By Fatskills Exam Guides Team — the exam nerds behind 28,500+ quizzes and 2.1M practice questions across 500+ global exams.
Retirement Planning Assumptions and Financial Needs Retirees must make a few assumptions in planning for their lives after work. For one thing, inflation tends to affect the prices of goods and services used by retirees to a degree slightly higher than the Consumer Price Index. Estimating costs and expenses for the retirement income also requires being able to estimate the years that will be spent in retirement, so a general idea of family longevity is helpful. Clients should also project their investment return and the future tax rate. In order to determine a client’s financial needs in retirement, one should estimate their cost of living, anticipated medical costs, and any other extraneous costs that can be predicted. Total Return Assumptions and Probabilistic Analysis Assumptions In order to accurately plan for retirement, clients need to make some assumptions about their total returns in the future. Return assumptions must include qualified retirement plans, Social Security, and tax-deferred plans.
There are a few different systems that try to predict future income by analyzing several factors. The Monte Carlo system takes an individual’s age and investments and then makes certain assumptions about the future inflation rates, life expectancy, and investment returns for the individual.
In order to compensate for a projected shortfall in cash-flow, individuals may: make the maximum contribution to a retirement plan; decrease current and future expenditures; make more aggressive investments; advance their retirement age; or consider making increasing annual payments instead of level annual payments.
Social Security Eligibility and Benefit Individuals are said to be fully insured with Social Security when they have received 40 quarters of coverage. They are said to be currently insured if they have 6 quarters of coverage during the entire 13-quarter period ending with the calendar quarter in which the person died, became entitled to disability benefits, or became entitled to retirement benefits. Individuals are entitled to retirement benefits if they are fully insured and at least 62 years of age. The retirement benefit at a normal retirement age will be equal to the worker’s primary insurance amount. Some individuals may seek to take their retirement benefit before full retirement age: if this is done, the individual will collect benefits for a longer period of time, but the benefit will be permanently reduced.
Individuals are entitled to disability benefits if they: are insured for disability benefits; are under the age of 65; have been disabled for a year or expect to be; have filed an application for disability benefits; and have either completed a five-month waiting period or been exempted from this period. In order to be considered disabled, individuals must be so impaired that they cannot perform gainful work. Benefits may also be paid for the following types of survivors of a deceased insured individual: widows and widowers with the care of one or more children; children either under age 18, between 18 and 22 and disabled, or under age 19 and a full-time student; widows and widowers over the age of 60; disabled widows and widowers between ages 50 and 60; and parents over the age of 62 who were dependent on a deceased worker for support. Though a spouse is entitled to as much as 50% of an employee’s full retirement benefit, this benefit will end in the event of: the spouse’s death; the worker’s death; the termination of the worker’ entitlement to disability; the spouse being under age 62 and with no child under age 16; or the spouse becoming eligible to receive retirement or disability benefits with a PIA at least half as large as that of the employee. Qualified children may receive monthly payments of up to 50% of an employee’s full retirement benefit, though there is a limit on the amount that can be paid to the family as a whole. The child’s benefit ends if: the child dies; the child marries; the child’s parent is no longer eligible for disability benefits; or the child turns 18 and is neither disabled nor a full-time student. Family Limitations Primary insurance amount, or PIA, is the fundamental unit that is used to calculate the amount of each monthly benefit. In order to determine an individual’s PIA, one must know the average indexed monthly earnings (AIME), which is based on the lifetime earnings history of the individual. To figure Social Security benefits, one must know the average of 35 years of the worker’s best earnings. AIME is determined by dividing the total earnings by 420. The formula for then finding PIA for persons who reached retirement age in 2020, or became disabled or died in 2020 before reaching retirement age, is found by adding 90% of the first $960 of AIME, 32% of the next $4,825 of AIME, and 15% of the AIME in excess of $5,785. Reduction of Social Security Benefits If individuals work after the full retirement age, they lose no benefits from collected Social Security. If individuals are younger than the full retirement age, they lose no benefits if they earn less than $18,240 (as of 2020). If they earn more than $18,240, one dollar of benefits is deducted for every two dollars earned in excess of $18,240. In the year when a person reaches full retirement age, the person can earn up to $48,600 in the months before his or her birthday without deductions; after he or she reaches $48,600 in income during those months, $1 of benefits is deducted for every $3 earned in excess of the $48,600 limit. Taxation of Social Security Benefits Up to 85% of Social Security benefits can be included in AGI based on the IRS’s complex formula. This percentage is ultimately a comparison of one’s provisional income (PI) to two IRS-established thresholds. The calculation of PI = AGI + tax-exempt interest + 50% of SS income; and these thresholds are $32,000 and $44,000 for MFJ filers. (The thresholds are $25,000 and $34,000 for all other taxpayers, except MFS filers who have a $0 threshold.) For a MFJ filer, if PI < $32,000, then none of his SS benefits will be taxed, if PI is between $32,000 and $44,000, then up to 50% could be taxed, and if PI > $44,000, then up to 85% could be taxed (as of 2020). Calculation of Taxable Social Security Income If a MFJ taxpayer’s SS benefits fall between the $32,000 and $44,000 thresholds, then he will take the lesser of (a) 50% of his total SS benefits and (b) 50% of the excess of his PI over the lower threshold ($32,000). For example, a MFJ has PI of $38,000 and SS benefits of $9,000. His PI exceeds the lower threshold by $6,000 ($38,000 - $32,000 = $6,000), 50% of which is $3,000. $3,000 is less than 50% of his total SS benefits ($9,000 x 50% = $4,500); therefore $3,000 of his SS benefits will be included in taxable income. If a MFJ taxpayer’s SS benefits exceed the $44,000 threshold, the calculation is more complex. First, take 85% of the excess of the taxpayer’s PI over the upper threshold; call this the “first figure.” Second, take the lesser of (a) 50% of his total SS benefits or (b) 50% of the span between the thresholds; call this the “second figure.” Third, add the first and second figures together; call this the “third figure.” The lesser of (i) the third figure and (ii) 85% of the taxpayer’s total SS benefits is the amount of his taxable SS income. For example, a MFJ taxpayer has PI of $46,000 and SS benefits of $10,000. His PI exceeds the upper threshold by $2,000 ($46,000 - $44,000 = $2,000), 85% of which is $1,700. 50% of his total SS benefits is $5,000, which is less than 50% of the span between the thresholds ($44,000 - $36,000 = $12,000 x 50% = $6,000). His “third figure” is therefore $1,700 + $5,000 = $6,700. 85% of his total SS benefits is $8,500 ($10,000 x 85%). Since $6,700 < $8,500, his total taxable SS income is $6,700. Working after Retirement, Taxation Any individual who is older than 65 and is eligible for retirement benefits is eligible for Medicare Part A, as are those who have received disability benefits for more than two years, and others, including individuals requiring kidney transplants. If an individual is eligible for Medicare Part A, he or she is automatically eligible for Part B. Enrollment in Medicare Part B is voluntary, however. In order to receive benefits from Part B, an individual must make a monthly premium payment. Only people eligible for Medicare Parts A and B are eligible for Medicare Part C, also known as Medicare + Choice. Medicare + Choice provides managed care through contracts with Medicare.
