module 3 fundamentals of defined contribution plans

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Module 3Fundamentals of Defined Contribution Plans

CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMRetirement Planning & Employee Benefits

Learning Objectives

3–1 Describe the basic characteristics of defined contribution plans.3–2 Describe the basic characteristics of money purchase plans.3–3 Describe the basic characteristics of target benefit plans.3–4 Describe the basic characteristics of profit sharing plans.3–5 Describe the basic characteristics of stock bonus plans.3–6 Describe the basic characteristics of employee stock ownership

plans (ESOPs).3–7 Describe the basic characteristics of age-weighted profit sharing

plans.3–8 Describe the basic characteristics of cross-tested profit sharing

plans.3–9 Describe the basic characteristics of a Keogh plan, and calculate

the owner’s contribution amount.3–10 Evaluate a situation to recommend whether integration is

appropriate in the design of a qualified retirement plan.3–11 Describe similarities and differences among defined contribution

retirement plans.

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Questions to Get Us Warmed Up

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Learning Objectives







retirement plans.

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Qualified & Nonqualified Plans

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Qualified Plans Nonqualified Plans

Pension Plans

Profit Sharing Plans (DC)

Tax-Advantaged Plans

Other Nonqualified Plans

Defined Benefit (DB)

Profit Sharing Traditional IRA Section 457 Plans

Cash Balance (DB) Thrift Plan Roth IRA

Stock Bonus SIMPLE IRA ISO

Money Purchase (DC)

ESOP (LESOP) SEP ESPP

Target Benefit (DC) Age-Weighted (SARSEP) NQSO

Cross-Tested (Comparability)

401(k) Plan 403(b) (TSA) Deferred Compensation Plans

SIMPLE 401(k)

Profit Sharing & Pension Plans

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Annual Addition Limits

• Annual additions are comprised ofo employer contributionso employee contributionso forfeitures

• IRC Section 415(c) limit on “annual additions” is the lesser of o 100% of compensation, or o $51,000 (2013)

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Contribution Limits

• Employer deduction limit: 25% of payroll (does not include employee deferral amounts)

• Combined employee and employer contribution limit: $51,000 (2013) or 100% of compensation

• Maximum includible compensation: $255,000 (2013)

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Money Purchase Plan

• Employer contributions are up to 25% of covered payroll.

• Forfeitures may be reallocated to remaining participants’ accounts or applied to reduce employer contributions.

• It is subject to minimum funding standard; contributions are mandatory.

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Safe Harbor Money Purchase Plan for Leasing Organizations

• Generally applies to leased employees working full-time for at least one year with one employer; they should participate in the employer’s retirement plan unless the leasing organization has a safe harbor money purchase plan that provideso 10% of compensation contribution

(minimum),o immediate participation, ando immediate vesting

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Survivor Annuities

Money purchase plans, as is the case with all four pension plans, must provide survivor annuities (these were covered with defined benefit plans):o QJSAo QOSAo QPSA

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Target Benefit Plan

• Employer contributions are up to 25% of covered payroll; age-weighted contributions.

• Forfeitures may be reallocated to remaining participants’ accounts or applied to reduce employer contributions.

• It is subject to minimum funding standard; contributions are mandatory.

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Target Benefit Plans

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Pension Plans & Profit Sharing Plans

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Pension Plans Profit Sharing

Mandatory funding?

Yes No

Employer stock limitation?

Yes, no more than 10%

No, up to 100% can be in employer stock

Survivor annuities?

Yes No

In-service withdrawals allowed?

No, unless age 62 or older if plan allows

Yes, after two years if the plan allows

Types of Profit Sharing Plans

• profit sharing • thrift (allows after-tax employee

deferrals)• stock bonus • ESOP or LESOP • age weighted • cross-tested • 401(k) (allows pre-tax

employee deferrals, will be covered in the next module)

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Profit Sharing Plans

Basic Provisions•25% employer deduction limit

•Employer contributions usually are discretionary, but must be “substantial and recurring”

•Forfeitures usually are reallocated to remaining participants’ accounts

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Participant

Employer

Vesting & Top Heavy Plans

• Maximum vesting schedule for profit sharing plans is either 3-year cliff or 2- to 6-year graded (since PPA)

• If plan is top heavy (more than 60% of the sum of account balances are for key employees), then non-key participants must receive a contribution of at least 3% of compensation (or less if the key employees are also receiving less)

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Key Employee (for Top Heavy Testing)

• a “5% owner” (ownership of >5%), or

• owned >1% of the company and received compensation >$150,000, or

• was an officer of the company and received

compensation >$165,000 (2013)

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Profit Sharing Plan Withdrawals

In-service distributions •hardship withdrawals

•non-hardship withdrawalso cannot exceed vested

amounto must have been a

participant for at least two years

•subject to early withdrawal penalty

Loans•subject to special rules including loan limits

•Distributions will be covered in more detail in subsequent modules.

