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industry in the last 19 th century 1921 - Congress provides preferential treatment to retirement plans, Revenue Act of 1921 1930s & 40s – Congress provided that retirement funds had to be used for employees and plans could not discriminate in favor of highly compensated employees ERISA (Employee Retirement Income Security Act) was signed in 1974 and was designed to provide greatly enhanced protection for pension and retirement benefits Qualified Plans
Pension Plans (4 Types) Defined Benefit (2 Types) Pension Plans Plans Stock Bonus Plans Cash Balance Pension Plans Money Purchase Pension Plans Pension Plans (2 Types) Contribution Employee Stock Ownership Plans 401(k) Plans Thrift Plans New Comparability Target Benefit Pension Plans Plans Age-Based Profit Sharing Plans (All 7) Defined Contribution Profit Sharing Plans Profit Sharing Plans (7 Types) Profit Sharing Pension Plans
Plan sponsor and participants
will benefit from tax deferral, asset protection The number of defined benefit pension plans has decreased greatly because of promises not being made, and because of people changing jobs (pension plans require many year of continuous service with the same employer to attain expected retirement benefits) Profit sharing plans became much popular because the employee became responsible for the management of the fund and is
responsible for personal contributions (no defined benefit because result is unknown) All defined benefit plans are pension plans Defined contribution plans can be either pension plans or profit sharing plans Under the Pension Protection Act of 2006, defined contribution plans that hold publicly traded securities of the employer much allow participants to diversify their pre-tax deferrals, after-tax contributions, and employer contributions
Legal promise of the plan Are in-service withdrawals permitted? Is the plan subject to mandatory funding standards? Percent of plan assets available to be invested in employer securities Must the plan provide qualified joint and survivor annuity and a qualified pre-survivor annuity?
Paying a pension at retirement No Yes 10%
Deferral of compensation and taxation Yes (after two years) if plan document permits No Up to 100%
Advantages of Qualified Plans Taxation of Contributions to Plans o Income Tax Employees
have taxable income and the employer has a tax deduction for the same amount— referred to as the matching principle because of the matching of income and deductions Example 3.1 Carla works 40 hours a week at Best Feed Supply for $6.00 per hour. In addition, if Carla sells more than 200 pounds of feed during the week, she receives a bonus of $200. In a week that Carla works 40 hours and sells 300 pounds of feed, Carla has taxable income of $440 (($6.00 x 40) + $200), and Best Feed Supply has a tax deductible wage expense of $440. Employee does not pay taxes on the amounts until they receive them in distributions Example 3.2 Computer Connection, a C Corporation, employs fifteen service technicians, each earning $40,000 per year. The sole-shareholder of Computer Connection, Jason, who is also a service technician and employee, pays himself $120,000 per year. For 2012, Computer Connection contributed 20 percent of each employee s salary to a qualified profit sharing plan. For 2012, Computer Connection will have a deductible business expense for contributions to the profit sharing plan of $144,000 ((15 x $40,000) x 20% + 20% x ($120,000)). Neither employees nor Jason will have any taxable income related to the contribution to the qualified profit sharing plan, but any distributions from the plan will be taxable as ordinary income (and may be subject to penalties) to the recipients at the time of distribution. However, neither the contributions nor the distributions will ever be subject to payroll tax. o Payroll Taxes When the employer makes a contribution to a qualified retirement plan on behalf of its employees, the employer’s contribution is not subject to payroll tax even though the contribution was on account of services rendered Example 3.3 If Butcher Block paid its two employees $50,000 each in wages and did not contribute to a qualified profit sharing plan for the year, Butcher Block would incur payroll taxes relating to the wages of $7,650 ($100,000 x 7.65%). Butcher Blocks employees would have also incurred payroll taxes of $7,650 for total payroll taxes of $15,300. Example 3.4 In comparison, if Butcher Block would have paid its 2 employees $45,000 each in wages and contributed $5,000 to a qualified profit sharing plan for each employee, Butcher Block would incur total payroll taxes relating to the wages and profit sharing plan contribution of $6,885 ($90,000 x 7.65%). In this
case, Butcher Block's employees would also only incur $6,885 of payroll taxes for a total of $13,770 of payroll taxes. The combined payroll tax savings would be $1,530 ($15,300-$ 13,770); however, Butcher Blocks employees received total payments for services rendered equal to $50,000, $45,000 as cash compensation and $5,000 in contributions to a qualified profit sharing plan. Note that even at the time distributions are taken from the qualified profit sharing plan, the distributions will not be subjected to any payroll taxes. The $1,530 of payroll tax is permanently avoided. No avoidance of payroll tax for contributions to employee elective deferrals If an employee defers income by making a pretax elective deferral contribution into a 401(k), 403(b), SIMPLEs, SARSEPs, or 457 plan, then these amounts being deferred are subject to payroll taxes If employer matches, those contributions are not subject to payroll taxes Example 3.5 Joseph earns $166,667 and is a participant in his employersponsored 401(k) plan that offers a 75 percent match for contributions up to three percent of salary. Joseph elects to defer three percent of his salary, or $5,000, into the qualified 401(k) plan, and his employer marches the contribution with a $3,750 (75% x $5,000) contribution into the plan. Joseph’s contribution of $5,000 is subject to payroll taxes, but the employer’s contribution of $3,750 is not subject to employee or employer payroll taxes. Note that because Josephs earnings are In excess of the Social Security wage base and the OASDI of 6.2 percent is only paid on compensation up to the Social Security wage base, the employer is only saving the Medicare tax portion of 1.45 percent on the matching contribution to Josephs 401(k) plan. However, in other cases where the employee’s earnings are below the Social Security wage base, the employer is saving the full payroll taxes of 7.65 percent of the compensation. o Tax Deferral of Earnings and Income Assets contributed to a qualified retirement plan are held in a tax exempt trust by a fiduciary, the plan sponsor, or an appointee of the plan sponsor and the earnings on these investments are not subject to current income tax Example 3.6 Mark’s employer contributed $4,000 to a money purchase pension plan on his behalf. The funds were invested in a mutual fund that earned $300 in income during the year. The $300 is paid to Mark’s money purchase o ERISA to Protection Advantages the Employer
