1. Defined Contribution Plans Profit Sharing 401(k) ESOP / Stock Bonus

2. Common Rules  Minimum Eligibility Rules – service = 1,000 hours/year Age 21 and 1 year of service OR Age 21 and 2 years of service  Requires 100% vesting  Maximum Covered Compensation - $245,000  Maximum Company Contributions Per Account = $49,000 Not to exceed 25% of total participant payroll  Vesting 100% at 3 years, or 2 to 6 year vesting Special rules for Total Disability, Death, or Normal Retirement  Forfeitures Used to Reduce Company Contributions OR increase Participants’ Accounts

3. Profit Sharing Plan Features  Fixed or Discretionary Company Contributions  Can be made even if no current profits  Must meet “substantial and recurring” rule  Can usually be made only once each year  Company stock permitted beyond 10% of asset  No benefits are applied to past service  Individual participant accounts  Bears full risk of investment results and inflation  Company stock account can be distributed as stock at termination of employment  Plan may permit – but not required to offer– IN CASH Partial Withdrawals after 2 years on account.. AND Full Distributions after 5 years of participation

4. Contribution vs. Allocation  Maximum Annual Contribution is subject to 25%/$49,000 limits  Allocation to individual accounts must be pre-determined by formula % of individual pay relative to all participants  Allocation cannot be integrated with Social Security benefits  Allocation can be weighted based on service and/or age  1 Point for each $ of covered compensation ½ Point for those ages 21 to 30, 1 Point for those ages 31 to 40, etc.  Life Insurance can be used as a funding option particularly for small organizations to cover “key officer” exposure

5. Major Adopters of Profit Sharing Plans  Companies who are: likely expecting substantial growth in revenue focused on future net profit increases tie most compensation to profitability in small, growing arena with low levels of operating cash Subject to wide changes in annual cash flow from operations expect stock values to increase dramatically likely candidates for acquisition by a larger company  Companies who: Want to track competitive standards in their industry – not necessarily focused on retirement income adequacy for participants Want to allow a form of short-term deferrals for their employees Want maximum contribution flexibility for any reason Want employees to keep stock and profit from it Want to maximize ability to give key employees the most benefits (within contribution limits using age/service weighting)

6. 401(k) or CODA (Profit Sharing) Plans  Profit Sharing with employee contributions – that can be matched Fixed Match vs. Fixed and Variable Match Do NOT offer 2 or 5 year Withdrawals as in pure Profit Sharing plans  Participants can elect to defer a % of their covered compensation up to $16,500  Subject to a $5,500 “catch up” allowance at age 50 +  Employee contributions can be pre-tax or post-tax  Special limits for highly-compensated group based on average deferral rate of other eligible employees  Employees can choose among a variety of investment options in the 401(k) Plan – generally 5 to 20 funds

7. Sample Company Contribution Patterns Standard 401(k)  Company contributes – 50% on employees’ contributions to 3% of covered compensation – then 25% on 4% to 6% of covered compensation  Alternatives: Leverage company contributions on length of service The second tier is based ONLY on minimum company profitability Profit Sharing / 401(k)  All contributions – Basic and Matching -- are based on profitability (3 of 5 year rule)

8. Special 401(k) /CODA Rules  Employee contributions are always 100% vested  Company contributions vest based on years of service –- 3 year cliff or 2 through 6 years except for special cases:  100% if 2-years of service are required to participate  100% if a “Top Heavy” or “Safe Harbor” Plan  100% if Plan is terminated or “frozen”  All contributions must be allocated to participants’ accounts within 30-days of closing of monthly payroll cycle Except for company Profit Sharing contributions  Actual Deferral Percentage (ADP) test must be passed OR corrective action must be taken by employer  Return money to highly paid employees ($110,000 or more)  Increase contributions to all ELIGIBLE non-highly paid employees

