1 topic 44: retirement needs analysis assumptions inflation retirement life expectancy lifestyle...
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Topic 44: Retirement Needs Analysis
Assumptions Inflation Retirement life expectancy Lifestyle Returns on investments
Income Sources Pension Deferred compensation Social security: inflation indexed Investments
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Topic 44: Retirement Needs Analysis Financial Needs
Medical/Long-term care Charitable
Projection of returns Straight-line Versus reality (Monte Carlo)
Capital preservation Preserve value as of retirement in:
Nominal dollars (don’t inflate) Real dollars (inflate)
Capital utilization (depletion) Assets are liquidated during retirement Buy an annuity No legacy
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Topic 44: Retirement Needs Analysis
Projecting Financial Needs Estimate of the percentage of an individual’s
income earned prior to retirement needed during retirement.
Methods of Calculating
Top-Down Approach Uses percentages and common sense. “Best guess” when not close to retirement
Bottom-Up (Budgeting) Approach Determines which preretirement expenses are
needed during retirement. More accurate when close to retirement
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Topic 44: Retirement Needs Analysis Projecting Required Savings
Determine first year retirement income BEG mode problems Want to have funds at start of year; not end
Determine funds needed at retirement to fund income Use real rate of return to discount
Determine required annual savings to accumulate funds Use actual rate of return Use present savings as present value Serial payments: increase investment each
year Consequently, initial payment is smaller
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Topic 45: Social Security Contributions to Social Security and Medicare
6.2% FICA on first $117,000 in 2014 Employers match employees’ contributions Although in 2012 4.2%
1.45% on all earnings for Medicare An additional .9% for compensation above $250,000 MFJ
beginning in 2013 (for employees only) Unearned income above $250,000 MFJ is subject to a 3.8%
Medicare tax beginning in 2013 Self-employed
Pay both employer and employee Retirement benefits
40 quarters of coverage $1,200 per credit in 2014; four credits per year
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Topic 45: Social Security
Retirement benefits Highest 35 years of earnings
AIME: monthly earnings PIA: replace 90% of first $816 but only 15%
of AIME over $4,917 in 2014 40 quarters of coverage
Children under 18 employed by family, ministers, railroad workers: no coverage
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Topic 45: Social Security
Retirement benefits Age at retirement
Early retirement: 62 Currently receive 75% normal benefits
Normal retirement age: 66 years By 2027, will be age 67
Delayed retirement: increase benefits up to 32% by delaying until age 70
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Topic 45: Social Security Retirement benefits
Spouse over 62 50% of employee’s benefit
If higher than own benefits Spouse caring for child under age 16 Ex-spouse: married 10 years
Children Under age 18
Retired parent: 50% of employee’s benefit Deceased parent: 75% of benefit
Widows at age 60 Family limitation: 1.5 times employee benefit
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Topic 45: Social Security Working after retirement
Reduction of 50% of benefits for workers below normal retirement age earning more than $15,840 in 2014
Death benefits: $255 to widow or child Taxation of benefits:
Up to 85% of benefits taxable if MAGI exceeds $55,000 MFJ Muni bond interest income included in calculating taxable
social security benefits
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Topic 45: Social Security
Disability benefits Five month waiting period Disability must last a year Can’t do any work suited for Benefits stop at retirement age Benefits also paid to:
Children under 18 Spouse over 62
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Topic 46: Types of Qualified Plans Characteristics Defined Benefit Defined Contribution
What is the Annual Contribution Limit?
Not less than the unfunded current
liability*
25% of Covered Compensation
Who assumes the investment risk?
Employer Employee
How are forfeitures allocated? Reduce Plan CostsReduce plan costs or allocate
to other participants
Is the plan subject to Pension Benefit Guaranty Corporation
(PBGC) coverage?
Yes (except professional firms with less than 25
employees)No
Does the plan have separate investment
accounts?
No, they are commingled
Yes, they are usually separate
Can credit be given for prior service?
Yes No
* This is the annual contribution limit for 2006 and 2007.
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Topic 46: Types of Qualified Plans
Characteristic Pension Plan Profit Sharing Plan
Legal Promise of the Plan
Paying a pension at retirement
Deferral of Compensation
In-Service Withdrawals?
No* Yes (after two years)
Mandatory Funding?