• Contributions are currently tax deductible • Contributions to the plan are not subject to payroll taxes
Advantages to the Employee
• Availability of pretax contributions • Tax deferral of earnings • ERISA protection • Lump-sum distribution options (ten-year averaging, NUA, Pre-1974 capital gain treatment)
pension plan account and reinvested in the mutual fund. Neither Mark nor his
The court awarded Georges creditors $0. most of OJ.000 of qualified retirement plan assets to his creditors.s remaining assets (after the trial and his subsequent bankruptcy) were qualified retirement plan assets that are protected under ERISA. However. George’s business failed and George personally filed for federal bankruptcy (Chapter 7). the recipient of the distribution will have taxable income at the ordinary income tax rate regardless of whether the plan distributes cash.7 George has $4.000. Example 3.000. At the time of the bankruptcy filing.000 and debts totaling $650. both from creditors and from plan sponsors Anti-Alienation Protection Prohibits any action that may cause the plan assets to be assigned. or subject to bankruptcy proceedings Assets in a retirement plan covered by ERISA can only be seized to pay federal tax liens Example 3. the Brown and Goldman families have been unable to collect much. municipal bonds.employer will currently recognize any taxable income from the $300 of income from the mutual fund.000 in qualified retirement plan assets. levied. Because of the ERISA afforded anti-alienation protection. Because of the ERISA protection.J. George will continue to have full rights over the assets of his qualified retirement plan. SEP IRA.38 on the dollar and discharged George of any remaining creditor claims.8 Nicole Brown Simpson's family and Ron Goldman's family won a civil judgment that exceeded $30 million dollars against O.000. George had other assets totaling $250.000) and earnings ($300) be subject to income tax. When funds are distributed. of the $30 million dollar judgment even though the value of O. if any. garnished.J. Protection from Employers o Protects employees from abuse and misuse of the qualified plan by employers as plan sponsors Special Taxation Options for Lump Sum Distributions Lump-sum distribution is a complete distribution of a participant’s account balance within one taxable year of death. or even stocks with ―built-in‖ or unrealized capital gains Employee Retirement Income and Security Act (ERISA) in 1974 to provide protection for an employee’s retirement assets. the court could not award any of Georges $4. disability. Treasury bonds. or separation from service Pre-1974 Capital Gain Treatment 10-Year Forward Averaging (only for qualified plans) Distributions from an IRA.’s retirement assets is large enough to defray some of the debt. or SIMPLE IRA do not qualify and are taxed at ordinary income tax rates Net Unrealized Appreciation . Simpson in 1997. Only upon distribution will the contribution ($4. This left George with nothing except his qualified retirement plan assets. attainment of age 59½.
o Special Eligibility Rules Special election to require two years of service—100% immediate vesting requirement Help employer if they have high turnover Example 3. Doctors Resources stock bonus plan must provide its plan participants with a 100 percent immediate vested account balance after completing two years of service. age 25. Bob turned 21 years old and celebrated three years of service. 2012. On November 15. any employer contributions to the plan will be automatically fully vested for the employee as of age 21 and 2 years of service. 2012 and Cathy a participant in the plan at January 1. The plan has entrance dates of January 1 and July 1 of each year. celebrated her one-year anniversary of employment. Helium Limited considered Bob a participant in the plan at July 1. but neither was required to wait for more than six months past their exact eligibility date. Therefore. or the date the employee completes one year of service (12 month period of 1. To retain qualified status for the stock bonus plan. Cathy. en employer can make the employee wait until the next plan entrance date after the date the employee is eligible as long as it is not more than 6 months after the date of eligibility Example 3. the plan meets IRC entrance requirements.10 Doctors Resource sponsors a stock bonus plan (a qualified plan) that requires that its employees be 21 years old and complete two years of service before being considered eligible to participate in the stock bonus plan.9 Helium Limited operates a money purchase pension plan on behalf of its employees. On April 12. These distribution options are intended to lower the overall income tax payable by the distribution recipient Qualification Requirements Plan Document o Plan document and the administration of the plan must be consistent with the IRC qualification requirements Eligibility o o o o A qualified retirement plan must provide rules regarding when an employee becomes eligible for participation in the plan The IRC provides standard eligibility requirements that state: Eligible when the later of either the date the employee turns 21. Thus. 401(k) does not have this option because most of these contributions are employee elective deferral contributions Tax-exempt educational institutions can require the later of age 26. Both employees were required to wait for entrance into the qualified retirement plan past their exact eligibility date.000 working hours) Plan Entrance Date The IRC provides an elective grace period for the employer that states that even if an employee meets the requirements for eligibility. or one year of service . 2012. 2013.
