Chapter 1
What are the tax advantages common to all types of tax-advantaged retirement savings plans?
Answer: Employers receive a tax deduction for contributions that they make to the tax-advantaged retirement plans. At the same time, employees will not recognize taxable income until the benefits are distributed to them. It is presumed that the benefits will not be distributed until retirement. You will learn later in this course that tax-advantaged retirement plans can usually be rolled over into an IRA, which will further delay taxation.
Do tax-advantaged plans need to invest in tax-favorable investments in order to remain tax-advantaged?
Answer: There are certain investment prohibitions that you will learn about in a later chapter, but in general, the tax-advantaged status of a retirement savings plan is not impacted by the tax status of the investment options. It is actually a bad idea to invest in a municipal bond in a tax-advantaged plan. The assets are already sheltered from taxation. Tax-favored investments, like a municipal bond, offer lower interest than their other bond counterparts of the same risk category. The lower interest rate reflects the tax benefit that the investor enjoys. It is counterproductive for an investor to invest in a tax-favored investment within a tax-advantaged retirement savings plan.
Which are the common requirements shared by all tax-advantaged retirement plans?
Answer: For the owners and other highly compensated employees to participate in the tax-advantaged plan, it must cover a certain amount of rank-and-file employees. The plan will also have a requirement on vesting, which will depend upon the plan type. (You will learn the specific schedules in a different chapter). All employees must be notified of the terms and conditions of the plan and for which benefits an employee is eligible. A notification of the available benefits must be stated clearly and in a language that the employees can understand.
What are some nontax-related benefits of participating in an employer-sponsored retirement plan?
Answer: If an employer offers matching contributions, then participants have an instant return on their savings. The matching contribution amplifies the employee’s personal contributions. The participants may also benefit from some preformed investment options, which can be very helpful for someone who is not well-educated in investment allocation strategies. Sometimes, the employer will even provide the participants with investment education opportunities.
There is a small smartphone supplier with maximum younger employees. Their industry is highly competitive. How could offering an employer-sponsored retirement plan help this company better compete with its rivals?
Answer: The key selling point for this company is that offering an employer-sponsored tax-advantaged retirement plan will help them to attract and retain key employees who have valuable technical skills and knowledge necessary for the smartphone revolution. An employer-sponsored plan may also help the company avoid unionization of its workers because the employees feel valued. This non-unionization may help the company contain their costs and enable them to remain competitive for a longer period of time. Offering a plan will also give them a reputation as a good corporate citizen.
Chapter 2
What were the major reforms instituted by ERISA?
Answer: ERISA has four major reforms which are organized into “Titles.” Title I mandates certain levels of benefit disclosure. Title II establishes the parameters on the tax-deferral of contributions. For example, employers must meet certain vesting schedule requirements in order to remain a tax-advantaged plan. Title III created a regulatory system to monitor and implement the rules of ERISA. Title IV established the Pension Benefit Guaranty Corporation (PBGC), which is an agency that insures pension benefits in defined-benefit plans.
Describe the post-ERISA trends in the world of retirement planning.
Answer: The post-ERISA world for retirement planning is constantly evolving. ERISA introduced IRAs as a plan type. This has presented many more retirement savers with an option to accumulate savings. It has also provided a tax-deferred outlet once a participant leaves a company. ERISA provided more access to retirement plans for businesses. The contribution limits have been raised, and this provides business owners with more incentive to provide a plan. ERISA also limited the length of deferral by imposing a mandatory timing of when withdrawals during retirement must begin. The participants must begin to take withdrawals by the time they reach 70.5 years. (You will learn more about this topic in the chapter on distributions.) ERISA also tried to curb small employer abuses by imposing rules that require certain levels of coverage for the rank-and-file employees.
What is the role of an ADL in the creation of a new employer-sponsored tax-advantaged retirement plan?
Answer: To begin with, an ADL is a completely voluntary process. However, it is highly recommended that an employer who wishes to establish a new tax-advantaged plan should file the necessary paperwork with the Internal Revenue Service (IRS) to request an ADL. Essentially, an ADL communicates to the employer that the IRS has reviewed the proposed plan and that they have given their stamp of approval. This greatly reduces the possibility that the IRS would later step in to disqualify the plan, which would have countless negative side effects.
What is the role of the IRS in the retirement market?
Answer: The IRS (1) supervises the installation (creation) of new tax-advantaged retirement plans, (2) monitors and audits the operation of the existing plans, and (3) interprets federal legislation related to the tax consequences of certain plan design features.
What is the role of the DOL in the pension process?
Answer: The DOL (1) enforces some of the reporting and disclosure rules, (2) supervises the investment of plan assets, (3) monitors the actions of those responsible for operating pension plans, and (4) also interprets legislation.
Chapter 3
What are two typical roadblocks that financial professionals face when helping a client plan their retirement?
Answer: One common roadblock is the client having unrealistic expectations, given their budget. Some clients will aim for the moon with their desires, but desires must be rooted in reality. Some clients are not willing to make the current budgetary sacrifices necessary to have a higher probability of a secure retirement. If the client is a business, another common roadblock is not having all of the decision makers coordinated around common goals. Sometimes, the role of the financial professional is to help business owners understand different plan types and choose the one that most closely aligns with their objectives. Clients usually come to a financial professional for advice because they do not know how to proceed on their own.
Answer these potential client questions:
Can a defined-benefit plan pay the owner of a small business $210,000 (2016 indexed) per year, beginning at age 60?
Is it true that if an individual works for a company and participates in two separate 401(k) plans (through different subsidiaries) that they can contribute $18,000 (2016 indexed) into each plan for a total contribution of $35,000?
Answers:
No, this client is 60 years old, which means that their maximum benefit must be reduced by an actuary. If this client waited until age 62 to retire, then they would be able to receive the full $210,000.
No, the two 401(k) plans are aggregated because the subsidiaries have common ownership. The individual is limited to a total of $18,000 between the two plans. They could contribute some to one plan and some to another if they offer different investment choices.
John Smith, the owner of Smith’s European Delicacies, has expressed an interest in establishing a qualified plan for his employees. His goals are to (1) provide a meaningful benefit for his employees, (2) help out a few long-serviced employees who have been with him for over 15 years, (3) and encourage employment loyalty to his company. Would you recommend a DB plan or a DC plan to Mr. Hopkins and why?
Answer: You should clearly recommend a defined-benefit plan for Smith’s European Delicacies. The key trigger for this type of plan is his second stipulation. Only a defined-benefit plan will offer credit for past service. Both plans could provide a meaningful retirement benefit although the statement of “meaningful retirement” is also usually associated with DB plans. Both plan types could be used to encourage employment loyalty. However, the prior-service request tips the scale in favor of the DB plan without a question.
Is there a scenario where an employer might choose to combine a DB plan and a DC plan?
Answer: Yes, this combination approach is sometimes used by very large companies who are trying to compete for the most talented employees by offering the very best retirement packages available. This combination is very rare in small- or medium-sized companies due to the costs associated with defined-benefit plans. You will learn about other combinations for attraction and retention later in this course.
Chapter 4
The owner of a regional car dealership would like to establish a DB plan that helps to retain and reward experienced employees. He also wants to give a meaningful reward to both himself (owner) and other highly compensated employees. His goal is to replace 60 percent of the employees’ working wages on retirement.
What type of benefit formula should be used? Why?
Give an example of how the benefit formula can be written.
Answer:
They should use a unit-benefit formula because it can reward long-serviced employees and those with higher compensation (subject to certain limits). The unit-benefit formula also can factor the desired retirement income replacement ratio of 60 percent.
The company should use a unit-benefit formula factoring 2 percent times monthly FAC times years of service with a cap of 30 years. The 30-year cap times the 2 percent figure will supply the 60 percent replacement ration requested by the owner.
Most employers want to minimize their costs while still offering some benefit to their employees. Why would an employer want to account for past service in a DB plan?
Answer: Using past service is a way to reward the long-serviced employees. In small businesses, it usually has the effect of providing a significant advantage for the owner. In large companies, which are more likely to use a defined-benefit plan, the past service feature could help retain key talent that has been with the company for several years.
Why would a flat dollar amount per year of service be more attractive to union-based employees?
Answer: Union employees are most concerned with fair treatment. They want to level the playing field with management as much as possible. If everyone receives the same dollar amount per year of service regardless of their pay-grade, then the unions tend to feel that fair treatment has been applied.
A group of construction companies has established a small business with one full-time employee and one part-time employee. The purpose of the small business is to manage union negotiations within the local construction worker population. They would like to establish a retirement benefit for the full-time employee, and they are willing to make regular, but small contributions. What plan type would you recommend? Why?
Answer: The best plan choice for this scenario is a money-purchase pension plan. The group of construction companies wants to provide a retirement benefit, and they are willing to make “regular but small contributions.” A money-purchase pension plan has required contributions, but they can be relatively small. The company could offer 3 to 5 percent of compensation as a flat contribution. The contribution is the only obligation of the plan. All investment risk is then borne by the employee.
A 54-year-old rural dentist realizes that he waited way too long to begin planning for retirement. He wants to establish a qualified retirement plan for himself and two younger employees (both in their mid-20s). They are only able to afford an aggregate $20,000 annual contribution. What type of pension plan would you recommend? Why?
Answer: One idea is a target-benefit plan. At first glance, you might think that answer should have been a straight defined-benefit plan because it accounts for past service. This is good logic, but the contributions into a defined-benefit plan would likely be much larger than the combined $20,000 that the dentist is prepared to contribute. The target-benefit plan will also have the added benefit of funneling the majority of the savings to the dentist who has not planned well (because they are much older than their employees). The “target” can be customized to fit the aggregate amount available to save.
Chapter 5
An employer approaches you for advice on which type of retirement plan might be the best for them. After completing a fact-finding meeting with the employer, you learn that the company has highly unpredictable cash flows. They do not want to assume any investment risk, but they do want the ability to provide retirement value to their employees. The executives also want the ability to take plan loans, should the need arise. They do not have any interest in accounting for past years of service. The employer simply wants to offer a benefit to retain their most valuable employees. Which type of plan would you recommend to the business owners? Why?
Answer: The statement about unpredictable cash flows would point directly at a profit-sharing plan. The employer would not need to be concerned with investment risk because that belongs to the employees in a PSRP. All plan participants will have access to loans two years after the employer’s contributions settle into the account. If the executives can handle the two-year lockup period, then a profit-sharing plan is the best alternative for them.
A surgeon for a hospital system in rural Kentucky contributes $18,000 in salary deferrals into the 403(b) account at their hospital. This doctor also operates a private medical practice. They are considering establishing a 401(k) within the medical practice to shelter even more money from taxes. How much can this doctor contribute to the new 401(k) plan if it is established?
Answer: The contribution limits are aggregated between 403(b)s, 401(k)s, and SIMPLE plans. Because this doctor is already making a maximum contribution into a 403(b), they will not have the ability to make any deductible contributions into a new 401(k) plan. If the doctor wants to shift tax deductions to their private practice, then they could stop making contributions into the 403(b) at the hospital and then install a new 401(k). A tax advisor would need to come into the discussion to see which way would provide the more favorable overall tax picture for the doctor.
A company has adopted a 401(k) plan. The participants, their respective compensation, and their applicable percentage contributed (including the employee and employer match) are as follows:
Eligible employee
2015 compensation ($)
ACP (%)
Employee A (CEO/75% owner)
150,000
8
Employee B (VP/21% owner)
80,000
8
Employee C (4% owner)
60,000
5
Employee D
40,000
5
Employee E
30,000
9
Employee F
20,000
5
Employee G
20,000
5
For 2016, who are the HCEs and what will be their maximum allowable contribution percentage?
Answer: Only Employee A and Employee B are considered “highly compensated employees.” If Employee C owned 5 percent, then they would also be included in the list. The average contribution percentage for the HCEs is 8 percent ([8% + 8%]/2). The average contribution percentage for the NHCEs is 5.8 percent ([5% + 5% + 9% + 5% + 5%]/5). Under the ACP 1.25 test, the maximum HCE contribution percentage is 7.25 percent (5.8% × 1.25). Under the ACP 2.0 test, the maximum HCE contribution percentage is 7.8 percent (5.8% × 2; max is 2 percent higher than the NHCEs’ percentage). Therefore, the maximum allowable contribution percentage for the HCEs is 7.8 percent for 2016.
An employee who is covered by a 401(k) plan mentions to you that they are planning on taking a $15,000 hardship withdrawal from their retirement plan to pay for an unforeseen “emergency” to renovate their kitchen before the holidays. What would you tell them?
Answer: The first thing that the employee needs to know is that this “emergency” is not really an emergency and that their employer might not permit a hardship withdrawal for this perceived need. Even if the employer did permit it, the employee needs to know that this withdrawal will not meet the requirements for a penalty-free withdrawal. They will pay a 10 percent penalty of $1,500 plus they will also pay taxes on the full $15,000. Taping retirement savings for the current consumption desires is not a good idea ... in fact, it is a terrible idea.
A closely-held company has an original owner who is about to retire. The company has a defined-benefit pension plan, which has already served the purpose of providing benefits for the current owner. Assume that the owner does not have any family members interested in the business and that the employees have worked for the company for a long time. The owner considers their employees to be potential buyers of the company. Which plan type will you suggest?
Answer: Since the owner wants to retire soon and the employees are potential suitors, the owner should consider several steps that will culminate in the installation of an ESOP. They might consider terminating the defined-benefit plan to save on costs and subsequently, converting it into a cash-balance plan. This could benefit the current owner and allow for a more appropriate plan to take its place. The owner should then install an ESOP. The ESOP could borrow money to purchase the shares from the current owner, and as company pays off the loan, shares can be distributed to the current employees (new owners). The departing owner can also use the unrecognition of gains rule to further sweeten the approach.
