Module 3 Profit-Sharing and Other Defined Contribution Plans Flashcards
All of the following statements regarding traditional profit-sharing plans are correct except
A)
the plans require the employer to assume the risk of poor investment performance.
B)
the plans may allow in-service distributions.
C)
the plans are suitable for employers with fluctuating cash flows.
D)
hardship withdrawals may be available.
a
Traditional profit-sharing plans are defined contribution plans with individual participant-controlled accounts, so the employee assumes the risk of poor investment performance.
LO 3.1.1
What is the maximum percentage of net self-employment income that can be a deductible contribution to a Keogh profit-sharing plan on behalf of the owner-employee?
A)
25%
B)
15%
C)
20%
D)
10%
c
Because this is a Keogh plan, a special calculation must be done to determine the maximum deductible contribution for the owner-employee. The contribution percentage is calculated by dividing the maximum employer-deductible contribution percentage (25%) by (1 + the percentage or .25). This results in an adjusted (and allowable) contribution percentage of 20% (25% ÷ 1.25).
LO 3.3.3
Which one of these statements about Roth 401(k) accounts is not correct?
A)
Even if a Roth 401(k) participant already has a Roth IRA account, a new five-year clock is required for the Roth 401(k).
B)
Unlike traditional Roth IRA accounts that have phaseouts based upon income, there are no income restrictions applicable to participation in a Roth 401(k).
C)
Just as with a Roth IRA, there are no required minimum distributions that must be made from a Roth 401(k) account.
D)
A Roth 401(k) can be rolled into a Roth IRA, but a Roth IRA cannot be rolled into a Roth 401(k).
c
Roth 401(k) accounts, just as with traditional 401(k) accounts, have required minimum distribution (RMD) rules that apply, meaning that distributions must start in the year the participant reaches age 73 (unless the participant is still working). This can be avoided by rolling the Roth 401(k) over into a Roth IRA because there are no required minimum distribution rules with Roth IRAs. There is a new clock that is started for a Roth 401(k) account, even if the participant already has a Roth IRA account. However, if a participant transfers the Roth 401(k) into a Roth IRA, then the Roth IRA clock will be the one that applies, not the Roth 401(k) clock.
LO 3.3.3
if a business owner-client is of an older age, near her retirement date, and just establishing a qualified plan, which of these plans would generally NOT be advantageous to the owner?
A)
Traditional profit-sharing plan
B)
An age-weighted profit-sharing plan
C)
New comparability plan
D)
Traditional defined benefit pension plan
a
A traditional profit-sharing plan would not allow the plan contributions to be skewed for the benefit of the owner. All of the other plan choices listed would allow greater contributions for the owner.
LO LO 3.2.1
An age-based (age-weighted) profit-sharing plan is a plan in which
A)
the employer contribution is allocated in such a way that the benefit at retirement is guaranteed.
B)
compliance with the nondiscrimination (coverage) rules is tested in accordance with contributions rather than benefits.
C)
younger employees generally receive the greatest allocation.
D)
allocations to participants are made in proportion to the participant’s age-adjusted compensation.
d
A participant’s compensation is age-adjusted by multiplying the participant’s actual compensation by a discount factor based on the participant’s age and the interest rate elected by the plan sponsor. As a result, older employees generally receive the greatest allocation under an age-based profit-sharing plan. Nondiscrimination rules are tested in accordance with benefits rather than contributions. The final retirement benefit is not guaranteed in any type of profit-sharing plan.
LO LO 3.2.1
An age-weighted profit-sharing plan is appropriate when
a closely held business or professional corporation has a relatively large number of key employees who are approximately age 50 or older.
there are older employees whose retirement benefits would be inadequate under a traditional profit-sharing plan because of the relatively few years remaining for participation in the plan.
an alternative to a defined benefit plan is needed to provide older employees adequate retirement benefits but has the lower cost and simplicity of a defined contribution plan.
the employer wants to terminate an existing defined benefit plan to avoid the increasing cost and regulatory burdens associated with these plans.