Example 3.S. All qualified plans must pass at least ONE of the following tests annually to be considered a qualified retirement plan: Participation in a qualified retirement plan counts as coverage in the plan: An employee is considered covered when the employee receives a benefit o Coverage Tests o General safe harbor test Ratio percentage test Average benefits test All of the non-excludable employees are further segregated into two classifications. In this case.12 A tax-exempt middle school sponsors a qualified money purchase pension plan. the money purchase pension plan must provide 100 percent vesting to participant s accrued benefit. The IRC allows this as an incentive to establish qualified plan because it does not benefit from the tax deductions—it creates additional costs to maintain the plan Example 3. the profit sharing plan retains its qualified status under §401 (a) even though participant account balances are not 100 percent vested after they complete one year of service because the plan did not increase the age requirement for eligibility to 26. highly compensated (HC) and non-highly compensated (NHC) Highly compensated employee is either: More than 5% owner at any time during the plan year or preceding plan year Compensation in excess of $115. To be considered eligible for the money purchase pension plan. The qualified retirement plan follows a three-year cliff-vesting schedule. the employees must complete one year of service and attain the age of 24. Because the money-purchase pension plan does not permit eligibility based on the general rule of completing one year of service and attaining the age of 21. Coverage o o All employees who are non-excludable must be considered for participation in the qualified plan Can exclude: o o Ineligible employees Employees covered under a collective bargaining agreement Nonresident alien employees that do not perform services in the U.000 for the prior plan year Contribution to a profit sharing plan for the year Accrues a benefit for a defined benefit plan Makes an elective deferral contribution Forfeiture of making an elective deferral contribution Must be nondiscriminatory Highly Compensated Employees .11 A qualified profit sharing plan of a tax-exempt high school permits its employees to be eligible for the profit sharing plan after completing six months of service and attaining the age of 20.
his son Sam. to run the day-today operations and grow the business.15 Jeanette and her husband Don started Trophy Shop.13 Harold.000 $150. Don died last year and left his shares to Jeanette.000 for the limited amount of work they do. For purposes of determining the amount of stock owned by Harold. In the current year. Thus. partnerships. each of them is deemed to own 100 percent of the stock of the Great Corporation. his wife Wanda. estates. or Steve. each owning 25 shares. 5-Percent Owner Defined: Individually owns shares. Together they owned 95% of the business and their only employee at that time.000. Bob. Example 3. Cheryl. George is considered as owning only 50 shares (his own and his father’s). Inc. Wanda. all three individuals are considered highly compensated for the current year. Cheryl hired Delano. own the 100 outstanding shares of BWSG. and Sam are each considered as owning 100 shares of BWSG.000 OWNERSHIP % 65% 35% - . and his son Steve. stock. his wife Wilma. and trusts Example 3. owned the remaining 5%.000 $145. Jeanette wanted to give up a majority of her responsibilities at the trophy shop and spend more time with her grandchildren. Example 3. Cheryl is highly compensated because she is a greater than 5% owner in the current year. Wilma. EMPLOYEE A B C SALARY $200. a successful salesman. Delano is highly compensated because his income exceeds the compensation test for the current year. Delano’s salary is $150. plus Attributes of shares owned by: o o o o Spouse Children Grandchildren Parents Ownership of corporations. Cheryl and Jeanette each receive a salary of $50.14 Bob. Jeanette sold all but a 5% interest to Cheryl. each own one-third of the stock of the Great Corporation. the amount of stock held by the other members of the family is added together. Jeanette now owns 5% of the business and Cheryl owns 95%. Even though Jeanette does not own more than 5% in the current year. Cheryl recently had a baby and no longer wants to work full time. Inc. Inc. many years ago. Which of the three employees are considered highly compensated based on the qualified plan rules? In this example. and his grandson (Sam’s son) George. for coverage testing. she is considered highly compensated because she owned greater than 5% last year.