Medicare Eligibility Under Medicare Part A, individuals are eligible to have their hospital expenses paid in full for 60 days during the period. An additional 30 days are provided with co-payment, and there is a 60-day lifetime reserve. The benefit period begins when the individual is hospitalized and does not end until the person has been out or 60 days. Individuals may have an unlimited number of benefit periods in their lifetime. Benefits in a skilled-nursing facility are only provided if the individual was forced to stay in a hospital for at least 3 of the last 30 days and if a doctor specifies that a stay in a skilled-nursing facility is required. These benefits will be paid for 20 days in full, and an additional 80 days will be covered with co-payment.
In order for a facility to qualify, the individual must be under round-the-clock care and a doctor must be constantly available.
Benefits Covered by Medicare Part A Hospitalization and Skilled-Nursing Facilities
Under Medicare Part A, individuals are eligible to have their hospital expenses paid in full for 60 days during the period. An additional 30 days are provided with co-payment, and there is a 60-day lifetime reserve. The benefit period begins when the individual is hospitalized and does not end until the person has been out or 60 days. Individuals may have an unlimited number of benefit periods in their lifetime. Benefits in a skilled-nursing facility are only provided if the individual was forced to stay in a hospital for at least 3 of the last 30 days and a doctor specifies that a stay in a skilled-nursing facility is required. These benefits will be paid for 20 days in full, and an additional 80 days will be covered with co-payment. In order for a facility to qualify, the individual must be under round-the-clock care and a doctor must be constantly available. Home Health Care and Hospice; and the Benefits Covered by Medicare Part B Recipients of Medicare Part A will have their home health care benefits paid in full. In order to receive these benefits, however, an individual must be confined to his or her home and must be treated according to a home health plan established by a physician. Individuals may receive benefits for hospice under Medicare if they are certified as terminally ill with a life expectancy of less than six months. Under Medicare Part B, individuals may receive coverage for physician and surgeon fees, diagnostic tests, physical therapy, medical supplies, prescription drugs that cannot be self-administered, rental of medical equipment, prosthetic devices, ambulance services, cancer screening, and bone mass measurements. Benefits Not Covered by Medicare, Benefits Covered by Medicare + Choice, and Cost of Coverage Medicare does not cover: custodial care; dental work; cosmetic surgery; routine foot care; eye and hearing examinations; prescription glasses and hearing aids; most prescription drugs; private rooms in hospitals or nursing homes; most chiropractic care; acupuncture; or most immunizations. Medicare + Choice, also known as Medicare Part C, covers everything covered by Parts A and B as well as services like prescription drugs. The prices charged for Medicare + Choice coverage, in addition to Medigap premiums, will vary between companies.
Medicaid
While Medicare is publicly funded health insurance for the elderly (age 65 and older), Medicaid is publicly funded health insurance for the poor and disabled (including blind). Medicare is purely a federal program, but Medicaid is administered as a coordinated effort of both federal and state governments. Different state governments will accordingly have different names for their particular Medicaid program, with some not using the word “Medicaid” at all (e.g. Tennessee’s is called TennCare). Furthermore, these different state Medicaid programs will have their own requirements for eligibility and for benefits, although always within certain limits that the federal government sets. Medicaid can be for the poor of any age, and this includes elderly Americans with low income and low assets. In such cases Medicaid can sometimes assist the elderly poor with nursing home care and long-term care. Medicaid Planning If the assets of a client exceed a certain amount, he or she will be ineligible for Medicaid. Strict rules have been established to prevent individuals from shifting assets solely for the purpose of becoming eligible for Medicaid. For instance, any assets that are transferred within 36 months of a request for Medicaid will be considered available. Assets in a revocable trust will also be considered as available, regardless of the date on which the trust was created. It is considered a misdemeanor for financial planners to assist clients in these suspicious asset transfers that are sometimes described as “Medicaid planning.”
Qualified Retirement Plans (QRP)
Some retirement plans are given special tax treatment because they meet certain requirements of the Internal Revenue Code. The tax advantages of such plans include: an immediate tax deduction for the employer for the amount contributed to the plan in that year; no current income tax for the employee on the amounts contributed by the employer; tax-exempt earnings; reduced income tax on lump-sum distributions; deferred income taxes on some distributions; and annuity or installment payments that are only taxed when they are received. Qualified plans may be defined benefit plans in which the maximum allowable benefit payable is the smaller of 100% of salary or $230,000 a year (as of 2020), in which the retirement benefit is certain, and in which deductible contributions may vary from year to year. Qualified plans also may be defined contribution plans, in which the maximum allowable benefit payable is either 100% of salary or $57,000 (as of 2020), which are not subject to the minimum participation rule, and in which the retirement benefit is uncertain.
Nonqualified Retirement Plans and Government Retirement Plans
Nonqualified retirement plans offer executives an alternative to qualified plans. They have few design restrictions as regard their structure of benefits, vesting requirements, or coverage, and are set up to defer the payment of income taxes until benefits are paid out. The employer deduction is deferred until payout, and it is matched to employer income. Nonqualified retirement plans may be either salary reduction plans, in which participants have the choice to defer compensation, bonuses, or commission, or they may be supplemental executive retirement plans, in which there are additional employer-provided benefits. As for government retirement plans, they are outlined in Section 457 of the Internal Revenue Code. In these plans, the decision to defer compensation must be made before it is earned, and the employer may discriminately choose any employee for coverage.
Qualified Retirement Plans Money Purchase In the type of qualified retirement plan known as a money purchase, the employer must make contributions in an amount determined by a contribution formula: the contributions will be calculated as a percentage of income. Such plans will be subject to a minimum funding standard, regardless of whether or not the company made a profit. Any forfeitures can be allocated to the accounts of the remaining participants or used to reduce employer contributions. Investment in the stock of the sponsoring company is limited to 10%. Money purchase plans can be integrated with Social Security. Typically, younger employees will accumulate more with this kind of plan than they would with a defined benefit plan, though it will often not produce as large of a contribution for older employees. Profit Sharing In the type of qualified retirement plan known as profit sharing, the contributions made by employers must be significant and regular. It is not required that the company makes a profit for contributions to be made, and any forfeitures may be allocated among the remaining participants. In this kind of plan, the allocation of contributions is nondiscriminatory and there is no limit on the amount that can be invested in the stock of the sponsoring company. Profit sharing plans can be integrated with Social Security. They will tend to benefit younger employees more so than older ones and are common in new companies because they allow flexible contributions in times when earnings may fluctuate or not exist at all. Age-Weighted, New Comparability, and Tandem Plan An age-weighted profit sharing plan allocates contributions based on age and compensation. This kind of plan tends to benefit older employees, since they have fewer years until retirement. In the profit sharing or money purchase plan known as a new comparability plan, the contribution percentage formula for one group of participants may be greater for one group than it is for another. In order to meet nondiscrimination requirements, these plans must be cross-tested. In what is known as a tandem plan, the employer uses both a money purchase plan and a profit sharing plan in order to maximize flexibility. In this plan, profit-sharing contributions are not required annually, though money-purchase contributions are. This plan is typical in businesses with young, highly paid employees. Section 401(k) Plans Section 401(k) plans, also known as cash or deferred arrangements (CODA), cannot exist by themselves. These plans must be combined with a qualified retirement plan and may be combined with a salary reduction simplified employee pension or a savings incentive match plan for employees. In a traditional 401(k) plan, the set-up is much like that of a profit sharing plan: contributions can be funded entirely from an employee salary reduction and rules of nondiscrimination apply. In a SIMPLE 401(k) plan or safe harbor 401(k) plan there is no nondiscrimination regulation, though there are funding requirements for the employer. Employees may choose to have their contribution annually in cash as a bonus or they may defer it as a tax-deferred retirement plan contribution. Employee Stock Ownership Plan In the qualified retirement plan known as the employee stock ownership plan (ESOP), the investment must be made primarily in employer stock. The portfolio for this plan is required to be 100% company stock, although there may be some diversification requirements for participants over age 55 and with more than ten years of service. It is possible to leverage one of these plans in order to buy company stock. These plans are good for corporations because they provide a market for company stock, give a tax deduction without in any way affecting cash flow, and protect company stock from hostile takeovers. ESOPs can be integrated with Social Security, though not if they have been leveraged. Stock