Planning for Retirement Needs. Profit-Sharing Plans, 401(k) Plans, Stock Bonus Plans, and ESOPs Chapter 5

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1 Planning for Retirement Needs Profit-Sharing Plans, 401(k) Plans, Stock Bonus Plans, and ESOPs Chapter 5

2 Chapter 5: Profit Sharing Profit sharing 401(k) Stock bonus ESOP

3 Why Profit Sharing? Discretionary contributions Or state as percentage of profits Or state as percentage of pay Withdrawal flexibility Tie contributions into profits Cross-tested allocation formula

4 Allocation Formula Employer contributions made for the year will be allocated, as of the last day of each plan year, to each participant s account in the proportion which that participant s compensation bears to the total compensation of all eligible participants for the plan year.

5 Investments Pooled assets with trustee investment Key person life insurance Owned by trust/trust is beneficiary Death benefit treated as investment earnings Investment direction by participants

6 Choosing a Profit-Sharing Plan For Contribution flexibility Allocate to key employees Against Can t replace % of salary Can t use past service

7 401(k) Plans Employee salary deferrals (stand alone) Employer matching contributions Employer profit-sharing contributions Employee after-tax contributions Roth election

8 Special Requirements Employee deferrals 100 percent vested Withdrawals Termination of employment Attainment of age 59 1/2 Financial hardship General rule Safe harbor

9 Safe Harbor Hardship Hardship events Medical expenses Purchase principal residence College education for family member Foreclosure Burial expenses for family member Repair of damage to principal residence Reasonably available requirement Receive all distributions and loans available first Suspend deferrals for 6 months

10 ADP Test Average deferral percentage test Compare contributions made by HCEs in relation to non-hce contributions Mathematical test Satisfy one of two alternative tests Failure requires correction (not disqualification)

11 Highly Compensated Employees 5-percent owners in current or prior year Earn more than dollar limit in prior year $115,000 in 2013 Election to limit group earning more than the dollar limit to only the highest paid employees (in the top 20 percent) Example if 100 employees the 20 highest paid employees are counted

12 Performing the Test Calculate deferral percentage in prior year for each non-hce Calculate average deferral of entire group Determine maximum deferral for HCE group

13 ADP Test 1.25 Average ADP of the HCEs for the current year can not exceed 125 percent of the average ADP for the nonhighly compensated for the prior year. Example: 6% deferral for non-hces means 7.5% for HCEs

14 ADP Test 2.0 The average of the ADP for the HCEs for the current year can not exceed more than 200 percent of the average ADP for the nonhighly compensated for the prior year. In addition, the difference between the averages for each group cannot exceed 2 percentage points. Example: 6% for non HCEs means 8% for HCEs

15 Questions If the average ADP of the NHCE group is 2 percent, what is the maximum for the HCE group? (4%) How about 8 percent? (10%) How about 10 percent? (12.50%)

16 Satisfying the ADP Test Current or prior-year testing Safe harbor provision Nonelective option-3% for all participants Matching option-100% match on first 3% and 50% on next 2% deferred (4% contribution) Both require full vesting Correcting excess

17 Automatic Enrollment Employees who fail to elect out of plan Make contributions at default rate Default investment Auto enrollment safe harbor Minimum election 3% 1 st year, 4% 2 nd, 5% 3 rd, 6% thereafter 3% nonelection contribution or Matching option-100% match on first 1% and 50% on next 5% deferred (3.5% max. contribution) Can have 2 year cliff vesting

18 401(k) Contribution Limits Salary deferrals $17,500 limit (for 2013) $5,500 catchup for 50+ Limit applies to all 401(k), 403(b), SIMPLE salary deferrals (aggregate unrelated Ers) Total allocations limited to Sec. 415 ($51,000 in 2013) (catchup exception) Indirect limit on HCEs under ADP and ACP test

19 Roth 401(k) Roth elections Elect Roth tax treatment on salary deferrals Qualified Roth distributions are tax free Roth account can be rolled to a Roth IRA Several tax differences between Roth 401(k) and Roth IRA Impact on 401(k) plan Roth salary deferrals are counted under maximum deferral limits and ADP testing Can not elect Roth treatment on ER contributions