Only those employees considered nonexcludable were considered for . By making the election. So. C is not in the top 20 percent.000 $50. NHC employees Considers only NHC employees.000 - Example 3.16 Desk Emporium has the following 10 employees.000 Compensation 20% Election Top 20% > 5% Owner (ranked by compensation) he is not an owner of the company and if ranked by salary. In a situation like this. the employer might make the 20% election and reduce the number of highly compensated employees to help pass the coverage tests. Union. The profit sharing plan meets the general safe harbor coverage test because it benefits 73.000 for 2012). in this example. The company's qualified profit sharing plan benefits 21 of the highly compensated employees and 55 of the nonhighly compensated employees. three of the 10 employees would be considered highly compensated. often called the rank-and-file Not concerned with the percentage of HC employees covered Example 3. In a company with 10 employees. o General Safe Harbor Test Plan needs to benefit 70% or more of non-excludable. employee C is ranked third by salary and is therefore not considered highly compensated.000 for 2012. Employee C would not be considered highly compensated because Employee A B C D-J DESK EMPORIUM HIGHLY COMPENSATED TEST General Rule > 5% Owner > $115. In this case.000 OWNERSHIP % CURRENT YEAR 5% 95% 0 OWNERSHIP % LAST YEAR 95% 5% 0 five percent owner or compensation greater than $115. Utilizing the general definition of highly compensated (greater than EMPLOYEE Jeanette Cheryl Delano SALARY $50. etc. employee A and B would be highly compensated because both are greater than five percent owners of Desk Emporium.D-J $30. only employees A and B would be considered highly compensated.33 percent (55/75) of the nonhighly compensated NHC HC Total Nonexcludable Employees Covered 55 21 76 Not Covered 20 4 24 Excludable (Not 21&1. Employee C would also be considered a highly compensated employee because his salary is in excess of $115.17 Gerard’s Automotive has 125 employees (26 highly compensated and 99 nonhighly compensated). If Desk Emporium elected to only count those employees as highly compensated if they were also in the top 20 percent of employees ranked by compensation. 100 of these employees are nonexcludable and 25 of those are highly compensated (75 are nonhighly compensated).000 $150. only the top two ranked by salary would be considered as in the top 20 percent.) 24 1 25 Total All 99 26 125 eligible employees. Desk Emporium was able to reduce the number of highly compensated employees to two of the 10 employees.
and. The above plan has failed two tests. failing the ratio percentage test.the calculation of the safe harbor coverage test. the plan only has to pass one test and this one passed the ratio percentage test. All of these employees meet the eligibility rules of the qualified retirement plan yet are not covered under the plan. Keep in mind that the plan does not cover each of those nonexcludable employees. o Average Benefits Test . Provided that the selection of the beneficial class was based on a nondiscriminatory classification (for example. In fact. This profit sharing plans ratio percentage is 75 percent (60%/80%). the plan will automatically meet the coverage test. o Ratio Percentage Test If a plan does not meet the safe harbor coverage test Compares the percentage of covered NHC employees to the percentage of covered HC employees Needs to be 70% or more of covered nonexcludable HC employees Example 3. thus. Example 3. the plan will satisfy the safe harbor coverage test because it covers at least 70 percent of the NHC employees. Remember. 60%). satisfies the ratio percentage test. If an employer only has HC employees. The plans ratio percentage is 66. 20 (75-55) of the nonexcludable NHC employees and four (25-21) of the nonexcludable HC employees are not covered by the plan. the plan would not pass the general safe harbor coverage test because the plan only covered 60 percent (not 70%) of the nonhighly compensated employees. In this example.18 A qualified profit sharing plan covers 60 of the 100 (60%) nonexcludable NHC employees and 40 of the 50 (80%) nonexcludable HC employees. it is subject to disqualification. the plan only benefits Gerald’s Automotive's mechanics).19 A qualified profit sharing plan covers 40 percent of the nonexcludable (80 out of 200) NHC Ratio Percentage (%) Test Nonexcludable Employees NHC HC Total Ratio % Test = 200 50 150 % of NHC Covered % of HC Covered = Covered Employees 80 30 100 40% 60% = 67% ≤ 70% Fail (%) Covered Employees 40% 60% NHC HC Total Ratio % Test = Ratio Percentage (%) Test Nonexcludable Employees 100 50 150 % of NHC Covered % of HC Covered = Covered Employees 60 40 100 60% 80% = 75% ≥ 70% Pass (%) Covered Employees 60% 80% employees and 60 percent of the nonexcludable HC employees (30 out of 50). The plan also fails the safe harbor rest because the plan does not cover > 70 percent of the NHC.67 percent (40%. Note: If the plan meets the general safe harbor test. but gets a chance to pass the third test (the average benefits rest). If a qualified plan fails to meet all of the coverage tests. then it will always meet the ratio percentage test.
The HC have a calculated average benefit percentage of 10 percent. which is greater than the requirement of 70 percent. Of the 350 nonexcludable employees.000 Benefit $ $15.000 $50.21 Waggaman’s Meat Market employs 400 people and sponsors a money purchase pension plan for its employees. This money purchase pension plans satisfies the average benefit percentage test of the average benefits test because the ratio of the average benefit of the nonhighly compensated (8%) to the average benefit = 8% 10% = 80% ≥ 70% Pass Average Benefit Percentage (%) Test Covered Employees NHC HC Total AB % Test = 300 50 350 % of NHC Covered % of HC Covered Average Benefit % 8% 10% of the highly compensated (10%) is 80 percent (8%/ 10%).000 $11.000 $0 Benefit % 10% 10% 6% 10% 0% 5. Benefit % 10% E xample 3.20 The company’s plan does not pass the average benefits test because 5. or 40% of all non-excludable employees on each day of the plan year Safe harbor test Facts and circumstances test The plan must satisfy all three requirements to pass the average benefits test .000 $50.000 $110. in addition to one of the other three coverage tests Defined benefit plan needs to cover the lesser of 50 non-excludable employees.33%/10% = 53% ≤ 70% Employee A B C D E Status HC HC NHC NHC NHC Example 3.000 $5. and the NHC have a calculated average benefit percentage of eight percent.000 $50.33% Avg.000 $3. This plan must also satisfy the nondiscriminatory classification test to satisfy the average benefits test. Nondiscriminatory Classification Test Classification must be reasonable and established Classification must be nondiscriminatory and pass two tests: o o o 50/40 Test Must satisfy this test. Determines whether the plan adequately benefits the NHC employees compared with the benefits received by the HC employees Consists of two tests: Average benefits percentage test The nondiscriminatory classification test Average Benefits Percentage Test Average Benefit Percentage of NHC Employees Average Benefit Percentage of HC Employees ≥ 70% Salary $150. 50 are HC employees and 300 are NHC employees.