A)
I, II, and III
B)
III and IV
C)
I, II, III, and IV
D)
I and II
All statements are correct.
LO LO 3.2.1
The major difference between a stock bonus plan and a traditional profit-sharing plan is that
A)
the maximum annual additions limit is higher for a stock bonus plan.
B)
a stock bonus plan generally distributes benefits in employer stock, not cash.
C)
in a stock bonus plan, the employer can only contribute employer securities to the plan.
D)
a profit-sharing plan is subject to nondiscrimination requirements while a stock bonus plan is not.
A stock bonus plan generally distributes benefits in employer stock, not cash. The maximum annual additions limit is $66,000 in 2023 for all defined contribution plans. In a stock bonus plan, the employer can contribute either cash or employer securities to the plan. The contributions are determined in a variety of ways (a percentage of either profits or covered payroll). Stock bonus plans are subject to the same nondiscrimination requirements as profit-sharing plans.
LO 3.2.2
Which of the following is NOT a characteristic of an owner-employee’s participation in a Keogh plan?
A)
Lump sum distribution treatment is not available to an owner-employee who is under age 59½ and separates from service.
B)
Lump sum distribution treatment may be available to the owner-employee if the distribution is due to the owner-employee’s death or disability.
C)
The employer contribution to the owner-employee’s account is based on net earnings (with required modifications) rather than on W-2 compensation.
D)
An owner-employee may not get a retirement plan loan based on her individual account because that would be a prohibited transaction.
d
Common-law employees, an owner-employee in a sole proprietorship, a partner in a partnership, or a shareholder-employee in an S corporation may borrow from their plan accounts, in accordance with plan provisions. It would be a prohibited transaction for the retirement plan to loan overall plan assets to an owner-employee. However, getting a normal retirement plan loan based on the owner-employee’s particular account under the same rules as anyone else would not be a prohibited transaction.
LO 3.3.3
Which of the following plans is a qualified defined contribution profit-sharing plan that gives participants the option of reducing their currently taxable compensation by contributing on a pretax basis to an individual account for retirement purposes?
A)
Section 403(b) plan
B)
Money purchase pension plan
C)
Section 401(k) plan
D)
Simplified employee pension (SEP) plan
The statement describes a Section 401(k) plan. A Section 403(b) plan is a retirement plan that is available to certain tax-exempt organizations and to public schools that allows employee elective deferrals but is not a qualified plan. A money purchase pension plan is a defined contribution plan that specifies an employer level of contribution (for example, 10% of salary) to each participant’s account each year. A SEP plan is not a qualified plan and does not allow employee elective deferrals.
LO 3.1.1
Gwen is 38 years old and hopes to retire at age 60.
She is president and 100% owner of BaseLine Economics Inc.
Gwen is paid $190,000 in salary plus bonuses by the corporation.
BaseLine Economics Inc. employs five rank-and-file employees with annual salaries ranging from $20,000 to $50,000.
Rank-and-file employees range in age from 28 to 56; turnover among these employees is low.
Cash flow for BaseLine Economics Inc. has been increasing for the past five years and is expected to increase in the future.
Gwen would like to implement a qualified plan that will maximize her retirement benefits and minimize corporate income taxes.
Which of the following are advantages of adding a 401(k) provision to the profit sharing plan?
The 401(k) feature will permit the participants to save money pretax.
Employee contributions will still be subject to FICA and FUTA.
The 401(k) feature can be integrated to give Gwen an even greater deferral amount.
Adding a 401(k) plan to the profit-sharing plan can help BaseLine Economics Inc. to fund the employees’ retirement account, but it will not increase the limit of 25% of aggregate covered compensation.