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Learning Objectives







retirement plans.

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Stock Bonus Plans

Basic Provisions•Same provisions as profit sharing plans, except contribution is in employer stock

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Participant

Employer

Stock Bonus Plan Diversification Rules for Publicly Traded Companies

• Employee deferral amounts must be allowed to invest in alternative investments (other than the employer’s stock) immediately.

• After three years of service, employees must be permitted to direct account balances attributable to employer contributions into alternative investments.

• These rules came about after Enron and Worldcom, over concern about employees having too much of their retirement money concentrated in company stock.

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Net Unrealized Appreciation (NUA)

• NUA treatment is available for any employer stock distributed from a qualified plan

• Stock bonus, ESOPs, 401(k) profit sharing, are all qualified plans, so the NUA rules would apply

• An advantage of NUA is that it is taxed as a long-term capital gain, not as ordinary income

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NUA Example

Josephine, age 53, takes a distribution on March 1, 2013, of 3,000 shares of company stock. Her cost basis is $65,000 (the amount of employer contributions) and the stock is worth $255,000 when distributed. She sells all 3,000 shares on July 15, 2013, for $270,000. Ramifications are:o $65,000 taxed as ordinary income, and subject to

10% penalty taxo $190,000 NUA taxed as a long-term capital gaino $15,000 additional gain taxed as

a short-term capital gain (if held for more than one year from distribution date, then any additional gain would be long-term)

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NUA Example

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401(k) account balance $300,000

Company stock ($10,000 basis) taken as a taxable distribution in kind1

$100,000

Other assets rolled over to Traditional IRA $200,000

Taxed as ordinary income when received $10,000

Taxed as long-term capital gains when stock is sold

$90,000

Taxed as ordinary income when withdrawn from IRA2

$200,000

1 Does not consider the possibility of early distribution penalties.2 Assumes no increase in value.

NUA Tax Implications

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Value

Income Tax Bracket1

25% 35%

Tax on company cost basis $10,000 $2,500 $3,500

Tax on NUA Gain2 (15%) $90,000 $13,500 $13,500

Tax on IRA Rollover when withdrawn3 $200,000 $50,000 $70,000

Total Income Tax $66,000 $87,000

Tax when withdrawn if entire amount rolled over to an IRA

$300,000 $75,000 $105,000

NUA income tax savings $9,000 $18,0001 State and local income taxes are not considered.2 Assumes securities are sold at the distribution price3 Assumes no increase in value.

Employee Stock Ownership Plan (ESOP)

Basic Provisions

•Primary purpose of ESOP is to invest in qualifying employer securities.

•Contributions of up to 25% of payroll may be used to buy securities for plan.

•There are diversification requirements for older participants.

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Participant

Employer

ESOP

Mechanics of ESOPs

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Employer

Stock Purchase $

OwnerParticipant’s Account

Employer Securities

Owner

Plan Contribution $

Allocation of EmployerSecurities

ESOP

Mechanics of LESOPs

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Employer

Stock Purchase $

OwnerParticipant’s Account

Employer Securities

Owner

Plan Contribution $

EmployerSecurities (allocated as loan is paid down)

BankInterest

Principal Repayment $

Loan $

ESOP Diversification Requirements

These requirements apply to ESOPs that are entirely employer funded (which most are).• A participant who has

o attained age 55, ando has at least 10 years of participation in

the plan, • must be permitted to diversify up to 25% into

other assets, and as much as 50% into other assets in the final year before normal retirement age as determined by the plan document.

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Stock Bonus & ESOPs Compared

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Stock Bonus ESOP

Law requires to invest primarily in employer securities

No Yes

Borrowing allowed to acquire securities

No Yes

Social Security integration allowed

Yes No

NUA treatment allowed

Yes Yes

Diversification requirement for employer contributions

If company is publicly traded, after 3 years of service employee must be permitted to diversify entirely out of company stock into qualified alternative investments.

Upon attaining age 55 and having at least 10 years of service, employee must be allowed to begin diversifying out of company stock (up to 25% initially).

Age-Weighted Profit Sharing Plan

• Uses a combination of age and compensation as the basis for allocating contributions to the participants’ accounts.