Bonus Plan, Thrift or Savings Plan, and Target Benefit In a stock bonus plan, benefit payments are made in shares of company stock, though it is possible for participants to receive cash in lieu of stock. These plans typically offer a diversified portfolio since individuals may choose not to buy company stock. Stock bonus plans are also capable of being integrated with Social Security. In a thrift or savings plan, contributions are made in after-tax dollars and earnings are tax-deferred. In these plans, employees are required to contribute so that they can receive a matching contribution. In a target benefit plan, the allocation of contributions is based on an age-weighted formula, which favors older employees. In these plans, the investment in the sponsoring company’s stock is limited to 10%. These plans can be integrated with Social Security. Defined Benefit Plan In a defined benefit plan, benefits can be determined by a formula. If the interest rate that is earned on plan assets is higher or lower than the actuarial assumptions, then the employer will increase or decrease future contributions to the plan in order to reach the target benefit. The formulas for these plans, which can be integrated with Social Security, are geared to retirement benefits rather than contributions. Forfeitures will always be used to reduce the employer’s contribution, and benefits will always be paid, even if the plan is terminated. The plans give a larger benefit to employees who are closer to retirement. In such a plan, the investment risk rests on the employer. The benefits of such a plan are not portable, and the plan may have higher administration costs. Cash Balance Plan In the qualified retirement plan known as the cash balance plan, a separate account with a hypothetical account balance will be established for each participant. Employee balance will grow based on hypothetical earnings (interest credits). The interest rate will vary annually and will be determined independently. The minimum interest rate cannot be more than the lowest standard interest rate, and the maximum rate cannot be less than the highest standard interest rate. An actuary will determine the required contribution for each year. Forfeitures must be used to reduce the employer’s contribution, and the employer must pay out benefits in accordance with the provisions of the plan even in years in which profits are low or nonexistent. In these plans the investment risk rests on the employer, benefits are not portable, and there may be somewhat higher administration costs.
Feasibility of Installation Advantages In order to determine whether to recommend a qualified retirement plan, it is a good idea to review the objectives of the client that may be satisfied by such a plan. A qualified retirement plan may maximize personal tax benefits and personal retirement benefits, while at the same time it may provide protection for an estate. For a business, qualified retirement plans can reduce corporate income tax, reward important employees, reduce turnover, and increase employee job satisfaction. Moreover, qualified retirement plans provide employees with retirement income, promote employee savings, and provide employees with a share in ownership and a share in profits. These plans also provide flexible means of compensation for employers and employees alike. Constraints In order to provide a qualified retirement plan that meets all of the needs of the client, a financial planner needs to know: the personnel characteristics and profile of the employee (age, service, compensation, etc.); the profits and cash flows of the business (that is, whether they are variable or stable); the profile of the employees (long- or short-term, full- or part-time); the profile of the business owner; the client’s degree of sophistication and commitment (fiduciary responsibility, administrative costs, etc.); and the types of retirement plans that are available for specific kinds of businesses.
Coverage and Eligibility Requirements
In order to be included in the vesting schedule for a qualified retirement plan, an employee must have reached age 21 and have been in service for more than one year. In plans where full and immediate benefits are provided, the employee must have reached age 21 and have been in service for more than one year but less than two. Employers may exclude employees who are already covered by a collective bargaining agreement, nonresident aliens, part-time employees who have worked less than 1,000 hours in a year, employees who have worked less than a year, and employees who are under the age of 21. Coverage requirements ensure that highly compensated employees (HCEs) do not receive benefits at the expense of non-highly compensated employees (NHCEs). In order to receive favorable tax treatment, a plan must either pass the ratio percentage test or the average benefits test. The standard for minimum participation in a qualified retirement plan is sometimes referred to as the 50/40 test. In defined benefit plans, minimum participation must benefit either 50 employees or 40% of all employees (whichever is less). Employers cannot combine different plans to satisfy this requirement. The actual deferral percentage test and the actual contribution percentage test are nondiscrimination tests for retirement plans that allow salary deferral and matching contributions. In the actual deferral percentage test, the deferral rates of NHCEs relative to their compensation are compared to that of HCEs. The actual deferred percentage of HCEs will be limited by that of NHCEs. The ADP of the HCEs cannot exceed the greater of: 125% of ADP of all other employees, or the lesser of ADP of all other employees plus 2% or ADP of all other employees multiplied by 2. The actual contribution percentage test is similar. Highly Compensated Employees One will need both the look-back year and the determination year in order to measure whether an employee can be considered a highly compensated employee. In the look-back year, the employee must either own 5% of the employer or must have received compensation above $130,000 (as of 2020) and be among the top 20% of employees in that business in rank of compensation. Employers may choose to include an individual in this group of the top 20%, and if this is done then it may be possible for a company to have fewer HCEs. In the determination year, an individual only needs to own 5% of the company in order to be considered a highly compensated employee. Controlled Group The IRS has set up rules that make it impossible for employers to set up two different businesses that have two different retirement plans. A control group, which indicates that the employer’s retirement plans must be consistent, is said to exist when there is a parent-subsidiary relationship, a brother-sister relationship, or an affiliated service group. In a parent-subsidiary relationship, there is common ownership of 80% or greater by one or more companies in the group, and the parent owns 80% of at least one company. In a brother-sister relationship, five or fewer people own at least 80% of the stock value, and the same five or fewer people own more than half of the stock or voting power of each corporation. Affiliated service groups consist of a first-service organization (organization whose principal business is the performance of a professional service) and one or more “A” and “B” organizations. An “A” organization is an owner of an FSO and a “B” organization spends most of its time performing services for the FSO or “A” organization. Vesting Schedule In a qualified retirement plan vesting schedule, employee contributions are entirely vested immediately. All of the employer-matching contributions that were made after 2001 must vest under a faster vesting schedule than in earlier years. In a three-year vesting, otherwise known as a Cliff vesting, 100% is vested after three years. In a two- to six-year vesting, vested is graded. Faster vesting schedules are also available for top-heavy plans. The portion of the benefit or account that is attributable to employer contributions other than the matching contributions will remain subject to five-year and three- to seven-year vesting standard. Both SIMPLE and SEP provide instantaneous 100% vesting. Integration with Social Security Plans/Disparity Limits
For workers that make less than the taxable wage base, Social Security will provide greater benefit coverage. However, Social Security will provide no additional income to workers making more than the taxable wage base. This disparity in retirement benefits between high- and low-income workers can be corrected by integrating Social Security into a qualified retirement plan benefit. As long as it is not discriminatory and observes the regulatory limits, this practice is allowed by the IRC. In a defined benefit plan, one may want to use the excess method of integration with Social Security. In this method, a compensation level known as the integration level is defined by the plan, which then provides a higher rate of benefits for the compensation above this level. When Social Security is integrated with a defined benefit plan, the percentage spread between the benefit as a percentage of compensation above and below the integration level will be restricted. There are a few terms that are used in such transaction. The base benefit percentage is the percentage of compensation that is provided for compensation below the integration level. The excess benefit percentage is the percentage of compensation that is above the integration level; excess benefit percentage cannot exceed the base percentage by three-fourths of a percentage point for any year or service. In the offset method of integration with Social Security, there is no integration level, and the plan formula is reduced by a fixed amount or some amount derived from a formula that is meant to replicate Social Security. Defined Contribution Plan and Integration with Social Security Defined contribution plans are only allowed to use the excess method to integrate with Social Security. In this method, a compensation level known as the integration level is defined and the plan then provides a higher level of benefits for compensation above this level. If the integration level is equal to the Social Security taxable wage base currently in effect, then the spread between the allocation percentages above and below the integration level can be no more than the lesser of: the percentage contribution below the integration level, or the greater of 5.7% or the old age portion of the Social Security tax rate. The following plans offer no integration with Social Security: LESOP, SARSEP, and employer-matching 401(k) elective contributions.
