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Understanding Taxes and Pension Plan Qualifications: Key Concepts and Formulas

This lecture provides a comprehensive overview of pension plan qualifications, focusing on the tax advantages of qualified plans, different types of pensions, and funding requirements. By the end, you'll learn to explain the various qualified plans, the importance of tax deferral, and how benefit accruals work. We will discuss defined benefit versus defined contribution plans, eligibility and participation criteria, and non-discrimination regulations. Gain insight into the value of tax deferral and the impact of contributions on long-term savings.

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Understanding Taxes and Pension Plan Qualifications: Key Concepts and Formulas

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Presentation Transcript

  1. Lecture 3: Taxes, Pension Plan Qualification, & DB Formulas Wednesday August 30, 2006

  2. By the end of this lecture, you should be able to: • Explain tax advantages to having a “qualified plan” • Describe different types of qualified plans • Explain requirements for pension to be considered a “qualified plan” • Explain the different types of DB formulas • Describe how benefit accruals work

  3. Basic Overview of Pensions • Qualified Plan: • “Qualifies” for valuable federal tax benefits • Most employees with pension are in qualified plans • Design, funding, and administration must meet very complex set of federal statutory and regulatory requirements • Non-qualified Plan – any other retirement or deferred compensation • Less regulation, but less favorable tax treatment • Mainly used as a form of executive compensation

  4. Tax Benefits for Qualified Plans • Employer receives immediate tax deduction for contributions to the plan (within limits) • Note – this is no different than salary, etc. • Employee is not taxed at the time of the employer contribution, but is taxed when benefits are received • Note – Roth IRAs work opposite way • Earnings accumulate tax free (“inside buildup”) • THIS IS WHERE THE VALUE IS!

  5. How Valuable is Tax Deferral? • Invest $1000 today and hold for 30 years • Before tax interest rate r = .10 • Tax rate t = .35 (assume same for all types of income) How much is deferral worth?

  6. How Valuable is Inside Build-Up?

  7. Tax Deferral • To have $100k in account in 30 years, how much do I need to save today with and without tax deferral? • Assume 10% return and t=.35

  8. Tax Deferral

  9. Tax Revenue Loss • In general, contributions to qualified plans are not taxed until withdrawal • According to the President’s FY 2004 budget, annual cost to federal treasury in 2004 of preferential tax treatment for pensions was nearly $150 billion • Sometimes called a “tax expenditure”

  10. Types of Qualified Plans • Two ways to classify plans • DB versus DC • Discussed last time • Distinction that we will focus on • “Pension plans” versus “profit-sharing plans” • Pension – provide income at retirement • Profit sharing – allow for deferral of income, perhaps based on corporations profitability, and may allow earlier access to funds

  11. Specific Types of Plans • Figure 20-1 from Beam & McFadden

  12. Plan Qualification Requirements • Eligibility and Participation • Age and Service Requirements • Coverage Tests • Vesting • Retirement Age • Nondiscrimination Rules • Non-tax regulations

  13. Eligibility and Participation • An employer must decide what group of employees is to be covered by a plan • In “closely held” corporation, there is often desire to maximize benefits to key employees and to be less generous to rank-and-file workers • Large corporations may want different plans for different groups • Ex: Most airlines have separate pensions for pilots vs. flight attendants vs. mechanics vs. office workers • Public policy designed to prevent firms from discriminating in favor of highly compensated employees

  14. Age and Service Requirements • While not required, most employers prefer age & service requirements to avoid administrative expense of short-term employees • No need to cover college students in summer jobs • Generally, cannot require more than 1 year of service before eligibility • (Exception: may require 2 year waiting period if then provide 100% vesting upon entry) • An employee age 21+ must be allowed to participate (if meets other requirements)

  15. Age & Service Example • If employee is hired at age 18, employer may require that she wait 3 years to participate • If employee hired at age 30, employer may require only a 1 year wait • Small employers with high turnover may benefit from 2-year / 100% vesting rule (if few employees last that long!)