Having heard that you took a class on retirement planning; your cousin approaches you with a question about ESOPs. Your cousin owns a portion of a regional engineering company and he is planning on selling his interest to the ESOP sponsored by his employer. The ESOP currently owns 52 percent of the company, and your cousin acquired his 10 percent ownership interest 15 years ago for $50,000. The company has done very well, and now that your cousin’s portion of the company has risen to $1,000,000, he feels ready to retire at his current age of 66. What advice would you give him?
Answer: Your cousin made a very wise investment. He now has the opportunity to apply the nonrecognition of gains rule. He could sell his position to the ESOP and then immediately deposit the money into his nontax-advantaged retirement account at his broker. Then, use all $1,000,000 to buy shares of other domestic publicly traded corporations. By doing this, he will defer the $950,000 of capital gains until he chooses to sell his replacement stocks at some point in the future. As long as he is willing to be a buy-and-hold investor, then this strategy might be a great tax management tool for him. Of course, he should consult his tax professional before he proceeds with this plan.
Chapter 6
A company wants to establish a tax-advantaged plan for its employees. The company is relatively new, and profits are unpredictable with a meaningful amount of variability. The employer would like to reward its employees when the company does well, and is somewhat concerned that the company has no retirement plan at all, which might make it difficult to attract experienced people to work there. Due to the inherent uncertainty of their profits, the company is extremely concerned about minimizing the costs of maintaining the plan. Which type of plan should this employer consider?
Answer: The key clues are that this is a new company whose profits are “unpredictable with a meaningful amount of variability.” This company is looking for a motivational tool to reward employees when the company does well. If this were all that we knew about the company, then a consultant would likely recommend a profit-sharing plan. But, the company has also told us that they are extremely concerned about minimizing the costs. With this last criterion, a financial professional should recommend an SEP Plan.
A small employer wants to offer a tax-advantaged retirement plan to only their full-time employees. Is an SEP plan a good idea to recommend?
Answer: No, an SEP plan is not a good idea to recommend because any employee aged 21 or older who has earned at least $500 in each of three out of the last five years will be eligible. This means that part-time employees are eligible. This small employer needs to either alter this criterion or consider a different plan type.
A small employer with 75 employees already has a profit-sharing plan in place for their employees. They are trying to be a good corporate citizen, and they are considering also adding a SIMPLE plan following the 3 percent dollar-for-dollar matching formula. What advice do you have for this company?
Answer: Many small businesses do not offer any retirement plan. It is admirable that this company wants to provide even greater benefit for their employees. The company is below the 100 employee cut-off, but they already offer a plan. SIMPLE plans cannot be offered in conjunction with any other plan type. The employer will need to choose between the profit-sharing or the SIMPLE. They might consider adding a 401(k), which will pair well with a profit-sharing plan.
A company with very stable earnings and cash flow has had a modest money-purchase pension plan for a long time. The participation in the plan precludes employees (87 employees) from participating in other plan types. The company wants to encourage its employees to save for retirement themselves. They also want the employees to have access to plan loans. What steps should this employer consider?
Answer: The key clues are that the company wants to encourage employee participation in saving for their own retirement, and that they want employees to have access to plan loans. The first step is to terminate their MPPP so that they can consolidate funds to pay for a new plan’s administrative costs. Then they should consider establishing a 401(k). They need to understand the application of ADP and ACP compliance testing, but if this is acceptable, then a 401(k) is probably the best choice.
A very small S-Corporation has four employees. The owner realizes that the competing employers are sponsoring 401(k) plans. To compete with the other employers, the owner would like a similar plan, but is not willing to pay significant administrative expenses. Which plan would you suggest?
Answer: This small employer wants to replicate the look and feel of a 401(k) for its employees, but without the higher administrative costs of a 401(k). The best plan for this employer is a SIMPLE Plan.
A church-based nonprofit organization wants to install a retirement plan that could cover everyone who works at the organization. They have three full-time employees and 10 self-employed subcontractors. They are planning on allowing their workers to choose from a list of 15 mutual funds. They are trying to keep administrative costs as low as possible. What advice would you give them?
Answer: Because they are a nonprofit organization, they would naturally be thinking of installing a 403(b) plan. They can certainly do this, but they could only cover the three full-time employees. The subcontractors are not eligible for coverage in a 403(b) plan. Many plan types will exclude the subcontractors. They could be made part-time employees and then a 403(b) might be a decent option. They are certainly welcome to use mutual funds within a 403(b), but doing so will yield ERISA compliance issues. They would be much better served to consider something other than a 403(b). If they truly want to keep administrative costs low while offering mutual funds, and they are willing to make the subcontractors part-time employees, then the nonprofit should consider either an SEP or a SIMPLE.
Chapter 7
You approach the CFO of a small company about adding a retirement plan for their employees. The CFO tells you that your timing is perfect. The company is actively considering adding an SEP plan. They further tell you that they have already put together an adoption agreement and have sent it to the Department of Labor for approval. Once the official approval is received via mail, the company would be happy to talk with you about your ideas for implementing an SEP plan. What would you communicate to the CFO before you leave their office?
Answer: Start by thanking them for the opportunity, and tell them that you have a working knowledge of SEP plans and would be happy to provide information on what you can do to help them with their retirement plan needs. Also, be sure to tell them that an adoption agreement is intended only for internal purposes and not a document subject to regulatory approval. The company might be waiting a while to receive an official approval from the DOL only to find out that no such approval will be forthcoming.
Why do you think that a company might choose to define its HCE as the top 20 percent of wage earners?
Answer: A company might define its highly compensated employees as the top 20 percent of wage earners if a substantial percentage of their employees already earn more than the dollar threshold. If they did not employ the 20 percent rule, then they would have hardly any nonhighly compensated employees for compliance testing.
A plastics company it trying to find a loophole for 410(b) coverage testing. They have separated their production department from their materials acquisition department. The idea is to only offer a plan to the materials acquisition department, which mainly comprises skilled workers, while the production department is mainly hourly employees who are easily replaceable. What advice would you give them?
Answer: This plastics company is certainly trying to push the limits on separate lines of business. If they can justify that there is a legitimate business reason that the separate lines need to separate, then they could possibly get away with doing this. From the information given, it sounds as if there is not a justifiable business reason and that the employer is violating the law.
A company has 20 retirement plan-eligible HCE, and 16 of them participate. They also have 75 eligible NHCE, and 37 of them participate. Does this company pass the ratio test?
Answer: In a word ... no. This company does not pass the ratio test. They have a participation percentage of 80 percent (16/20) within the HCE population. The nonhighly compensated employees would need to have a percentage that is at least 70 percent of 80 percent, which means 56 percent coverage. The NHCEs only have a participation percentage of 49.33 percent (37/75). This company fails the ratio test. They will need to either drop a few HCEs off the plan or encourage participation within the NHCE population.
Is it correct that a company can extend the normal eligibility rule of 21 year of age with one year of service to 21 years of age with two years of service if they offer full vesting within two years of inception of contributions?
Answer: No, this is not true. They can only extend to a 21 and 2 rule if they offer 100 percent immediate vesting.
You are the HR manager at a small company. A mid-tier manager who earns $150,000 annually requests a meeting to discuss his lack of access to the company’s 401(k) plan. He appreciates the other benefits and the stock option grants, but by the tone in his voice over the phone, you get the idea that he is frustrated. In fact, he even mentioned that he is being discriminated because he does not have access to the plan. What would you tell him when he comes to your office?
Answer: You certainly want to be careful in the way that you address this manager. They are obviously contributing to the company in a significant way to receive this salary and stock options. However, you do need to inform them that from a regulatory perspective, the company is not illegally discriminating against them. They are a highly compensated employee (HCE) and a company can discriminate against an HCE with retirement plan access if they so choose without any compliance issues. You could explain that their lack of access is due to low participation from the NHCE population and that is why, they are disallowed from participating. The company is compensating for this scenario by offering the stock options.
Consider the following scenario where three individuals have differing levels of common ownership over two separate companies. Company A offers a retirement plan, while company B does not. From the perspective of a controlled group, is there any issue here?
Shareholder
Company A (%)
Company B (%)
Tim
20
15
Susan
42
15
Roger
23
60
Totals
85
90
Answer: Yes, there is an issue. Company A and company B are considered a brother-sister controlled group because the identical ownership equals 53 percent. They must, therefore, aggregate their plans for compliance testing to see if they meet 410(b) coverage testing.
Shareholder
Company A (%)
Company B (%)
Identical ownership (%)
Tim
20
15
15
Susan
42
15
15
Roger
23
60
23
Totals
85
90
53
In the previous example, Roger has transferred 10 percent of his ownership interest in Company A to his 12-year-old daughter. Can he use this technique to avoid any potential issues with the controlled group status?
Answer: No, Roger cannot use this compliance avoidance technique because of family attribution rules, which state that the ownership interest of a minor child is attributed to the owner parent.
In the previous example, assume that Roger only owns 13 percent of Company A, while his wife, who manages the sales team at Company A, owns the other 10 percent. Does this new information change the potential issues with the controlled group status?
Answer: No, it does not. Because Roger’s wife is actively involved in the business, her ownership interest is merged with his for purposes of calculating the ownership percentages. If she were not involved with the business operations or if they were either divorced or separated, then family attribution would not apply and the brother-sister controlled group would not be an issue.
A company is in the habit of hiring long-term temporary workers for its manufacturing plant. They only use temporary workers for noncore production jobs. Of the 400-member population of NHCE, there are typically 95 long-term temporary workers with the remainder being full-time employees. The company’s policy is to exclude temporary workers from both health benefits and retirement plan benefits. The temporary agency provides those services for the workers albeit a lesser benefit than the company itself would have otherwise provided. Are this company’s actions justified?
Answer: The long-term temp workers are considered leased employees. As such, we must apply the 20 percent threshold test. In this case, the company’s population of nonhighly compensated employees is comprised of 23.75 percent (95/400) leased employees. Because they are above the 20 percent threshold, they must offer their retirement plan to the leased employees. If they dropped down to 79 leased employees, then they would fall below the 20 percent threshold. In this scenario, the company could exclude the leased employees only if they offer a safe harbor plan to all other employees.
Chapter 8
A friend from your college days has just been told by their employer that the economic conditions necessitate that they will be losing their access to an employer-sponsored retirement plan. Your friend tells you that he remembers reading somewhere that the employer cannot alter any projected benefits within their DB plan. Your friend recalls that you took a class on retirement planning and asks if you know anything about this. What would you tell them?
Answer: Your friend is thinking about the anticutback rule, but they are a bit mixed up. The anticutback rule applies to accrued benefits, not projected benefits. Accrued benefits are those earned from past service. Projected benefits are an estimation of future benefits to be earned with future estimated service.
A different friend tells you that their employer offers an MPPP, which is integrated with social security. They tell you that they are planning on not participating in the integration portion of the plan because they do not want to sacrifice any money from their take-home pay as a contribution. What advice would you give them?
Answer: Tell them that a money-purchase pension plan, which is integrated with social security, is a tremendous opportunity. Explain that the additional contribution is entirely made by their employer and will not affect their take-home pay at all.
An employer contacts you to provide advice about what to do with their employer-sponsored retirement plans. They have an MPPP, and they also have a profit-sharing plan to allow for contribution flexibility. They want to give their HCEs an extra incentive to stay with the company, and so, they plan to integrate both plans with social security. What would you need to communicate to them?
Answer: This employer needs to understand that both profit-sharing plans and money-purchase pension plans are eligible to be integrated with social security, but that they must choose only one plan to integrate. It is an either/or proposition.
An employer contributes 4.25 percent of the total compensation for each employee into an MPPP that is integrated with social security. They use the TWB as the integration level. A certain HCE who grosses $500,000 noticed that they had an excess contribution of $6,226.25 into their account. They were expecting a much larger number. How would you explain this number to them?
Answer: When the integration level is equal to the taxable wage base and the contribution percentage on total compensation is 4.25 percent, then the maximum contribution for wages earned in excess of the taxable wage base is limited to 4.25 percent, not the full 5.7 percent. This excess percentage contribution is further limited with a compensation cap of $265,000 (2016 limit). Their excess contribution of $6,226.25 is based on 4.25 percent multiplied with the difference between the taxable wage base ($118,500) and the compensation cap ($265,000).
If an employer contributes 6.0 percent of the total compensation for each employee, then how much more could be contributed for the employees who earn more than the integration level, which is set at 75 percent of the TWB?
Answer: Because the integration level is only 75 percent of the taxable wage base, the maximum contribution for wages earned in excess of the taxable wage base is limited to 4.3 percent.
How can cross-testing be used to skew the employer’s contributions in favor of the older employees?
Answer: Cross-testing involves converting the contributions into an equivalent annuity and then testing those equivalent annuity benefits. The math will all be handled by an actuary. Older participants will have a shorter time to retirement. Therefore, the annuity calculations for older employees will naturally be higher than for a younger participant.
Does the inclusion of older NHCEs limit the ability of an age-weighted contribution formula to skew the benefits in favor of the HCEs?
Answer: Yes, the inclusion of even one older NHCE could significantly disrupt the ability to skew benefits in favor of the highly compensated employees.
A small business owner approaches you with an interest to integrate their SIMPLE plan with social security so that the company’s HCEs are realizing greater value. What comments should you make?
Answer: A SIMPLE plan has its own contribution allocation formulae and integration with social security is not on the list. This business owner will need to change plan types if integration with social security is a vital issue. They might consider other means of compensating the highly compensated employees in order to be competitive with their peers.
