. Know how to calculate tax consequences (W-2 Income, AMT adj., capital gains, employer deduct.) related to Grant, Exercise, Sale date vi. IRC Section 83b—what is this basically? What is the benefit of making this election? What is it? Employee election to include value of stock in taxable income at date of grant rather than at date of vesting or when restrictions are lifted. The benefit is taxation; if elected: Any subsequent gain in value over the grant date is capital gain rather than W-2 income; If the employee does not vest, or otherwise loses rights, no tax deductible loss on previously reported income; lastly, employee’s holding period for stock received begins the date the amount was included in gross income. 42 AAEC 4104 – Retirement Planning Final Exam Study Guide Any property or service provided to employee by employer that is so small that it makes accounting for it unreasonable. Generally excludable from employee gross income: i.e. meals, transportation. May be discretionary. l. Qualifying Moving Expense Reimbursement i. Qualifying move—distance b/w new job location and old home must be >50 miles greater than distance between old job location and old home (old commute) 1. Also, employee must be full-time (FT) in new location >39 weeks (w/n 1 year of move), or combined FT/self-employed > 78 weeks (w/n 2 years of move) ii. Deductible Moving Expenses (for qualified move) 1. Moving household goods (moving co.—actual expenses, yourself—actual expenses or 16.5 cents/mile (2010) 2. Traveling and Lodging (traveling—actual or 16.5 cents/mile, lodging—actual expenses) iii. Examples of nondeductible moving expenses—temporary living expenses, meals, pre-housing hunting, costs to purchase new home or sell previous home m.Qualified Tuition Reduction Programs— what are these basically and when will the value of this fringe benefit generally be excluded from the employee's taxable income? An Employee may exclude from gross income any amount representing a qualified tuition reduction. A qualified tuition reduction is a reduction in tuition provided to employee of education institution for education. They are generally for education below graduate level. Employee, spouse, or dependent children may be eligible. n. Adoption Assistance Programs—must be in writing, exclusion limited (~$12k per child), know that there generally is an AGI phase out (don’t have to memorize) Phase out begins at $182,520. o. Discrimination i. Fringe benefits must generally be provided on a nondiscriminatory basis (otherwise must be included in employee’s taxable income) ii. Be able to recognize exceptions of benefits that can discriminate-- Athletic facilities, working condition fringe benefits, de minimis, qualified transportation & parking p. Valuation Rules Applying to Fringe Benefits i. General rule—Value=FMV of fringe benefits (Know THIS!) 45 AAEC 4104 – Retirement Planning Final Exam Study Guide ii. Exception for special valuation of employer-provided vehicle (may choose): 1. Cents per mile rule (Amt included Gross Income=50 cents/mi*personal mi.) a. To use this rule, must use vehicle regularly for business, 50% or more of total annual mileage is for the employer’s trade or business or the employer sponsors a commuting pool to transport no less than 3 employees to and from work. 2. Commuting rule--Amt included Gross Income=$1.5*each one- way commute {one-way commute is to and from work or from and to work} a. To use this rule, generally employer must have written policy that requires vehicle only to be used for commuting 3. Lease Value Rule—Amt included Gross Income=Annual Lease Value*% personal use a. Lease Value i. Employer purchased vehicle —Look up “Annual Lease Value” in Annual Lease Table (Note: Use FMV on day first available to employee) ii. Employer leased vehicle—valuation of vehicle is primarily based on invoice, suggested retail, or nationally recognized retail iii. Know how to calculate value of employer provided vehicle to be included in annual gross income (if provided Annual Lease table) How to calculate: The amount included in Employee Gross Income = Annual Lease Value x (4 x Number of days of Availability)/(365) XIII. Chapter 14 Employee Group Benefits a. Describe in general what the COBRA provisions require employers to do. Can employers require that employees pay COBRA insurance premiums? If so, up to what amount COBRA provisions requires employer with a group health plan (and > 20 employees) to continue to provide benefits to covered employees and qualified beneficiaries, such as for: -Normal Termination (covers for 18 months) -Qualified Dependent – Reaches age no longer eligible for plan (36 months coverage) 46 AAEC 4104 – Retirement Planning Final Exam Study Guide -Death of Employee (covers for 36 months) The employer can pay the premiums or require the employee to pay premiums, but the premium to employee can never exceed 102% of plan costs. b. Describe cafeteria plans generally and how they are used to provide employer benefits. Can you discriminate using these plans? Also known as “Section 125 Plans” It’s a written plan that allows employees to receive cash (as compensation) or defer receipt of the cash to purchase various tax-free fringe benefits. Qualified benefits under this plan include medical insurance, dependent care, adoption assistance, and group term life insurance. You CAN discriminate, so the plan must be Nondiscriminatory. Some uses and applications of Cafeteria Plans are as such: -Employee benefit needs vary within employee group (employee group mixed— i.e. several young and old employees); Employees want to choose the benefit package most suitable for themselves and their family; it also helps employer manage cost of fringe benefit plan. c. Describe flexible spending accounts (FSAs). When would one generally prefer using an FSA to cover dependent care expenses versus using the dependent care credit? An FSA is a type of cafeteria plan, Employees can defer cash (salary) into a FSA; the deferred amounts are not subject to INCOME or PAYROLL taxes. The advantages are: Funds may be used towards the cost of certain employee selected benefits and after-tax employee expenditures become pretax employee expenditures. BUT WAIT! The major disadvantage of this plan Is that unused funds each year are forfeited – “Use it, or lose it” captain planet. Did you understand all that shit? Great! Look here compadre, The Dependent Care Credit is the amount used to pay expenses and is an after-tax credit. The amount is subject to payroll taxes, and the credit percentage is based on AGI (Higher credit is given the lower the AGI). How do we know which one to fucking use?! You evaluate each scenario to determine which is most beneficial. Generally, employee is better off using FSA unless AGI <$43k. d. Describe Health savings accounts (HSAs). Can only be set up with what type of deductible insurance plan? How are these similar to IRAs? How are they generally different (i.e. withdrawals for medical expenses, age can begin using for retirement)? HAS’s may be established year 2004 or later; they are very similar to Archer MSA’s (discontinued) with fewer restrictions. 47