Module 3 Fundamentals of Defined Contribution Plans

CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMRetirement Planning & Employee Benefits Module 3Fundamentals of Defined Contribution Plans

Learning Objectives 3–1 Describe the basic characteristics of defined contribution plans. 3–2 Describe the basic characteristics of money purchase plans. 3–3 Describe the basic characteristics of target benefit plans. 3–4 Describe the basic characteristics of profit sharing plans. 3–5 Describe the basic characteristics of stock bonus plans. 3–6 Describe the basic characteristics of employee stock ownership plans (ESOPs). 3–7 Describe the basic characteristics of age-weighted profit sharing plans. 3–8 Describe the basic characteristics of cross-tested profit sharing plans. 3–9 Describe the basic characteristics of a Keogh plan, and calculate the owner’s contribution amount. 3–10 Evaluate a situation to recommend whether integration is appropriate in the design of a qualified retirement plan. 3–11 Describe similarities and differences among defined contribution retirement plans.

Questions to Get Us Warmed Up

Qualified & Nonqualified Plans

Profit Sharing & Pension Plans

Annual Addition Limits • Annual additions are comprised of • employer contributions • employee contributions • forfeitures • IRC Section 415(c) limit on “annual additions” is the lesser of • 100% of compensation, or • $51,000 (2013)

Contribution Limits • Employer deduction limit: 25% of payroll (does not include employee deferral amounts) • Combined employee and employer contribution limit: $51,000 (2013) or 100% of compensation • Maximum includible compensation: $255,000 (2013)

Money Purchase Plan • Employer contributions are up to 25% of covered payroll. • Forfeitures may be reallocated to remaining participants’ accounts or applied to reduce employer contributions. • It is subject to minimum funding standard; contributions are mandatory.

Safe Harbor Money Purchase Plan for Leasing Organizations • Generally applies to leased employees working full-time for at least one year with one employer; they should participate in the employer’s retirement plan unless the leasing organization has a safe harbor money purchase plan that provides • 10% of compensation contribution (minimum), • immediate participation, and • immediate vesting

Survivor Annuities Money purchase plans, as is the case with all four pension plans, must provide survivor annuities (these were covered with defined benefit plans): • QJSA • QOSA • QPSA

Target Benefit Plan • Employer contributions are up to 25% of covered payroll; age-weighted contributions. • Forfeitures may be reallocated to remaining participants’ accounts or applied to reduce employer contributions. • It is subject to minimum funding standard; contributions are mandatory.

Target Benefit Plans

Pension Plans & Profit Sharing Plans

Types of Profit Sharing Plans • profit sharing • thrift (allows after-tax employee deferrals) • stock bonus • ESOP or LESOP • age weighted • cross-tested • 401(k) (allows pre-tax employee deferrals, will be covered in the next module)

Profit Sharing Plans Basic Provisions • 25% employer deduction limit • Employer contributions usually are discretionary, but must be “substantial and recurring” • Forfeitures usually are reallocated to remaining participants’ accounts Employer Participant

Vesting & Top Heavy Plans • Maximum vesting schedule for profit sharing plans is either 3-year cliff or 2- to 6-year graded (since PPA) • If plan is top heavy (more than 60% of the sum of account balances are for key employees), then non-key participants must receive a contribution of at least 3% of compensation (or less if the key employees are also receiving less)

Key Employee (for Top Heavy Testing) • a “5% owner” (ownership of >5%), or • owned >1% of the company and received compensation >$150,000, or • was an officer of the company and received compensation >$165,000 (2013)

Profit Sharing Plan Withdrawals In-service distributions • hardship withdrawals • non-hardship withdrawals • cannot exceed vested amount • must have been a participant for at least two years • subject to early withdrawal penalty Loans • subject to special rules including loan limits • Distributions will be covered in more detail in subsequent modules.

Stock Bonus Plans Basic Provisions • Same provisions as profit sharing plans, except contribution is in employer stock Employer Participant

Stock Bonus Plan Diversification Rules for Publicly Traded Companies • Employee deferral amounts must be allowed to invest in alternative investments (other than the employer’s stock) immediately. • After three years of service, employees must be permitted to direct account balances attributable to employer contributions into alternative investments. • These rules came about after Enron and Worldcom, over concern about employees having too much of their retirement money concentrated in company stock.