A company comes to you for advice after learning that they have not passed the mandatory coverage testing in their 401(k) plan. Upon inspection of their plan, you learn that the employer offers matching contributions and that many of the executives also make voluntary after-tax contributions. What would you say to this employer?
Answer: Specifically, this employer is having a difficult time passing the ACP test. We know this because matching contributions are involved. The reason that they are having a difficult time passing the test might be because the executives (highly compensated employees) are also making voluntary after-tax contributions. The voluntary after-tax contributions are also counted in the ACP calculation. The company needs to limit the executives to a certain percentage of the total contribution so that they can pass the ACP test from the ratio test, the percentage test, or the average benefits test.
Chapter 9
A friend of yours owns a small business and offers a SIMPLE plan to his employees. His restrictive cash management policy has created a short-term problem, leaving him short on cash for the payroll. He is considering taking a short-term loan from his personal SIMPLE account to fix the problem. What would you tell your friend?
Answer: You should advise your friend that he cannot take a plan loan from a SIMPLE plan because it is funded with an IRA. He will need to talk with a bank or some other lender to secure short-term financing. You also might talk to him about changing his cash management philosophy so that this is not repeated.
A different friend works at a company with a 401(k) plan. His vested balance is $75,000, and he is planning on taking a loan for the whole vested balance to buy a rental property. What advice would you have for your friend?
Answer: The IRS mandates that the loan balance cannot exceed the lesser of 50 percent of the vested balance or $50,000. Your friend’s wishes are not in compliance with either of these constraints. Advise your friend to consider a financing source other than his retirement account for the purchase of the rental property.
A medium-sized employer is planning on offering a plan loan feature within their 401(k). They have decided that 2.5 percent is a decent interest rate to offer to their employees. What advice would you have for this employer?
Answer: The chosen interest rate of 2.5 percent may or may not be appropriate. This should be a moving target that is indexed to the current market interest rate. If the current rates were 1.5 percent, then this company would not have any issue (other than that they are charging too high an interest rate). However, if market interest rates are 5 percent, then they will have an issue because they cannot offer special reduced rates within the retirement plan.
Is the following vesting schedule permitted in a DB plan?
Years of service
Percentage vested (%)
0–2
0
3
10
4
30
5
70
6
90
7
100
Answer: No, this schedule is not permitted. It is more restrictive than the required seven-year graded vesting schedule for defined-benefit plans.
Is the following vesting schedule permitted in a DB plan?
Years of service
Percentage vested (%)
0–2
0
3
25
4
50
5
75
6
100
Answer: Yes, this schedule is permitted. It is more generous than the required six-year graded vesting schedule for defined-contribution plans. Employers can always be more generous than the regulations demand!
Is the following vesting schedule permitted in a DC plan?
Years of service
Percentage vested (%)
0–1
0
2
20
3
40
4
60
5
80
6
100
Answer: Yes, this schedule is permitted. It is more generous than the required six-year graded vesting schedule for defined-contribution plans. Employers can always be more generous than the regulations demand!
Is the following vesting schedule permitted in a DC plan?
Years of service
Percentage vested (%)
0–1
0
2
10
3
30
4
100
Answer: No, this schedule is not permitted. Defined-contribution plans can either use a specific six-year graded schedule or a three-year cliff vesting schedule. This vesting schedule is an odd combination of both concepts. It does not pass either standard.
What is the maximum loan that can be taken by the following employees?
Employee
Vested account balance ($)
% of ownership
Employee A
17,000
0
Employee B
160,000
0
Employee C
200,000
50
Answer: The maximum loan for Employee A is $8,500 (50% of the vested plan balance). If this employee needed to take a loan for perhaps $10,000, then the company could make the loan, but require additional collateral from outside the plan assets. The maximum loan for Employee B is $50,000, which is the lesser of 50 percent of the vested plan balance or $50,000. The maximum loan for Employee/ Owner C is also $50,000. This employee or owner’s available loan amount is not influenced by their status as an owner.
A 41-year-old employee has taken a plan loan for 50 percent of their vested balance ($20,000 loan) to buy a car. Three years into the loan repayment, they lose their job. They are single and end up being unemployed for over a year while looking for a new job. During this job search process, they are unable to repay the remainder of their 401(k) loan, and they default on themselves. What happens?
Answer: The default is treated like a distribution. In this case, it is a premature distribution, which means not only current taxation, but also a 10 percent premature distribution penalty. The taxation and penalty hit this poor soul at a time when finances are already tight. They will likely need to enter a payment plan with the government and forego tax refunds that otherwise would have been very helpful to regain their financial footing.
Respond to an employer’s statement that they “are concerned about the administrative hassles of implementing the required break-in-service rules.”
Answer: The break-in-service rules can be cumbersome to apply. The good news is that they are available, but entirely voluntary in their application.
In a DB plan, how can the employer legally limit the benefits for older, longer-serviced employees without violating the age discrimination laws?
Answer: The employer can legally use a cap on the years of service it uses when calculating retirement benefits. The employer must disclose this cap well in advance to all employees.
Chapter 10
An employee receives a notice from their employer that because they are married, they are eligible for QJSA. They are told that QJSA requires that a payment to a surviving spouse must be at least 40 percent of the participant’s benefit. They are also told that they can waive the QJSA option, which would lower their monthly payment in retirement by a reasonable margin, by simply signing a form themselves. Is this company’s disclosure correct?
Answer: It is correct that a married participant in an employer-sponsored qualified plan will have access to a QJSA and that acceptance of a QJSA benefit usually results in a reduced payment for the participant during their lifetime. That is where the true stops in this employer’s disclosure. The QJSA must be at least 50 percent (not 40 percent) of the participant’s benefit. Also, the waiver for a QJSA must be signed by both the participant and their spouse.
A 55-year-old participant recently got married. While on their honeymoon, there was a tragic accident and he was accidentally killed while parasailing in the Caribbean. His surviving spouse is surprised to learn that the now deceased spouse’s DB plan will not pay her any benefits under the QPSA arrangement. Explain the reasoning to this bereaved and bewildered person.
Answer: Under law, the QPSA must be available for participants who have been married for at least one year. Unfortunately, this surviving spouse was only married for less than one week. The employer could elect to waive the one-year requirement, but they cannot do so on a case-by-case basis. She could petition the company to change their policy to be more participant-friendly, but other than that, she has no recourse under the current law.
Other than instantly creating an estate, what are the top two reasons that an employer might offer a life insurance option within their qualified retirement plan?
Answer: One major reason that an employer might offer life insurance within a retirement plan is to bypass the underwriting standards for either the decision makers or for a group of employees. This type of life insurance does not need to go through normal underwriting due diligence because it is a group plan. The second major reason for offering life insurance within a qualified plan is to apply to more favorable group rates to everyone in the plan. It is much more affordable to by insurance at a group rate than at an individual rate.
The owner of a business wants to purchase a large amount of whole life insurance with their own profit-sharing plan account. Is there any want to satisfy the incidental benefit problem?
Answer: Generally, only 50 percent of the aggregate contributions could be used to purchase whole life insurance in a qualified plan. However, if a profit-sharing plan allows for in-service withdrawals, the entire portion of the account that is eligible for withdrawal can be used to purchase life insurance within the plan.
What is the difference in tax treatment between whether an insurance policy is owned inside or outside of a retirement savings account?
Answer: If insurance is owned outside of a retirement savings account, then all premiums are paid with after-tax money and all proceeds from the insurance policy are income tax-free (although inheritance taxes may apply, depending upon how the insurance is set up). However, if the insurance is held within a retirement savings account, then the pure cost of insurance (government estimate of annual insurance premiums) is added to the employee’s taxable income each year and they accrue a cost basis in the retirement account. The ultimate proceeds are then paid into the retirement account, where they simply build up a higher retirement account balance. Under normal circumstances, retirement account balances are fully taxable as ordinary income when the money is withdrawn, subject to pro-rata cost basis recovery (which you will learn about in another lesson).
Assess the accuracy of this statement: “Most large employer prefer to offer life insurance benefits through their retirement savings accounts.”
Answer: This statement is not true. In fact, most large employers prefer to offer life insurance coverage outside of the constraints of retirement plan coverage rules. Outside of the plan, they are not limited on the level of insurance coverage (there is no incidental benefit rule). It is actually small employers who prefer to use coverage inside of a retirement account.
At the end of a given plan year, a company’s MPPP had the following participants:
Employee
% ownership
Salary ($)
Account balance ($)
Employee A
95
85,000
100,000
Employee B
3
170,000
60,000
Employee C
2
50,000
40,000
Employee D
0
45,000
12,000
Employee E
0
35,000
8,000
Which employees are the “key employees” and does this company’s MPPP have a top-heavy problem?
Answer: Employee A is a key employee because they own more than 5 percent of the business. Employee B is also a key employee because they earn more than the required dollar limit. Employees C, D, and E are not key employees as per the required testing thresholds. To determine if this company’s money-purchase pension plan is top-heavy, we must check whether more than 60 percent of the aggregate account balances belong to the key employees. The key employees are Employee A ($100,000) and Employee B ($60,000), and combined they hold $160,000 of the plan’s assets. The nonkey employees are having $40,000, $12,000, and $8,000 respectively; combined they hold $60,000 of the plan’s assets. Because the $160,000 in assets held by the key employees is 72 percent of the total plan assets ($220,000), this plan is top-heavy. This company will need to implement special contribution rules to remedy their top-heavy status.
What is the minimum required top-heavy contribution if an employer has a top-heavy 401(k) plan that only contains employee salary deferrals and at least one key employee makes a 5 percent salary deferral within the plan?
Answer: An employer in this situation with a top-heavy plan would be required to contribute 3 percent of the compensation for all non-key employees. If their current contribution is substantially lower than 3 percent, then the employer could see a significant increase in the cost to offer a retirement savings plan.
Which two pitfalls should an employer be wary of with respect to offering disability benefits within their retirement savings plan?
Answer: The employer should be very cautious about the definition to select for “disability.” The path of least resistance is to use the Social Security Administration’s definition. If the board of directors chooses their own definition, then they may be opening themselves up to potential litigation. The second pitfall to avoid is the possibility of offering disability benefits within their retirement savings plan that conflict with the disability insurance benefits. The insurance company may deny a claim due to duplication of coverage. Employers should be careful on both of these fronts.
Chapter 11
What is the biggest concern with using the actuarial cost method to determine the DB plan funding needs?
Answer: The biggest concern with using the actuarial cost method is that it relies heavily on estimation, which involves forecasting risk.
Is it true that DB plans are established as a pay-as-you-go system just like social security?
Answer: No, this is not true. Defined-benefit plans were once a pay-as-you-go system, but now they are required to be prefunded.
You read on Wikipedia that the funding target for a DB plan is equal to the present value of the accrued benefits for a given year. Is this correct?
Answer: Wikipedia is not evil, but do not believe everything that you read on the Internet. This definition of a defined-benefit plan’s funding target is not correct. The funding target is equal to the present value of the accrued benefits for a given year plus any special contributions necessary to correct any underfunded status.
You overhear the CFO at your company telling the head of HR that the PPA of 2006 permits an employer to correct any underfunded status over a seven-year period. The CFO goes on to say that your company’s plan is 25 percent underfunded and they plan to use this smoothing effect. What would you say about this conversation?
Answer: The CFO is correct that under normal circumstances a seven-year time period is permitted to correct an underfunded status. However, the disclosure that your company’s plan is 25 percent underfunded means that they are considered an “at risk” plan, which means that they must use a more accelerated plan to catch up.
You read in your local newspaper that DB plans are only allowed to make contributions up to the point of being fully funded. After this point, no more contributions (employer deductions) are permitted until more benefits accrue from the employees completing another year of service. Is this concept correct?
Answer: No, this concept is not correct. Employers are permitted to contribute an extra amount, known as a cushion amount.
What is one technique for outsourcing the responsibility for a plan’s funded status?
Answer: A fully insured plan is essentially outsourcing the risk and responsibility of the funded status. The insurance company is then responsible for making all payments. The employer only needs to make the level payments established by the insurance company’s actuaries.
We know that DB plans have the required levels of funding. Is there a type of DC plan that also has required funding?
Answer: Both money-purchase pension plans and target-benefit plans have required funding.
Is there a way to contribute more than the $18,000 (2016 limit) cap into a 401(k)?
Answer: Yes, the company could offer both a 401(k) and a profit-sharing plan. The employee could contribute up to $18,000 into their 401(k) with an employer match, while the employer could contribute up to a total of 25 percent of aggregate compensation or $53,000 using a profit-sharing plan for the additional amount.
What is a common trust and why would it be used?
Answer: A common trust is a pool of several smaller employer-sponsored plans. They will comingle into a larger pool to gain access to more prominent money managers who may only deal with very large clients. In this way, they can achieve economies of scale, and in theory, access better return possibilities.
What is the purpose of an IPS?
Answer: An investment policy statement is a useful tool to organize and direct the investment operations of an investment strategy. The document will clearly list who is responsible for which activities and any objectives, risk constraints, or prohibited investments. An IPS is very useful for a plan fiduciary because if the document is followed, they have a scapegoat in the event of a negative outcome within the fund.
You are having lunch with an employer who is a prospective client. They tell you that their primary goal with their DB plan is to minimize the unpredictability in their contributions. What would you tell them?
Answer: You could tell them that this certainly is an appropriate goal for a defined-benefit plan, but that it should be secondary to providing the promised benefit. Providing the promised benefit is the most important role of a defined-benefit plan.
What is the most common diversification tool in the DC world?
Answer: Mutual funds are the most common diversification tool in the defined-contribution universe. They are instant diversification and are commonly offered to plan participants who may not have much experience with investments.
