Module 4 Fundamentals of 401(k) Plans

CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMRetirement Planning & Employee Benefits Module 4Fundamentals of 401(k) Plans

Learning Objectives 4–1 Describe the basic characteristics of a 401(k) plan. 4–2 Identify the minimum coverage rules for 401(k) plans, including the ADP and ACP tests. 4–3 Describe the basic characteristics of the safe harbor 401(k) plan and the qualified automatic contribution arrangements (QACAs). 4–4 Describe the basic characteristics of profit sharing 401(k) plans, 401(k) stock ownership plans (KSOPs), solo 401(k)s, and Roth 401(k) plans. 4–5 Describe the basic characteristics of the SIMPLE 401(k) plan and how it compares to the regular profit sharing 401(k) plan. 4–6 Identify the rules dealing with investments offered in a 401(k) plan, and describe how qualified default investment alternatives need to be structured. 4–7 Describe the basic types of distributions available from a 401(k) plan. 4–8 Determine the factors that employers should consider when evaluating if a 401(k) plan would be appropriate.

Questions to Get Us Warmed Up

401(k) Provision • Allows pretax employee deferrals • Must be offered as part of either a profit sharing plan (including stock bonus plans) or a SIMPLE plan • SARSEPs may offer 401(k) provisions, however new SARSEPs cannot be established (since 1997)

Profit Sharing 401(k) Contribution Sources • Employee discretionary deferral of up to $17,500 or 100% of compensation ($5,500 age 50 catch-up) • Employer discretionary contributions • Employer matching or nonelective contributions

Eligible Entities • Sole proprietors • Partnerships • Corporations (C & S) • Tax-exempt organizations • Indian tribal governments Note: State and local governments can no longer establish new 401(k) plans, but plan established under prior law can continue.

401(k) Employer Participant

Nondiscrimination – Coverage & Discrimination Testing Coverage tests • Ratio percentage • Average benefits Discrimination testing • ADP • ACP All four of these tests use highly compensated employees

Highly Compensated Employee • Was a “5% owner” (ownership of >5%) in the determination year or in the preceding plan year, or • A person whose compensation was in excess of $115,000 in 2012 (lookback year for 2013) • Employer has the option to limit highly compensated to the top-paid 20% employees.

ADP & ACP Tests • ADP (actual deferral percentage) – employee deferrals (does not include age 50 catch-up contributions) • ACP (actual contribution percentage) – employer contributions and employee after-tax contributions must pass both tests, unless plan is a safe harbor plan

Summary of ADP & ACP Tests

Compliance Options if Plan Fails Either Test • Corrective distribution • Recharacterization • Qualified Matching Contributions (QMACs) • Qualified Nonelective Contributions (QNECs)

Qualified Plan Vesting Schedules

Key Employee – Top Heavy Testing A “key employee” is an employee who, at any time during the plan year containing the determination date for the plan year to be tested, met either of the following criteria: • was a “5% owner” (ownership of >5%), or • owned >1% of the company and received compensation >$150,000, or • was an officer of the company and received compensation >$165,000 (2013)

Testing – HCE & Key Employees

401(k) Safe Harbor Provisions A plan may be a safe harbor plan if: • Notice is given, and • the employer makes a contribution: • Deferrals are matched as follows: • 100% match on the first 3% of compensation and • 50% match on between 3% and 5% of compensation • (or 100% match on the first 4% of compensation) • or a non-elective contribution of 3% is made for all non-highly compensated employees • and all employer contributions are 100% immediately vested.

Automatic Deferral Arrangements Created under the PPA of 2006 • Participants must make a negative election to “opt out” – meant to encourage participation • ACA – Automatic Contribution Arrangement • EACA – Eligible Automatic Contribution Arrangement • QACA – Qualified Automatic Contribution Arrangement • QACA is a safe harbor plan • maximum vesting schedule is two-year cliff

401(k) Plan Types • profit sharing plans • solo 401(k) • KSOPs • Roth 401(k) • SIMPLE 401(k) • SARSEPs

Profit Sharing 401(k) • Employee deferrals ($17,500/$5,500) • Employer contribution maximum is 25% of covered payroll (employee deferrals do not count against the 25%) • Employer contributions may be discretionary, matching, or nonelective

The Solo 401(k) Plan for Sole Employee Companies

401(k) Stock Ownership Plans (KSOPs) • Stock bonus plan with 401(k) provisions • Must be a corporation since stock involved • Employee deferrals and employer contributions, including matching contributions, are invested in employer stock • Since company stock – eligible for NUA treatment

Roth 401(k) • Same employee deferral limits as profit sharing 401(k) • No income phaseouts as with Roth IRAs • Roth 401(k): • has its own five-year “clock” • has required minimum distributions (RMDs) starting at age 70½ • if rolled into a Roth IRA then the Roth IRA clock applies, and there are no RMDs

SIMPLE 401(k) • 100 or fewer employees paid at least $5,000 in the preceding year • Must be only plan offered by the employer • Employees with less than 1,000 hours of service in the past year can be left out of the plan • Permits employee elective deferrals ($12,000/$2,500) • 100% immediate vesting • No discrimination testing • Mandatory employer contribution