  16. Older Ages • In a defined benefit plan, the cost of funding a fixed monthly retirement benefit rises steeply with age • Ex: To fund a fixed monthly benefit starting at age 65 will cost the firm 30 times more for a 60 year old than a 30 year old • Age discrimination law prohibits exclusion from pension based on age • May define “normal retirement age” such that employee requires 5 years of service no matter their age

  17. Definition of Service • “Year of service” is generally 12-month period during which employee has 1,000 of work. • Complex set of “breaks in service” rules • Allows employee with break in service to lose credit for service prior to the break

  18. Coverage Tests for Non-Discrimination • A qualified plan must satisfy one of two “coverage tests” • Ratio Percentage Test: The plan must cover a % of non-highly compensated employees (NHCE) that is at least 70% of the % of highly compensated employees (HCE) covered • Average Benefit Test: The average benefit as a % of compensation for NHCEs must be at least 70% of that for HCEs • HCE: Owns more than 5% of employer, OR, received compensation exceeding a threshold ($90,000 in 2004 – indexed for inflation)

  19. Example of Ratio Percentage Test • Suppose firm has 5 HCEs, 4 of which participate in the plan = 80% participation rate by HCEs • If there are 20 NHCEs, then at least 70% * 80% * 20 = 11.2 of these NHCEs must participate to meet coverage test

  20. Vesting • A “vested” benefit means that it is non-forfeitable, i.e., cannot be taken away • Employee contributions are always 100% vested • Employer contributions must vest at least as fast as two methods • Cliff vesting • Three- to Seven-Year Vesting

  21. Cliff Vesting • Cliff vesting, also known as “five-year vesting,” requires that an employee with at least 5 years of service be 100% vested in the employer provided portion of the accrued benefit • It is okay to have 0% vesting up until the five year mark

  22. Three- to Seven-Year Vesting • Requires at least 20% vesting after 3 years, 40% after 4 years, … 100% after 7 years. • Note: all years of service must be considered, even years prior to plan participation • Exception – can ignore years before age 18 • “Top heavy” plans (defined later) must vest more quickly

  23. Cliff vs. 3-to-7-Year Vesting % Vested Years of service

  24. Retirement Age • A plan’s Normal Retirement Age is the age at which individual can retire and receive full benefits • Under IRC, can be no greater than • Age 65 • 5th anniversary of plan entry if participant entered within 5 years of NRA • A plan may designate an early retirement age at which person can take actuarially reduced benefits

  25. Nondiscrimination • In addition to coverage tests, plan must provide same percentage of compensation for all employees covered under the plan • Three exceptions allowed: • Permitted disparity rules when integrated with Social Security • 401(k) plans allow HCEs to contribute higher % if meet separate ADP rules (we will discuss later) • DC plans can be age-weighted (discuss later)

  26. Integration with Social Security • Social Security benefit formula is similar to a DB pension formula • Career average compensation up to a cap • Wage indexed pre-retirement, CPI indexed post-retirement • Qualified plans are permitted to “integrate” with participant’s Social Security benefit • Avoid benefit duplication • Lower employer costs by making benefit less generous • The vast majority of DB plans are integrated in some way

  27. Integrated Plan Example: % of final average compensation (FAC) provided by OASDI and private DB Benefits as % of FAC Social Security 50% DB Plan FAC $10,000 $30,000 $50,000 $100,000

  28. Section 415 Limits • DB plans: The plan benefit at age 65 cannot exceed the lesser of 100% of the participant’s compensation over the three years of highest compensation, or $165,000 (in 2004, indexed for inflation) • DC plans: Limits annual contribution to the account. Contribution cannot exceed the lesser of 100% of annual compensation or $41,000 (2004, indexed)

  29. Top Heavy Rules • Policy goal: To reduce “excessive discrimination” in favor of business owners • A “Top Heavy” plan is one in which more than 60% of benefits or balances are for key employees • If plan is top heavy, it must: • Meet more rapid vesting schedule • Provide min benefits for non-key employees

  30. Payout Restrictions • 10% tax penalty if withdrawn before early retirement, age 59½, disability or death • Payouts must begin by April 1 of the year after the participant reaches 70½ • Minimum distribution requirements specified by IRS • Restrictions on loans