Chapter 12
The CFO of a large company only has discretion over the assets of the employer’s retirement plan. Is this individual a fiduciary?
Answer: Yes, this individual is a fiduciary. Anyone who has discretion over either plan assets or plan administration is considered a fiduciary.
An attorney, who only recently passed their bar exam (allowing them to become an attorney), for a given employer-sponsored plan is under the impression that they are free of fiduciary obligation for the retirement plan. Are they correct?
Answer: Yes, they are correct. Attorneys and accountants are free from fiduciary responsibility unless they meet the criteria for some other role that they play within the plan’s operations.
You overhear a legitimate plan fiduciary saying that they are able to be a bit more liberal with their judgments because they have no personal consequences if something goes wrong. What would you tell them?
Answer: Unless either they or their employer has taken specific measures to mitigate fiduciary liability, this fiduciary does understand the situation correctly. Fiduciaries are personally liable for any negative financial effects of a breach of their fiduciary responsibility.
A legitimate fiduciary uses the same brokerage company personally that they use for plan assets. Due to the size of the business relationship, the brokerage company has given the fiduciary a 50 percent reduction on trading costs for both plan assets and personal assets. Is this an issue?
Answer: Yes, this is a big issue. The fiduciary is receiving collateral benefits resulting from their role as a plan fiduciary. This is not a conflict that should simply be disclosed ... it should be removed by either demanding normal trading costs for personal assets or transferring personal assets to another brokerage company.
Is the prudence of a fiduciary’s investment decisions based on the ultimate investment outcome?
Answer: No, the prudence standard is measured at the time that an investment decision is made. The ultimate outcome is out of the hands of the fiduciary, although they may be required to use certain risk mitigation strategies per the investment policy statement.
There are many required duties of a fiduciary. However, diversification of the pool of investments is a voluntary duty. Is this understanding correct?
Answer: No, it is not correct. Diversification of plan assets is a fiduciary requirement.
In an attempt to access the reduced responsibilities offered by §404(c), a fiduciary decides to alter their operations to allow each participant to exercise investment authority. Those who do not exercise discretion will automatically be placed in a well-diversified large company mutual fund. They simply make the change and provide a notice to all the participants stating that they “will now have the opportunity to exercise investment discretion. Anyone who does not exercise this discretion will be automatically allocated into XYZ Large Core Mutual Fund.” What issues, if any, do you see in this scenario?
Answer: Fiduciaries are able to reduce their regulatory responsibility by applying §404(c). They are correct that if a participant does not exercise their right to investment discretion, then a qualified default investment must be established. The problem is that a “well-diversified large company mutual fund” does not solve this problem. The QDI should either be a balanced mutual fund, and lifecycle fund, or a target dated fund. Also, their disclosure to the plan participants does not mention anything about the fiduciary reducing their regulatory responsibilities by applying §404(c). This must be prominently disclosed in advance to all participants.
A plan’s fiduciary receives a notification of what they perceive to be a fantastic investment opportunity. It meets all of the requirements for prudence ... it truly is a good investment. This would be an investment in a privately held business, which is part-owned by the cousin of one of the owners of the plan sponsor. Is there any issue?
Answer: Yes, there is an issue. This would be considered a prohibited transaction due to the relationship of the owner of the privately held company and the ownership of the plan sponsor. The investment might truly meet the standards of prudence, but if anything were to go wrong, the participants would be justified to sue the fiduciary for breach of duty.
A loan from an employer-sponsored retirement plan to an employee is a violation of the prohibited transactions rules. Is this statement correct?
Answer: Yes, it is correct. However, there is a statutory exemption, which allows employees to take a loan from their own plan account under certain circumstances.
You are an investment advisor working for XYZ Capital Management. You have been hired to educate the participants in ABC Manufacturing’s 401(k) plan. Are you considered to be a fiduciary?
Answer: No, an investment advisor whose only role is to provide education is not considered to be a fiduciary.
How could the inherent personal liability associated with being a fiduciary be limited or removed?
Answer: There are four ways this could be accomplished. The first way is for the fiduciary to simply follow the IPS to the letter. This will effectively limit the fiduciary liability. The second way is for the fiduciary to outsource any areas where they are not an expert. The outsourced entity (or person) will now have the liability, and not the fiduciary. The third way is for the company to outright indemnify the fiduciary. This means that the plan sponsor will assume any legal risks that the fiduciary would otherwise be exposed to. The fourth way is for either the plan sponsor or the fiduciary themselves to purchase a fiduciary bond, which is an insurance policy against the fiduciary messing up.
Chapter 13
A medium-sized company has decided to begin offering a DB plan. Do they need to host an enrollment meeting?
Answer: No, this employer does not need to host an enrollment meeting. Enrollment meetings are intended for plans that involve employee salary deferrals. The idea is to encourage participation among the rank-and-file so that discrimination testing is easier to pass.
Why is the SPD frequently used as a means of fulfilling the employer’s obligation to explain the plan to participants?
Answer: The summary plan description (SPD) is uniquely suited for this task because it bridges the gap between the legalese of the pension plan and the understanding of a normal person (who does not have a finance degree). It is also cost-effective since it is really just a summary of the plan document.
Who is typically appointed to be the plan administrator?
Answer: The plan administrator is typically either the company itself or an officer of the company.
Is it correct that the only tax-related form that an employer-sponsored plan needs to file is a form 1099-R in the event of a distribution?
Answer: No, all qualified plans also need to file a form 5500 annually to communicate relevant plan information to the IRS. Defined-benefit plans also need to file an annual report with the PBGC, although this is not a tax form.
From the perspective of an employee disclosure, what happens when a significant change is made within the structure of an employer-sponsored tax-advantaged plan? (i.e., change in the eligibility or vesting schedules)
Answer: The company will need to provide each participant with a summary of material modifications (SMM) report. They will also need to provide a new summary plan description (SDP) within a five-year timeframe of making the change. The idea is to tell them about the change in an isolated report and then give them a periodically refreshed complete SPD to ensure that they know what is being offered by their plan.
If there have not been any significant changes in the plan, then the employer only needs to provide the SPD when the participant enrolls in the plan for the first time. Is this statement correct?
Answer: No, it is not correct. Employees are required to receive a new SPD every 10 years even if no significant changes have occurred.
A plan administrator receives a valid court order instructing that a portion of a participant’s account should be paid to their ex-spouse. This QDRO specifies the parties involved and the amount to be paid. How should the plan administrator proceed?
Answer: This QDRO is not in good order. It is a valid court order, but they neglected to include the number of payments to be made. It is important to know if there should be one lump sum payment or a series of payments over some number of years. The plan administrator should send a letter to the court clerk requesting a court order that includes this specification. After a new court order is received, the plan administrator should promptly begin distributions in accordance with the document.
A plan administrator finds an accidental compliance infringement while performing a routine review of the plan operations. What should they do?
Answer: The first step is to fix the problem immediately. Then, they should report the problem to the appropriate regulator. All of the regulators have programs for voluntary compliance infringement reporting. They should report it because the regulator will eventually discover the accidental violation. If they find it themselves, then they will assess a fine, and perhaps, put the company on a watch list for more frequent (and intense) reviews. However, if the company self-reports, then the regulator will typically assess a greatly reduced fine (if at all). Self-reporting also communicates to the regulator that the employer is genuinely trying to do the right thing and may even move the employer to a list of lower risk employers, which could mean easier and less frequent audits. Honesty pays dividends!
Chapter 14
What are the common reasons for initiating a plan termination?
Answer: The common reasons for initiating a plan termination include, but are not limited to, the plan no longer being affordable for the plan sponsor, the plan sponsor desiring to change plan types to offer a different level of benefits for their employees, or possibly, the result of a business merger.
What are common alternatives to a plan termination?
Answer: One common alternative to plan termination is to freeze future benefit accruals. In this step, all currently accrued benefits would remain intact, while future benefits would not accrue. The second common alternative is to amend one plan type into another plan type. Using this method, the employees will still have an ongoing retirement benefit in a different type of account.
An employer with a DB plan approaches you about amending their plan into a 410(k). How would you advise them?
Answer: A defined-benefit plan cannot be amended into any type of defined-contribution plan. This employer will need to formally terminate their defined-benefit plan and then install a new 401(k). The ultimate effect can be approximately similar to simply amending a plan, but the intermediate steps will be different.
At your 10-year college reunion, an old friend tells you that he started a business five years ago and installed a 401(k) at the time. He has rethought of offering an employer-sponsored plan and has decided that it is too cumbersome and costly to retain the plan. He is planning on terminating the plan. What advice would you give him?
Answer: Your friend needs to be aware that he is going to generate substantial inquiry from the IRS when he decides to terminate because it is within the first 10 years of plan installation. If the review goes the wrong way, the IRS could disqualify the plan retroactively, which could be very harmful to both the company and your friend’s employees. Before terminating, he should gather enough information about the business’ conditions and projections that he could prove, through facts and circumstances, to the IRS that this is a necessary business strategy shift in order to remain competitive. Proving this is the only way to avoid retroactive plan disqualification in his circumstance.
A client comes to you with information that they have discovered a major, yet accidental, compliance violation within their profit-sharing plan. They have decided to terminate the plan, rather than fix the problem with additional contributions. What advice would you give to this client?
Answer: The IRS will closely scrutinize all plans upon termination. The employer will need to fix any regulatory violations and will also have fines to pay. For some reason, the IRS does not like employers who attempt to dodge issues. It would be much wiser in this situation to fix the problem, utilize the voluntary reporting system, and then consider whether or not to terminate the profit-sharing plan.
Is the only time that a voluntary ADL is recommended to be used at the installation of a plan?
Answer: No, it is also recommended to use file for an ADL upon plan termination. The IRS will scrutinize a plan upon termination either way, but filing for an ADL communicates goodwill to the regulators and may make the subsequent review much easier to navigate.
What differences exist between the process of terminating a DC plan and a DB plan, assuming that the DB plan termination is a standard termination?
Answer: With a defined-contribution plan, employees must receive a 15-day notice. On the other hand, a defined-benefit plan must provide 60 to 90 days of notice. A defined-benefit plan will also need to notify the PBGC of the planned standard termination and notify all participants that PBGC coverage will expire when the plan is terminated.
A large employer has been a very good steward of their DB plan. They have a PBO (plan liability) of $100 million dollars, but they have accumulated $125 million in the plan assets through contributions and market performance. They have decided to amend the DB plan into a cash-balance plan with frozen accruals, and then they plan to install a 401(k). The company is planning to take back the $25 million in excess plan assets. Is there a way to avoid paying $12.5 million as fines to the government?
Answer: If this employer proceeds with their current plans as stated, they will be assessed the 50 percent penalty, which is equal to $12.5 million (50 percent of the excess contribution). This strategy would net the company $12.5 million dollars. However, they could bring the penalty down to 20 percent if they also give 20 percent to employees. The company could reallocate $5 million (20 percent of the excess contributions) into the employee’s new cash-balance plan accounts. This would reduce the government penalty to $5 million and net the company $15 million instead of $12.5 million. They end up with more money. Their employees end up with more money. The only entity with less is the federal government. Sounds good ....
A plan administrator is in the process of terminating their DB plan. They have chosen to use an SPAC for all participants. What issues does the plan administrator need to be aware of?
Answer: The first matter is that all participants will need to receive the contact information for the insurance company. The big issue is that, as a fiduciary, the plan administrator needs to be aware that their choice of insurance company is a fiduciary decision, which means personal liability, if something goes wrong with the insurance company’s financial health. The plan administrator needs to solicit multiple bids from multiple insurance companies. They will need to check with multiple insurance ratings agencies to assess the financial health of each company. They should then rule out the lowest bid to eliminate a lawsuit alleging misconduct by choosing the cheapest alternative, which eventually goes bankrupt. The plan administrator also needs to document this entire process.
A small bicycle repair shop has established a 401(k). They have a total of four employees, including the business owner. One employee, who has a reasonable unvested balance, has been with the company for two years when their employment is terminated. From the perspective of regulatory oversight, what issues might this scenario present?
Answer: This business has a turnover rate of 25 percent, which crosses over the 20 percent threshold for partial terminations. If the scenario were ruled a partial termination by regulators, then the departing employee will need to be fully vested upon termination. However, if the business can prove that the termination was due to general business conditions, then the regulator may rule that it was not a partial termination and the unvested balance can revert to the employer.
What is an involuntary termination? Why does it occur? What happens when this does occur?
Answer: An involuntary termination occurs when the PBGC grows concerned about the financial health of a defined-benefit plan sponsor and their funded status is problematic. In this scenario, the PBGC is trying to cap their risk before it gets out of hand. The PBGC will seize all plan assets and they may also go after other assets of the plan–sponsor if the courts (bankruptcy or otherwise) permit. The purpose in seizing assets is to create a pool of assets that can be used for the PBGC to continue making payments to the plan participants (current retirees and those still working, but expecting benefits in the future).
Chapter 15
What are the differences between a qualified and a nonqualified plan?
Answer: In a qualified plan, the plan sponsor receives a current tax deduction for the amount of the contribution, while the employee receives a pretax (tax-deductible) contribution that is later taxed when distributed. In a nonqualified plan, the employer only receives a deduction when the employee realizes taxable income. This may be in retirement or significantly sooner depending on how the plan is set up.
An employee will not pay taxes on the full value of a nonqualified deferred compensation plan until certain requirements have been met. However, they must pay taxes on the earnings during the deferral period. Is this a correct understanding of how nonqualified deferred compensation works?
Answer: It is partly true. The statement is correct that “an employee will not pay taxes on the full value of a nonqualified deferred compensation plan until certain requirements have been met,” but it is not true that employees pay taxes on the earnings during the deferral period. The plan sponsor will pay taxes on earnings and then receive an offsetting deduction when the whole package becomes taxable income to the employee.