Yes** No
Investment in ER Securities
10% 100%
QJSA & QPSA? Yes No
*Under the PPA 200, defined benefit pension plans can provide for in-service distributions to participants who are age 62 or older.
13Topic 46: Types of Qualified Plans
Pension PlansProfit Sharing
Plans
Defined Benefit Pension PlansCash Balance Pension Plans
Profit Sharing PlansStock Bonus PlansESOPs401(k) Plans
Money Purchase Pension PlansTarget Benefit Pension Plans
Thrift PlansNew Comparability PlansAge-Based Profit Sharing Plans
Def
ined
B
enef
it P
lan
s
Def
ined
C
ontr
ibu
tion
P
lan
s
Defin
ed C
ontrib
ution
Plan
s
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Topic 46: Types of Qualified Plans Money Purchase Pension Plans
Mandatory funding of a fixed percentage of the employee’s compensation – up to 25% Can integrate with Social Security
Participant bears investment risk Not likely to be established after EGTRRA 2001
Shift to profit sharing plans as no mandatory contributions
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Topic 46: Types of Qualified Plans Target Benefit Pension Plan
Special type of money purchase pension plan Actuary determines annual funding needed for
target benefit Then contributions are made to achieve
target benefit Contribution based on the participant’s age Participant selects investments and bears risk
May not achieve target benefit Favors older plan entrants: can make larger
contributions
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Topic 46: Types of Qualified Plans Profit sharing plans
Contributions must be made by the due date of the company’s income tax return (including extensions) Plan must be established by end of year, however
Contributions are discretionary, but must be “substantial and recurring.” No requirement of company profit for contribution.
Limited to 25% of total employer covered compensation.
Limited to the lesser of 100% of compensation, or $52,000 for 2014 per employee per year.
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Topic 46: Types of Qualified Plans
Cash or Deferred Arrangements (CODA) – 401(k) Permits employees to defer compensation to a qualified plan.
Limited to $17,500 for 2014 per year, or $23,000 for 2014 for those age 50 and over.
Employers may (buy are not required to) match the employee’s deferral.
Can treat as Roth contribution No AGI limitation on contribution
Always vested Subject to social security taxes; not income tax
Employer contributions Limited to 25% of total employer covered compensation. Limited to the lesser of 100% of compensation, or $52,000
for 2014 per employee per year. Vest: three year cliff or 2 – 6 year graduated
18Topic 46: Types of Qualified Plans
Cash or Deferred Arrangements (CODA) – 401(k) Benefits must be provided to a certain percentage of
rank-and-file employees. Two tests for 401(k) in addition to qualified plan tests
Actual Deferral Percentage Test (ADP Test) Actual Contribution Percentage Test (ACP Test)
Limits the employee elective deferrals for the HC based on the elective deferrals of the NHC.
ADP test: Top Dogs: >5% owner; or comp>$100K Peons < 2%; Top Dogs= 2 x Peon% Peons 2 – 8%; Top Dogs= 2 + Peon% Peons >8%; Top Dogs= 1.25 x Peon%
19Topic 46: Types of Qualified Plans
Cash or Deferred Arrangements (CODA) – 401(k) ACP test:
Same scale for testing as ADP Includes both
Employee contributions Employer matching contributions
Age-Based (Cross Testing) Profit Sharing Plans Use a combination of age and compensation to
allocate the plan contribution. Larger contributions for older workers Can only take into account $260,000 of
compensation in 2014 (all qualified plans)
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Topic 46: Types of Qualified Plans Simple 401(k) plans
Maximum deferral $12,000 in 2014; over 50 additional $2,500 Fully vested in both employer/employee contributions < 100 employees to establish Cover employees earning > $5,000 Not limited to 25% compensation
Safe Harbor 401(k) Plans Not required to pass ADP or ACP tests. Employer must provide any one of the following:
3% nonelective contribution To all eligible employees
Matching contribution 100% up to 3%, and 50% from 3% to 5%
Employer contributions are 100% vested at all times.