Contributions and Benefits Tax Consideration, Nature of the Defined Benefit, and Nature of Defined Contribution
When deciding on contributions or benefits in a qualified retirement plan, employers should determine the deductible expense to the employer in the year of the contribution. Contributions should be made from pre-tax dollars and should be excluded from the current income of both employers and employees. Earnings will be tax-deferred until they are distributed at retirement. As for the defined benefit, it should not exceed whichever is less, $230,000 (as of 2020) or the full amount of the participant’s compensation averaged over three years of highest compensation. The yearly additions payable under the plan cannot exceed whichever is less, $57,000 (as of 2020) or the full amount of the participant’s compensation. Comparison of Defined Contribution and Defined Benefit and the Definition of Compensation When calculating a plan’s benefit or contribution formula, one can only take into account the first $420,000 of each employee’s annual compensation (as of 2020). This limit is scheduled to be indexed for inflation in increments of $5,000. Compensation is defined as any wages, salaries, fees for professional services, and any other payments received for services rendered in the course of employment, to the extent that these amounts are able to be included in income. Compensation may also include the following: elective or salary contributions to a 401(k), 403(b), or SIMPLE plan; amounts either contributed or deferred under a 457 plan; and elective or salary reduction contributions to a cafeteria plan. Multiple Plans and Special Rules for the Self-Employed
Multiple plans are to be aggregated when calculating the maximum contribution or benefit. It is typical for the administrative cost of multiple plans to be higher than it is for single plans. Keogh plans are qualified retirement plans that cover one or more individuals in an unincorporated business. These plans are designed to provide coverage for self-employed individuals who are not considered to be employees, although really any retirement plan can be set up to cover the self-employed. Plans for the self-employed are usually set up as either money purchase or profit sharing plans.
In defined contribution Keogh plans in 2020, the maximum contribution is $57,000. When applying the rules of qualified plans for the self-employed, earned income will take the place of compensation.
Top-Heavy Plans
A defined benefit plan is considered top-heavy when more than 60% of the current value of the accrued benefits has been allotted to key employees. A defined contribution plan is considered top-heavy when more than 60% of the total amount in the accounts of all employees is allotted to key employees. There are no top-heavy requirements for SIMPLE and safe harbor 401(k) plans. Key employees are those who have more than 5% ownership, are officers with compensation greater than $185,000, or are more than 1% owners and receive compensation in excess of $150,000 (as of 2020). When plans are top-heavy, they are required to provide 100% vesting after three years of service or after a six-year graded vesting.
When a qualified retirement plan is classified as top-heavy, it must also provide minimum benefits or contributions for non-key employees. In a defined benefit plan, non-key employees must receive benefits equal to 2% of compensation multiplied by the employee’s years of service, up to 20%. In this formula, the figure for average compensation is based on the highest five years of compensation. In a defined contribution plan, in a top-heavy year the employer contributions must be at least 3% of compensation. When more than 90% of the total plan benefits are allotted to key employees, a retirement plan is considered to be super-top-heavy. In a defined contribution plan, contributions must be increased from 3 to 4% in a super-top-heavy year, whereas in a defined benefit plan they must be increased from 2 to 3%.
Loans from Qualified Plans
As long as loans have been incorporated into the plan documents, they are allowed for all qualified plans. The stipulations for such loans are as follows: loans must be available to all participants and beneficiaries; loans cannot be available to highly compensated employees in greater proportions than they are for non-highly compensated employees; loans must be made in accordance with plan documents; loans must be made at a reasonable interest rate; and there must be adequate collateral given in exchange for loans. In order to avoid having a loan characterized as a distribution, the term of the loan cannot exceed five years and the loan amount must be whichever is less, $50,000 or 50% of the present value of the employee’s vested account balance. Also, the plan documents may allow a $10,000 minimum loan, even when this is greater than half of the present value.
Traditional IRA
In the tax-advantaged retirement plan known as the traditional IRA, individuals are allowed to contribute up to the minimum contribution amount and are allowed to deduct this amount from current taxable income. In traditional IRAs, investment earnings are tax-deferred and premature withdrawals are subject to a 10% penalty. Typically, withdrawals are not eligible for the special averaging tax calculation that may apply to some lump sum distributions from qualified plans. Required minimum distributions (RMDs) must be made by April 1 of the year in which the individual reaches age 72. Loans are not available in a traditional IRA. The following investments are prohibited in traditional IRAs: artworks, rugs, antiques, metals, gems, stamps, coins, and any other tangible property, although some exceptions are made for US gold, silver, and platinum coins. The deduction limit in a traditional IRA is the lesser of the maximum annual contribution amount or 100% of the individuals earned income. In 2020, the maximum contribution amount is $6,000. Traditional IRAs also have what are called active participant restrictions. Active participants are defined as those who have contributions and forfeitures made to a defined contribution plan, or those who are eligible but decline to participate in a defined benefit plan. For active participants, fully deductible contributions are only allowed if adjusted gross income is under a certain amount. This deduction will begin to decrease, or phase out, when income reaches a certain amount and will disappear altogether when it reaches a higher amount.
IRAs may be established any time prior to the due date of the individual’s tax return, so for most taxpayers the cut-off date will be April 15. Since earnings will be tax-deferred, it is a good idea to make contributions as early as possible in order to maximize the benefit from compounding. Limited nonrefundable tax credits are available for low-income taxpayers who make contributions to a traditional IRA. Whereas nondeductible contributions can be withdrawn tax-free on a pro rata basis, deductible contributions and earnings will be treated as ordinary income and will be subject to federal income tax. When an individual contributes more than is allowed to a traditional IRA, there may be a 6% excise tax on the excess contribution.
Roth IRA
In a Roth IRA, the contribution amount is limited for each year and will be eliminated beyond a certain amount of adjusted gross income. Qualified withdrawals are totally tax-free, but premature withdrawals in excess of contributions are taxed in full and are subject to a 10% penalty. Eligibility for contributions is not affected by active participation. Loans are not available in a Roth IRA; minimum distribution rules do not apply until the death of the owner. The maximum annual deductible IRA contribution is the lesser of the maximum annual contribution amount or 100% of the individual’s earned income, minus the contributions to traditional IRAs. The nondeductible contribution will equal the after-tax contribution. In 2020, the maximum annual contribution amount is $6,000, or $7,000 for people over the age of 50. In a Roth IRA, the adjusted gross income used for figuring phase-out limits excludes taxable income from the conversion of a traditional IRA to a Roth IRA. As of 2020, the phase-out limits are between $124,000 and $139,000 for unmarried individuals, and $196,000 to $206,000 for married joint return filers. The time limits and nonrefundable credit are the same as for traditional IRAs. Employers are allowed to sponsor Roth IRAs for employees as a limited alternative to qualified plans. As of 2005, employers were allowed to amend their Section 401(k) and 403(b) plans to transfer the elective deferrals of participants into a qualified Roth contribution program.
