13-2 Learning Objectives 1. Describe the tax and nontax aspects of employer- provided defined benefit plans from both the employer’s and employee’s perspective. 2. Explain and determine the tax consequences associated with employer-provided defined contribution plans, including traditional 401(k) and Roth 401(k) plans. 3. Describe the tax implications of deferred compensation from both the employer’s and employee’s perspective.
13-3 Learning Objectives 4. Determine the tax consequences of traditional and Roth Individual Retirement Accounts and explain the differences between them. 5.Describe the retirement savings options available to self-employed taxpayers and compute the limitations for deductible contributions to retirement accounts for self-employed taxpayers. 6.Compute the saver’s credit.
13-4 Employer Provided Plans Qualified Plans Must not discriminate between employees Two main types: Defined benefit plan Defined contribution plan
13-5 Defined Benefit Plans Standard benefits based on fixed formula Average compensation Years of service Employers deduct liability as they contribute to plan Funding requirements based on actuarial assumptions Employer not employee bears investment risk
13-6 Defined Benefit Plans Vesting schedules 5-year cliff or 7-year graded Distributions from defined benefit plans are taxable to employee when received. Ordinary income Early distributions subject to 10% penalty
13-7 Defined Benefit Plans Example CBA provides a defined benefit plan to its employees. Under the plan, employees earn a benefit equal to 2 percent for every year of service of their average salary for their three highest years of compensation. CBA implements a seven-year graded vesting schedule as part of the plan. If Tina works for CBA for four years, earning annual salaries of $60,000, $65,000, $70,000, and $75,000, and then leaves to work for another employer, what benefit would she be entitled to receive (her vested benefit)?
13-8 Defined Benefit Plans Example Solution
13-9 Defined Contribution Plans Employer specifies up-front contribution on employee’s behalf Employers typically match employee contributions Employees may contribute to plan Employees choose how to invest contributions Alternatives depend on employer’s plan 401(k), 403(b), and 457
13-10 Defined Contribution Plans Annual contribution limits for 2011 Employee contributions $16,500 if not 50 years of age by year end $22,000 if at least 50 years old by year end Employer + Employee contributions Limited to lesser of $49,000 ($54,500 if at least 50 years old at end of year) or 100% of the employee’s compensation.
13-11 Defined Contribution Plan Example Before Dave retires at the end of 2011 he continues to contribute to his CBA-sponsored 401(k) account. CBA matches employee contributions on a two-for-one basis up to 4 percent of the employee’s salary. Dave is 72 years old at the end of the year and he earned a salary of $450,000 during the year. Dave contributed $22,000 to his 401(k) account. How much would CBA contribute to Dave’s 401(k) account?
13-12 Defined Contribution Plan Example Solution Answer: $32,500 [$54,500 (Dave is 50+ years old) minus $22,000 (Dave’s contribution)]. Without the limitation, CBA would have contributed $36,000 ($450,000 × 4% × 2) to Dave’s account.
13-13 Defined Contribution Plans Vesting Employee contributions and earnings on employee contributions Vest immediately. Employer contributions and earnings on employer contributions Minimum vesting requirements 3-year cliff or 6-year graded schedule.
13-14 Defined Contribution Plans
13-15 Defined Contribution Plans Distributions Distributions are ordinary income Early distributions subject to a 10% penalty Before 59 ½ year of age if still working or Before 55 years old and separated from service (retired)
13-16 Defined Contribution Plans Distributions Example Assume that when Lisa is 57 years of age and still employed by CBA, she requests and receives a $60,000 distribution from her 401(k) account. What amount of tax and penalty is Lisa required to pay on the distribution (assume her marginal tax rate is 33%)?
13-17 Defined Contribution Plans Distributions Example Solution Answer: $19,800 taxes ($60,000 × 33%) + $6,000 penalty ($60,000 × 10%).
13-18 Defined Contribution Plans Required minimum distributions For the year in which employee reaches age 70 ½ or when the employee retires, if later (and each subsequent year) May defer first required distribution to April 1 of next year, otherwise distribution must be received by December 31 of current year Based on applicable percentage of balance at end of prior year 50% penalty on undistributed portion of minimum distribution requirement.
13-19 Minimum Distributions Example Assume that Dave retires from CBA in 2011 at age 72 (age at year end). Also assume that his 401(k) account balance on December 31, 2010 was $3,500,000. What is the amount of minimum distribution he must receive for 2011 and when must he receive it?
13-20 Minimum Distributions Example Solution Answer: $136,850 by April 1, 2012 ($3,500,000 × 3.92% from the IRS table).