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Topic 46: Types of Qualified Plans Stock bonus plans
Employer contributes company stock Distributions typically is company stock
Appreciation taxed as capital gains Value at time of contribution ordinary income at
time of distribution ESOPs
Participant receives allocations of the employer stock from the ESOP. At age 55 with 10 YOS, can diversify 25% of stock
each year Employer receives a tax deduction for the value of
the stock contributed to the plan. Allows owner to diversify holding without capital
gains tax if reinvests
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Topic 46: Types of Qualified Plans New comparability
Cross test for age; salary or job classification Increases benefits to owner
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Topic 46: Types of Qualified Plans Defined Benefit Plans
Pension benefit based on a defined funding formula Flat Amount Formula – $600 per month Flat Percentage Formula – 60% of salary Unit Credit Formula –2% x YOS up to 70% of average
salary Maximum benefits
Lesser of $210,000 per year Average compensation in three highest years of
earnings May still have five year cliff vesting or 3 to 7
year vesting
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Topic 46: Types of Qualified Plans
Defined Benefit Plans Cash balance plans
Employer guarantees rate of return 412(i) plan
Funded with life insurance or annuities
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Topic 47: Qualified Plan Rules Age and service requirements
Qualified plans Enter plan within six months after reaching later
of Age 21 One year of service
Can require two YOS if immediately vest SEP
Made $500 three of last five years and age 21 SIMPLE IRA
Earned $5,000 in last two years
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Topic 47: Qualified Plan Rules Coverage requirements: all qualified plans meet one of
these tests Cover 70% of peons Peons covered/Top dogs covered > 70% Peon benefits/Top dog benefits > 70%
Defined benefit plan: cover lesser of 50 employees or 40% of employees
Top dogs Own 5% of company Make > $100,000 and in top 20% of compensation
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Topic 47: Qualified Plan Rules
Vesting Employee contributions: always vested Employer contributions:
Three year cliff Two to six year graduated SEP and SIMPLE: vest immediately
Social security integration: defined benefit plans Excess method: 26.25% increase in monthly benefit or double
monthly benefit if it’s less than 26.25% Offset method: reduce benefits up to 50%
Social security integration: defined contribution plans Twice lower contribution rate; 5.7% max additional rate
Compensation: can’t consider compensation > $260,000 in 2014
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Topic 47: Qualified Plan Rules
Payroll taxes Imposed on employee contributions Not imposed on employer contributions
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Topic 47: Qualified Plan Rules
Top Heavy plan: > 60% of benefits go to top dogs Top dogs:
Own more than 5% Own more than 1% and make > $150,000 Officer make > $150,000
Loans Maximum lesser of $50,000 or 50% balance
Can always borrow $10,000 if have that much vested in account
Loans not repaid are distributions Up to five year term
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Topic 48: Other plans Traditional IRA
Contribute $5,500 in 2014 Over 50: $1,000 catch up
Must be under age 70 ½ Must have earned income
Can use spouse’s earned income 6% excise tax on excess contributions
Limitation on deducting contribution Not covered by plan; spouse not covered
No AGI limitation Not covered by plan; spouse is covered Active participant if could but don’t participate
Phase out $181,000 - $191,000 Covered by plan
MFJ phase out $96,000 - $116,000
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Topic 48: Other plans
Traditional IRA Distributions: income not taxed until
distributed Ordinary income
Unless made nondeductible contributions
Must begin by April 1 of year following turn 70 ½ Unless still working for 401(k); not IRA 50% tax for failing to take RMD Inherited Roth IRAs also must take RMD
But not Roth IRA
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Topic 48: Other plans
Roth IRA Contribute $5,500 in 2014
Over 50: $1,000 catch up Can be any age Must have earned income
Can use spouse’s earned income Limitation on making contributions
MFJ phase out $181,000 - $191,000
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Topic 48: Other plans
Roth IRA Conversions of Traditional to Roth
Ordinary income No 10% penalty early withdrawal
AGI must be less than $100,000 Does not include income from conversion No limit in 2010 and two years to pay tax on
conversion
Distributions not taxable if Made five years after contribution and After 59 ½, dead, disabled or buying first home
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Topic 48: Other plans
Roth IRA Distributions ordering
First, contributions so no tax or penalty Then, conversions so no tax but maybe penalty Then, earnings so maybe tax and maybe
penalty
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Topic 48: Other plans SEPs
Coverage: everyone 21, worked three of last five years and earned $500
Employer contributions only Up to $52,000 or employee comp 25% of payroll
Plan can be established up to due date of return including extensions
Contributions can be skipped in any year Considered an active participant in a plan
May not be able to deduct IRA contribution