IRA Rollovers (Roth Conversions)
An individual is allowed to make a qualified rollover contribution to a Roth IRA from a traditional IRA. When this is done, the amount will become fully taxable as ordinary income. The conversion amount is not included in the assessment of AGI, so conversion will accelerate all the taxes on a traditional IRA that would have been deferred otherwise. If the individual has a qualified retirement plan, this must be rolled over into a traditional IRA before it can be converted to a Roth IRA. Conversion Analysis for Roth Conversions
When deciding whether it is a good idea to convert a traditional IRA into a Roth IRA, there are a few things one should keep in mind. For one thing, it has been consistently shown that a Roth IRA will produce more money at retirement than a traditional IRA with the same investment and tax rates. This is mainly because when investors place the entire contribution limit, this whole amount is at work in a Roth IRA (whereas only the net investment is at work in a traditional IRA). It has also been demonstrated that conversion to a Roth IRA will produce better long-term results than leaving assets in a traditional IRA. The advantage held by the Roth IRA is even greater when taxes are not paid out of the amount converted. The advantage of conversion grows greater the longer assets remain in a Roth IRA before withdrawal.
Distribution Rules
If a distribution from a Roth IRA is a qualified distribution, then it will not be included in the owner’s gross income. Any distributions of earnings will be tax-free as long as the individual is at least 59.5 and the Roth IRA has been established for more than 5 years. Contributions are typically made with after-tax dollars and are never taxed. Any withdrawals from a Roth IRA must occur in a specific order. First will be withdrawals from excess contribution limits, which are generally free from federal income tax. Then next will be withdrawals from annual Roth IRA contributions, which can be recovered without tax penalty. Next, withdrawals are made from the taxed income component resulting from the first conversion contribution, and then from the conversion contributions made in later taxable years. Finally, withdrawals are made from the earnings from all contributions.
Simplified Employee Pensions (SEPs)
In a simplified employee pension (SEP), the annual employer tax-deductible contributions are limited to 25% of compensation for common-law employees; for owner/employees the limit will be 20% of net earnings. These pensions are subject to funding only by the employer. The rules for nondiscrimination and top-heavy plans will apply here. Also, it is possible to integrate a SEP with Social Security. When determining active participation status for a deductible IRA contribution, participation in a SEP will qualify an individual as an active participant. The controlled group/affiliated services group rules will apply to SEPs. All of the above mentioned characteristics are shared by the simplified employee pension with defined contribution plans. A simplified employee pension (SEP) can cover all employees who are at least 21 years of age, have worked for three of the past five years (including the contribution year), and received compensation of more than $600 (as of 2020). Employees may be rendered ineligible if they are members of a collective bargaining unit or are nonresident aliens. Contributions to a SEP are fully discretionary, meaning that the employer has total control and flexibility. Loans are not permitted in a SEP. Small employer may decide to set up a SEP because the coverage rules are easier to work with than those of a qualified plan, shorter-term employees can be excluded from the plan, and the costs and administrative expenses are typically low. SEPs are not appropriate for businesses that have many long-term part-time employees.
SIMPLE IRAs Characteristics SIMPLE IRAs are very easy to administer and offer benefits that are totally portable because the employees are always 100% vested. In a SIMPLE IRA, employees can get the benefit of a broad range of investments. The plans may be funded in part by salary reductions made by employees. Typically, qualified plans allow for a greater amount of annual contributions than do SIMPLE IRAs. Distributions will not be eligible for ten-year averaging. Employers who adopt such a plan cannot also maintain a qualified plan, SEP, 403(a) annuity, 403(b) plan, or 457 plan. Deferrals that are employee elected can be excluded from income, employer contributions are deductible, and earnings are tax-deferred. The rules for nondiscrimination testing and top-heavy plans do not apply. Contributions When an employer establishes a SIMPLE IRA plan, all employees of the employer who received at least $5,000 in compensation from the employer during any 2 preceding calendar years (consecutive or not) and who are reasonably expected to receive at least $5,000 in compensation during the calendar year, must be eligible to participate in the SIMPLE IRA plan for the calendar year. An employee may defer up to $13,500 for 2020 (subject to cost-of-living adjustments for later years). Employees age 50 or over can make an additional catch-up contribution of up to $3,000 (also subject to cost-of-living adjustments).
Section 403(b) Plans Eligibility and Plan Characteristics Section 403(b) plans, also known as tax-deferred annuity plans or tax-sheltered annuity plans, cannot be offered without being available to all employees regardless of age, service, or union affiliation. In order to adopt such a plan, an organization must be either an educational organization or a tax-exempt employer as described in Section 501(c) (3) of the Code. These plans are funded by employee contributions and may be rolled over to traditional IRAs as well as other 403(b) plans, 401(k) plans, or 457 plans that are maintained by a state or local government. Although they are not considered to be qualified plans, they are subject to similar restrictions. These plans are subject to ERISA if an employer contributes but are exempt if employee participation is voluntary or if the participant controls all the rights under the annuity contract. Plan Investments, Contribution Limits, and Distributions In a Section 403(b) plan, investments are limited to: annuity contracts, mutual fund shares, life insurance, and retirement income accounts maintained by churches or church-related organizations. The amount of employee salary reductions is subject to an annual limit. The limit on salary deferrals will apply in the aggregate of all elective deferrals under SIMPLE, SARSEP, 401(K), and 403(b) plans. The elective deferral limit may be increased if the employee has worked for 15 years for an educational organization, hospital, home health care agency, church, or other religious organization. Participants over the age of 50 may be eligible for additional elective deferrals. Distributions will be subject to the rules for qualified plan distribution. Loans may be given if they are allowed in the plan documents.
Section 457 Plans Eligibility and Funding Section 457 plans can be offered to all employees, to any group of employees, or to a single employee. These plans are available for employees of state and local governments, agencies of these governments, and other tax-exempt organizations. Governmental plans are required to be funded according to the requirements of the Small Business Job Protection Act: all plan assets and income are held in trust, or in custodial accounts or annuity contracts, for the exclusive benefits of participants and beneficiaries. The funded 457 plans of nongovernmental organizations are subject to ERISA. If a 457 plan is unfunded, then assets remain the property of the employer and are subject to the claims of the employer’s creditors. Contributions The amount of income that is deferred by an employee every year cannot exceed either 100% of compensation or the applicable dollar limit (whichever is less). There are additional salary reduction contributions for participants in the 457 plan of a government employer who are older than 50. A three-year catch-up provision will be applied in the last three years before the plan’s retirement of eligible 457 plans; in these years, the limit of deferral will be increased to the lesser of twice the amount of the regularly applicable dollar limit, or the sum of the otherwise applicable limit for the year and the amount by which the applicable limit in preceding years exceeded the participant’s actual deferral for those years. Distributions Distributions cannot be made to a Section 457 plan before the employee is severed from employment, attains the age of 59.5, or has an unforeseen emergency that is defined in the regulations. One-time distributions by the participant are permitted so long as the total amount payable does not exceed $5,000, no deferred compensation has been made for at least two years, and the participant has not already used this option. There may also be a mandatory cash-out by the 457 plan if the account does not exceed $5,000, if no deferred compensation has been made for at least two years, and if there has been no previous use of the cash-out provision. In Section 457 plans, there is no forward averaging option, loans are permitted if allowed by the plan documents, and the participant may delay distribution one time if this choice is made prior to the start of distribution.