Why is the notion of a substantial risk of forfeiture such a major issue for nonqualified deferred compensation?
Answer: This is a major threshold for taxation. Once the substantial risk of forfeiture has been removed, the benefits are fully taxable to the employee unless certain other requirements are met.
Describe the economic benefit rule and its importance.
Answer: The economic benefit rule relates to whether or not the dollar amount that will be received from a nonqualified deferred compensation is known with certainty. For example, if money is placed into an irrevocable trust, then the dollar amount is guaranteed because it has already been irrevocably reserved for the participant. If the economic benefit rule has been violated (meaning that the dollar amount is known and reserved exclusively for the participant) and the substantial risk of forfeiture has elapsed, then the benefits will be currently taxable.
What is “constructive receipt” and how can it be avoided?
Answer: The concept of constructive receipt states that a participant in a nonqualified deferred compensation plan cannot choose case-by-case whether they want to receive their compensation now or defer it to later. If this benefit was permitted, then individuals could easily manage their tax bracket. In order to not violate this rule, a participant must make an election about deferring compensation before the end of the previous calendar year’s end.
What are the objectives of a nonqualified deferred compensation plan?
Answer: The primary objectives of a nonqualified deferred compensation plan are attraction and retention of key talent.
What is the difference between a SERP and an offset SERP?
Answer: A supplemental executive retirement plan (SERP) is a form of additional compensation specifically for executives. It involves payment of deferred compensation, which exceeds their normal salary. An offset SERP is the same thing except that it is specially designed to offset the qualified plans offered by the employer to provide a certain retirement replacement ratio.
What roadblocks can cause a substantial risk of forfeiture?
Answer: The common features used to create and maintain a substantial risk of forfeiture include extended vesting schedules, performance benchmarks, consulting clauses, and noncompete clauses.
What must exist in order for a noncompete clause to be enforceable?
Answer: In order to be enforceable, a noncompete clause must be limited in both time and geography. A court would not honor a noncompete clause that extends for a prohibitively long time period. They would also not enforce too large of a geographic region.
What is the difference between a COLI and executive bonus life insurance?
Answer: A corporate-owned life insurance (COLI) policy is a whole life insurance contract that is owned by the corporation. The covered employee must consent to the coverage, but the corporation is the beneficiary of the policy. The idea here is to protect the company in the event of the premature death of the covered employee who has a nonqualified deferred compensation plan. The proceeds of the COLI would be used to pay off the survivors of the deceased employee. On the other hand, executive bonus life insurance is owned by the executive, which enables the executive to establish their own beneficiary. The company will pay the insurance premiums, and they will generally pay a “double bonus,” which covers not only the insurance premiums, but also any taxes that the executive would owe on the premiums, which are considered to be taxable income.
A company has one employee whose industry contacts have been extremely valuable to the business. The employee is now nearing the normal retirement age, and the company is concerned that they might leave the company through either retirement or attrition. How can a nonqualified deferred compensation plan help the company manage this risk?
Answer: The company should consider either a noncompete clause or a consulting clause attached to a nonqualified deferred compensation plan.
Explain the function and purpose of a rabbi trust.
Answer: The assets in a rabbi trust are contributed to an irrevocable trust, which protects the participants. However, to avoid the current taxation to the participants, assets must continue to be subject to any claims by the plan sponsor’s creditors. The purpose of the rabbi trust is to avoid the economic benefit rule so that after the lapse of forfeiture risk, the participant does not get hit with unwanted taxable income.
What is the “top hat” rule and why is it important?
Answer: The top hat rule states that nonqualified deferred compensation plans must be limited in access to only a “select group of management.” If eligibility is limited to a select group of management, then most ERISA requirements can be avoided. The big one is the requirement to be funded. If the plan is made available to everyone, then it would be subject to ERISA and required to be funded. This would mean that the economic benefit rule would be violated and the current taxation would be the result.
What is the difference between the two types of nonqualified deferred compensation plans that are available to nonprofit organizations?
Answer: The special category of nonqualified deferred compensation that is available to nonprofit organizations is called a 457 plan. A 457(b) plan is eligible for tax deferral because it limits the contributions to the 403(b) limit (which is $18,000 in 2016). 457(b) participants can make month-by-month deferral elections unlike the constructive receipt rule, which requires the election to be made before the end of the previous calendar year. The other plan type is called a 457(f) plan, which is not eligible for tax deferral after the substantial risk of forfeiture has elapsed. 457(f) plans are ineligible because they choose to forego the contribution cap.
Chapter 16
Identify two reasons why an equity-based compensation might be used in practice today.
Answer: One reason that equity-based compensation is used is that it has the potential to offer the recipient employees capital gains treatment on a portion of their “compensation” package. Another reason is that it functions as an effective incentive for employees because it links the employee’s financial well-being with that of the company.
How could an equity-based compensation be used to mitigate the agency conflict?
Answer: The agency conflict occurs when the interests of management deviate from the interests of the shareholders (owners) of a business. Equity-based compensation helps the management to become a part of the group of owners, which means that they benefit when the shareholder’s benefit. Of course, this can be taken to an unhealthy extreme, where the management encourages unwise accounting practices and short-term volatility in the stock, which only creates short-term bubbles and no long-term value for the owners.
What are some of the key considerations for a closely held company that wants to offer an equity-based compensation?
Answer: With respect to offering equity-based compensation, one challenge for a closely held business is to establish a cost-effective and objective method of valuation. They could pay a consultant annually to value the business, but it might be wiser to simply use a certain multiple over sales. They may need to pay a consultant a fee to help figure out the appropriate multiple over sales, but this can then be used on an ongoing basis. Another challenge is repurchasing an ownership interest when a covered employee leaves the company. Is there an internal market for the shares? Another challenge is the potential dilution of the current owners by giving an ownership stake to someone else. If the company is an S-Corporation, then they will also need to be careful that the ownership interest does not grow to 2 percent of the company because 2 percent (or greater) owners will have negative personal tax effects.
What is one reason why some companies have become less willing to use equity-based compensation in the recent years?
Answer: One factor that has diminished the employer interest in equity-based compensation is the requirement to expense a model-derived amount in the current period for any options granted during the period. Companies are still using equity-based compensation, but this roadblock has slowed the adoption of the method.
Why would current shareholders not like an equity-based compensation?
Answer: The current shareholders would not like equity-based compensation because it would dilute their ownership interest.
How does a new offering of an equity-based compensation avoid the costly process of filing as a new public offering with the SEC?
Answer: If a company decides to offer equity-based compensation to a broad group of its employees, the offering might be deemed a public offering, which would require a costly process of filing with the SEC. A company can avoid this path if they limit the pool of those being offered equity-based compensation to only a select group of management (top hat exemption).
What is the mandatory vesting requirement for NQSOs?
Answer: There is not a mandatory vesting schedule for nonqualified stock options because they are not under the umbrella of ERISA. In fact, longer vesting schedules are common with equity-based compensation.
What are the tax consequences of NQSOs?
Answer: At the time the options are granted, there are no income tax consequences. At the time of exercise, the participant has ordinary income in the amount of the difference between the option price and the current market price. The employer receives a deduction of this same amount. When the stock is eventually sold, the gain is taxed as a capital gain with the rates dependent on the holding period postexercise. Taxes for social security (FICA) are also due when the employee receives taxable income (at exercise).
Describe the limitations inherent with an ISO plan. Why would an executive be willing to accept these limitations?
Answer: Incentive stock options have two significant limitations. The first is that the amount cannot exceed $100,000. The second limitation is that 10 percent owners must increase their grant price from 100 percent of the fair market value to 110 percent of the fair market value, and their offering period is reduced from 10 years to 5 years. An executive would be willing to accept this limitation because of the more favorable tax treatment that is available to incentive stock options if certain conditions are met.
What are the differences in coverage eligibility between a NQSO and an ISO?
Answer: Nonqualified stock options (NQSO) can be awarded to any person that the board so chooses. They could award an NQSO to an independent contractor or a supplier if they so desired. An incentive stock option (ISO) can only be awarded to an employee of the company.
An impatient executive who has been granted an ISO waits one year from the grant date to exercise and subsequently, sell their options. What is the tax implication of this transaction?
Answer: This impatient executive will be subject to all of the tax implications of a nonqualified stock option. They will have ordinary income equal to the difference between the strike price and the fair market value when sold. There will not be any capital gains taxes because they sold at exercise. If they had waited any length of time to sell their shares, then the difference in price between the exercise date and the date of the sale would receive capital gains rates linked to the length of the holding period.
A different executive has been granted an ISO, they wait two years from the grant date to exercise their options and an additional two years before selling their shares. What is the tax implication of their timing choices?
Answer: This wise executive has fully realized the tax potential of an incentive stock option. They held their shares for longer than the required window of two years past the grant date and one year past exercising. All of their gains will be taxed at the lower long-term capital gains rates.
Describe the limitations and tax consequences of an ESPP if the participant has satisfied the two-year or one-year threshold.
Answer: There are two significant limitations with an employee stock purchase plan. First, employees cannot purchase more than $25,000 worth of shares in any given tax year. Second, the program must be made broadly available to all employees (including rank-and-file), but it is not available to those who own more than 5 percent of a company. If the holding period requirements have been met, then the employee will have ordinary income for the amount of the discount with any remaining value taxed as a capital gain linked to the holding period of the investment.
Why is phantom stock attractive to a small business?
Answer: Small businesses use phantom stock as a replacement for stock options. This option allows the recipient to receive financial value if the company does well, but it does not involve any actual ownership interest ... no voting privileges.
How is phantom stock taxed?
Answer: Phantom stock is taxed as ordinary income in the period in which it is received.
Why is a §83 election a risky bet for an employee with restricted stock?
Answer: A §83 election enables an employee with restricted stock to choose whether to have the value of the restricted stock taxed once the stock is vested and no longer restricted or very close to the grant date. Clearly, the executive would be better off paying taxes at the current fair market value if the stock is expected to rise, but this is only a benefit if the executive completes the tenure necessary to remove the restriction. They could end up paying taxes and they not receiving the stock because the restriction was never removed before they changed employers.
What is the difference between phantom stock and SAR?
Answer: Phantom stock and stock appreciation rights are very similar. They both offer units of appreciation, which are linked to the financial performance of a company without involving actual ownership. Phantom stock will have an exercise date, which is selected by the employer. On the other hand, stock appreciation rights generally have a flexible exercise date, which can be selected by the covered employee.
Chapter 17
Compare traditional IRAs with qualified plans.
Answer: Both qualified plans and traditional IRAs are tax-advantaged retirement plans that enable pretax contributions. They may have very different contribution limits and eligibility rules. Qualified plans are sponsored by an employer, while traditional IRAs are constructed outside of the employer’s purview.
How is a Roth IRA different to a traditional IRA?
Answer: A traditional IRA will typically contain deductible (pretax) contributions, but they could also contain nondeductible (after-tax) contributions. On the other hand, Roth IRAs can only contain nondeductible contributions. The other major difference relates to the ultimate distributions. Traditional IRAs have taxable distributions, while Roth IRA distributions are tax-free.
What is the difference between tax-deferred growth and tax-free growth?
Answer: Tax-deferred growth refers to the operations of a traditional IRA. This relationship involves a pretax contribution with growth that is not taxed during the accumulation years’ preretirement. However, in retirement, any distributions are taxed as ordinary income. Tax-free growth refers to Roth IRAs, which utilize after-tax contributions. No taxes are paid on the growth as it accrues during the accumulation years, and no taxes are due on the ultimate distributions in retirement.
When should someone begin making contributions to an IRA?
Answer: Individuals should be encouraged to begin making IRA contributions as soon as they have earned income. This means that once a teen gets their first job, they should be encouraged to begin saving and learning about the stock and bond markets.
Is it true that catch-up contributions are available to taxpayers after they reach age 55?
Answer: Actually, the increased contribution limit is available to taxpayers after they turn 50.
You are married and also covered by a SIMPLE plan at the small company where you earn a salary of $150,000. You would like to save more and heard from someone on MSNBC that if you are not an active participant, you can contribute to an IRA. What are your options?
Answer: The news story on MSNBC was correct that if you are not an active participant, then you can contribute to a traditional IRA without any conflicts. You, on the other hand, are considered an active participant because of the SIMPLE plan coverage. You are above the threshold to contribute into a traditional IRA. However, you could make a nondeductible contrition to a Roth IRA if you so choose.
A married couple, who files a joint tax return, has combined AGI in 2016 of $135,000. The husband is an active participant in his employer’s 401(k), but the wife stays at home to raise their two-year-old daughter. Her only source of income is a rental property that she inherited from her grandfather. What deductible contributions can be made into a traditional IRA for both taxpayers?
Answer: The husband is not able to make any deductible contribution because he is above the $118,000 threshold for 2016. The wife’s income is considered passive income, which does not count as compensation for IRA contribution purposes. She will still be able to contribute $5,500 (2016 limit) because their income is below the $184,000 threshold for 2016.
A friend tells you that they think that you are not able to make nondeductible traditional IRA contributions because you earn $500,000 per year. Is this correct?
Answer: No, this is not correct. There is no income limit on nondeductible contributions.
Why should someone prefer a direct rollover to an indirect rollover?
Answer: A direct rollover is a transfer directly from one retirement account custodian to another. This is a seamless process for the taxpayer and requires not much more than a few signatures. On the other hand, an indirect rollover can create a nightmare. The departing retirement custodian must withhold 20 percent in taxes and remit this to the federal government. The taxpayer is then responsible for depositing all remaining funds plus the missing 20 percent into the new custodians account. Failure to follow this path will result in a distribution by default and possibly, early distribution penalties.