A)
I, II, and IV
B)
I and III
C)
II, III, and IV
D)
I and IV
a
Option I is true. Option II is true. Employee contributions are subject to FICA and FUTA; however, employer contributions would not be subject to FICA or FUTA. Option III is not true because deferrals and matching contributions may not be integrated. Option IV is true. Profit sharing plans allow an employer to contribute up to 25% of covered compensation, but very few employers actually do. By adding a 401(k) with a match and/or a nonelective contribution, the employer will have an additional avenue to contribute to the retirement plan, but the overall employer contribution limit of 25% of covered compensation is not changed.
LO 3.3.1
Garces Product Wholesalers, Inc., a regular C corporation, is considering the adoption of a qualified retirement plan. The company has recently had fluctuating cash flows, and such fluctuations are expected to continue. The average age of nonowner employees at Garces Products is 24, and the average number of years of service is three, with the high being four and the low being one. Approximately 25% of the 12-person labor force turns over each year. The salaries of the two owners account for approximately two-thirds of covered compensation. Which is the most appropriate plan for Garces Product Wholesalers?
A)
Target benefit pension plan
B)
Defined benefit pension plan
C)
Profit-sharing plan
D)
Money purchase pension plan
C
I figured this one out with this logic.
You don’t want to HAVE to contribute to pension plans if you don’t have stable/predictable cash flows. If you have a profit sharing plan, then you share profits when there are profits.
Irregular cash flows suggest a profit-sharing plan. All of the other plans listed have some mandatory contribution component.
LO 3.1.1
Bland Foods, Inc., has six owners, ranging in age from 30 to 60 years old, and 25 employees. The owners want to adopt a qualified retirement plan that would allow them to maximize the contributions to the owners’ accounts and to minimize the contributions to the employees’ accounts. Which of the following plans would best meet the owners’ needs?
A)
Age-based profit-sharing plan
B)
New comparability plan
C)
Target benefit pension plan
D)
Section 401(k) plan
B
A new comparability plan would allow the owners to divide the participants into two classes and allocate different contribution levels to the classes. An age-based profit-sharing plan or a target benefit pension plan wouldn’t meet their objectives because the owners’ ages are significantly different. Restrictive nondiscrimination testing in a Section 401(k) plan would not favor the ownership group.
LO LO 3.2.1
In a Section 401(k) plan, which of the following must be considered in complying with the maximum annual additions limit?
Employee after-tax contributions
Catch-up contributions for an employee age 50 or older
Dividends paid on employer stock held in a Section 401(k) plan
Employer qualified non-elective contributions
A)
I and IV
B)
III and IV
C)
I and III
D)
I and II
a
Statement I is correct. Employee after-tax contributions are counted against the annual additions limit. Statement II is incorrect. Catch-up contributions for an employee age 50 or older are not counted against the annual additions limit. Note that catch-up contributions are also not taken into account for purposes of ADP testing or plan limits. Statement III is incorrect. Earnings on plan investments are not taken into account when computing the maximum annual additions limit. Statement IV is correct.
LO LO 3.3.1
Safe harbor 401(k) plans are designed primarily for
A)
small employers that are administratively unable to meet the regulatory requirements set forth by the Department of Labor.
B)
any British Virgin Islands domiciled employer that is administratively unable to meet the regulatory requirements set forth by the Department of Labor.
C)
any nongovernmental employer that is administratively unable to meet the regulatory requirements set forth by the Department of Labor.
D)
large employers that are administratively unable to meet the regulatory requirements set forth by the Department of Labor.
c
Safe harbor 401(k) plans are designed primarily for any domestic, nongovernmental employer is eligible establish a safe harbor 401(k). The number of employees within the organization is not an issue. The point of a safe harbor 401(k) is to give the nonhighly compensated employees a sufficient benefit so that the highly compensated can save more money and also to avoid the costs of full nondiscrimination testing.
LO 3.3.1
Which of these qualification requirements applies to an employee stock ownership plan (ESOP)?
A)
At retirement, a lump-sum distribution of employer securities is subject to ordinary income tax on the fair market value of the securities at the time of the distribution.
B)
Stock is sold via a public offering and the cash received on the sale is contributed to the qualified plan by the employer.