ERISA
The Employee Retirement Income Security Act (ERISA) defines a fiduciary as any person who exercises any discretionary authority or control over plan management, exercises any authority or control over management or disposition of plan assets, renders investment advice for a fee or other compensation, or has discretionary authority or responsibility over plan administration. According to this act, the IRS must approve all new plans. The IRS will also monitor existing plans, interpret existing law, issue regulations that must be applied to all plans, and judge matters of employer deductibility of plan contributions. The Department of Labor is charged with monitoring investment of plan assets and the actions of those who administer plans, as well as cooperating with the IRS on the oversight of prohibited transactions. The Employee Retirement Income Security Act (ERISA) established the Pension Benefit Guarantee Corporation to provide mandatory insurance for defined benefit plans, as well as to plan termination insurance. This plan termination insurance guarantees retirement benefits, death benefits in pay status, survivor benefits in pay status, and disability benefits owed or in pay status. Qualified plan terminations are established for the benefit of the beneficiary and his or her family. These terminations cannot be made arbitrarily; they can only be made out of business necessity. Terminations may be either standard, in which a single employer terminates so long as he or she has sufficient assets for benefit liabilities, or distress, in which the employer does not have the assets to pay benefits. The Pension Benefit Guarantee Corporation is allowed to terminate an underfunded plan for any of the following reasons: the plan does not comply with the minimum funding standard; the plan cannot pay benefits when due; the plan has unfunded liabilities following a distribution of more than $10,000 to an owner. Additionally, the plan can be terminated if not terminating the plan would lead to unacceptably high losses to the PBGC. In order to switch from a defined benefit plan to a defined contribution plan, the defined benefit plan must be cancelled and a new defined contribution plan created. This must be a voluntary standard termination, with 100% vesting for all the affected participants and all distributions of plan assets made in accordance with ERISA standards. When a defined benefit plan is switched into a cash balance plan, all that is required is for the defined benefit plan to be amended. This means it is not necessary to undergo vesting, distribution, and plan termination. There is an order of priority established by ERISA for allocating plan assets: employee voluntary contributions; employee mandatory contributions; certain annuity payments in pay status; other guaranteed benefits; other nonguaranteed vested benefits; and, finally, all other plan-provided benefits. As for the reversion of residual assets to the employee, there will be a 50% penalty assessed. This penalty may be reduced to 20% if the employer either transfers 25% of the potential reversion amount to a replacement plan or increases the participants’ accrued benefit by at least 20%.
Department of Labor Regulations and Fiduciary Obligations
The Department of Labor (DOL) has established guidelines for qualified and nonqualified employee benefit plans that involve retirement income. The DOL has also established the nondiscriminatory rules for favored employee groups: highly compensated employees and key employees. Finally, the DOL has established vesting schedules for employees and requires sufficient funding for pension plans. According to ERISA, a fiduciary must act solely in the interest of the participants and their beneficiaries. More specifically, fiduciaries must: act for the purpose of providing benefits and defraying the expenses of administering a plan; act with the prudence and diligence of a responsible individual; diversify investments so as to minimize the risk of large losses; and act in accordance with the plan document and the instruments governing the plan
Prohibited Transactions
There are six prohibited transactions between a retirement plan and a disqualified person/party: the sale, exchange, or lease of property; lending money or extending credit; furnishing goods, services, or facilities; transfer to or use of plan assets by a disqualified person; (if a fiduciary) dealing with plan income or assets in own account; and (if a fiduciary) receiving consideration for own account from a party involved in the plan transaction. Disqualified persons or parties include: fiduciaries; those providing services to the plan; an employer or employee organization whose members are covered by the plan; a 50% owner of such an organization; a family member of any of these people; a corporation, partnership or trust that is 50% owned by one of these people; or an officer, director, highly compensated employee, or 10% or more joint partner of one of these people.
Regulation of Retirement Plans Tax Consequences of Prohibited Transactions When it is determined that a transaction has occurred between a retirement plan and a disqualified person or party, a two-tier penalty is imposed. First, there is a penalty tax equal to 15% of the amount involved in the transaction. This tax is levied on all the disqualified persons involved in the transaction for each year or part of a year in which the transaction remains uncorrected. And, since this tax may carry over from year to year, it may pyramid. Second, there is an additional penalty tax of 100% of the amount involved if the prohibited transaction is not corrected in a timely fashion. Exemptions from Prohibited Transaction Rules and Reporting Requirements The following transactions are exempt from the rules concerning prohibited transactions: receipt of benefits under the terms of the plan; distribution of plan assets according to the allocation provisions; loans that are available to plan participants and beneficiaries; loans made to an ESOP; purchase or sale of qualifying employer securities by an individual account, profit sharing, stock bonus, thrift or savings plan, or ESOP, without commission; and providing office space or services for the plan for reasonable compensation. As for reporting requirements for retirement plans, new plans are required to submit an Advance Determination Letter; plans that have been preapproved by the IRS must submit prototypes or model plans; and all plans must submit plan descriptions to participants and their beneficiaries.
Process of Selecting a Retirement Plan for a Business Owner’s Objectives and Business’ Objectives When deciding on which kind of retirement plan to establish for a business, the business owner must try to find the plan that maximizes his or her personal tax benefits, maximizes his or her own personal retirement benefits, and provides estate protection. From the perspective of the business, a good retirement plan should reduce the corporate income tax; provide a variable, stable, or increasing cash flow; and allow for adequate cash flow in the future. It is also important for a business to consider the needs of its employees; a good retirement plan will reward valued employees, motivate employees, reduce turnover, and increase employee satisfaction. Comparison of Defined Contribution and Defined Benefit Plans (Rewarding HCEs) A good retirement plan will maximize the proportion of plan costs that benefit highly compensated employees. In a defined benefit plan, the maximum benefit is derived for key employees if they are older on average than other employees. Age-weighted plans use an allocation method to increase contributions to a QRP for older highly compensated employees by weighting for age and compensation. As long as this formula is applied universally, it is not considered discriminatory. When cross-testing is used, nondiscrimination in a defined contribution plan is calculated by looking at the projected benefits under the plan at various retirement ages. In 401(k) plans, there can be higher contributions to HCEs as long as there is maximum participation by NHCEs. Typically, integration with Social Security will discriminate against high-income employees. Comparison of Defined Contribution and Defined Benefit Plans A good retirement plan will provide a savings medium employees consider valuable. Defined contribution plans feature individual accounts, so employees will always know exactly how much they have saved. Cash balance plans, on the other hand, may be more attractive to younger employees. Any plans with employee participation, as for instance 401(k) plans, will allow employees to make before-tax salary reductions. Retirement plans should also seek to provide sufficient replacement income for each employee’s retirement. If this is the main objective of the employer, a defined benefit plan is the best option because employer funding is mandatory, the plan provides maximum life insurance, and benefit is based on compensation rather than years of service. Creating Incentive for Employees, Minimizing Turnover, and Encouraging Retirement Profit-sharing plans, ESOP/stock bonus plans, and any other defined contribution plan or cash balance plan will give employees incentive to improve performance. As for plans that will minimize employee turnover, a defined benefit plan will give benefits that are based on years of service, while a defined contribution plan will give benefits that increase with each year of service. Defined contribution plans, however, are portable, meaning employees can transfer benefits to another job. Defined benefit plans seem to be the best at encouraging retirement, because they design a subsidized early retirement incentive and do not offer any additional benefits after the retirement age is reached.