What is the process for a Roth conversion?
Answer: Any portion of a traditional IRA can be converted into a Roth IRA at any time. This scenario will involve the IRA owner realizing the current ordinary (taxable) income in the amount of the conversion. They should be able to pay the taxes from assets outside of the conversion process. This will effectively convert tax-deferred assets into tax-free assets, but the cost is the current taxation. Various calculators are available on the Internet to help someone assess if this might be a good option for them to consider.
What is the five-year rule as it pertains to Roth IRAs?
Answer: The assets within a Roth IRA are not available for tax-free withdrawals, assuming age constraints or other special scenarios have been met, until five calendar years have passed after the first contribution into any Roth IRA registered in the taxpayer’s name.
What is the most common event that could create an excess contribution, and how is the problem remedied?
Answer: Excess contributions will occur in a traditional IRA if the taxpayer, who is also an active participant, makes a contribution into their IRA only to find later in the tax year that they have crossed above the income threshold. A taxpayer in this situation has three choices. They could pay a 6 percent excise tax. They could withdraw all of the excess contribution plus any growth during the respective time period. They could recharacterize the excess contribution as either a Roth IRA (if they qualify based on the AGI) or as a nondeductible traditional IRA contribution.
Chapter 18
There are two different types of accounts that are both known as an “IRA.” Discuss their differences.
Answer: An individual retirement account is the first type of account known as an IRA. It involves a custodian holding the assets in the account and managing the application of IRA rules. Individual retirement accounts can invest in mutual funds, exchange traded funds, individual stocks, and bonds. The other type of IRA is called an individual retirement annuity. This is an IRA that is funded using either a fixed or variable annuity.
Why would an investor choose to invest in an individual retirement annuity?
Answer: An individual retirement annuity can be a good alternative for an investor who does not have any idea how to allocate their investments. This is a “do-it-for-me” retirement option. Also, an individual retirement annuity can be used to reduce exposure to the risk of “living too long” by establishing a lifetime payout option.
Is it true that individual retirement annuities enable a retirement saver to save more money than using an IRA?
Answer: No, it is not true. They both use the same contribution limit rules.
Why would a retirement saver want to go through the hassle of using a self-directed IRA?
Answer: A retirement saver might use a self-directed IRA to introduce alternative investments into their portfolio. They might want to own real estate directly rather than through a real estate investment trust (REIT) or perhaps a self-storage unit or an interest in a franchise.
A 49-year-old retirement saver has decided to use a self-directed IRA to purchase a self-storage unit. There are 100 units in the facility, and the owner uses one unit to the store rental unit supplies and one to store the owner’s Porsche during the winter months. They sunk their entire IRA balance into the asset. A tree falls on one corner of the unit and does $10,000 worth of damage. The owner does not want to file an insurance claim, which would raise their insurance rates, so, they simply write a check out of a personal checking account. Are there any issues with this scenario?
Answer: The matter of storing the owner’s Porsche is a self-dealing conflict. The other issue is that the owner has essentially contributed $10,000 into a self-directed IRA, which can only receive $5,500 (2014 limit). This presents an excess contribution issue.
A 35-year-old taxpayer is planning on contributing the maximum amount into their IRA this year. Assume that they are eligible to do so. They are planning on contributing shares of a technology company that they own in a taxable (non-IRA) account because they think that this company will appreciate substantially and within the IRA, the appreciation will be tax-deferred. Are there any issues with this scenario?
Answer: IRA contributions are only permitted in cash. A transfer of shares (in-kind) is not permitted. They could sell their shares, pay any applicable capital gains taxes based upon their length of ownership, contribute cash into the IRA, and repurchase the technology company using the cash contribution.
A client of yours has spoken to their long-time bank about receiving a loan to start a small business. Their only collateral that is large enough to secure the loan is their IRA. The bank is not willing to use their IRA as collateral. Your client is very frustrated and is planning on changing banks. What counsel would you give your client?
Answer: The problem is not the bank. The problem is the law. An IRA cannot be used as collateral for a loan. Your client would encounter this issue no matter which bank they spoke with.
What choice should an investor make if they are given an option of choosing a Roth IRA contribution or a nondeductible traditional IRA contribution?
Answer: Presented with the options of making a Roth IRA contribution or a nondeductible traditional IRA contribution, a retirement saver should always choose to make the Roth IRA contribution. Both options involve after-tax (nondeductible) contributions. The distributions from a Roth IRA are completely tax-free, while nondeductible traditional IRA have a mixed tax treatment. The nondeductible contributions can always be withdrawn tax-free, but any growth in the money will be taxed as ordinary income.
What is the one advantage of using a taxable account as a repository for savings?
Answer: Stepped up basis is an outstanding feature of a taxable account. It permits a portion of the taxable cost basis to be forgiven!
A married taxpayer recently died leaving his surviving spouse with a taxable account balance of $424,000. The original cost basis was $78,000. What is the surviving spouse’s new cost basis in this account?
Answer: The surviving spouse’s new cost basis is $251,000 ([50% × $424,000] + [50% × $78,000]).
A taxpayer is expecting their tax rate to increase during retirement due to an expected inheritance. Should they be saving with a Roth IRA or a traditional IRA?
Answer: This taxpayer should be saving with a Roth IRA because they are expecting to have a higher tax rate in retirement.
What type of client might be a good candidate for a Roth conversion?
Answer: There are two types of clients for which a Roth IRA could be ideal. The first is someone who is expecting their tax rate to rise during retirement, relative to their current tax rate. The second type of client who might be a good candidate is one who has a temporary drop in tax rate perhaps through unemployment or a special tax scenario, which artificially lowers their tax rate for one or more tax years.
A client of yours has a taxable account, a 401(k), and a traditional IRA, which was the result of a rollover from a previous employer’s profit-sharing plan. They are thinking about converting their traditional IRA into a Roth IRA. They are concerned about realizing a substantial amount of additional taxable income in one tax year. What would you tell them?
Answer: Roth conversions can be initiated in small amounts. They need not convert the entire traditional IRA in one batch. They could convert whatever amount they feel that they can handle as additional taxable income.
A different client approaches you about converting $30,000 from their traditional IRA into their Roth IRA. They have a 15 percent effective tax rate. They only have $1,500 in savings that could be used to pay the conversion taxes. They are planning on withholding the remainder of the taxes from the assets that are being transferred. What would you advise them?
Answer: This client will need to pay $4,500 (15% × $30,000) in taxes. They only have one-third of that money in savings available to pay the conversion taxes. They cannot withhold money from their assets in the conversion process because this would be treated as a distribution. They should consider only converting $10,000 in the current tax year because they have enough in savings to pay taxes on this amount.
Chapter 19
What was described as perhaps the most important step in the financial planning process, which is sadly sometimes missed?
Answer: In the chapter, the relationship building process was described as, perhaps, the most important step in the planning process. Without a relationship built on mutual trust, a well-intentioned plan could be derailed by greed.
Two financial planning students are discussing their career intentions. One says to the other that they are considering a career in personal financial planning because they like the fact that it is a relatively precise science that involves applying a formula to a client and coming up with a savings goal. They like the certainty and predictability of this process that can simply be reapplied to multiple clients fairly easily. What would your comments be if you overheard this conversation?
Answer: This student has misunderstood the profession. The “relatively precise science” of financial planning involves a great deal of estimation, which will need to be adjusted for revised realities as the client progresses through time. The retirement planning process is a constant moving target. The other fallacy is that every client is different. That is part of what keeps the job interesting ... new clients and new challenges. There will not be a template that can just be applied to every client across the board. If that were the case, then a computer program could solve the problems without the assistance of a qualified financial professional.
Some retirees have been sold the notion that a 6 to 7 percent withdrawal rate from their savings is sustainable. Is this wise? Why or why not?
Answer: The key word is “sustainable.” A retiree could potentially get a withdrawal rate this high with an annuity product that pays out principal along with earnings to arrive at the desired 6 to 7 percent withdrawal rate. At the end of this arrangement, the entire principal has been depleted. The better option is to include a mix of dividend paying equities and highly rated bonds to achieve a withdrawal rate of 3 to 4 percent. This would increase the chances of not outliving their retirement savings.
A 55-year old decides to pay a professional to develop a financial plan. Once the plan is designed and implemented, the taxpayer feels that there is no need to pay further fees to a financial professional because the plan is now in place and on autopilot. Is their thinking correct?
Answer: No, their thinking is not correct. Developing and implementing a plan are only the first several steps. The plan must be monitored on an ongoing basis to adjust with the changing markets. It would be unthinkable for the financial professional to accurately guess the average inflation rate and the average investment return a decade before retirement will begin for this individual much less 30 years in advance of when they might potentially leave an estate.
What one retirement planning issue should all college students know about if they plan to work for a small business upon graduation?
Answer: Small businesses are much less likely to offer either a defined-benefit plan or a defined-contribution plan. If their employer does offer a plan with an employer matching feature, then they should maximize this opportunity as quickly as possible. If there is not a plan being offered, then they should take the initiative to save through an IRA on their own.
What retirement planning issues are more prone to affect female clients?
Answer: Women are less likely to be covered by an employer-sponsored plan than men. Women also typically have lower earnings, which makes it harder to save for retirement. On average, women outlive men, so all else being equal, women need to save more than men. Women are more likely to take time off from working full-time to be caregivers than men. Women usually invest more conservatively than men, which places a higher need on savings because their investments might not grow as much due to lower risk investing.
What are some of the common roadblocks to retirement?
Answer: One common roadblock is poor planning. If taxpayers do not budget and plan for retirement, then they should not be surprised if retirement is not as comfortable as they would have liked. Another roadblock is the advent of unexpected expenses. Poor insurance coverage, especially medical, can also crush a retirement plan. For many, the most significant roadblock is simply not enough wages to provide for basic living needs and savings. Individuals in this category should consider creative ways to save, and possibly, alternate ways to increase earnings (second job, retraining) if those options exist.
Is a comfortable retirement guaranteed for those who have an employer-sponsored plan and save privately using a customized financial plan?
Answer: No, it is not guaranteed. They will have the highest chance of reaching a comfortable retirement, but there are no guarantees. Circumstances can always arise that will negate an otherwise well-planned scenario. The goal is to give a retiree the best chance at succeeding by following a plan.
Chapter 20
Social security is arguably the most important retirement system in America, yet some workers are not covered under social security. Who are these people?
Answer: Workers who are not covered under social security include: those with less than 40 credited quarters, railroad workers (who have their own system), employees of the state and local governments (unless the state or local government has entered into a special agreement with the Social Security Administration), some expatriate working for foreign affiliates of U.S. employers, and ministers who elect out of coverage.
Some people say that social security creates a moral hazard. Why would they say such a thing?
Answer: The retirement safety net provided by social security may incentivize Americans to save less than they otherwise would. With the hope of a certain level of retirement income, American’s spend way more than they should. If social security did not exist, then taxpayers would spend less and save more to prepare for their own retirement.
Stacey earned a compensation totaling $11,000 from a single employer between January 1 and April 1. She then stopped working to care for her mother who was in failing health. How many quarters of coverage does Stacey earn for this taxable year?
Answer: For 2016, a worker will receive a credit for one quarter of coverage for each $1,260 in annual earnings on which social security taxes are earned, up to a maximum of four quarters of coverage. Stacey earns four quarters of coverage because she has earned more than $5,040. It does not matter that she works for only part of the year.
A certain woman has been out of the work force for the last 10 years as she has been focusing on raising three children. She has recently decided to re-enter the job market. How long will she need to work before her spouse would be eligible for surviving spouse benefits should that unfortunate circumstance become necessary?
Answer: Assume that 2015 was the year when the first 4 credits were accrued and that 2016 is the second year, when 2 more credited quarters are needed. In this scenario, this woman would need to earn at least $2,520 over two quarters before survivor benefits would be earned.
What is the earliest age at which at which a retired worker is eligible to receive social security benefits?
Answer: Age 62 is the earliest age at which benefits can be received. This is 48 months before the normal retirement age.
One of your uncles, who was born in 1948, tells you that he is planning to retire with full social security benefits this year at age 65. What advice would you give your uncle?
Answer: Since your uncle was born between 1943 and 1954, his normal retirement age has recently been adjusted upwards to 66. According to the Social Security Administration’s rules, if he proceeds with his plan to retire at age 65, then he will be subject to an early retirement benefits reduction.
A certain couple divorced five years ago. They were married for eight years and neither has remarried. The ex-wife is now 66 years old and interested in applying for social security. What are her options?
Answer: This woman has reached her normal retirement age. Unfortunately, her marriage did not last the full 10 years required to be eligible for divorced spouse benefits. She will only be able to apply for benefits based upon her earnings history. Had the couple been married for longer than 10 years, then she would have been eligible to test if divorced spouse benefits would be higher than benefits based upon her earnings history.
A tragic car accident claimed the life of a devoted husband and father. The survivors are a 45-year-old wife, a 24-year-old mentally disabled child who has been disabled from birth, a 21-year-old college student, and an 18.5-year old who will be graduating high school in another 10 months. What are the survivor’s benefits available to this family assuming that the deceased father was fully insured?
Answer: Because the surviving spouse is caring for a child who was mentally disabled from birth, she will be eligible for surviving spouse social security benefits beginning now. The 21-year-old college student is not eligible for any benefits. The youngest child (the 18.5-year-old high school student) is eligible for dependent benefits until they reach age 19.
Following is a series of indexed annual salaries for an individual. They began with a $45,000 indexed salary straight out of college and had annual increases of 3 percent with the exception that every seven years they changed jobs and received a salary increase larger than 3 percent. What is this individual’s AIME?