C)
Assets may be invested primarily in qualifying employer securities.
D)
No more than 50% of plan assets may be invested in employer securities.
c
ESOP assets may be invested primarily in employer securities. This is an exception to the normal rule prohibiting more than 10% of qualified plan assets to be held in employer stock or securities. In an ESOP, stock is not sold to the public, but, rather, the plan trustee purchases stock from the employer. A lump-sum distribution of employer securities may be eligible for NUA treatment and LTCG taxation on the NUA portion, rather than ordinary income taxes on the entire distribution.
LO 3.2.2
Safe harbor Section 401(k) plans are appropriate for employers who
want to encourage plan participation among highly compensated employees.
want a plan that must be tested annually for coverage requirements.
want to provide for a high level of employee elective deferrals without annual discrimination testing.
have highly compensated employees whose elective deferrals would be limited in a traditional Section 401(k) plan because of ADP testing.
A)
I and II
B)
III and IV
C)
I, II, and III
D)
I, II, III, and IV
Statements III and IV are correct. Safe harbor Section 401(k) plans are appropriate for employers who want a plan that does not need to be tested annually for coverage requirements and encourages plan participation among rank-and-file employees. These plans also ease the employer’s administrative burden and costs by eliminating the tests ordinarily applied under a traditional Section 401(k) plan.
LO LO 3.3.1
Which of these statements about a solo 401(k) plan for 2023 is CORRECT?
A)
Contributions to a solo 401(k) do not make the person an active participant for IRA deduction purposes.
B)
A solo 401(k) enables the sole proprietor to contribute up to 25% into the plan as the business contribution, and the owner can also personally defer up to $22,500 (plus an additional $7,500 if age 50 or older).
C)
A solo 401(k) enables the unincorporated business to contribute up to 20% into the plan for the owner, and the owner can also personally defer up to $22,500 (plus an additional $7,500 if age 50 or older).
D)
A solo 401(k) enables the unincorporated business to contribute up to 20% into the plan for the owner, and the owner can also personally defer up to $15,500 (plus an additional $3,500 if age 50 or older).
c
This is a big advantage of solo 401(k)s—the ability to have both the business and owner contribute to the plan. Contributions to a solo 401(k) would make the person an active participant.
LO 3.3.3
Which of the following is a permitted vesting schedule for a SIMPLE 401(k)?
Three-year cliff
Two-to-six-year graded
100% immediate vesting
Three-to-seven-year graded
A)
I, II, and III
B)
IV only
C)
III only
D)
I, II, III, and IV
III
Vesting schedules are not permitted in SIMPLE 401(k)s. Employees are always 100% vested in employer contributions.
LO 3.3.3
Which statements describe one or more characteristics of hardship withdrawals from Section 401(k) plans?
Hardship withdrawals may be taken only from elective deferral amounts and nothing else.
The participant must demonstrate “immediate and heavy financial need” and not have any other resources that are “reasonably available.”
A hardship withdrawal is exempt from the 10% early withdrawal penalty if the participant has not reached age 59½.
Hardship conditions must be established for hardship withdrawals from profit sharing or stock bonus 401(k) plans.
A)
I and III
B)
II and IV
C)
II, III, and IV
D)
I and II
II IV
Hardship withdrawals from profit sharing or stock bonus Section 401(k) plans require that hardship conditions (“immediate and heavy financial need” and other resources not “reasonably available”) be demonstrated. Today, hardship withdrawals can be taken from all the following sources: worker deferrals, QNECs, and QMACs. In addition, the earnings on these sources are also available for hardship withdrawals.
George Cobb owns Cobb Construction Inc., which is worth $3 million with an annual payroll of $1.3 million. George receives a salary of $300,000. The company initiated a profit-sharing plan last year and makes contributions at year-end. The plan has about $120,000 in assets. George’s account has a balance of $28,000. He is 60 and wants to retire this year and sell his company. His problem is that the construction industry is very slow this year, and the major companies are retrenching, not expanding. George’s company is very profitable from year to year, earning a profit of $550,000 to $650,000 each year. George has an excellent management team in place that he has carefully built and trained over the years. His bank approached him recently, offering to loan him almost any amount, up to the value of his company, at 8%. Typically such loans are amortized over no more than 10 years.