Investment Considerations for Retirement Plans Suitability There are a few terms one should be familiar with when considering whether the investment package offered by a particular retirement plan is suitable. The time horizon is the interval in which one expects to reach the specific financial goal. Liquidity is the ability to quickly convert an investment into cash without the loss of principal. Marketability is the degree to which there is an active market for the investment. It is always a good idea to compare the expected return on various investments on a before-tax basis when selecting asset classes and investment vehicles. Retirement plan assets should be exempt from income taxes before distribution. It is important that investment strategies are appropriate for tax-exempt growth. Unrelated Business Taxable Income (UBTI) Unrelated business taxable income (UBTI) is any gross income above $1,000 generated by a qualified retirement plan trust that is carrying on a trade or business not related to the purpose of the trust. According to the IRS, a qualified retirement plan in which funds are invested into a common trust has unrelated business taxable income in the same amount as it would have if it made the same investment directly. The income generated either by a common trust fund operating a business or an IRA purchasing a limited partnership interest will be considered UBTI when it is passed through to a qualified retirement plan or IRA. Passive income is not considered UBTI. Dividends from stocks purchased on the margins, as well as income from non-real-estate partnership interest, are considered UBTI. Risk Tolerance and Diversification The selection of asset classes and investment vehicles in a retirement plan may depend on the investor’s tolerance of risk. The required liquidity and marketability will have a big influence on the risk assumed by the portfolio. In a defined benefit plan, the participant’s benefits are fixed and the employer assumes the investment risk; in a defined contribution plan, benefits are variable and the employee assumes the investment risk. It is sound policy, and policy mandated by ERISA, for a portfolio to contain diversified investments that are not all subject to the same amount of risk. It is also standard policy for the asset classes and investments to be monitored periodically, and for the plan to be required to submit detailed plans. Life Insurance As long as the benefits are incidental to the overall plan, life insurance is allowed in qualified retirement plans. There are some restrictions on the premiums that can be paid for life insurance in a qualified retirement plan. In an ordinary policy (whole life) defined contribution plan, the premiums paid by the plan cannot be more than half of the contributions made to the plan on the participant’s behalf. In a nonordinary policy (term or universal life), the premium is not allowed to exceed a quarter of the contribution made to the plan on behalf of the participant. Upon retirement, the contract must either be converted to a payout option of the start of benefits or distributed to the participant. In a defined benefit plan, the insurance benefit cannot be 100 times greater than the expected monthly retirement benefit.
Retirement Plans Premature Distributions and Hardship Withdrawals Individuals will be subject to penalties for premature distributions if they receive a distribution before the age of 59.5. These distributions will be subject to a 10% nondeductible penalty and will be taxed as ordinary income. Of course, the participant is always given 60 days in which to undo the distribution. In qualified plans and 403(b) plans, an individual must experience some triggering event in order to qualify for a hardship withdrawal. Safe harbor triggering events include: medical care for the participant, a spouse, or dependent; purchase of principal residence; tuition and related fees; or the prevention of eviction or foreclosure. Clients will still have to pay the 10% tax and the distribution will still be taxed as ordinary income. IRC Section 72(t) for Qualified and Tax-Advantaged Plans According to IRC Section 72(t), early distributions from qualified plans are not subject to the 10% penalty if they: are made to a beneficiary after the death of the participant; are made because the participant becomes disabled; are part of a series of equal payments made for life; are made to an employee after the end of service after age 55; are made on account of an IRS levy; are made to pay higher education fees for the participant, spouse, or a dependent; or are corrective distributions. Early distributions may be made from tax-advantaged plans if: they are made after the death of the participant; are attributable to the participant becoming disabled; are for medical expenses in excess of 10% (or sometimes 7.5%) of adjusted gross income; are made for expenses related to the first home purchase; are made on account of an IRS levy; or are corrective distributions. Substantially Equal Periodic Payments Individuals may be allowed to make take early distributions from a qualified or tax-advantaged retirement plan if they are part of a series of substantially equal periodic payments made for the life of the individual or the joint lives of the participant and a beneficiary. There is no minimum age requirement for these, and the IRS does not have to find out why the withdrawals are made. It is necessary for the payments to be made at least annually. There are three ways to calculate these payments: the life-expectancy method creates the exact annual payment required and will result in the smallest payment; the amortization method will simply amortize the account balance using a reasonable interest rate; and the annuitization method will divide the account balance by an annuity factor based on a reasonable interest rate.
Election of Distribution Options Lump Sum Distributions There are four conditions that must be met by lump sum distributions: they must be distributed in one taxable year; they must represent the full account balance to the participant’s credit from all the qualified plans of a single type; they must be payable in a lump sum; and they must be made from a qualified pension plan, a profit sharing plan, or a stock bonus plan. Lump sum distributions will be taxed as ordinary income, though taxes may be deferred if the distribution is rolled over to another qualified retirement plan, to a traditional IRA, or to a conduit IRA. A lump sum distribution may qualify for ten-year forward-averaging treatment if the participant was born in 1935 or before and has been a plan participant for at least five years. Annuity Options Qualified pension plans are required to provide two kinds of survivorship benefits for spouses. There must be an automatic lifetime survivor benefit in the form of a qualified joint and survivor annuity that provides an annuity between 50-100% of the annuity payable during the joint lives. Qualified pension plans are also required to offer an automatic lifetime survivor benefit in the form of a qualified preretirement survivor annuity that will provide a survivor benefit if the participant should die before retirement. The nonparticipant spouse may opt for a different benefit form. A life annuity is an automatic form of benefit for an unmarried employee. A period certain annuity provides payments for a predetermined period of time. Annuity payments will either be taxed on a noncontributory basis, in which the full amount of the payment is includible in gross income and is taxed as ordinary income, or on a contributory basis, in which the payment consists of taxable and nontaxable components of gross income. Rollover and Direct Transfer When benefits from a retirement plan are distributed through a rollover, the participant is said to have constructive receipt of the money. Only one rollover per account per year is allowed. The following distributions are not eligible for rollover: amounts that are part of a series of equal periodic payments; nontaxable portions of a distribution; hardship withdrawals; corrective distributions of excess contributions and excess deferrals; and the cost of life insurance coverage. The form of distribution known as direct transfer occurs when the assets of a qualified retirement plan or IRA are transferred from a custodian/trustee to another custodian/trustee. When this occurs, the participant does not have constructive receipt of the funds, and he or she avoids the 20% mandatory withholding.
Required Minimum Distribution Rules and the Life Expectancy Method of Calculation A required minimum distribution (RMD) will apply to qualified plans, IRAs, SEPs, SIMPLE IRAs, and Section 457 government deferred compensation plans. The calculation base for RMD is the balance as of the end of the previous calendar year to the distribution. Required minimum distribution will be calculated separately for each IRA, though distributions may be taken from any account in order to satisfy the minimum. In the life expectancy method of calculating RMD, the owner’s account balance is divided by the appropriate life expectancy. In order to satisfy the rules of RMD, the entire interest must be distributed by the required beginning date, or interest must be distributed over the lifetime of the participant, or the life of the participant and beneficiary.