$45,000.00
$55,000.00
$67,500.00
$87,500.00
$112,500.00
$46,350.00
$56,650.00
$69,525.00
$90,125.00
$115,875.00
$47,740.50
$58,349.50
$71,610.75
$92,828.75
$119,351.25
$49,172.72
$60,099.99
$73,759.07
$95,613.61
$122,931.79
$50,647.90
$61,902.98
$75,971.84
$98,482.02
$126,619.74
$52,167.33
$63,760.07
$78,251.00
$101,436.48
$130,418.33
$53,732.35
$65,672.88
$80,598.53
$104,479.58
$134,330.88
Answer: The cumulative indexed gross earnings for this individual for the highest 30 years are $2,815,954.84. Dividing this number by 360 (30 × 12), which is the total number of months in 30 years, provides an AIME of $7,822.10.
Using the AIME you calculated in the previous question, what is this individual’s PIA (using the 2016 bend points), assuming that they retire at their normal retirement age?
Answer: Using the 2016 schedule for computing PIA, this individual’s PIA would be $2,546.49 according to the following table:
Threshold percentage (%)
2016 AIME bend points ($)
Benefit ($)
90
856
770.40
32
4,301 (5,157 - 856)
1,376.32
15
2,665.10 (7,822.10 - 5,157)
399.77
Cumulative benefit (PIA) =
$2,546.49
What would happen if the individual whose PIA you just calculated needed to retire at age 63 instead of their normal retirement age of 66?
Answer: This individual’s early retirement decision will decrease their PIA by $509.30 for the remainder of their retirement. Their adjusted PIA benefit will be $2,037.19 ($2,546.49 - $509.30). The details of the decrease in benefits can be seen in the following table:
Percentage reduction
Applicable months
Total percentage reduction (%)
Dollar reduction in PIA ($)
5/9th of 1%
36
20
509.30
5/12th of 1%
0
0
0.00
Cumulative reduction =
20
509.30
A married client who has been retired for several years has an annual pension from their previous employer equal to $25,000 per year. The combined required IRA distribution for this couple is $12,500. They have taxable capital gains income of $4,500 from their non-IRA account. They have combined social security benefits of $35,000. They are considering taking an additional IRA distribution of $10,000 to gift money to their only child. What advice would you have for them relative to their social security benefits?
Answer: Before taking out an additional IRA distribution, they already have AGI equal to $42,000 ($25,000 + $12,500 + $4,500). Under this scenario, they already have 50 percent of their social security benefits treated as taxable income. This means $17,500 (50% × $35,000) will also be fully taxed in addition to the $42,000 of pre-social security AGI. If they take the additional distribution, then their AGI will now be $52,000 ($42,000 + $10,000). This puts them into a situation where 85 percent not 50 percent of their social security benefits are now taxable. That means $29,750 (85% × $35,000). To access the additional $10,000 from their IRA will cost them $22,250 ($10,000 + [$29,750 - $17,500]) in additional taxable income. They should consider either gifting to their child from a source other than their IRAs or altering their gifting plans altogether.
A worker born in 1953 is currently planning to file for deferred social security benefits at age 68. How much benefit would they expect to receive if their PIA at their normal retirement age would equal $2,473.49?
Answer: Deferred social security filing will increase PIA by 8 percent per year after full retirement age. This employee’s normal retirement age is 66; deferring benefits until age 68 means they will increase their benefit by 16 percent (8 percent for each of the two years they waited). The deferred retirement PIA will equal $2,869.25 ($2,473.49 × 1.16).
A taxpayer was forced to “retire” (layoff) at age 63. They filed for early social security benefits and begin to receive a check for $1,976.43. Six months later, they are able to find a part-time job where they can earn $1,700 per month. This is not enough to cover their living expenses and so, they need to keep receiving social security benefits as well. The SSA finds out that they now have a part-time job. What will happen to their monthly social security benefits?
Answer: This taxpayer will still be able to receive monthly social security benefits, but because they are receiving early retirement benefits, their monthly check will be reduced due to the earnings test. The amount of excess annual earnings per the earnings test is $5,280.00 ([$1,700 × 12] - $15,120). The next step is to divide this number by 2 to determine the annual benefits reduction because there is a reduction in benefits by $1 for every $2 earned over the threshold. This number is $2,640 ($5,280/2). Then, divide this result by 12 to find the monthly social security reduction of $220. This taxpayer’s social security benefits will be reduced to $1,756.43 ($1,976.43 - $220.00). This reduction will remain in effect until the year in which they will reach normal retirement age. A much higher earnings limit in that year will mean that no reduction will apply for this taxpayer due to the level of income they receive. After they reach normal retirement age, their benefit will resume at $1,976.43 plus an upward adjustment factored by the Social Security Administration for the years when an earnings test-induced reduction was in force.
Chapter 21
Is it true that the normal retirement age derives its name because that is when most people tend to retire?
Answer: No, this is not true. According to Gallup, most people retire much earlier than the normal retirement age. The average age reported by Gallup was 61. The normal retirement age is what the Social Security Administration is trying to encourage everyone to use.
What are some of the risks posed by an early retirement?
Answer: Social security benefits will be permanently reduced if a client elects early retirement by a percentage that is based on how many months they apply for benefits before their normal retirement age. This effect is further amplified by missing out on potentially higher earning years of employment, which would theoretically increase the AIME, which would also impact the size of the monthly social security benefit checks. Early retirement could also impact a client’s pension benefits by reducing either FAC or possibly years of service if the cap has not been breached. In a DC plan, early retirement will mean missing out on several years of employer contributions. Retirement savers will also miss out on several key saving years. Typically, older clients no longer have a mortgage loan, which means that they could potentially save more during their final working years. Health insurance issues will also need to be addressed.
How should a life expectancy be chosen for a given client?
Answer: Life expectancy, based on the government tables, will be revised throughout the planning process, but it will be most accurate when the client reaches their normal retirement age. This is not an exact science, but a client’s life expectancy should be adjusted up or down based on the personal and family health history. A planner should stress test various different ages to find a scenario that is reasonable for a client. Always plan conservatively with a longer life expectancy than might, otherwise, be justified.
What trends are visible in the life expectancy data presented in this chapter?
Answer: One trend is that women tend to live longer than men. This concept presents a planning challenge for female clients. Another trend is that educational attainment makes a difference. Graduating from college will increase a person’s life expectancy. Apparently, buying very expensive textbooks is good for your longevity. Also of note is the trend that while women do outlive men, the gap is shortening somewhat in recent years. At some point, this trend could even reverse.
What is the recommended range of replacement ratios? Why would the range be less than 100 percent?
Answer: The recommended range of total retirement income replacement ratio is between 60 and 80 percent. This number is less than 100 percent because the retiree will have certain tax breaks, reduced living expenses, and most importantly, they are no longer saving for retirement.
Does everyone receive the same replacement percentage from social security?
Answer: No, there is a declining scale of replacement ratios such that those earning lower wages will have a higher replacement ratio albeit a lower dollar amount of benefit. Those earning only $10,000 per year will have a replacement ratio of 87.05 percent. Those earning $80,000 per year will have a replacement ratio of 34.04 percent, while those earning $200,000 per year will have a replacement ratio of only 22.62 percent.
Why is it not recommended to simply use the long-term inflation average of 3.34 percent as the inflation assumption in retirement planning projections?
Answer: Different time periods have different levels of inflation. The last 40 years averaged 4.32 percent while the last 20 years averaged 2.45 percent. Using a long-term average does help smooth out differences, but it may also miss a new trend. Medical services are widely used by retirees and medical inflation is much higher than mainline inflation. The last 40 years of medical inflation averaged 6.1 percent, while the last 20 years averaged 3.9 percent. This is somewhat an art form, but the inflation rate needs to be customized to the region where the taxpayer lives and the level of medical services they do use or plan to use.
What is the recommended method for selecting an investment return rate?
Answer: It is best to use historical investment returns. Longer time horizons, such as the preretirement (accumulation years) savings time period, will enable a greater allocation to stocks as opposed to bonds. It is imperative to be realistic in investment return assumptions. Lower return assumptions will yield more conservative retirement planning results. Under normal circumstances, many retirees will select a mix of perhaps 60 percent stocks and 40 percent bonds. Most retirees should use a return assumption ranging from 7 to 9 percent. Investment return assumptions should be lowered as the cost of failure rises.
Chapter 22
What factors should be considered by someone who is planning to remain in their long-term residence (home) rather than relocate?
Answer: Someone desiring to remain in their home should consider several important factors. Is the home suitable for the needs of a retiree? What about stairs and the location of the bathrooms, the kitchen, and the laundry facilities? Are there any deferred maintenance issues that could become problematic either physically or financially for the retiree? Is the neighborhood still a safe place to live? Is it a financial necessity that the retiree sells their home in order to live off of the equity they have accrued?
What factors should be considered by a client who is planning to relocate out of state?
Answer: Out-of-state relocation is a difficult decision to reverse. A client who is considering moving out of state when they retire should consider moving expenses, income tax and property tax differentials, inheritance tax differences, proximity to those who could help if needed (children or other younger relatives), and access to critical support facilities like hospitals and skilled nursing homes.
Describe a sale-leaseback transaction.
Answer: A sale-leaseback occurs when a homeowner sells their house to an investor and then proceeds to rent the same property from the new owner on a lifetime lease. A lifetime lease means that they can remain in the home with a predetermined rent schedule for as long as they live. Once they have passed away, the new owner can do whatever they like with the property (live there themselves, find a new renter, or sell it).
Describe a reverse mortgage.
Answer: In complex terms, a reverse mortgage is a nonrecourse negative amortizing loan. A homeowner can remain in their home and receive a series of payments from a lender. At the homeowner’s death (or if they decide to move before that stage), the loan is settled. If there is remaining equity in the house, then either the homeowner or their estate will receive those proceeds. If the proceeds from the home’s sale are less than the loan amount, then the lender has lost money that cannot be recovered from either the homeowner or the homeowner’s estate.
If a client decides to enter into a reverse mortgage contract and the value of the reverse mortgage loan at the retiree’s death exceeds the value of the house itself, then what happens to the excess loan balance? What if the value of the house exceeds the value of the loan?
Answer: Reverse mortgages are nonrecourse loans, which means that any loan amount that exceeds the value of the house at the retiree’s death is the problem of the lender. Neither the retiree nor their heirs will be responsible for any shortfall. However, if the value of the home exceeds the outstanding loan balance, then any residual equity is the property of either the retiree or their heirs.
Can retirees access Medicare benefits if they file for early retirement benefits?
Answer: No, under all scenarios, retirees must be at least age 65 in order to file for their own benefits.
Is it true that there are an unlimited number of reserve days, but a limited number of benefit periods?
Answer: No, this is backwards (don’t get tricked). There are an unlimited number of benefit periods in a lifetime, but reserve days are limited to 60 days.
Bill is hospitalized for 75 days, then he goes home for four months before being hospitalized for an unrelated illness for an additional 37 days. How will Medicare treat these two periods of hospitalization?
Answer: Part A of Medicare pays for inpatient hospitalization up to 90 days in each benefit period. The first period of hospitalization certainly qualifies as a covered hospital stay. Because Bill was out of the hospital for more than 60 days, the second illness will be treated as a new benefit period, and therefore, fully covered.
What if Bill were instead hospitalized for 75 days, then he goes home for four weeks before being hospitalized for an unrelated illness for an additional 37 days. How will Medicare treat these two periods of hospitalization?
Answer: Part A of Medicare pays for inpatient hospitalization up to 90 days in each benefit period. The first period of hospitalization certainly qualifies as a covered hospital stay. However, the reset period of 60 days is not satisfied. It does not matter that the illnesses are actually unrelated; they are treated as one “benefit period.” As such, Bill has a 112-day billable illness. Only the first 90 days are covered. The other 22 days could be deducted from the lifetime reserve bank of 60 days, if he has unused reserve days. Otherwise, Bill will be paying for 22 days out-of-pocket.
Can a 65-year old who is fully insured simply apply for Part D benefits?
Answer: No, they must first apply for Part A and Part B.
Describe Medicare Part C.
Answer: With Part C benefits, Medicare participants may elect to have their medical benefits provided by a third-party insurance company. The participant must still pay the Part B premium for Medicare and may be required to pay an additional premium. Each Medicare Advantage plan subcontracts with the federal government to provide benefits at least equal to, and often better than, those available under Medicare. Sometimes, either eye care or dental coverage is rolled into a Part C plan. The Medicare Advantage plan may be limited geographically and so, it is not ideal for a retiree who plans to travel a reasonable amount.
Describe the donut hole. Has it been fixed?
Answer: The donut hole is the fundamental flaw in Medicare Part D that leaves a retiree without any prescription drug coverage during a certain window of drug benefit costs. The problem has not been completely fixed. For now, the Affordable Care Act (ACA) of 2010 has enabled those who fall into the donut hole to receive a mandatory discount on prescription medication until they cross into the upper category. The goal of the ACA is to fix the donut hole completely by 2020, but no immediate resolution has been enacted.
How does COBRA coverage help to solve the problem of pre-Medicare postretirement healthcare coverage concerns?
Answer: COBRA provides a recent retiree the ability to purchase coverage at group rates for the next 18 months. This guarantees coverage under a health insurance plan for this period of time. The 18-month period may not be long enough to carry the retiree up to the eligibility for Medicare at age 65.
How is an indemnity long-term healthcare policy different to a reimbursement policy? Which one would you expect to be more costly?
Answer: An indemnity policy only offers a certain dollar benefit per day, while a reimbursement plan covers all the relevant costs. For this reason, the reimbursement plan will clearly cost more to purchase than an indemnity policy.