• Appropriate when owners or key employees are older than most other employees and company wants contribution to favor them.

• Based on theory of “comparable benefits” at retirement ageo Employees closer to retirement

require higher contributions to obtain comparable retirement benefits

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Age-Weighted Profit Sharing Plan

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Benefit Valuation Allocation Example

Participant(A)Age

(B)Annual

Pay

(C)Annual Value of 1%

Annuity

(D)Age 65 PV

of a 1% Annuity*

(E)PV

Benefit Today

Employer Contribution to Age-Weighted Profit

Sharing Plan

(F) % of TotalCont.

(E÷ E)

(G)Amount

(Fx33,500)

(H)% of Pay

(G÷B)

Abe 50 $150,000 $1,500 $15,402 $4,530 70% $23,450 16%

Betty 40 $100,000 $1,000 $10,268 $1,336 21% $7,035 7%

Doris 35 $40,000 $400 $4,107 $355 5% $1,675 4%

Ed 30 $30,000 $300 $3,080 $177 3% $1,005 3%

Hilda 26 $15,000 $150 $1,540 $64 1% $335 2%

Total $335,0000

$6,462 100% $33,500

*Assuming 20-year life expectancy and 8.5% discount rate. (The IRC regs specify that a rate between 7.5% and 8.5% must be used.)

Cross-Tested Profit Sharing Plans

• In cross-tested (new comparability) plans, eligible participants are placed into one of several employee classes based on a number of characteristics such as o compensation,o years of service, o job type, ando department.

• By structuring the plan around these employee classes, the business can allocate a large portion

of the plan contribution to select employee groups.

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Learning Objectives







retirement plans.

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Cross-Tested Profit Sharing Plans

The regulations allow disproportionate allocations to a select class provided:•the nondiscrimination cross-testing is passed, and

•a minimum contribution (called a “gateway contribution”) is made in the amount of either:

o a 5% allocation for all eligible non-highly compensated employees, or

o a lesser amount as long as the highest allocation any highly compensated employee receives is no more than three times the lowest non-highly compensated employee’s allocation.

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Cross-Tested Profit Sharing Plan Example

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Name(A)Age

(B)Annual

Pay Group

(C)AmountContrib.

(D)% of Total

Contrib.

(H)% of Pay

(C÷B)

Abe 50 $150,000

A $44,000

83% 29%

Betty 40 100,000 B 5,000 9% 5%

Doris 35 40,000 B 2,000 4% 5%

Ed 30 30,000 B 1,500 3% 5%

Hilda 26 15,000 B 750 1% 5%

Total $335,000

$53,250

100%

Name Age Pay

Cross-Tested Age-Weighted

Cont.% of Total

% of Pay Cont.

% of Total

% of Pay

Abe 50$150,00

0$44,00

083% 29%

$44,000

70% 29%

Betty 40 100,000 5,000 9% 5% 13,200 21%13.2

%

Doris 35 40,000 2,000 4% 5% 3,143 5% 5%

Ed 30 30,000 1,500 3% 5% 1,886 3% 5%

Hilda 26 15,000 750 1% 5% 629 1% 5%

Total$335,00

0$53,25

0100%

$62,857

100%

Profit-Sharing Comparison

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Defined Contribution Hybrid Plan Comparison

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Target BenefitAge-Weighted Profit Sharing

Cross-tested (Comparability)

Contributions mandatory funding

flexible funding

flexible funding

Primarily benefits

older employees

older employees

specific class of employees

Unique requirements

uses an actuary when first set up, not required thereafter

if top heavy requires a min. 3% contribution for all eligible non-HCEs

requires a “gateway” contribution for all eligible non-HCEs—typically 5%

Learning Objectives







retirement plans.

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Keogh Plans—Basic Provisions

• Available only to unincorporated businesses—sole proprietor or partnership

• Takes the form of a qualified plan (defined contribution or defined benefit).

• Certain provisions for owner/employee are unique to Keoghs:o Owner/employee’s contribution is

calculated on net earnings.o Lump-sum distribution treatment is not

available to owner/employee for separation from service before age 59½—available only for death, disability, or attainment of age 59½.