  31. Non-Tax Regulations • Civil Rights Act of 1964 • What does sex discrimination mean? • Same contributions, or same benefits? • Age Discrimination in Employment Act • Americans with Disabilities Act • Family and Medical Leave Act of 1993

  32. How Do DB Plans Work? • Formula specifies benefit to be paid to the employee • Investment risk rests with plan sponsor • Payment of benefit is obligation of the employer, and thus employer is required to fund the plan in advance so that the funds will be there to pay • Typically insured by the PBGC (within limits) • Formulas and funding can be complex

  33. DB Formula Characteristics • Employer objectives • Provide reasonable income “replacement ratio” • Maximize value of tax shelter for key employees • “Manage” work force (e.g., encourage retention, incentives for early retirement, etc.) • Two useful characteristics of DB formulas • Benefit need not be function of total compensation • Can design plan around desired retirement income for employee • Permitted to favor employers who enter plan at later ages • At plan inception, often favors key employees of closely held businesses

  34. Replacement Ratio • Also known as “replacement rate” • = retirement income / earnings while working • Generally < 1 is required to maintain living standard • May need to be higher for lower income employees • Many plans aim for income from qualified plan plus Social Security to provide 50-75% of pre-retirement income • Still leaves important role for the “3rd leg of the stool”

  35. Types of DB Formulas • Wide variation • Limited by: • Accrual rules • Social Security integration rules • Non discrimination requirements

  36. Allowable DB Formulas • Flat-Benefit Formula • Does not take into account years of service • Flat-Amount Formula ($10,000 per year during retirement) • Flat-Percentage Formula (50% of final salary) • Unit-Benefit Formula • Benefit is based on length of service • $10 per month x (Years of Service) • Annual Benefit = (2%) x (Yrs. of Service) x (Final Salary) • Role of Past service

  37. What is Compensation? • Firms have some flexibility • Two categories • Career Average • Final Average • Base salary or total compensation • Bonuses, overtime, etc. • If use something other than total compensation, must be careful about discrimination

  38. Inflation • Since 1926, inflation has averaged a bit over 3% annually • Can reduce purchasing power by 25% in only 10 years, 45% in 20 years. • Inflation uncertainty is also important • Double digit in late 1970s • Difference between inflation indexation and fixed growth rate

  39. How Protect Workers from Inflation? • Pre-retirement Inflation • Final average compensation formula • Index wages (Social Security) • Postretirement Inflation • Ad Hoc Adjustments (quite common) • Increase Benefits by a Formula • Index Benefits to CPI

  40. DB Benefit Accruals • Benefits owed to employees if: • Terminate of employment prior to retirement • Terminate plan before retirement • DB Plans: benefits must accrue at least as fast as one of these 3 rules: • 3% Rule • Accrual > 3% of max accrual if in plan for entire career • 133% Rule • Accrual < 133% of prior year’s accrual • Fractional Rule • Proportional to normal retirement benefits

  41. 3% Rule Example Data: If individual entered plan and stayed until retirement: Benefit = $100,000 Question: If individual leaves after 10 years what is benefit? Answer:

  42. 133 1/3% Rule Example Benefit Accrual Rate Years Accrual 1-5 $ 5,000/year 6-10 $ 6,000/year 11-20 $ 8,000/year 21-35 $16,000/year Does this meet the rule?

  43. Fractional Rule Example Data: Benefit at retirement after 40 years is $50,000/year Question: If employee leaves after 10 years what is benefit? Answer:

  44. Death & Disability Benefits • Pre-retirement Survivor Annuity • Mandated for spouse of vested plan participant • Provides income to surviving spouse • Qualified Joint and Survivor Annuity (QJSA) • Post retirement death benefit • Survivor benefit must be >50% of amount paid when both alive • Automatic, unless spouse provides notarized signature • Treatment of disability (access to benefits, accrual and vesting)

  45. Funding • Complex set of funding rules to ensure solvency of the plan in the event of plans sponsor’s bankruptcy • PBGC provides insurance • More in next lecture

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