A client tells you that they have a living will. Who should have a copy of this document and why?
Answer: You should advise your client to make sure that their physician has a copy of the document. This way, if the document needs to be applied to a health crisis, the doctor will be already aware of your client’s wishes.
A different client tells you that they have established a healthcare POA with both of their children listed as the co-POAs. What advice would you provide them?
Answer: This client should be aware that by having dual POAs, they have created a potential conflict. What would happen if one child wanted to resuscitate, while the other wanted to forego that option? Which child’s orders does the doctor follow? What if one of the two cannot be reached? The client should select one child to be the POA and explain their wishes to both children.
Chapter 23
Is it true that a 72(t) penalty amounts to a 10 percent penalty for all plan types?
Answer: This statement is incorrect. The 72(t) penalty is 10 percent except for SIMPLE plans. For a SIMPLE plan, the penalty increases to 25 percent if the penalty applies within the first two years.
Are all hardship withdrawals exempt from a 72(t) penalty?
Answer: No, all hardship withdrawals do not have a 72(t) penalty. Exceptions are hardship withdrawals for disability, certain medical expenses, and a qualified domestic relations order.
What are the three generic exemptions to a 72(t) penalty?
Answer: The first generic exemption to 72(t) penalty is for an inherited IRA. A nonspousal beneficiary will need to begin taking RMD immediately after inheriting the IRA, and these distributions are not subject to the 72(t) 10 percent penalty. The second generic exemption is for disability. The third generic exemption is for a series of substantially equal payments (a 72(t) distribution).
What is the tenure requirement for a 72(t) distribution (SOSEP) should that be applied to an account?
Answer: A series of substantially equal payments must continue for the greater of five years or the time until the taxpayer reaches age 59.5.
What special 72(t) exemption is available to qualified plan participants?
Answer: A qualified plan participant could withdraw money from their qualified plan account if they are over age 55 and they have been separated from service (employment terminated). This only works if the money remains in a qualified plan.
What special 72(t) exemptions are available only for traditional and Roth IRA owners?
Answer: There are special 72(t) exemptions available to only IRAs. They include payment of qualified secondary education expenses, a $10,000 first-time home buyer exemption, and the payment of health insurance premiums for someone who is unemployed.
An IRA owner has nondeductible contributions of $25,000 into his traditional IRA, which is valued at $300,000. He plans to take a distribution of $20,000 and understands that the nondeductible contributions have created a tax-free cost basis. He thinks that the full $20,000 will be tax-free. Is he correct?
Answer: No, he is not correct. The nondeductible contributions will be subject to pro-rata cost basis recovery because they have been comingled with deductible-contributions and the inherent growth of those two types of contributions.
Reconsider an IRA owner who has nondeductible contributions of $25,000 into his traditional IRA, which is valued at $300,000. He still plans to take a distribution of $20,000. What is his cost basis recovery?
Answer: His cost basis recovery will be $1,666.67 ($20,000 × [$25,000/$300,000]). This means that he will have $1,666.67 of tax-free income, 18,333.33 of taxable income, and $23,333.33 of the remaining cost basis yet to be recovered in the future.
A client needs to withdraw money from her Roth IRA. She is 49 years old and has contributed $57,000 into a Roth IRA, which is now worth $242,000. What are her options if she needs to withdraw $32,000 to purchase a new car? What if she needed to withdraw $65,000 to pay for an executive MBA degree?
Answer: This client is younger than the 59.5 threshold in order to be considered a qualifying distribution. This is a nonqualifying distribution. However, the distribution she needs is less than her contributions. She could withdraw the $32,000 without an issue. With respect to the scenario of a $65,000 withdrawal, this is acceptable because it is for qualifying postsecondary education expenses.
With respect to the five-year rule, are all Roth IRAs and Roth 401(k)s aggregated in meeting the test of tenure?
Answer: All Roth IRAs can be aggregated for meeting the five-year rule test. Roth 401(k)s cannot be aggregated.
Why might a spousal beneficiary keep an IRA in their now deceased spouse’s name?
Answer: A spouse might keep an IRA registered in their deceased spouse’s name if the decedent was older than 59.5 when they died and the surviving spouse was younger than the 72(t) penalty-free threshold. If the spouse leaves the account registered in the decedent’s name, then the surviving spouse would have access to the 72(t) penalty-free withdrawals. Once the surviving spouse is older than 59.5, then the account should be reregistered into their own name.
Are applications of the NUA rule free from 72(t) penalties?
Answer: No, the 72(t) penalty rules still apply if a client applies the net unrealized appreciation (NUA) rule to their employer stock in a qualified plan.
Name two significant limitations imposed by the NUA rule.
Answer: One significant limitation is that applying the NUA rule will negate the ability to apply stepped up basis at the participant’s death. Another significant limitation is that it cannot be applied to either SEPs or SIMPLE plans.
A client of yours applies the NUA rule. They had a cost basis of $57,000 and the employer stock was worth $233,000 when they applied the rule and removed the stock from the umbrella of a tax-advantaged plan. The client waits for two years until the stock’s value is $311,000 before selling. Describe the tax implications and when the taxes will be paid?
Answer: This client will pay ordinary income tax on the full $57,000 cost basis at the time that the stock is removed from the cover of a tax-advantaged retirement account. They will have $176,000 ($233,000 - $57,000) of the net unrealized appreciation that will be subject to long-term capital gains rates. Because they held the stock for more than one year after the NUA rule was applied, the subsequent growth of $78,000 ($311,000 - $233,000) will also receive long-term capital gains treatment. They will have a net long-term capital gain of $254,000 ($176,000 + $78,000) on which they will owe capital gains taxes.
This same client applies the NUA rule with a cost basis of $57,000 and the employer stock was worth $233,000 when they applied the rule and removed the stock from the umbrella of a tax-advantaged plan. However, when the client sells the stock, two-years later, its value has declined to $174,000. Describe the tax implications and when the taxes will be paid in this circumstance.
Answer: This client will pay ordinary income tax on the full $57,000 cost basis at the time that the stock is removed from the cover of a tax-advantaged retirement account. They will have $176,000 ($233,000 - $57,000) of the net unrealized appreciation that will be subject to long-term capital gains rates. Because they held the stock for more than one year after the NUA rule was applied, the subsequent capital loss of $59,000 ($233,000 - $174,000) will also receive long-term capital gains treatment. They will have a net long-term capital gain of $117,000 ($176,000 - $59,000) on which they will owe capital gains taxes.
Is it true that a client must begin taking required minimum distributions by the time they reach age 59.5?
Answer: No, this is the age when the 72(t) penalty will no longer apply. The required beginning date for RMD is 70.5.
A client reached their required beginning date on April 24, 2016. They elected to apply to the April 1st rule. With respect to distributions from tax-deferred accounts, what does their tax situation look like in 2016 and in 2017?
Answer: In 2016, they will not have any tax impact from retirement plan distributions. Because they applied the April 1st rule, they will be taking their 2016 distribution as taxable income in 2017 and they will also be taking their 2017 RMD as taxable income in 2017. They will double-dip on taxable income in their first year of the RMD cycle because they chose to apply the April 1st rule.
A client dies at age 75 and leaves an IRA to their heirs. With respect to the RMD, what must happen before the IRA is distributed?
Answer: The RMD must be distributed from the decedent’s account before the account is distributed to the respective heirs.
A client dies before their RBD. With respect to the RMD, what happens if their spouse inherits the IRA?
Answer: The spouse would roll the decedent’s IRA into an IRA registered in their own name and take RMD based upon their own life expectancy after they reach age 70.5.
A client dies before their RBD. With respect to the RMD, what happens if their children inherit the IRA?
Answer: If the children inherit the IRA, then the RMD must begin immediately. It is not delayed until the children reach age 70.5. The RMD is based on the children’s life expectancy.
Chapter 24
What investment withdrawal rate is prudent for the conservative investors? Why this number?
Answer: Conventional investment wisdom dictates that conservative retirees gravitate toward a mix of at least 50 percent bonds and only 50 percent stocks. This design is intended to reduce volatility. With this allocation mix, an investor should not expect more than a 4 percent withdrawal rate to be sustainable. In very low interest rate environments, where the yields on the bond portion of the allocation are very low, a 50–50 investor should lower their withdrawal rate to 2.5 percent in order to be long-term viable. The trouble is that many cannot live on this dollar amount. For someone with a $100,000 portfolio, a 4 percent withdrawal rate means that they could withdraw $4,000 per year not per month.
An employee has only $978 in their employer-sponsored plan when their employment is terminated. What will happen to their account balance?
Answer: If the plan document permits it, then this employee will likely be subject to an involuntary cash-out. Their employer will most likely send them a check for $978 less 20 percent for taxes. This will be an early withdrawal unless they are older than 59.5.
An employee has $4,978 in their employer-sponsored plan when their employment is terminated. What will happen to their account balance?
Answer: This employee falls just shy of the $5,000 threshold. The employer is not required to offer all available distribution options. If the plan document permits it, then this employee could be subject to an involuntary cash-out. They would certainly have the ability to select a direct rollover instead of the default indirect rollover, but they would need to be proactive themselves.
An employee has only $6,978 in their employer-sponsored plan when their employment is terminated. What will happen to their account balance?
Answer: This employee will have all choices offered by the plan available to them without any risk of an involuntary cash-out.
What is the difference between a life annuity and an annuity certain?
Answer: A life annuity will have a stream of payments that last for the length of an individual’s life and then stop altogether. An annuity certain, or period certain annuity, will last for a specified period of time and then stop. If the retiree is still living, it does not matter. The annuity was only designed to last for a specified period of time.
Would a life annuity or a life annuity with a period certain have a higher dollar payment to the retiree?
Answer: All things equal, a straight life annuity should have a higher monthly payment than a life annuity with the period certain. The period certain feature is a benefit for the retiree, and therefore, it will cost something. Either the retiree or their employer will need to pay for this feature. If the employee pays, then it will be payable in the form of a decreased monthly benefit check.
A company offers their employees an installment payment option in their retirement plan. What should an employee know before choosing this option?
Answer: This employee should know that an installment payment regime is managed by the company itself. This is not outsourced to an insurance company as are all of the annuity options. The employee’s payments could be cut-short if the company either runs out of pension money or files for bankruptcy. This is a riskier option for the employee.
A middle-class single female is employed as a manager in a hospital system in rural Pennsylvania. She earns $75,000 per year. She is 63 years old and is considering when to retire. She has a defined-benefit plan that will replace 25 percent of her pre-retirement income, and she has $300,000 in a 403(b) account. She is wondering if she can comfortably retire in the near future. Digging deeper, you find out that she has no home mortgage and wants to relocate to Raleigh, NC, to be near her children. How would you advise her?
Answer: There is certainly a lot going on with this fictitious client. Her home being mortgage debt-free is one sign that she may be close to planning a retirement party. Recall that her replacement ratio from only social security will be approximately 30 percent (look at the chart in Module 5 Lesson 3 in the “Approaches to Retirement Income” section) and 25 percent from her defined-benefit plan. This combination brings her up to a cumulative replacement ratio of 55 percent without even touching her investments. She should not even consider retiring before her normal retirement age, which should be age 66, given her age. If she delays until age 66 to get full SSI benefits and earns only 6 percent for the next three years and contributes $10,000 per year ... she should end with roughly $389,140.80 in her 403(b). This translates into $15,565.63 per year (using the 4 percent rule) or $11,674.22 (using the more conservative 3 percent rule). This is a 15.57 percent replacement ratio. Now, her combined replacement ratio is 70.57 percent (15.57% from investments + 25% + 30%). She has another issue related to her desire to relocate. If she could sell her home and move to something less costly to maintain, then she could use some of the home equity (which is not used to repurchase a new home) to boost her retirement savings pool. The challenge for her is that housing costs in rural Pennsylvania will be much lower than in urban Raleigh, NC. This desire may not be feasible for this client. She may need to consider moving to another rural area closer to Raleigh, which has a standard of living (and cost of real estate) much more in comparison to her current rural PA lifestyle.
A promising young engineer in their early 30s has decided to change their job. At their former employer, they had a defined-benefit plan with an accrued vested balance of $4,000 and the plan document specifies that any vested balance has all options available to it. They also have a 401(k) with $22,000 balance. This rising star has come to you for advice on what do with the benefits from their former employer. They disclose that they will not be eligible for their new employer’s plan for one year. What should this young engineer do?
Answer: The good news is that this engineer is young and is already planning for retirement. They will have a greater likelihood of a comfortable retirement because they started planning early. Because they are vested in a DB plan and the balance is below $5,000, they may have automatic cash-out if the plan document permits this action. They may also be able to roll the balance into a traditional IRA if the “all options” given by the plan document permits this option. The 401(k) should be rolled over into a traditional IRA and withdrawn to be spent on an immediate consumption desire. During the year in which the engineer is not covered by their new employer’s plan, they are not an active participant and can, therefore, contribute $5,500 (2016 limit) to the traditional IRA, which received the 401(k) rollover assets.
An executive in their mid-50s approaches you for retirement advice. They have accumulated retirement savings of $6.7 million. This executive is married with two children, who are both managers in Fortune 500 companies. This executive enjoys working and plans to work until age 70. What issues should this executive be considering?
Answer: This executive is clearly not concerned with having a comfortable retirement. Assuming that they and their spouse are not living a lifestyle of excess, then they should be able to retire comfortably. Delaying retirement to age 70 will yield an 8 percent per year bonus in social security benefits. The executive’s children are also doing fine. This executive should be thinking about estate planning issues. They might want to establish a trust to direct the assets after their death and also to maximize the estate tax credits. They may also have a need for an irrevocable life insurance trust to pay any relevant estate taxes.