usually 3 Graduated Vesting Schedule Provides employee with full rights to a certain percentage benefit (less than 100%) after completing a certain number of years of service and provides the employee with an additional percentage for additional years of service o Since the passage of the Pension Protection Act of 2006 All defined contribution plans must vest employer contributions under a 2 to 6 year graded or 3-year cliff schedule Minimum vesting for defined benefit plans is either a 5-year cliff or 3 to 7 year graded vesting. Vesting o o Defined: ownership interest accrues to employee May always be more beneficial towards employees Cliff Vesting Schedule Provides employee full rights to the plan’s assets immediately upon the passage of a certain number of years of service. Must benefit at least 2 employees in a company of 4 or less nonexcludable employees.25 A defined benefit plan being sponsored by an employer with 5.40 x 100 employees).23 A defined benefit plan being sponsored by an employer with 100 nonexcludable employees must benefit at least 40 employees.in this case 50 employees is less than 2. The determination is calculated based on the rule that states that a plan with less than four employees must benefit at least two of the employees. but must still pass one of the previously discussed coverage tests. except for top-heavy plans—same as defined contribution plans o o Cash balance plans are required to provide a 3 year cliff schedule A plan must vest an employee 100% in any accrued benefit when the employee attains retirement age (65) or upon termination of the plan Defined Contribution Plan Vesting Schedules: YEARS OF ALL EMPLOYER CONTRIBUTIONS 2-YEAR ELIGIBILITY EMPLOYEE CONTRIBUTIONS . The determination is calculated by determining the lesser of 50 employees or 40 percent of the employees . Example 3.24 A defined benefit plan being sponsored by an employer with three nonexcludable employees must benefit at least two employees. Note: A plan does not ever need to cover more than 50 employees to meet this test. This is calculated by determining the lesser of 50 employees or 40 percent of the employees. Example 3. Example 3. or the employee if there is only 1 nonexcludable employee Does not segregate the calculation between HC and NHC employees Example 3. The determination is calculated by determining the lesser of 50 employees or 40 percent of the employees .000 nonexcludable employees must benefit at least 50 employees. either calculation provides a requirement of exactly 50 employees.000). In this case.22 A defined benefit plan sponsored by an employer with 125 nonexcludable employees must benefit at least 50 of the employees.000 employees (40 percent of 5.in this case 40 employees (0.
000.000 (40% of $60. Craig has attained three years of service with Stone Corporation. o Example 3.000 will be forfeited if Marcus terminates employment before reaching three years of service. The $14.000). Craig has a vested account balance of $24.28 Craig has received employer contributions to a qualified profit sharing plan \n the amount of $60. she would be entitled to a benefit of $12 (40% x $30) per month at retirement. Any forfeited funds will then be used by the plan co either reduce current plan costs or to increase the benefit provided to remaining participants. If the plan follows a 3 to 7 year graduated vesting schedule and Mallory terminated her employment today. he is a benefiting participant of Blue Cliff's qualified profit sharing plan. o Example 3. Pharmex sponsors a defined benefit plan that is not top-heavy and does not permit employee contributions. If the plan follows a 2 to 6 year graduated vesting schedule. After meeting the plans eligibility rules.29 Mallory has attained four years of service with Pharmex Corporation.SERVICE 2 TO 6 YEAR GRADUATED 0 20% 40% 60% 80% 100% 3YEAR CLIFF 0 0 100% 100% 100% 100% ELECTION 1 2 3 4 5 6 0 100% 100% 100% 100% 100% 0 0 100% 100% 100% 100% o Defined Benefit Plan Vesting Schedule YEARS OF SERVICE 1 2 3 4 5 6 7 ALL EMPLOYER CONTRIBUTIONS 53 TO 7 YEAR YEAR GRADUATED CLIFF 0 0 20% 40% 60% 80% 100% 0 0 0 0 100% 100% 100% 2-YEAR ELIGIBILITY ELECTION 0 100% 100% 100% 100% 100% 100% TOP-HEAVY PLAN 2 TO 6 YEAR GRADUATED 0 20% 40% 60% 80% 100% 100% 3YEAR CLIFF 0 0 100% 100% 100% 100% 100% CASH BALANCE PLAN 0 0 100% 100% 100% 100% 100% o Example 3. which consists of employer contributions only and follows a 3-year cliff vesting schedule. Mallory has an accrued benefit to date under the plan of $30 per month at retirement.000. YEARS OF SERVICE 1 2 3 4 5 PERMITTED 2 TO 6 GRADUATED 0 20% 40% 60% 80% PERMITTED 3-YEAR CLIFF 0 0 100% 100% 100% PERMITTED SCHEDULE (A) 5% 25% 45% 75% 100% NOT PERMITTED SCHEDULE (B) 5% 25% 35% 60% 80% PERMITTED SCHEDULE (C) 33% 66% 100% 100% 100% NOT PERMITTED SCHEDULE (D) 0 0 50% 75% 100% .27 Marcus has been employed by Blue Cliff Supply Stores for two years. The current balance of Marcus' profit sharing plan is $14. Over those three years.