SIMPLE Plan Employer Contributions

SARSEP • SEP with employee deferrals through 401(k) provisions • May not be established after 12/31/96 • May have up to 25 employees, 50% of whom must participate • No matching contributions allowed • Contribution limit, lesser of 25% of compensation or $17,500 ($5,500 catch-up) • Special ADP test • HC ADP less than 125% of NHC, or • ADP for each HC not greater than double the NHC ADP and the difference is less than 2% • IRA rules generally apply to distributions

Investments in 401(k) Accounts • Must offer a broad range of investment alternatives – defined as at least three alternatives, each of which is diversified with materially different risk and return characteristics • Plan fiduciary responsibilities • Qualified default investment alternatives (QDIAs): • life-cycle or target retirement funds • balanced funds • professionally managed fund • variable annuity that offers any of the above • capital preservation product

Distributions from 401(k) Plans • In-service (after 2 years) • Loans (allowed but not required) – maximum is 50% or $50,000, whichever is less • Hardship withdrawals (allowed but not required) – can only withdraw deferral amounts, generally subject to 10% early withdrawal penalty tax

Multiple Choice Question 1 “Annual additions” consist of which of the following in a defined contribution plan account? • employer contributions • employee contributions • investment earnings • forfeiture reallocations • I only • I and II only • I, II, and III only • I, II, and IV only

Multiple Choice Question 2 Which of the following types of retirement plans are currently permitted to offer 401(k) provisions? • money purchase plans • SEPs • profit sharing plans • stock bonus plans • I and II only • I and IV only • II and III only • III and IV only • I, II, III, and IV

Multiple Choice Question 3 If the nonhighly compensated employees’ average deferral percentage (ADP) is 4%, what is the maximum allowable ADP for highly compensated participants? • 4% • 5% (4% × 125%) • 6% (4% + 2%) • 7% (4% + (75% × 4%)) • 8% (4% × 2)

Multiple Choice Question 4 Which of the following accurately describe provisions under the hardship withdrawals from a profit sharing 401(k) plan? • A withdrawal may be made from employee elective deferrals and associated earnings. • A participant must establish an “immediate and heavy financial need.” • A withdrawal is exempt from the 10% early withdrawal penalty. • A participant must exhaust other available resources. • I and II only • II and III only • II and IV only • I, III, and IV only • II, III, and IV only

Multiple Choice Question 5 LMN Corporation provides a profit sharing 401(k) plan that covers 10 participants. The participants’ total compensation is $300,000, and their elective deferrals for the year total $20,000. What is the maximum additional amount the employer can contribute and deduct as a plan contribution for the year? • $50,000 (25% of $280,000, minus $20,000 of elective deferrals) • $55,000 (25% of $300,000, minus $20,000 of elective deferrals) • $70,000 (25% of $280,000) • $75,000 (25% of $300,000)

Multiple Choice Question 6 Which one of the following is a characteristic of a SARSEP? • Employees who are age 21 with one year of service must be allowed to participate in the plan. • Only employers with up to 25 eligible employees may offer the plan if established prior to 1997. • Participants are 100% vested and may withdraw account balances without penalty. • No discrimination tests are required.

Multiple Choice Question 7 Which of the following are correct statements regarding requirements an employer must satisfy in order to offer a SIMPLE plan? • The employer cannot have more than 25 employees who earn $300 (indexed) or more. • The employer cannot have more than 100 employees who earn $5,000 or more. • An employer can combine a SIMPLE plan with either a profit sharing plan or an ESOP. • To offer a SIMPLE plan, the employer cannot sponsor another qualified plan, a 403(b) plan, or a SEP. • I only • II and IV only • III and IV only • I, III, and IV only

Multiple Choice Question 8 Employee elective deferrals cannot exceed which one of the following under a SIMPLE plan in 2013? • 25% of compensation • $5,500 • $11,000 • $12,000 • $17,500

Multiple Choice Question 9 Joan Smith works for XYZ Corp. and earns $268,000. XYZ Corp. provides a matching contribution under a SIMPLE 401(k) plan. What would be the maximum amount that could go into Joan’s account? (The Section 401(a)(17) limit on includible compensation is $255,000 in 2013.) • $8,040 • $12,000 • $14,300 • $19,650 • $19,800

Multiple Choice Question 10 LMN Corp. made the 3% matching contribution under its SIMPLE 401(k) plan in the prior three years. Due to extensive capital expenses anticipated for this year, the company is considering options on cutting back other expenses. Last year, the 3% matching contribution was actually 2.7% of the total aggregate salary. The company wants you to discuss its options for this year regarding the SIMPLE plan. Which one of the following would you recommend? • Since the company has satisfied the 3% matching contribution for three years, it could reduce the contribution to 1%. • By providing adequate notice, the company could move to the 2% nonelective contribution for this year. • Employer contributions under a SIMPLE plan are “discretionary,” and the company could provide notice that it will not provide any contributions for this year.

CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMRetirement Planning & Employee Benefits Module 4End of Slides

Module 4 Fundamentals of 401(k) Plans