Retirement: 4 Fundamentals of 401k Plans Flashcards Preview

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Flashcards in Retirement: 4 Fundamentals of 401k Plans Deck (80)
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1

Retirement 4-1: Basic characteristics of a 401(k) plan

A 401(k) plan must allow plan participation to any employee who

1. has completed one year of service and has worked a minimum of 1,000 hours during that period, and

2. is at least __ years old.

a. 17

b. 18

c. 21

c. 21

2

Retirement 4-1: Basic characteristics of a 401(k) plan

Matching contributions from employers (called 401(m) contributions); employers can match employee contributions in whole or in part. These matching contributions are tax deductible for the employer to the extent that they do not exceed certain limits (__% of participating employees’ payroll).

a. 5%

b. 20%

c. 25%

c. 25%

3

Retirement 4-1: Basic characteristics of a 401(k) plan

Example. Uptick Financial Group Inc. established a 401(k) profit sharing plan and elected in the plan documents to make matching contributions equal to 50% of each participant’s 401(k) deferrals, up to 15% of compensation. Jeff, an Uptick employee, earns $60,000 annually and makes employee deferrals equal to 20% of his earnings. What is the total amount going into the plan for Jeff?

a. $15,500

b. $16,500

c. $17,500

b. $16,500

$60,000 Income
* 20% EE contribution election
= $12,000 EE contribution

$60,000 Income
* 15%
= $9,000
* 50%
= $4,500 Employer Match

$12,000 EE contribution
+ $4,500 Employer Match
= $16,500 total amount going into the plan

First, let’s look at the matching contribution. Uptick will make a total matching contribution of $4,500 ($60,000 × .15 = $9,000; this means that Uptick will match each dollar that Jeff contributes up to $9,000 with 50
cents). The first $9,000 that Jeff contributes will then be matched with $4,500. The additional $3,000 that Jeff contributes will not be matched. So the total contributed to the plan for Jeff for the year would be $16,500: $12,000 from Jeff and $4,500 from the employer.

4

Retirement 4-1: Basic characteristics of a 401(k) plan

Example. Uptick Financial Group Inc. established a 401(k) profit sharing plan and elected in the plan documents to make matching contributions equal to 50% of each participant’s 401(k) deferrals, up to 15% of compensation. Jeff, an Uptick employee, earns $60,000 annually and makes employee deferrals equal to 5% of his earnings. What is the total amount going into the plan for Jeff?

a. $3,000

b. $4,500

c. $5,500

b. $4,500

5% of $60,000 would be $3,000, and Uptick would match 50 cents for each dollar, making the company match $1,500, for a total of $4,500 going into the plan for Jeff. Note that in this case Jeff is leaving “free money” on the table, as he is not taking full advantage of the match.

5

Retirement 4–2: Minimum coverage rules for 401(k) plans

The percentage of eligible nonhighly compensated
employees benefiting from the plan must be at least 70% of the percentage of eligible highly compensated employees benefiting from the plan.

a. The ratio percentage test

b. Average benefits percentage test

a. The ratio percentage test

6

Retirement 4–2: Minimum coverage rules for 401(k) plans

Both parts of this two-part test must be satisfied:

The plan must be nondiscriminatory and benefit a class of employees that reflects a reasonable business-related classification (the classification test).

The average benefit percentage for eligible non-highly compensated employees must be at least 70% of the average benefit percentage for eligible highly compensated employees

a. The ratio percentage test

b. Average benefits percentage test

b. Average benefits percentage test

7

Retirement 4–2: Minimum coverage rules for 401(k) plans

If the ADP test for a plan year is not satisfied, the portion of the 401(k) plan attributable to elective contributions—or, most likely, the plan in its entirety— will no longer be qualified. Fortunately, plan administrators have several mechanisms for making corrections, and they can use one or more of them to bring the plan into compliance with the test:

They can distribute excess contributions and
allocable income. This would mean returning part of the contributions made by highly compensated employees (HCEs), thus bringing down the HCE’s percentage.

a. Corrective distributions

b. Recharacterization.

c. Qualified matching contributions (QMACs)

d. Qualified nonelective contributions (QNECs)

a. Corrective distributions

8

Retirement 4–2: Minimum coverage rules for 401(k) plans

If the ADP test for a plan year is not satisfied, the portion of the 401(k) plan attributable to elective contributions—or, most likely, the plan in its entirety—
will no longer be qualified. Fortunately, plan administrators have several mechanisms for making corrections, and they can use one or more of them to
bring the plan into compliance with the test:

They can recharacterize excess contributions as
voluntary employee after-tax contributions, so HCEs would have part of their contribution treated as having been made after-tax rather than pretax. This would lower the ADP percentage for HCEs but would raise the ACP percentage for HCEs, making it more likely that the ACP test would fail.

a. Corrective distributions

b. Recharacterization.

c. Qualified matching contributions (QMACs)

d. Qualified nonelective contributions (QNECs)

b. Recharacterization.