20 Segregation of Assets Salary deferral elections are plan assets Must be contributed to plan by the earlier of 15 th business day of the following month Reasonable date 7 day safeharbor for plans with under 100 employees

21 Stock Bonus Plans Market for company stock Distributions in stock Key person life insurance Contributions: Cash In the form of employer securities Newly issued Existing Same allocation as a Profit Sharing Plan 401(k) deferral feature can be added to the plan Distributions: Employer Stock Cash Equivalent If stock is publically traded, diversification rules kick in 3 year vested Participant must have option to sell

22 Stock Bonus Plans (You could call it an ESOP Plan too) Accelerated Distributions Occur no later than 1 year after the end of the 5 th plan year after separation of service No later than 1 year after retirement, disability or death Equal payments over a period not longer than 5 years Allows for market change Put Option Non-Publically traded stock. Employer must create a market for stock: 60+ days following distribution Additional 60 day period of option not exercised Participant must be paid over no more than 5 years Voting rights: Publically trade stock Participant vote the stock Closely held stock Vote their shares only on items requiring majority vote

23 ESOP Similar to Stock Bonus Plans but with a loan Structure Plan borrows cash from bank Company guarantees loan Plan purchases stock from: Existing shareholders Directly from company Stock is placed in Suspense Account Annual contributions limits same as PS 25% Interest amounts not counted Dividends not counted

24 ESOP Structure Diversification age years of service Annual election requiring employer to diversify investment 5 year period after obtaining 55/10 can elect to diversify 25 percent In final year, 50 percent is diversified Market for stock for small business Borrow to purchase stock Distributions in stock Key person insurance

25 Bank Leveraged ESOP 5 Loan 2 Stock Repayments 1 Loan guarantee ESOP Suspense account 3 accounts 6 4 Contributions Company

26 Qualified Plan Scorecard Defined benefit Cash balance Target benefit Money purchase Profit sharing Stock bonus ESOP 401(k)

27 Vocabulary discretionary contributions cash or deferred arrangement (CODA) stand-alone plan matching contribution financial hardship actual deferral percentage (ADP) test highly compensated employees (HCEs) actual contribution percentage (ACP) test stock bonus plans leveraged ESOP

28 True/False Questions 1. Distributions from a profit-sharing plan may be made only after termination of employment resulting from death, retirement, or disability. 2. An allocation formula in a profit-sharing plan determines how much the employer must contribute on behalf of each participant. 3. Stock bonus plans and ESOPs are categorized as profit-sharing plans. 4. If a participant elects to defer cash compensation to a 401(k) plan, the amount deferred is taxed in the following year.

29 True/False Questions 5. An individual can defer a larger amount on a taxpreferential basis to a 401(k) plan than can be deferred to an individual retirement account (IRA). 6. Contributions attributable to 401(k) salary reduction elections are always 100-percent vested. 7. If a 401(k) plan offers a Roth election, a participant can elect Roth treatment on the employer s matching contribution. 8. One of the 401(k) safe-harbor financial hardship events is payment of college tuition for a family member.

30 Chapter 5 Review Profit-sharing DC/ profit-sharing Contribution flexibility In-service withdrawals Allocation formula is flexible Key person life insurance Calculate comp/comp allocation Stock bonus DC/profit-sharing Distributions in stock ESOP DC/profit-sharing Generally same limits Market for stock Diversification age 55 Borrow to purchase stock Invest primarily in stock Distributions in stock Key person insurance Small business

31 Chapter 5 Review 401(k) plans DC/profit-sharing 4 types of contributions Salary deferral Match Profit-sharing cont. After-tax Deferral limits $16,500 $ 5,500 catchup Aggregate with all deferrals Segregate salary deferrals 401(k) cont. Salary deferrals 100% vested Withdrawal restrictions ADP Impact of failing Safe-harbor contributions Prior/current year test Other contribution limits $49,000 limit 25% payroll Automatic enrollment Roth election