therefore it meets the requirements and is considered a permitted vesting schedule. Schedule B must be compared in a blended fashion to both the 3 to 7 year graduated and the 5year cliff. Since Vesting Schedule D does not meet the minimum vesting requirements of either schedule. but in years 5 to 7 its vesting schedule is only as rapid as the 3 to 7 year graduated vesting schedule. Vesting Schedule A provides a greater vested percentage in every year compared to the 3 to 7 year graduated vesting schedule. The "not permitted" vesting schedules provide a vesting schedule that is at least as rapid in some years than one of the schedules and at least as rapid as other vesting schedules in other years. it is not a permitted vesting schedule. it is not a permitted vesting schedule. Vesting Schedule C provides a greater vested percentage in each year as compared to the 5-year cliff. Vesting Schedule C provides vesting at least as rapid as compared to the 3-year cliff. Therefore. Years of Service . thus. it is not permissible. Vesting Schedule D meets the requirements compared to the 5-year cliff for years 1 to 4 and then only meets the requirements for years 5 to 7 in comparison to the 3 to 7 year graduated vesting schedule.31 The following chart illustrates various sample vesting schedules for a defined benefit plan and whether they meet the qualified. Specifically. but it is not as rapid as the 2 to 6 year vesting schedule in Year 3. Specifically.6 7 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% o Example 3. the "not permitted" vesting schedules provide a vesting schedule that is at least as rapid in some years than one of the schedules and at least as rapid as other vesting schedules in other years. o Example 3. Vesting Schedule B provides a greater vested percentage than the 2 to 6 year graduated vesting schedule in years 1 and 2. To provide a vested benefit at least as rapid as the permitted vesting schedules. therefore it meets the requirements and is considered a permitted vesting schedule.30 The following chart illustrates various sample vesting schedules for a defined contribution plan and whether they meet the qualified plan vesting requirements. The permitted vesting schedules for a defined contribution plans are at least as rapid as either the 2 to 6 year graduated vesting schedule or the 3-year cliff vesting schedule. Vesting Schedule D provides a better benefit than the 2 to 6 year graduated schedule except for year 2. Vesting Schedule B provides a greater vested percentage than the 5-year cliff vesting schedule in years 1 to 4. Whereas. Vesting Schedule A provides a greater vested percentage in every year compared to the 2 to 6 year graduated vesting schedule. nontop-heavy plan vesting requirements. The permitted vesting schedules for a defined YEARS OF SERVICE 1 2 3 4 5 6 7 PERMITTED 2 TO 6 GRADUATED 0 0 20% 40% 60% 80% 100% PERMITTED 3-YEAR CLIFF 0 0 0 0 100% 100% 100% PERMITTED SCHEDULE (A) 5% 10% 20% 60% 80% 100% 100% NOT PERMITTED SCHEDULE (B) 5% 10% 15% 60% 80% 100% 100% PERMITTED SCHEDULE (C) 0 5% 10% 15% 100% 100% 100% NOT PERMITTED SCHEDULE (D) 0 5% 20% 30% 60% 80% 100% benefit plan that is not top-heavy arc at least as rapid as either the 3 to 7 year graduated vesting schedule or the 5-year cliff vesting schedule.
500. As of today. Tax Heaven matches employee elective deferral contributions with an amount equal to 25 percent. he would be entitled to a benefit of $16 ($20 x 80%) per month at his retirement. The plan maintains the least generous graduated vesting schedule for the employer matching contributions. as a 12-month consecutive period with at least 1.000. If Brian terminated his employment with Taters Restaurant today. and receives an annual salary of $110.33 The employees of Tax Heaven are given the opportunity to contribute to a 401(k) plan after six months of continuous service.440 as illustrated in the chart below.000 for 2012. Key Employee Employee who is any one or more of the following: o o o Greater than 5% owner Greater than 1% owner with compensation in excess of $150. The Tater Restaurant's defined benefit plan is considered top-heavy and follows the least generous graduated vesting schedule.34 John owns five percent of the stock of Market Resources. Brian has been employed by Taters Restaurant for the past five years and has an accrued benefit to date under the plan of $20 per month at retirement.000) of employer marching contributions to the 401(k) plan. . Based on the number of years. Even though John is an owner. Example 3. he is not considered a key employee because his ownership percentage is not greater than five percent. Inc.500 (25% of $18. As part of the benefit. Taters Restaurant follows the 2 to 6 year graduated vesting schedule and not the 3 to 7 graduated vesting schedule because Taters Restaurants plan is considered top-heavy (see below for more information on top-heavy plans) and is a defined benefit plan.32 Taters Restaurant sponsors a defined benefit plan that does not permit employee contributions. and even though he is a greater than one percent owner. and has a current balance of $32.000 An officer with compensation of $165. his income is not greater than $165. Mike has received $4. has earnings of $9. Mike has a vested balance of $29. not when they are eligible for benefits Employer does not have to account for: o o o Years of service employee acquired before the age of 18 Years of service employee attained before plan was sponsored Years of service the employee attained during years when he did not contribute to an employee-contributory qualified plan Example 3.000 to his 401(k) account over those four years.000 hours worked for employer Employees begin accruing years of service when they begin work.000 for 2012 as determined last year Example 3. an 80 percent vested accrued benefit. Mike has four years of service with Tax Heaven and has contributed $18.000.