Describe the Required Minimum Distribution Three Life Expectancy Tables The Uniform Lifetime Table is used to determine the minimum required distributions during the lifetime of the participant if the retirement benefit is in the form of an account balance. This will be used in situations in which the employee’s spouse is either not the sole designated beneficiary or is the sole designated beneficiary but is not more than ten years younger than the employee. The Joint and Last Survivor Table is used in situations where the employee’s spouse is either the sole designated beneficiary or is more than ten years younger than the participant. If the designated beneficiary should be changed to anyone other than the spouse, this table can no loner be used. Designated beneficiaries, including a spouse, can use the Single Life Table. While a spouse can recalculate this every year, nonspouse beneficiaries cannot. Penalties If a certain amount of money that should be distributed is not, there is a 50% tax on this amount. If the value of the account has decreased below the calculated minimum based on the December 31 balance, then this 50% penalty will not apply. The 50% penalty on any shortfalls in required minimum distribution will apply to traditional IRAs and may apply to Roth IRAs. Since Roth IRAs are not subject to minimum required distributions during the lifetime of the participant, there is no required beginning date during the lifetime of the participant. However, Roth IRAs may be subject to minimum required distributions after the death of the participant. Designated Beneficiary A designated beneficiary must have been a beneficiary as of the date of death and must have been labeled as a designated beneficiary by September 30 of the year following the year of death. Beneficiaries can only be eliminated by a qualified disclaimer, which will be in writing, will be received by the transferor of the asset no more than nine months after the death, is made by someone who has not already accepted any assets of the deceased, and is made by a person who is not directing where the assets should go. Neither executors nor trustees have the ability to choose a beneficiary after the date of death. If a beneficiary should die in the interval between the owner’s death and the date of designation of beneficiaries, required distributions will be made using the life expectancy of the beneficiary. Death of Owner Prior to Required Beginning Date If the owner of a retirement plan should die before the required beginning date, the entire benefit must be distributed within five years. The only exception to this “five-year rule” occurs when the owner already has a designated beneficiary; in this case, distributions will be made over the life expectancy of the designated beneficiary. If the designated beneficiary is not the surviving spouse of the participant, then the entire interest of the participant must be distributed over the life expectancy of the designated beneficiary. Also, the minimum required distributions will begin by December 31 of the year following the year of the participant’s death. If the designated beneficiary is the surviving spouse of the participant, the entire interest of the participant must be distributed over the life expectancy of the spouse. Death of Owner after Required Beginning Date If the owner of a retirement plan should die after the required beginning date, then the entire balance must be distributed at least as rapidly as it was before the participant died. This rule is commonly followed by using whichever is longer, the life expectancy of the designated beneficiary or the remaining life expectancy of the participant minus one. If the sole designated beneficiary is the surviving spouse, distributions are made based on his or her life expectancy. If the designated beneficiary is not the surviving spouse, the “at least as rapidly” rule and method described above will apply. If no designated beneficiary was named, the distribution period will be the deceased owner’s life expectancy calculated in the year of death with one year subtracted for each subsequent year. Multiple Beneficiaries and Trust as Beneficiary If a retirement plan has more than one designated beneficiary, the required distributions must be made based on the age of the oldest beneficiary. Although each beneficiary can set up an individual account at any time, in order for a beneficiary to use his or her own life expectancy to calculate distributions, these separate accounts must have been set up by December 31 of the year following the owner’s death. If the beneficiary of a retirement policy is a trust, then it is possible to designate an underlying beneficiary of the trust as the beneficiary whose age will be used to calculate the required minimum distribution. If the trust is the beneficiary and the plan owner’s spouse is the sole beneficiary of the trust, the spouse cannot roll over the account into his or her own IRA account.
Qualified Domestic Relations Order (QDRO)
A domestic relations order is any judgment, decree, or order that is made according to state domestic relations law and related to the provision of child support, alimony, or marital property rights. A qualified domestic relations order (QRDO) is a domestic relations order that concerns the rights of an alternate payee to receive all or part of the benefits payable from a retirement plan. Before a property settlement can be a domestic order under ERISA, a state authority must first approve it. QDRO rules do not apply to IRAs or nonqualified plans. A legitimate QDRO will include the name and address of the participant and alternate payee, the amount of the benefit to be paid to alternate payee, the number of payments or the period to which the order applies, and the retirement plan to which the QDRO applies.
Taxation of Retirement Plan Distributions Waiver and Cost Basis Recovery If a nonparticipant spouse wants to consent to the waiver of a qualified pre-retirement survivor annuity or a qualified joint and survivor annuity, then this consent must be in writing, must acknowledge the effect of the waiver, and must be witnessed by either a notary public or a plan representative. As for the recovery of cost basis, no tax will be paid on distributions until those distributions are made. Moreover, the tax is paid on net distribution, and the cost basis is recovered tax-free. Cost basis consists of: all employee contributions that have not been considered deductions to federal income taxes; any loans included in the employee’s income; any employee contributions included in the employee’s income; and any life insurance costs that were included in the employee’s income. Capital Gains Treatment and Net Unrealized Appreciation Lump sum distributions from qualified retirement plans may be eligible for capital gains treatment. However, there are a couple of conditions that must be met: the employer contributions must be from before 1974, and the participants in the qualified retirement plan must have been 50 years old by January 1, 1986. The long-term capital gains tax rate is 20%. If the value of securities includes net unrealized appreciation, it will not be taxed to the employee at the time of distribution (that is, if a lump sum distribution includes employer securities). The amount of appreciation is taxed when the employee sells the securities at long-term capital gains tax rates. However, the employee may choose to pay the tax on the amount of appreciation at the time securities are distributed by including this amount in income.
Old-Age, Survivors, and Disability Insurance
Old-Age, Survivors, and Disability Insurance, also known by the acronym OASDI, is a form of social insurance in the United States that is designed to help retirees pay expenses when their income has been reduced because they have entered into retirement. OASDI is more commonly called Social Security. For many retirees, Social Security income is an important part of their retirement income, and their financial planner should assist them in managing their benefits to take the most advantage of it. It is important that planners also discuss Social Security with their clients who are still in the workforce, as it is funded with taxes that are withheld from the worker’s paycheck. Additionally, the planner should be able to discuss with self-employed individuals that their part (the self-employed) of the Social Security tax is higher than a person working for someone else, as the company pays half of the Social Security tax.
Business Succession Planning
A substantial aspect of retirement for business owners is determining how their business should be passed on. While this can be as simple as choosing a relative, friend, or other associate and teaching him the ropes before one retires, it also can involve more complex scenarios. If a business owner wishes to sell his ownership interest, he can choose to sell it to other owners (e.g. in a partnership) or to an outside party. In either case, he will likely need to have his business undergo an official valuation (i.e. appraisal) to determine a fair price. This may sometimes involve life insurance, so that unexpected business successions can occur more smoothly. For example, partners in a business may arrange a cross-purchase agreement, where each partner has a life insurance policy on every other partner. Then if any partner unexpectedly dies, each other partner receives sufficient cash to buy out a portion of the deceased partner’s share in the partnership. (The death benefit on such life insurance policies can either be a set number or a formula, to reduce the need for updating death benefits whenever the business’s value changes.) A less complex arrangement is an entity-purchase agreement, where the company itself (rather than the individual partners) purchases life insurance on each partner.
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