9

Retirement 4–2: Minimum coverage rules for 401(k) plans

If the ADP test for a plan year is not satisfied, the portion of the 401(k) plan attributable to elective contributions—or, most likely, the plan in its entirety—will no longer be qualified. Fortunately, plan administrators have several mechanisms for making corrections, and they can use one or more of them to bring the plan into compliance with the test:

They can make and treat qualified matching contributions for nonhighly compensated employees (NHCEs) as elective contributions for purposes of satisfying the ADP test. When combined with employee deferrals, this would raise the ADP percentage for NHCEs, which could then satisfy the ADP test.

a. Corrective distributions

b. Recharacterization.

c. Qualified matching contributions (QMACs)

d. Qualified nonelective contributions (QNECs)

c. Qualified matching contributions (QMACs)

10

Retirement 4–2: Minimum coverage rules for 401(k) plans

If the ADP test for a plan year is not satisfied, the portion of the 401(k) plan attributable to elective contributions—or, most likely, the plan in its entirety—will no longer be qualified. Fortunately, plan administrators have several mechanisms for making corrections, and they can use one or more of them to bring the plan into compliance with the test:

They can make and treat qualified non-elective contributions for non-highly compensated employees as elective contributions for purposes of satisfying the ADP test. When combined with employee deferrals, this would raise the ADP percentage for NHCEs, which could then satisfy the ADP test.

a. Corrective distributions

b. Recharacterization.

c. Qualified matching contributions (QMACs)

d. Qualified nonelective contributions (QNECs)

d. Qualified nonelective contributions (QNECs)

11

Retirement 4–2: Minimum coverage rules for 401(k) plans

Penalties for excess contributions. As we have discussed, a plan can run afoul of the ADP or ACP tests if it provides an “excess contribution” to HCEs, and corrective action needs to be taken. If the correction is not made within a time prescribed by the IRC, the employer is subjected to a penalty equal to __% of the excess contribution

a. 6%

b. 10%

b. 10%

12

Retirement 4–2: Minimum coverage rules for 401(k) plans

Who is considered to be a highly compensated employee (HCE)? An HCE is any employee who:

Is a greater than 5% owner during the current or preceding year

Received compensation greater than $120,000 in 2015, which is the lookback year for 2016.

Alternatively, the employer may elect to classify only the top __% of all employees as HCE

a. 10%

b. 15%

c. 20%

c. 20%

13

Retirement 4–2: Minimum coverage rules for 401(k) plans

What criteria is taken into account for the ADP and ACP tests?

It looks at the average deferral percentage of the HCEs and the NHCEs.

a. The ADP test

b. The ACP test

a. The ADP test is the “actual deferral percentage” test

14

Retirement 4–2: Minimum coverage rules for 401(k) plans

What criteria is taken into account for the ADP and ACP tests?

It compares the percentage of employer matching contributions and employee after-tax contributions of the HCEs and the NHCEs.

a. The ADP test

b. The ACP test

b. The ACP test, the “actual contributions percentage” test.

It compares the percentage of employer matching contributions and employee after-tax contributions of the HCEs and the NHCEs.

15

Retirement 4–2: Minimum coverage rules for 401(k) plans

What is the maximum vesting schedule, if any, for the following types of contributions?

100% vested at all times

a. employee elective deferrals, qualified employer matching contributions, employer qualified non-elective contributions

b. employer matching contributions (regular), employer discretionary contributions

a. employee elective deferrals, qualified employer matching contributions, employer qualified non-elective contributions

16

Retirement 4–2: Minimum coverage rules for 401(k) plans

What is the maximum vesting schedule, if any, for the following types of contributions?

