Preliminary ConcernsChapter 3

Planning for Retirement Needs

Chapter 3: Preliminary Concerns

• Fact-finding• Qualified versus other tax-sheltered

plans• Defined-benefit vs defined-

contribution• Pension versus profit-sharing• Keogh plans

Fact-Finding• Determine company objectives• Due diligence review• Coordinate with other advisors• Identify company budget• Review employee census• Identify affiliated companies

Qualified vs Other Tax-Sheltered

Qualified– Defined-benefit– Cash-balance– Money-purchase– Target-benefit– Profit-sharing– 401(k)– Stock bonus– ESOP

Other– SEP– SIMPLE– 403(b)

Qualified Plan Characteristics

• Complex documentation and reporting

• Complex yet flexible coverage• Complex yet flexible vesting• Complex yet flexible benefit

structure• Loans

• SEP– Profit-sharing look-alike– Simple documentation, reporting – Retains look and feel of profit-sharing

• SIMPLE– 401(k) look-alike– Simple documentation, reporting– Incredibly inflexible

• 403(b)– 401(k) for nonprofit and public schools– Simple and flexible

Other Tax-Sheltered Plans

DB/DC

Defined-benefit plans

• Defined-benefit PP• Cash-balance PP

Defined-contribution

• Money-purchase PP

• Target-benefit PP• Profit sharing• 401(k)• Stock bonus• ESOP

DB versus DC Approach• What is defined?

– Money going in – Define Contribution– Money going out – Define Benefit

• Define Contribution– Define what goes in.– Who knows what comes out

• Define benefit– Define what the benefit is and do the math– No one cares, except for the employer, what needs to go in!

DB versus DC Approach

Defined-benefit• Specifies benefit• Assets not allocated• Investment risk with

employer• Can count past

service• Costly to administer• Difficult to

understand• Unpredictable costs

Defined-contribution• Contribution/allocation• Individual accounts• Investment risk with

employees• No past service• Less costly• Easy to understand• Predictable costs

DB versus DC Rule Differences

Defined-benefit• Maximum benefit

$205,000 (2013)• Deduction limited

by actuarial cost• Subject to PBGC• Minimum

participation rule• Longer vesting

Defined-contribution

• Maximum contribution $51,000 a year (2013)

• Deduction 25 percent of compensation

• Not subject to PBGC• Not subject to

minimum participation rule

• Shorter vesting

415(b) Defined-Benefit Limits

• Life annuity at age 65 of the lesser of 100 percent of the highest consecutive 3-year average compensation or $205,000 (2013)

• No actuarial reductions 62-65 • Reductions prior to age 62• Actuarial increases post age 65

415(c) Defined-Contribution Limits

• Annual additions can not exceed the lesser of $51,000 (2013) or 100% of salary

• Include employer & employee contributions and forfeitures

• Exception: Age 50 catch up salary deferrals

• Compensation ⁻ Taxable wage income ⁻ Salary deferral contributions tax-sheltered

plans, cafeteria plans and fringe benefit programs

⁻ Compensation cap $245,000 (2009)

Today’s Market

• One-third of employees in mid-to-large companies covered by DB plan

• Less than 10% of small employers maintain DB plans (may still be tax shelter opportunity)

• More than 50 million covered in DC plans

• Most new plans are DC plans, in the small plan market most 401(k) and SIMPLE

Pension vs Profit-Sharing

Pension• Defined benefit• Cash balance• Money purchase• Target benefit

Profit Sharing• Profit sharing• 401(k)• Stock bonus• ESOP

Pension vs Profit-Sharing

Pension• Required funding• 10% of assets in

sponsor’s stock• Distribution requires

termination of employment (exception at age 62)

Profit-Sharing• Discretionary

funding• 100 percent invested

in sponsor’s stock• In-service

withdrawals• 2 years after

contribution is made • 5 years of plan

participation

Keogh

• Not a type of plan• Maximum deduction based on

income after contribution

Keogh Calculation

• Pre-contribution salary ($100,000)• Social Security deduction ($7,200)• Contribution rate (.25/1.25=.2)• Allowable contribution .2 x reduced

salary ($92,800 x .2 = $18,560

Vocabulary Review• defined-benefit plan• defined-contribution plan• minimum-participation rule• pension plan category• profit-sharing plan category• Keogh plans

True/False Questions

1. Using a fact finder provides a method for systematically gathering information necessary to make appropriate recommendations.

2. A thorough understanding of the ages and salary levels of employees who will be covered by the plan is essential to making the correct plan choice.

3. A fact finder can help the employer prioritize retirement plan objectives.

4. Understanding the ownership structure is important to ensure that controlled group problems do not exist.

5. SEPs and SIMPLEs will generally cost less to maintain than a qualified plan, but in exchange the employer will have fewer design options.

True/False Questions

6. A defined-benefit plan specifies the amount of contribution made annually to each employee’s account. 7. Defined-contribution plans can gear their retirement payments to salary levels used just prior to retirement. 8. Under a defined-contribution plan the employer bears the risk of preretirement inflation. 9. The maximum annual deductible employer contribution to a defined-contribution plan is 25 percent of aggregate participant payroll. 10. Individual accounts are established for each participant in a defined-benefit plan. 11. Defined contribution plans provide benefits based on a participant’s earnings each year.

True/False Questions12. From the employer’s perspective, defined-benefit plans are more economically risky than defined-contribution plans. 13. From the employee’s perspective defined-benefit plans provide a more predictable benefit. 14. Defined-contribution plans can never base benefits on past service. 15. Plans from the pension category can invest up to 25 percent of their assets in employer stock. 16. Under a profit-sharing plan an organization is committed to making annual payments to the plan. 17. Joe, a sole proprietor has a profit-sharing plan. He has Schedule C earnings of $210,000 and a deduction on his tax return for Social Security of $10,000. Joe’s maximum contribution is $40,000.

Chapter 3 Review• Fact finding

– Objectives– Budget – Employee census– Affiliation– Coordinate

professionals– Due diligence

• 415(b) DB limit– $195,000 life annuity– No reduction age 62

• 415(c) DC limit– 100% or $49,000

limit– Annual additions– Exception catchup

• 415 rules– All comp or test for

nondiscrimination– Aggregate plans of

related employers

Chapter 3 Review (Cont.)• DB features

– Promised benefits– Unallocated funds– Past service – Er financial risk– Hard to explain

• DC features– Predictable cost– Individual accounts– Uncertain benefits– Easy administration– Easy communication

• DB rules– 415(b)– PBGC– Additional coverage rule– Longer vesting– Deduction tied to

funding• DC rules

– 415(c)– Shorter vesting– Max deduction 25%

payroll

Chapter 3 Review (Cont.)• Pension

– No in-service prior to 62

– 10% assets in er stock

– Required funding • Profit-sharing

– In-service withdrawals

– 100% assets er stock– Discretionary

funding

• Keogh– Unincorporated

entity sponsoring plan

– Deduction limit for owner• 20% not 25%• Reduce Schedule C

by social security deduction (1/2 of SS taxes)