How can George use a qualified plan to accomplish his goal?
A)
George should amend the company profit-sharing plan and make it an employee stock ownership plan (ESOP) and have the ESOP buy his stock.
B)
George should amend the company profit-sharing plan and make it a leveraged employee stock ownership plan (LESOP), then have the plan borrow $3 million and buy his stock.
C)
George should have the company profit-sharing plan borrow $3 million and buy his stock.
D)
George should borrow $3 million from the bank and retire.
b
George should amend the profit-sharing plan, making it a LESOP. Then, as the LESOP trustee, he can borrow $3 million in the name of the LESOP from a bank familiar with LESOP loans. The LESOP will receive $3 million from the loan and it will use the proceeds to buy George’s $3 million worth of stock and become the owner of the company. George will receive the $3 million in cash and retire. Only a LESOP can borrow money. Borrowing $3 million doesn’t extract the value of his company for his benefit; it only creates debt and a nondeductible interest cost.
LO 3.2.2
Under profit-sharing plans
A)
the employer is legally obligated to make annual contributions.
B)
contribution formulas are usually based upon length of service.
C)
annual contributions are not mandatory, but the employer is obligated to make recurring and substantial contributions.
D)
in-service withdrawals are not permitted.
c
Under profit-sharing plans, the employer has flexibility in the contributions and in-service withdrawals are permitted. The contribution formula is usually based on an employee’s compensation, not length of service.
LO 3.1.1
Which statement regarding the plan trustee of an employee stock ownership plan (ESOP) is FALSE?
A)
is using leverage when the trustee borrows money to purchase the employer’s stock.
B)
can borrow funds to purchase employer stock.
C)
cannot borrow funds to purchase employer stock.
D)
uses loan proceeds to purchase stock of the employer from the corporation itself.
The answer is cannot borrow funds to purchase employer stock. This is FALSE. An ESOP may or may not have provisions for borrowing. An ESOP that has provisions for borrowing is known as a LESOP (leveraged ESOP). The employer receives the loan proceeds immediately. The loan can be used to purchase stock of the employer from the corporation or from the current owner and is paid back from employer contributions to the ESOP. Borrowing money is using leverage.
LO 3.2.2
Which of the following are CORRECT statements about profit-sharing plans?
They are permitted to invest plan assets in qualifying employer securities.
They are not subject to Employee Retirement Security Act of 1974 (ERISA) diversification requirements for investments made in qualifying employer securities.
They are subject to minimum funding requirements.
They are subject to Pension Benefit Guaranty Corporation (PBGC) coverage.
A)
II and III
B)
I and IV
C)
III and IV
D)
I and II
I II
Profit-sharing plans are permitted to invest in qualifying employer securities and are not subject to ERISA’s diversification requirements. Note: Profit-sharing plans are not subject to PBGC coverage.
LO 3.1.1
Marietta Marine, Inc., has a traditional Section 401(k) plan. The actual deferral percentage (ADP) for all eligible non-highly compensated employees (non-HCEs) is 4%. What is the maximum ADP for the eligible highly compensated employees (HCEs) group at Marietta Marine?
A)
5.25%
B)
5.5%
C)
6%
D)
4%
6%
The answer is 6%. The maximum ADP for the HCEs group at Marietta Marine, Inc., is 6%. The ADP for eligible HCEs must not exceed the ADP for other eligible employees by more than 2%, and the ADP for the eligible HCEs group must not be more than the ADP of all other eligible employees multiplied by 2. The other test is the 1.25 times test. In this case the answer is 5.% (4 × 1.25). Since 6% is higher, it is the limit here.