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Calculation of Maximum Deduction for Keogh Plan Contribution

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Step 1: Calculate self-employment tax

Schedule C net profit (business profit) $100,000

Less 7.65% of self-employment income ($7,650)

Self-employment income subject to self-employment taxes $92,350

Times 15.3% equals self-employment tax $14,129.55


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Step 2: Determine adjusted contribution percentage for ownerPercentage contribution for employee participants (employee percentage)

.25

Divide by 1 plus employee percentage 1.25

Equals adjusted contribution percentage for owner .20


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Step 3: Multiply net earnings by adjusted contribution percentageSchedule C net profit $100,000

Less income tax deduction (1/2 self-employment tax)

$7,064.78

Net earnings $92,935.23

Times contribution percentage for owner .20

Owner’s contribution for his own benefit $18,587.05

Learning Objectives







retirement plans.

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Permitted Disparity (Social Security Integration) in a Defined Contribution Plan

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5.7% of Social Security tax

Integration allows employer to contribute extra amounts to the qualified plan for compensation above the integration level, replacing what the employer contributes below the Social Security wage base.

Employer’s contribution to old age portion of FICA is zero for compensation above the wage base.

Amount Contributed$7,000

$6,000

$5,000

$4,000

$3,000

$2,000

$1,000

$0

5.7% FICA contribution to Old Age portion of OASDI

Additional contribution tointegrated retirement plan

Increasing annual income

Basic Features of Permitted Disparity for Defined Contribution Plans

• Maximum integration level: The Social Security taxable wage base

• Base contribution percentage: The rate of contribution for compensation below integration level

• Maximum permitted disparity: The lesser of 5.7% or base contribution percentage

• Formula:

• Compensation: Total compensation, up to $255,000 (2013)

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%oncontributiexcess disparity permitted % oncontributiBase

Non-Integrated DC Plan Example

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Employer Contribution to FICA and MPP as a Percentage of Salary

(employer FICA contribution + employer MPP contribution) ÷ comp.

2013 Compensation:

$130,000 (6,481 + 13,000) ÷ 130,000 = 14.99%

$120,000 (6,481 + 12,000) ÷ 120,000 = 15.4%

$113,700 (6,481 + 11,370) ÷ 113,700 = 15.7%

$100,000 (5,700 + 10,000) ÷ 106,800 = 15.7%

$90,000 (5,130 + 9,000) ÷ 90,000 = 15.7%

$80,000 (4,560 + 8,000) ÷ 80,000 = 15.7%

$60,000 (3,240 + 6,000) ÷ 60,000 = 15.7%

$50,000 (2,850 + 5,000) ÷ 50,000 = 15.7%

$40,000 (2,280 + 4,000) ÷ 40,000 = 15.7%

$30,000 (1,710 + 3,000) ÷ 30,000 = 15.7%

Integrated DC Plan Example

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2013 Employer Contribution to FICA and MPP as a Percentage of Salary

(employer FICA contribution + employer MPP contribution) ÷ comp.

$130,000 (6,481 + 13,000 + 929) ÷ 130,000 = 15.7%

$120,000 (6,481 + 12,000 + 359) ÷ 120,000 = 15.7%

$113,700 (6,481 + 11,370) ÷ 113,700 = 15.7%

$100,000 (5,700 + 10,000) ÷ 100,000 = 15.7%

$90,000 (5,130 + 9,000) ÷ 90,000 = 15.7%

$80,000 (4,560 + 8,000) ÷ 80,000 = 15.7%

$60,000 (3,240 + 6,000) ÷ 60,000 = 15.7%

$50,000 (2,850 + 5,000) ÷ 50,000 = 15.7%

$40,000 (2,280 + 4,000) ÷ 40,000 = 15.7%

$30,000 (1,710 + 3,000) ÷ 30,000 = 15.7%

$20,000 (1,140 + 2,000) ÷ 20,000 = 15.7%

$10,000 (570 + 1,000) ÷ 10,000 = 15.7%

Learning Objectives







retirement plans.

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Defined Contribution Retirement Benefits

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Type of Plan

Limits on Employer Contribution

Limits on EmployeeDeferrals

Allocation of Employer’sContributions

AdministrativeCosts/Burden

Target Benefit

25% deduction limit—subject to minimum funding standard

Not available

Age weighted Actuary first year

MoneyPurchase

25% deduction limit—subject to minimum funding standard

Not available

Fixed contributions,can be integratedwith Social Security

Relatively low

Profit Sharing

25% deduction limit

401(k)—(indexed)$17,500 plus catch-up if eligible

Plan formula may use salary or service; canbe age weighted or include integrationwith Social Security

Relatively low —employercontributions must be “substantial and recurring,” but employer has flexibility with annualcontributions

Multiple Choice Question 1

Match each item in the left-hand column with the

appropriate item in the right-hand column

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Characteristics of Employer Contributions Retirement Plans

A.Mandatory, uniform percentage of pay

_____Profit Sharing Plan

B.Mandatory, age-weighted allocation _____Cross-tested

C.Cashless_____Money purchase plan

D.Requires a gateway contribution _____Stock bonus plan

E. “Substantial and recurring” _____Target benefit plan


Which one of the following is not a characteristic of a target benefit plan?a. The retirement benefit is not certain;

investment risk is borne by the participant.

b. Annual additions are limited to the lesser of 100% of compensation or $51,000 in 2013.

c. Forfeitures may be applied to reduce the employer’s contribution, or they may reallocated to remaining participants.

d. The plan requires annual actuarial determination.