000 and James is not a key employee.35 Maurice is an officer of Whinny National Bank. has annual compensation equal to $65. the first 50 employees ranked by compensation Top-Heavy Vesting The plan must accelerate the vesting from the standard vesting schedules to either 2 to 6 year graduated to a 3-year cliff vesting schedule Since PPA 2006. Maurice is a key employee because he is an officer with compensation in excess of the limit. LLP is considered top-heavy for the year. if so. LLP must contribute to the qualified profit sharing plan on James' behalf is $1.000 x 3%) assuming that they contribute at least 3% to key employees. DEFINED BENEFIT PLANS ACCRUED BENEFIT PERCENTAGE AFTER YEARS OF SERVICE – . The minimum amount that MakeUps.36 The qualified profit sharing plan of MakeUps.950 ($65. o Officer An administrative executive who is in regular and continued service An employee who merely has the title of an officer but not the authority of an officer is not considered an officer for key employee test and vice versa No more than 50 employees must be treated as officers. He earns $500. a plan participant. James. defined contribution plan vesting has not been impacted by the top heavy rules Top-Heavy Funding Designed to ensure that qualified plans that significantly benefit owners and executives of the company must provide some minimum level of benefits for the rank-and-file employees Minimum Funding for Defined Contribution Plans o o o Employer must provide non-key employees with a contribution equal to at least 3% of employees compensation Except if key employee’s contribution is less than 3% Example 3. Example 3.000 per year in annual compensation.
0% 8.0% 14. and Kadeaux Corp.0% 11.0% 4.0% 42. made to a key employee (Employee B).0% 19. Boudreaux.0% (A) and 1. Inc. and Thibodeaux Corporations sponsor defined benefit plans providing benefits based on years of service and an employees average annual salary. The plan benefit formula is 1. Key employees with Boudreaux Corp. and 3% respectively for each year of service. therefore. sponsors Minimum Funding Requirement for Non-Key Employees if the Plan is TopHeavy (D) E Funding Schedules a qualified age-based profit sharing plan. The qualified profit sharing plan is topheavy.5% 3.0% 6. sponsors a defined benefit plan for its employees.0% 15. and Thibodeaux provide benefits of 1%.MINIMUM FUNDING FOR TOP-HEAVY PLANS o xample 3. the top-heavy rules no longer apply.0% 2. the funding schedule for non-key employees of Kadeaux Corp. Kadeaux. all eligible nonexcludable.5% 21. o Example 3. Defined Benefit Plans o Employer with top-heavy defined benefit plan must provide non-key employees with a benefit equal to 2% per years of service (limit 20%) multiplied by employees average annual compensation o Example 3.0% 9.5% 18.0% 22.0% 2. will not be impacted and will simply receive the benefits provided for in their plans (A) and (B). reverts back to the original schedule (B). must provide a benefit of 2.5%.0% 1. (B) Thibodeaux Corp.0% 16.37 Erasers.0% per year of service up to 20% (D) for non-key employees.38 Boudreaux.0% 4. non-key employees must receive at least a two percent contribution to the qualified age-based profit sharing plan on their behalf because this is the largest funding percent Years of Service Boudreaux Corp (A) Kadeaux Corp.0% 4. as defined in their plan documents. For the plan year.0% 13.0% 20.39 Entertainment Hourly.0% 36. Eraser made contributions to its two key employees of one percent of compensation to Key Employee A and two percent of compensation to Key Employee B based on the formula provided under the plan document.0% 30. Notice that in Year 14. 1. Thibodeaux Corp. (C) 1 2 3 4 … 10 11 12 13 14 15 1.0% 10.0% 12.5% 3.0% 6. the top-heavy rules would not apply and both key and nonkey employees would receive benefits as provided under their plan.0% *Beyond 20%.5% (B) per year of service. therefore. benefits are more generous than those provided by the top-heavy rules.0% 20.5 percent multiplied by .0% 39.0% 20.0% 20. Boudreaux Corp. Inc.0% 45.0% 15.0% 20. Kadeaux.0% 33.0% 12. rather than the 1. If the plans are top-heavy.0% 3. and Kadeaux Corp.0% 20.5% 6.