LO 3.3.2
A Section 401(k) plan allows plan participants the opportunity to defer taxation on a portion of regular salary or bonuses simply by electing to have such amounts contributed to the plan instead of receiving them in cash. Which of these statements are rules that apply to Section 401(k) plans?
Section 401(k) elective deferrals are immediately 100% vested and cannot be forfeited.
A Section 401(k) plan may allow in-service distributions.
Eligible catch-up contributions are not considered in the application of the maximum annual additions limit.
The maximum elective deferral contribution for 2023 is $22,500, with an additional $7,500 catch-up for individuals age 50 or older.
A)
I, II, and III
B)
I, II, III, and IV
C)
I, III, and IV
D)
II, III, and IV
all
Albert, 52, is the sole proprietor of a consulting business that will have Schedule C net income of $80,000 this year. The business maintains a profit-sharing Keogh plan and Albert is the only plan participant. What is the maximum that can be contributed to the plan this year on Albert’s behalf? The self-employment tax for Albert is $11,304.
A)
$16,680
B)
$23,500
C)
$14,870
D)
$20,000
Schedule C net income $ 80,000
Less 7.65% (6,120)
Self-employment income subject to self-employment taxes $ 73,880
Times 15.3%
Self-employment tax $ 11,304
One-half of the self-employment tax is deductible as an adjustment to income. In this example, the deductible portion is $5,652 ($11,304 ÷ 2).
Determine the adjusted contribution percentage for the Albert, the business owner.
Maximum percentage contribution for participants
(employee %)
.25
Divided by (1 + employee %) 1.25
Equals adjusted contribution percentage for owner = .20
Schedule C net profit (business profit) $80,000
Less income tax deduction allowed (1/2 self-employment tax) ($5,652)
Net earnings from self-employment $74,348
Multiply by .20 =
Owner’s contribution $14,870
Note that $14,870 is 25% of $59,478 and $59,478 is the amount you get from taking the net earnings of $74,348 and subtracting $14,870. Thus, the IRS would argue that the self-employed owner is getting the same 25% contribution as the worker after all the accounting is factored in.
LO 3.3.3
Which of the following statements regarding stock bonus plans and employee stock ownership plans (ESOPs) are CORRECT?
They allow employees to defer all income taxes on distributed stock until the stock is sold.
They can be costly and administratively cumbersome.
They always decrease corporate cash flows.
They create a market for employer stock.
A)
I, II, III, and IV
B)
II and IV
C)
II and III
D)
I and II
Statements II and IV are correct. Both ESOPs and stock bonus plans give employees a stake in the company through stock ownership. They may increase company cash flow because employers make cashless contributions to the retirement plan and create a market for employer stock. In addition, they both limit the availability of retirement funds to employees if an employer’s stock falls drastically in value and create an administrative and cash-flow problem for employers by requiring them to offer a repurchase option (put option) if their stock is not readily tradable on an established market. Employees must pay income tax on the value of the stock contributed to the plan at the time of distribution. Gain on the stock before a lump-sum distribution is net unrealized appreciation and is not taxed until the employee-participant sells the stock.
LO 3.2.2
The ABC Company’s 401(k) has just been changed to allow Roth elective deferrals. Which of these does a Roth 401(k) plan have in common with a Roth IRA?
They both are phased out for higher income earners.
Withdrawals after age 59½ are tax free if the account is at least five years old.
Contributions are not deductible.
They are both subject to required minimum distributions (RMDs) for retirees starting after attaining age 73.
A)
I and IV
B)
II and IV
C)
II and III
D)
I and II
c
Although Roth IRAs have an additional reason for qualified distributions (up to $10,000 of first-time homebuyer expenses), a distribution from either type of Roth account after five years and over age 59½ would be a qualified distribution. No type of Roth contribution is deductible. Roth IRAs are not subject to RMDs while the original owner is alive, but employer Roth accounts for retirees are subject to the normal RMD rules. Roth IRAs are phased out for higher earners, but not for employer Roth accounts.
LO 3.3.3
