1 Retirement Planning and Employee Benefits for Financial Planners Chapter 5: Profit Sharing Plans 2 Seven Types of Profit Sharing Plans Profit Sharing Plans Stock Bonus Plans Employee Stock Ownership Plans 401(k) Plans Thrift Plans Age Based Profit Sharing Plans New Comparability Plans 3 Characteristics Defined contribution plan. Established and maintained by an employer. Provides for employee participation in profits. Utilizes a definite predetermined formula for allocating the contributions to the plan. Must be nondiscriminatory. Either noncontributory or contributory. Noncontributory: Employee does not contribute to the plan and all contributions to the plan are from the employer. Contributory: Employee contributes to the plan. 4 Contributions and Deductions Contributions must be made by the due date of the company’s income tax return (including extensions) Plan must be established by end of year, however Contributions are discretionary, but must be “substantial and recurring.” No requirement of company profit for contribution. Limited to 25% of total employer covered compensation. Limited to the lesser of 100% of compensation, or $52,000 for 2014 per employee per year. 5 Allocation of Contributions Standard Allocation Equal percentage of comp to all participants. Social Security Integration Provides higher allocations to employees whose earnings are greater than the Social Security Wage base. Excess rate: < of double base rate or 5.7% if integration is at Social Security wage base ($117,000 in 2014) Everyone: 5%; top dogs 10% on salary above $117,000 up to $260,000 Everyone: 7%; top dogs 12.7% on salary above $117,000 up to $260,000 Profit sharing plans can only use the excess method. 6 Allocation of Contributions Age-Based Profit Sharing Plans Use a combination of age and compensation to allocate the plan contribution. Take comp x PV of $1 from age 65 based on Current age Discount rate of 7.5% to 8.5% What rate would you select? This equals age-weighted comp which is used to allocate contribution Example: Flintstone Quarry Fred: age 55, comp $100,000 Barney: age 25, comp $80,000 Company contributes $50,000 7 Cash or Deferred Arrangements (CODA) – 401(k) Most prevalent type of plan established today. Predominantly funded by employee deferral contributions. Attaches to a profit sharing plan or stock bonus plan. Permits employees to defer compensation to a qualified plan. Limited to $17,500 for 2014 per year, or $23,000 for 2014 for those age 50 and over ($5,500 additional contribution). Employers may (buy are not required to) match the employee’s deferral. 8 Establishing a 401(k) May be established by: Any legal form of business Cannot be established by governmental entities. 457 plans 9 Qualification Requirements Eligibility – Same as Chapter 3 Vesting Employee deferral contributions 100% at all times Employer matching contributions Must vest at least as rapidly as 2 to 6 graduated or 3-year cliff See Example 5.8 on pages 199. 10 Contributions to CODAs (1 of 2) Employee Contributions Elective deferral contributions Limited to $17,500 for 2014 per year. Additional $5,500 for 2014 for age 50 and older. Subject to payroll taxes. After-tax contributions available. Roth contributions allowed after 2005. Employer contributions: not Roth 11 Contributions to CODAs (2 of 2) Employer Contributions Matching contributions Profit sharing contributions Contributions to meet ADP/ACP CODAs are not permitted to use Social Security integration. 12 Tax Impact Contributions are not currently subject to income tax. Employee deferral contributions are subject to payroll taxes. Employer contributions are not subject to payroll taxes. 13 Negative Elections Negative Elections: the employee is deemed to have elected a specific employee deferral unless the employee elects out. In 2008, 20% of eligible employees don’t participate 40% of plans now include automatic enrollment for new hires 15% also auto-enroll non-participating employees Does this cause employees to contribute less than if not auto enrolled? Employee contribution: 3% in year 1 increasing 1% a year to 6% Match: 100% of 1% + 50% above 1% And top dog match = peon match Investment: default investment 53% now use target-date fund; in 2007 35% used money market funds as default 70% of negative elections stay in default Annual notices/Ability for employee to get funds back 14 Nondiscrimination Testing Benefits must be provided to a certain percentage of rank-and-file employees. Two tests for 401(k) in addition to qualified plan tests Actual Deferral Percentage Test (ADP Test) Actual Contribution Percentage Test (ACP Test) 15 Actual Deferral Percentage Test (ADP Test) Limits the employee elective deferrals for the HC based on the elective deferrals of the NHC. Top Dogs: >5% owner; or comp>$115K Peons < 2%; Top Dogs= 2 x Peon% Peons 2 – 8%; Top Dogs= 2 + Peon% Peons >8%; Top Dogs= 1.25 x Peon% 16 Failing the ADP Test Corrective Distributions: Give Them Back Decreases ADP of HC Recharacterization: After-Tax Decreases ADP of HC Impact ACP test Qualified Non-elective contributions (QNEC): to everyone Increases ADP of NHC 100% vested Qualified matching contributions (QMC) To those who participated IBM in 2012 started making 401(k) contributions once a year at end of year Increases ADP of NHC 100% vested 17 Actual Contribution Percentage (ACP) Like ADP, but determined utilizing: Employee after-tax contributions, and Employer matching contributions Uses same scale as ADP Uses same corrective procedures as ADP 18 Safe Harbor 401(k) Plans Not required to pass ADP or ACP tests. Employer must provide any one of the following: 3% nonelective contribution To all eligible employees Matching contribution 100% up to 3%, and 50% from 3% to 5% Employer contributions are 100% vested at all times. 19 Distributions Hardship Distributions Distribution for immediate and extreme financial need: Medical Expenses Funeral Expenses Purchase of principal residence No other sources of funds are available. May be subject to income tax and early withdrawal penalties.