the employee's years of service multiplied by the average of the employee's three highest consecutive years of compensation. The plan is determined to be top-heavy for the year. the top-heavy formula is not applicable because it would have only provided the employee with a 20 percent benefit (the minimum funding formula always tops out at a 20 percent benefit).000).41 Trinity Audio has employed Ronald for 12 years. Charlotte. Trinity Audio operates a defined benefit plan that provides a benefit to its employees equal to one percent per year of service of the average of employees three highest Plan Limitations on Benefits and Contributions . must satisfy each of the two following steps: o Actual Contribution Percentage (ACP) Test for employer matching contributions (and employee after-tax contributions Actual Deferral Percentage (ADP) Test for employee elective deferrals Covered Compensation (Limit) $250. An employee with 30 years of service and an average three highest consecutive years of compensation of $40. Under the current benefit formula. Inc. has been employed by Entertainment Hourly. the plan benefit formula is used. In this case.40 A defined benefit plans benefit formula is 25 percent of an employees average three highest consecutive years compensation at retirement.000 for 2012 100% of the average of the employee’s three highest consecutive years salary Example 3. When the plan benefit formula provides a greater benefit than the top-heavy benefit formula. The defined benefit plan funding formula is based on two percent times years of service in this case because the defined benefit plan is considered top-heavy and the benefit provided under the plan is less than that provided by the top-heavy rules. Cash or Deferred Arrangements o Any qualified plan that includes a cash or deferred arrangement (CODA). Charlotte should have an accrued benefit in the defined benefit plan of 16 percent (2% x 8 years) times her three highest consecutive years of compensation. for eight years. such as a 401(k) plan.000 for 2012 Any plan funding formula that requires the use of the employee’s compensation cannot consider any compensation above the covered compensation limit Defined Benefit Plans (Benefit Limit) The lesser of: o o $200.000 (25% x $40. a participant of the plan.000 has an accrued benefit equal to $10. The plan has been determined to be top-heavy for the year. o Example 3.
a long-term employee with compensation of $135. $325. because Jose has continued to work past his normal retirement age.000. and Employee Contributions.000 for 2012 Example 3. his highest consecutive years of compensation. age 68. and $350. his benefit will be increased to an amount actuarially equivalent to what it would have been if he had taken it at his normal retirement age.000 for 2012. o Multiple Plan Limitations An employer maintains both a defined benefit plan and a defined contribution plan General rule. Inc. Defined Contribution Plans Maximum contribution for the year o Lesser of: Limit consists of: o o o Employer Contributions. An individual who participates in a defined benefit plan for less than 10 years must reduce the calculated maximum benefit by 10% for every year less than 10 There are certain circumstances that may create the need to retire early.000 of forfeiture allocations. he will receive $200.000 for the plan year. Ashley could still defer $14.500 profit sharing plan contribution and $2.$33. or $50.000) annually.000 is $30.consecutive years compensation. and Any forfeitures allocated to participants account 100% of an employee’s compensation. or retire later as an incentive to accrue additional benefits o Example 3.000 .000) in the 401(k) plan to maximize her annual contribution limit of $50.000 for the past three years.000. The maximum benefit Trinity Audio can provide Ronald with at retirement considering the plan formula and the 2012 covered compensation of $250.000 (1% x 12 x $250.43 Pretzels. has received a $33.$2. However. Ronald has earned $275. age 46. maximum deductible is the GREATER of: 25% of the employer’s covered compensation. sponsors a defined contribution plan for its employees. Jose has calculated that under the company's defined benefit plan. has been employed by Whole Drinks Store for 39 years. Ashley.42 Jose. or The required minimum funding standard of the defined benefit plan No employees who benefit under both plans If the DB plan is subject to PBGC If a plan is multiemployer Multiple plan limitations does not apply in certain cases: .500 . He began employment as a grocery clerk and is now the President of the company.500 ($50.000 per year after his retirement.
Salary deferrals total $50.000 x 25%)$120.000.000.000 or 46%. then $54. If the required funding for the defined benefit plan is $50.000. then how much can be contributed to the profit-sharing plan? The answer is $225. In this case.000. Example 3.000.000) for the current year. then how much can be contributed to the profit-sharing plan? The answer is $75. The actuary has determined that a contribution of $120.000 must be made to the defined benefit plan.000 (6% of $900.000 had to be made to the defined benefit plan. Example 3. If the plan was not insured with the PBGC.000 for a total deduction of $460. If the required funding for the defined benefit plan is $200.000 for the defined benefit plan.000. The covered compensation for Saben LLC is $900.000. Controlled Groups o o o A controlled group consists of two or more commonly owned corporations The controlled group rules are intended to prevent potential abuses by taxpayers Types: o o Parent—subsidiary controlled groups Brother—sister controlled groups IRC – controlled groups are treated together for testing and limits IRC – provides similar treatment for nonincorporated businesses .44 Mary’s Carpentry Supplies (MCS) operates a defined benefit plan not covered by PBGC insurance and a defined contribution plan.000 since the plan is covered by the PBGC and the multiple plan limits do not apply.000) could be contributed to the profit sharing plan.45 Consider the same facts as above except that the actuary determined that a contribution of $400. In this case. Notice that the contributions to the defined contribution plan are in excess of 6%. MCS can make a tax deductible profit sharing plan contribution on behalf of its employees up to $130.000. the limits do not apply Example 3.000 and the $50.000.47 Saben LLC sponsors both a defined benefit plan and a profit sharing plan with a cash or deferred arrangement. Salary deferrals are not considered for purposes of the combined limits If contributions to the DC plan to not exceed 6% of compensation. MCS can make a tax deductible contribution to the profit sharing plan of up to 6% or $60. or the difference between 25% of $500. Example 3. which sponsors both a defined benefit plan (not covered by the PBGC) and a profit sharing plan. The covered compensation for Notlad is $500. The defined benefit plan is covered by the PBGC. The annual covered compensation for MCS is $1.000 (($1.46 Cheryl owns Notlad.
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