Net Unrealized Appreciation (NUA) • NUA treatment is available for any employer stock distributed from a qualified plan • Stock bonus, ESOPs, 401(k) profit sharing, are all qualified plans, so the NUA rules would apply • An advantage of NUA is that it is taxed as a long-term capital gain, not as ordinary income

NUA Example Josephine, age 53, takes a distribution on March 1, 2013, of 3,000 shares of company stock. Her cost basis is $65,000 (the amount of employer contributions) and the stock is worth $255,000 when distributed. She sells all 3,000 shares on July 15, 2013, for $270,000. Ramifications are: • $65,000 taxed as ordinary income, and subject to 10% penalty tax • $190,000 NUA taxed as a long-term capital gain • $15,000 additional gain taxed as a short-term capital gain (if held for more than one year from distribution date, then any additional gain would be long-term)

NUA Example

NUA Tax Implications

Employee Stock Ownership Plan (ESOP) Basic Provisions • Primary purpose of ESOP is to invest in qualifying employer securities. • Contributions of up to 25% of payroll may be used to buy securities for plan. • There are diversification requirements for older participants. Employer Participant

Mechanics of ESOPs Employer ESOP Plan Contribution $ Stock Purchase $ Allocation of Employer Securities Employer Securities Owner Owner Participant’s Account

Mechanics of LESOPs Bank Interest Principal Repayment $ Employer ESOP Loan $ Plan Contribution $ Stock Purchase $ Employer Securities (allocated as loan is paid down) Employer Securities Owner Owner Participant’sAccount

ESOP Diversification Requirements These requirements apply to ESOPs that are entirely employer funded (which most are). • A participant who has • attained age 55, and • has at least 10 years of participation in the plan, • must be permitted to diversify up to 25% into other assets, and as much as 50% into other assets in the final year before normal retirement age as determined by the plan document.

Stock Bonus & ESOPs Compared

Age-Weighted Profit Sharing Plan • Uses a combination of age and compensation as the basis for allocating contributions to the participants’ accounts. • Appropriate when owners or key employees are older than most other employees and company wants contribution to favor them. • Based on theory of “comparable benefits” at retirement age • Employees closer to retirement require higher contributions to obtain comparable retirement benefits

Age-Weighted Profit Sharing Plan

Cross-Tested Profit Sharing Plans • In cross-tested (new comparability) plans, eligible participants are placed into one of several employee classes based on a number of characteristics such as • compensation, • years of service, • job type, and • department. • By structuring the plan around these employee classes, the business can allocate a large portion of the plan contribution to select employee groups.

Cross-Tested Profit Sharing Plans The regulations allow disproportionate allocations to a select class provided: • the nondiscrimination cross-testing is passed, and • a minimum contribution (called a “gateway contribution”) is made in the amount of either: • a 5% allocation for all eligible non-highly compensated employees, or • a lesser amount as long as the highest allocation any highly compensated employee receives is no more than three times the lowest non-highly compensated employee’s allocation.

Cross-Tested Profit Sharing Plan Example

Profit-Sharing Comparison

Defined Contribution Hybrid Plan Comparison

Keogh Plans—Basic Provisions • Available only to unincorporated businesses—sole proprietor or partnership • Takes the form of a qualified plan (defined contribution or defined benefit). • Certain provisions for owner/employee are unique to Keoghs: • Owner/employee’s contribution is calculated on net earnings. • Lump-sum distribution treatment is not available to owner/employee for separation from service before age 59½—available only for death, disability, or attainment of age 59½.

Calculation of Maximum Deduction for Keogh Plan Contribution

Permitted Disparity (Social Security Integration) in a Defined Contribution Plan Amount Contributed $7,000 Additional contribution to integrated retirement plan 5.7% FICA contribution to Old Age portion of OASDI $6,000 $5,000 Integration allows employer to contribute extra amounts to the qualified plan for compensation above the integration level, replacing what the employer contributes below the Social Security wage base. $4,000 $3,000 $2,000 5.7% of Social Security tax $1,000 Employer’s contribution to old age portion of FICA is zero for compensation above the wage base. $0 Increasing annual income

Basic Features of Permitted Disparity for Defined Contribution Plans • Maximum integration level: The Social Security taxable wage base • Base contribution percentage: The rate of contribution for compensation below integration level • Maximum permitted disparity: The lesser of 5.7% or base contribution percentage • Formula: • Compensation: Total compensation, up to $255,000 (2013)

Non-Integrated DC Plan Example

Integrated DC Plan Example

Module 3 Fundamentals of Defined Contribution Plans