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Topic 48: Other plans SIMPLE 401(k)
< 100 employees Employees can contributed up to $12,000 in
2014 Over 50; $2,500 additional Employer contributes:
100% of employee’s deferral up to 3% or 2% to all employees Employer contributions are immediately vested
No ADP/ACP testing Employer can not have any other type of plan
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Topic 48: Other plans SIMPLE IRAs
Coverage: everyone making $5,000 in last two years No age 21 requirement
Employee can contribute up to $12,000 Over 50: additional $2,500 Considered an active participant in a plan
May not be able to deduct personal IRA contribution
Employer contributes: 100% of employee’s deferral up to 3% or 2% to all employees Employer contributions are immediately vested
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Topic 48: Other plans
Section 403(b): TSA 501(c)(3) and public schools
Can only invest in annuities/mutual funds Employee can contribute up to $17,500
Over 50: additional $5,500. Complicated additional $3,000 for geezers who
forgot to save Considered an active participant in a plan
May not be able to deduct IRA contribution
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Topic 48: Other plans
Keogh plans For self-employed Can be defined benefit/contribution Can contribute 20% of S-E income after
subtracting one-half of S-E taxes Can make loans
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Topic 49: Regulation of Plans ERISA
Governs qualified and nonqualified plans Established PBGC
Employers pay premiums to guarantee defined benefit plan benefits
Fiduciary standard: client best interest Also requires diversification; act as prudent man Also must invest consistent with time horizon and
risk tolerance Department of Labor
Polices investment of plan assets Polices prohibited transactions
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Topic 49: Regulation of Plans
Prohibited transactions Fiduciary/owner/investment advisor/officer
self-dealing with plan Exception: providing investment advice, office
space Penalties
15% annual penalty until corrected If not corrected, 100% penalty
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Topic 49: Regulation of Plans Reporting requirements
Plans must receive IRS approval Prototype
Summary Plan Descriptions Sent to Department of Labor Give to employees when starting plan And when employees enter plan
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Topic 49: Regulation of Plans Plan terminations
Standard Enough assets to pay benefits
Distress Bankrupt Not solvent, unable to pay bills
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Topic 50: Plan Selection Owners’ needs at retirement
Defined benefit plan: larger benefits If young peons
Old owner, well-paid peons Age-weighted plan
Old owner, under-paid peons Integrate with social security
Cash flow predictability Unstable: profit sharing
Administration: SIMPLEs and SEPs are easy
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Topic 51: Investing Retirement Plan Assets Fixed income versus equities
Ordinary income versus capital gain OID bonds
Muni bonds; life insurance; annuities ERISA required diversification of employee assets Must also be consistent with time horizon, risk tolerance Unrelated Business Taxable Income
If plan owns financed real estate; stock bought on margin
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Topic 52: Distributions Premature distributions
Penalty: 10% tax in addition to income tax 25% tax on SIMPLEs in first 2 years
Exceptions to penalty Both IRAs and Qualified Plans
After age 59 1/2 Death, disability Equal payments
Must continue until for at least five years or age 59 1/2
QDRO Must be consistent with terms of plan
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Topic 52: Distributions Premature distributions
Exceptions to penalty Qualified Plans Only
Early retire after 55
IRAs Only Medical; tuition; first time home
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Topic 52: Distributions Hardship withdrawals
Can withdraw elective deferrals for financial need due to: Illness, mortgage payments, prevent eviction
Still subject to 10% penalty and taxes Better to take loan?
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Topic 52: Distributions Joint and survivor annuity mandatory for qualified plans
Can waive with spouse’s written consent Annuity
Portion reflecting basis not taxable NUA in lump sum distributions of plans holding employer stock Rollovers
Must be made within 60 days Subject to 20% withholding if not direct to another plan
RMD By April 1 of year after turn 70 ½
Balance at end of prior year / divisor for age at end of year Trophy spouse – use different table
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Topic 52: Distributions Death before distributions begin
If spouse beneficiary, roll to her IRA or take distributions based on her life expectancy
Other beneficiary, over life expectancy for IRAs or roll 401(k) into beneficiaries own IRA
No beneficiary or estate beneficiary Distribute over five years
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Topic 52: Distributions Death after distributions begin
Over life expectancy of beneficiary Can roll into spouse’s IRA
If beneficiary is not charming spouse, two choices Cash out the IRA within five years of owner’s death or… Or elect to have distributions made over their life
expectancy Name grandchild to delay distributions
No beneficiary or estate beneficiary Distribute over deceased’s life expectancy