8. Plan Selection for Businesses

Question 1

Tax considerations for business owner in sole proprietorship/partnership

Answer 1

contributions to all retirement accounts within limits are tax-deductible to the owner.

Qualified plans for sole proprietorships and partnerships are Keogh plans and work the same as corporate aside from Keogh’s plan contribution is based on earned income as opposed to compensation; however self-employment tax must be computed:
-Determine net income from Sched C
- Subtract .5 of actual amount of self-employment tax
-Multiply by net contribution rate from table
OR:
Plan contribution rate/(1+Plan contribution rate)

Question 2

Calculation of capital needs at retirement

Answer 2

Replacement ratio, life expectancy, inflation rates and rate of return are used to determine lump sum required

Question 3

Calculation of capital needs at death

Answer 3

Buy-and-sell agreements funded by life and/or disability income insurance on the owner’s life can ensure continuation of business.

Question 4

Steps to design pension plan

Answer 4

-gathering relevant facts
-identification of employer objectives
-choose plan features

Question 5

Pension plan types

Answer 5

• Defined Benefit Pension Plan
• Cash Balance Pension Plan
• Target Benefit Pension Plan
• Money Purchase Pension Plan

Question 6

Exceptions to federal income tax on income from savings

Answer 6

-Tax deferral of gains in qualified plans, IRA’s, Section 529 College Savings plans, Coverdale Plans for education, annuity, and life insurance contracts.
- Tax deferral on capital gains until realized
- Limited exclusion of gain on sale of personal residence

Question 7

Compensation policy

Answer 7

• Recruit
• Reward
• Retain
• Retire

Question 8

How does a business encourage productivity

Answer 8

Plans whose contributions are profit-based or accounts invested in employer stock

Question 9

How to Discourage Collective Bargaining

Answer 9

attractive retirement package

Question 10

Tax benefits for qualified plan

Answer 10

-Amounts paid into plan are employer contributions/employee salary reduction contributions which are deductible/excludable in year paid
-Tax exempt fund: earnings accumulate tax-free
- lump sum benefits may be eligible for 10 year averaging(employees born <1936)
-tax benefits add up to substantial tax leverage, since it’s like an interest free loan from the US Treasury

Question 11

DC plans

Answer 11

Each plan participant account balance may include:
-employer contributions including forfeitures
-employee contributions
-earnings on account balance

3 principal types:
-money purchase
-target benefit
-profit sharing

Question 12

Money purchase plan

Answer 12

• employer is required to contribute fixed and stated amount to plan
• max deductible employer contribution may be up to 25% of aggregate covered compensation
  -used for collective bargaining agreement with a union, which won’t accept profit sharing since there is no min funding standard

Question 13

Target benefit pension plan

Answer 13

-employer must make annual contributions under formula based on compensation and age at plan entry so that each participant has approx same benefit level as a percentage of compensation for each participant at retirement

Question 14

Profit-sharing plan

Answer 14

DC plan based on profits, allocated to participant’s account using non-discretionary formula (based on compensation and service, can also be age-weighted)

May elect to adopt 401k provisions: salary reduction deferrals or cash/deferred arrangements for plan

IRC limit on employee deferrals is $22,500, plus catch up of $7,500 for 50+/

Annual additions limited to lesser of 100% compensation/$66,000 except for catch up of $7,500

Question 15

Designer’s goal in designing a retirement plan

Answer 15

Maximize benefits for those who want them and choose one that will be perceived as valuable by max number of employees

Question 16

Pure cost of plan

Answer 16

Money spent on plan benefits for employees who do not value them

Question 17

Techniques to maximize HCEs

Answer 17

• DB plans
• service based contribution or benefit formula
  -age weighting and cross testing
  -combination of DB & DC plans
  -401k plans
  -social security integration

Question 18

DB plans more favorable by key employees

Answer 18

*Assumptions must be reasonable:
Actuarial assumptions,
Retirement age and late retirement provisions,
Form of benefits, and
Level of Social Security integration

For employers:
- relatively easy to design a window plan to encourage early retirement.
-can be designed to allow full benefits to accrue after a specified period with no further benefits accruing thereafter.

Question 19

new comparability plan

Answer 19

designed to maximize benefits to controlling employees by using cross-testing so that projected benefits at retirement age is used in nondiscrimination regulation

Question 20

Combination of DB and DC plans

Answer 20

Possible after 1999, subject to overall limitation on employer deductions equal to 25% of covered payroll

Question 21

401(k)

Answer 21

ADP tests inherently allow higher rate of contribution for HCE, but also require max participation of NHCE for HCEs to fully enjoy extra contribution levels unless a SIMPLE of safe harbor 401(k) plan design is used.

Question 22

Valuable savings medium

Answer 22

Defined Contribution Plans
Cash Balance Plans
Plans with Employee Participation

Question 23

Cash balance plance

Answer 23

• Employer assumes investment risk and guarantees principal and interest rate.
• Operates like a DC money purchase plan.
• Provides >benefits to younger employees and those with shorter service than oter DB plans

Question 24

Adequate replacement income

Answer 24

ratio of post-retirement income to that received just before retirement, generally higher for lower-paid employees; previously 50-70% acceptable, however 80-85% desirable
DB plan is the best vehicle to reach this objective

Question 25

Objective: Adequate Replacement Income

Answer 25

Defined Benefit Plan

Question 26

Objective: Maximize Highly Compensated Benefits

Answer 26

Defined Benefit Plans
Service-based Contribution or Benefit Formula
Age-weighting and Cross-testing
Combination of DB and DC Plans
401(k) Plans
Social Security Integration

Question 27

Objective: Valuable Savings Medium

Answer 27

Defined Contribution Plans
Cash Balance Plans
Plans with Employee Participation

Question 28

Objective: Maximize Employee Performance

Answer 28

Profit sharing plans
ESOP/Stock bonus plan
DC or cash balance

Question 29

Objective: Minimize Turnover

Answer 29

Defined Benefit Plan
Graduated Vesting

Question 30

Objective: Encourage Retirement

Answer 30

Defined Benefit Plan: can be designed to allow full benefits to accrue after a specified period, such as 25 years, with no further benefits accruing thereafter, and can design a flexible window plan to encourage early retirement

Question 31

Objective: Maximize Employer Contribution Flexibility

Answer 31

Profit sharing plan- If a profit Sharing plan contains 401(k) provisions, the IRS will determine that the plan has met its standard of “substantial and recurring” contributions. Therefore, the employer never has to make a contribution to the plan.
Administrative Costs

Question 32

Lynn has net earnings from self-employment of $120,000 annually with self-employment tax of $16,596. If she maintains a profit-sharing plan with 25% annual contributions what is the maximum contribution she can make to her account this year?

Answer 32

Lynn may contribute $22,340 to her profit-sharing account this year.

$120,000 – (50% x $16,596) = $111,702

$111,702 x 0.20 (0.25 ÷ 1.25) = $22,340

Question 33

what is the maximum deductible employer contribution to a money purchase pension plan?

Answer 33

25% of aggregate covered compensation.

Question 34

Who bears the investment risk in a target benefit pension plan?

Answer 34

A target benefit pension plan is a defined contribution plan. All defined contribution plans have employee-directed individual accounts, and the employee bears the investment risk.

Question 35

Which of the following plans is suitable for a company that wants to make currently deductible contributions to a retirement plan but does not want the contributions to be currently taxable to the participant?

Answer 35

A SIMPLE meets the employer’s objectives. An NQ deferred compensation plan and a SERP is not currently deductible to the employer. A Section 162 bonus plan is currently taxable to the employee/participant.