13-21 Traditional 401k Plans Contributions are made with before-tax dollars. Tax deductible Distributions: Same rules as other defined contribution plans
13-22 Roth 401k Plans Contributions made with after-tax dollars. Not tax deductible Employer contributions must go into a traditional 401k plan (not a Roth 401k plan)
13-23 Roth 401k Plans Qualified distributions After account open for five years and employee has reached age 59 ½. Non-qualified distributions Distributions of earnings are taxable and subject to 10% penalty Distributions from contributions are not taxable Contributions divided by account balance multiplied by amount of distribution equals distribution from contributions
13-24 Deferred Compensation “Nonqualified plans” May discriminate Generally provided to executives or highly compensated rather than rank and file Can be used to make employee’s whole when contributions to qualified plans would be limited Deemed investment choices Risks to employees electing to defer salary?
13-25 Deferred Compensation Employer deducts for tax purposes when pays Compare to financial accounting Employee includes in income when received If paid after retirement, §162(m) limitation does not apply
13-26 Deferred Compensation Relevant variables Employer and employee current tax rates Employer and employee future tax rates Employer’s cost of capital or discount rate Employee’s cost of capital or discount rate
13-28 Individual Retirement Accounts (IRAs) For AGI deduction for contributions Generally not allowed if participant in employer- sponsored plan unless For single taxpayers Taxpayer is single, deduction allowed if participate in employer plan but income is below certain thresholds In 2011, lesser of $5,000 in 2011 or earned income If 50 years or older at end of year limit is $6,000 Additional “catch-up” contribution
13-29 Individual Retirement Accounts (IRAs) For AGI deduction for contributions Generally, not allowed if participant in employer- sponsored plan unless For married taxpayers deduction is allowed if participate in employer plan but income is below certain thresholds In 2011, lesser of $5,000 in 2011 or earned income of both spouses reduced by other spouse’s contributions to IRA or Roth IRA If 50 years or older at end of year limit is $6,000 Additional “catch-up” contribution
13-30 Individual Retirement Accounts (IRAs) May make nondeductible contributions Deductible + nondeductible cannot exceed $5,000 for one taxpayer (plus catch-up) Must contribute by April 15 th of subsequent year
13-31 Individual Retirement Accounts (IRAs) Distributions taxed as ordinary income 10% penalty if before 59 ½ Certain exceptions Medical expenses, insurance premiums, first home Same minimum distributions apply as to qualified contribution plans nontaxable percentage = nondeductible contributions divided by balance of account
13-32 Roth IRAs Nondeductible contributions Contributions to a Roth IRA Same $5,000 limit ($6,000 if 50 or older at year end) Phase-out based on AGI
13-33 Roth IRAs Distributions from a Roth Distributions of contributions never taxed Qualified distributions of earnings from Roth not taxed Account must be open for five years before can receive qualified distributions and Taxpayer must be at least 59 ½ to receive qualified distribution or Distributions on death of taxpayer or Taxpayer is disabled or First home (limited to $10,000) No minimum distribution requirements
13-34 Roth IRAs Rollover from traditional to Roth Tax consequences Why roll over? Marginal tax rates Contribution limits to Roth are effectively higher $5,000 limit of after tax vs. before-tax dollars
13-35 Rollover from Traditional to Roth IRA Example Assume when Tina graduated from college and began working for CBA, Tina made a fully deductible $4,000 contribution to a traditional IRA account. Three years later, when her marginal tax rate is 25 percent, Tina withdraws the $5,000 balance in the account and contributed (rolled over) $3,750 to a Roth IRA. What amount of taxes and penalty is she required to pay on the rollover?
13-36 Rollover from Traditional to Roth IRA Example Solution She must pay a $1,250 in taxes (25% × $5,000) and $125 penalty. The penalty is 10 percent of the $1,250 that she withdrew from the IRA and did not contribute to the Roth IRA ($5,000 - $3,750).
13-37 Plans for Self-Employed SEP IRA Individual 401(k)
13-38 SEP IRA Contribution limit Lesser of (1) $49,000 or (2) 20% of net earnings from self employment Must provide plan to employees if taxpayer has employees
13-39 SEP IRA Example Dave (age 64) receives director compensation of $30,000 during the current year and is reimbursed for all relevant expenses. Due to the specifics of the work arrangement, Dave is treated as a self-employed sole proprietor for tax purposes. If Dave sets up a SEP IRA for himself, what is the maximum contribution he may make to the plan (assuming he has no other source of employee or self-employment income)?
13-40 SEP IRA Example Solution
13-41 Individual 401(k) Contribution limit Lesser of (1) $49,000 or (2) 20% of net earnings from self employment + $16,500 Additional $5,500 if age by year end Maximum contribution is $54,500 ($49,000 + $5,500)
13-42 Individual 401(k) Example Assume the same facts as in the previous example except that Dave set up an individual 401(k) account. Dave is 64 years old at the end of the year, reports $30,000 of self-employment income, and has no other sources of income. What is the maximum amount he can contribute to his individual 401(k) account?
13-43 Individual 401(k) Example Solution
13-44 Saver’s Credit Credit for taxpayers contributing to qualified plans Credit in addition to deduction for contribution Available to lower income taxpayers Depends on filing status and AGI