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Which of the following plans are subject to a 25% limit on deductible employer contributions? I. money purchase plans II. profit sharing plans III. target benefit plans IV. tandem (paired) plans

a. I and IV only b. II and III only c. I, III, and IV only d. I, II, III, and IV

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Which of the following statements are correct descriptions of qualified plans?I. A target benefit plan is basically an age-

weighted money purchase plan.II. A target benefit plan is a defined benefit

plan.III. A money purchase plan is a pension plan.IV. A profit sharing plan is a flexible

contribution plan.a. I and IV onlyb. II and IV onlyc. I, III, and IV onlyd. II, III, and IV only

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The employer contribution to GHI Corporation’s money purchase plan is stated to be 4.5% of compensation up to the integration level.

Which of the following statements are correct?I. The integration level is a plan-specified dollar amount up to

the Social Security wage base.II. The maximum percentage contribution that GHI can make

for compensation in excess of the plan’s integration level is 9%.

III. The maximum percentage contribution that GHI can make for compensation in excess of the plan’s integration level is 10.2%.

IV. The plan’s permitted disparity is 4.5%.V. The plan’s permitted disparity is 5.7%.

a. II onlyb. I and V onlyc. II and IV onlyd. I, II, and IV onlye. I, III, and V only

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Which of the following statements correctly describe permitted disparity rules (Social Security integration) for qualified plans?I. Offset integration may be used only in a defined benefit

plan.II. Integration allows the owner of a business to skew plan

contributions or benefits in favor of highly paid employees.III. In integrated defined contribution plans, the excess

contribution percentage is the difference between the base contribution percentage and the permitted disparity.

IV. In offset integration, a participant’s qualified plan benefit may not be reduced by more than 50%.a. I onlyb. II and III onlyc. II and IV onlyd. I, II, and IV onlye. II, III, and IV only

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XYZ Company contributes 3% to a money purchase plan for eligible employees. The owner plans to use permitted disparity (Social Security integration) to increase contributions for higher-paid employees.

Which of the following statements is (are) correct regarding this money purchase plan?I. The maximum percentage contribution that XYZ can make for

compensation in excess of the plan’s integration level is 3%.II. The maximum percentage contribution that XYZ can make for

compensation in excess of the plan’s integration level is 6%.III. The maximum percentage contribution that XYZ can make for

compensation in excess of the plan’s integration level is 8.7%.IV. The plan’s permitted disparity is 3%.V. The plan’s permitted disparity is 5.7%.

a. II onlyb. I and V onlyc. II and IV onlyd. III and IV onlye. III and V only

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Which of the following are characteristics of an age-weighted profit sharing plan?I. An age-weighted allocation formula permits contributions to

favor older employees rather than younger employees because the younger employees have more time to accumulate contributions and earnings in their accounts.

II. An age-weighted allocation formula permits contributions to individual accounts to exceed the Section 415 limitations.

III. If an age-weighted plan becomes top heavy, the vesting schedule would be limited to either a three-year cliff or six-year graded schedule; the plan also must provide a minimum contribution of 3% of pay to non-key employees.

IV. An employer that uses an age-weighted allocation formula becomes subject to the minimum funding standards.a. I and III onlyb. II and III onlyc. I, II, and III onlyd. I, III, and IV only

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Which one of the following objectives for establishing a profit sharing plan would be best met through use of an age-weighted profit sharing plan?a. using the plan to motivate all employeesb. believing that it is more important to

motivate employees than it is to retain them

c. maximizing contributions for older employees

d. seeking to provide rank-and-file employees with a solid basis for retirement income

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Practice Problem

Hazel is a sole proprietor, and her company is experiencing their best year ever so she is going to contribute 25% into the company profit sharing plan for her two employees. After taking into account these contributions, her Schedule C net profit will be $200,000. How much can she contribute for herself into the profit sharing plan?

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module 3 fundamentals of defined contribution plans

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