2- to 6-year graded or 3-year cliff

a. employee elective deferrals, qualified employer matching contributions, employer qualified non-elective contributions

b. employer matching contributions (regular), employer discretionary contributions

b. employer matching contributions (regular), employer discretionary contributions

17

Retirement 4–2: Minimum coverage rules for 401(k) plans

A profit sharing 401(k) plan, or any defined contribution plan, becomes top heavy if more than __% of account balances are attributed to key employees.

a. 20%

b. 40%

c. 60%

c. 60%

A defined contribution plan is top heavy if more than 60% of account balances are attributed to key employees.

18

Retirement 4–2: Minimum coverage rules for 401(k) plans

What minimum contribution amount must be made for NHCEs in a defined contribution plan?

There is a minimum contribution amount of _% required for NHCEs, unless the amount being contributed for the HCEs is less, then the amount contributed for the NHCEs must be the same.

a. 3%

b. 4%

c. 5%

a. 3%

If this occurs and 2% is being contributed for the HCEs, then 2% must be contributed for the NHCEs.

19

Retirement 4–2: Minimum coverage rules for 401(k) plans

The ____ test is calculated the same way. It compares:

1. the percentage of employer matching contributions

2. nondeductible employee contributions (in other words, employee after-tax contributions) made by or on behalf of nonhighly compensated employees
with the percentage of matching contributions and nondeductible employee contributions made by or on behalf of HCEs.

a. The ADP test

b. The ACP test

b. The ACP test: actual contribution percentage

20

Retirement 4–2: Minimum coverage rules for 401(k) plans

The ____ test compares the deferral rates of non-highly compensated participants (NHCEs) with those of their highly compensated colleagues (HCEs). The actual deferral ratio of an eligible employee is calculated by dividing his or her elective contributions for the plan year by his or her compensation for the plan year.

a. The ADP test

b. The ACP test

a. The ADP test: actual deferral percentage

21

Retirement 4–2: Minimum coverage rules for 401(k) plans

Example. Suppose an individual participates in a 401(k) plan that provides for matching employer contributions, does not allow employee after-tax contributions to be made, and requires an employee-participant to complete 1,000 hours of service to be eligible to receive an employer matching contribution. If this individual completes more than 500 hours of service during the plan year but fails to complete at least _____ hours, he or she won’t receive an employer matching employer contribution and will not be treated as benefiting from the matching feature of the plan.

a. 500

b. 750

c. 1,000

c. 1,000

Nevertheless, IRS rules require this individual to be counted for purposes of determining whether or not the plan’s IRC Section 401(m) feature satisfies the minimum coverage requirements. The plan’s 1,000
hour requirement could cause the plan to fail the IRC’s minimum coverage requirements.

22

Retirement 4–2: Minimum coverage rules for 401(k) plans

Example. Mantra Enterprises has calculated the ADP test for its 401(k) plan and has come up with the following deferral percentages:

5% ADP for NHCEs

7.5% ADP for HCEs

Mantra has failed the test, and needs to take action to bring the plan into compliance. How could the following solution help?

Corrective distributions. Mantra could return some of the amounts contributed by the HCEs, and bring their ADP down to _%

a. 5%

b. 6%

c. 7%

c. 7% (reducing the spread between the HCEs and NHCEs to 2%).

23

Retirement 4–2: Minimum coverage rules for 401(k) plans

Example. Mantra Enterprises has calculated the ADP test for its 401(k) plan and has come up with the following deferral percentages:

5% ADP for NHCEs

7.5% ADP for HCEs

Mantra has failed the test, and needs to take action to bring the plan into compliance. How could the following solution help?

Qualified matching contributions. Mantra could make qualifying matching contributions to NHCEs only, and bring the NHCE ADP up to __%. This would reduce the spread to the 2% minimum required. Note that only
NHCEs making deferrals would receive the match.

a. 5.5%

b. 6.5%

c. 7.5%

a. 5.5%

24

Retirement 4–2: Minimum coverage rules for 401(k) plans

Penalties for excess contributions. As we have discussed, a plan can run afoul of the ADP or ACP tests if it provides an “excess contribution” to HCEs, and
corrective action needs to be taken. If the correction is not made within a time prescribed by the IRC, the employer is subjected to a penalty equal to __% of the
excess contribution.

a. 6%

b. 10%

c. 20%

b. 10%

The penalty on excess contributions does not apply to the extent such contributions and earnings on these contributions are distributed (or forfeited, in the case of nonvested amounts) within six months after the close of the plan year. If such amounts are distributed during this time period, the distribution shall be taxable to the participant for the year that the distribution is made.

25

Retirement 4–3: Safe harbor 401(k) and QACAs

Safe harbor nonelective contribution. The safe harbor nonelective contribution requirement is satisfied if, under the terms of the plan, the employer is required to make a safe harbor nonelective contribution on behalf of each nonhighly compensated employee (NHCE) who is an “eligible employee.” Contributions must be equal to:

_% nonelective contribution for all eligible employees

and

all nonelective contributions must be 100% vested

a. 1%

b. 2%

c. 3%

c. 3%

If a safe harbor 401(k) plan provides a nonelective contribution, this contribution is not discretionary; it is required. Note that this 3% contribution goes to all
eligible employees, whether they are deferring into the plan or not.

26

Retirement 4–3: Safe harbor 401(k) and QACAs

Safe harbor matching formulas. The safe harbor matching formula requirement is satisfied if, under the terms of the plan, matching contributions are made (as
described below) on behalf of each NHCE who is an eligible employee. A safe harbor matching contribution is not discretionary; it is required. This is typically
not the choice of employers, since they want to encourage participation in the plan. Most employers prefer to do some sort of matching contribution.

The matching formula must be in an amount equal to

100% match on the first 3% of compensation and a 50% match on amounts between 3% and 5% of the employee’s compensation,

or

100% match on the first _% of compensation, and
all matches must be 100% vested.

a. 2%

b. 3%

c. 4%

c. 4%

27

Retirement 4–3: Safe harbor 401(k) and QACAs

Example. Laughlin Corporation’s 401(k) plan provides the following employer matching contributions: 100% of each employee’s elective contributions that do not exceed 3% of compensation, plus 50% of each
employee’s elective contribution between 3% and 5%. Therefore, the plan satisfies the basic matching formula and is deemed to satisfy the safe harbor test. John Johnson is eligible to be in the Laughlin 401(k) plan, and has deferred $2,000 during the year. His compensation during the year was $80,000.

How much is his match?

a. $2,000

b. $2,200

c. $3,200

a. $3,200

$80,000
* 3%
= $2,400

$80,000
* 2%
= $2,400
* 50%
= $1,600

$2,400
+ $1,600
= $3,200

28

Retirement 4–3: Safe harbor 401(k) and QACAs

Example. Laughlin Corporation’s 401(k) plan provides the following employer matching contributions: 100% of each employee’s elective contributions that do not exceed 3% of compensation, plus 50% of each
employee’s elective contribution between 3% and 5%. Therefore, the plan satisfies the basic matching formula and is deemed to satisfy the safe harbor test. John Johnson is eligible to be in the Laughlin 401(k) plan, and has deferred $2,000 during the year. His compensation during the year was $80,000.

How much is his match?

a. $2,000

b. $2,200

c. $3,200

a. $2,000

$80,000
* 3%
= $2,400

$2,400 > $2,000 contribution, so only $2,000 would be matched

29

Retirement 4–3: Safe harbor 401(k) and QACAs

Example. Laughlin Corporation’s 401(k) plan provides the following employer matching contributions: 100% of each employee’s elective contributions that do not exceed 3% of compensation, plus 50% of each
employee’s elective contribution between 3% and 5%. Therefore, the plan satisfies the basic matching formula and is deemed to satisfy the safe harbor test. John Johnson is eligible to be in the Laughlin 401(k) plan, and has deferred $12,000 during the year. His compensation during the year was $80,000.

How much is his match?

a. $3,200

b. $4,200

c. $5,200

a. $3,200

$80,000
* 3%
= $2,400

$80,000
* 2%
= $1,600
*50%
= $1,600

$2,400
+ $1,600
= $3,200

30

Retirement 4–3: Safe harbor 401(k) and QACAs

Example. Laughlin Corporation’s 401(k) plan provides the following employer matching contributions: 100% of each employee’s elective contributions that do not exceed 3% of compensation, plus 50% of each
employee’s elective contribution between 3% and 5%. Therefore, the plan satisfies the basic matching formula and is deemed to satisfy the safe harbor test. John Johnson is eligible to be in the Laughlin 401(k) plan, and has deferred $3,000 during the year. His compensation during the year was $80,000.

How much is his match?

a. $2,700

b. $3,700

c. $4,700

$80,000
* 3%
= $2,400

$3000
- $2,400
= $600
* 50%
= $300

$2,400
+ $300
= $2,700