9. 401(k) /CODA Withdrawal Rules  Withdrawals on post-tax contributions are permitted at any age  Withdrawals are permitted on pre-tax contributions after age 59 ½  Hardship withdrawals are permitted at any age after using 401(k) loans, ESOP or Profit Sharing available funds  Unforeseen and large medical expenses  Funeral expenses  Purchase of, or repair to damage of, principle residence  Prevent eviction or foreclosure  Post-secondary education expenses for family  Participant barred for 6 months from making any new contributions  Withdrawals subject to 10% tax penalty (before age 59½) Exceptions: Death or Total Disability

10. 401(k) Employee Deferral (ADP)Test *  Snapshot of actual deferrals from eligible employees is taken at the end of the plan year  Can use current or prior year ADP levels for non-highly compensated group (NHCE)  Often Limits contributions from highly compensated (HCE) employees in many plans  HCE defined as 5% owners or those earnings $110,000 or more (but never more than top 20% of eligible population)  Test can be avoided with a safe harbor plan that offers 100% immediate vesting and minimum contributions on the 1 st 5% of employee contributions * Similar test is required on regular or Roth IRA after-tax contributions (ACP Test)

11. ADP Rule Simplified ADP of Non-Highly Compensated (NHCE) ADP Limit on Highly Compensated (HCE) Allowable HCE -ADP Current or Prior YearCurrent Year 0.01% to 2.99%200% of NHC group 0.02% to 5.99% 3.00% to 8.99%+ 2% spread over NHC group 5.00% to 10.99% 9.00% or higher125% of NHC group 11.25% or higher

12. Sample ADP Calculation Measured by individual based on Deferral $ / Covered Pay Covered PayDeferral %Average Deferral $105,000 Owner of 100% stock 6% $ 90,0008% Not 3.5% but 4.75% $ 60,0004% $ 40,0000% $ 20,0002%

13. 401(k) Plan Alternatives Feature401(k)Safe HarborDefault Enrollment Minimum Contributions: Company Employee Discretionary but generally a match 1% of pay 3% of Pay to all, OR 100% guaranteed Match on 3% plus 50% on next 2% 1% of Pay 3% of Pay, OR 100% match on 1% plus 50% on next 5% 3% to 6% of pay Maximum Contributions: Company: Employee: 25%/$49,000 $22,000 Same but not above 6% of pay + P/S Same Enrollment Vesting Voluntary Standard Voluntary 100% Mandatory Standard Withdrawals before Age 59 ½ Yes - PenaltyNoYes- Penalty ADP TestingYesNoYes Default Investment Probably Required

14. Major Adopters of 401(k) Plans  All types of “for-profit” companies but particularly— those with more than 100 employees who can’t use SIMPLE plans those with less than 100 employees with low turnover and who want a lower cost plan than SIMPLE those with a small group of HCEs compared to NHCEs those who offer Deferred Compensation to HCEs those who want a low fixed cost plus a discretionary contribution feature those who actively pursue enrollment of NHCEs and offer investment education

15. Stock Bonus and ESOP Plans Same as Profit Sharing –  Based on Profitability  Allocation Rules and Maximum Contribution Rules But, different in intent –  Almost always invested fully in company stock  Reduces cash flow burden to company  Offers a market for closely-held stock  ESOP allows for company borrowing to contribute stock (leverage) with loan as plan asset  Must permit distributions in form of stock for special capital gains treatment  ESOP must permit 50% investment diversification for employees who meet age 55 and have 10 years of service  Offers tax advantaged distributions in company stock

16. Major Adopters of ESOPs/Bonus Plans  Similar to Profit Sharing Candidates  Companies focused on:  Enhanced cash flow through leverage (borrowing cash to make contributions)  Create a market for stock among current employees  Companies expecting enormous stock growth potential to reap capital gains tax advantages

17. Assignment - Background  Complete an Excel spreadsheet to calculate the ADP results for the following company. Then, answer the questions listed on the next page and hand them in for the next class. Please show your calculations to receive credit. Company Profile:  Company is a “C” Corporation and has 15 employees. Employees #1 and #2 own most of the outstanding shares. Employee 11 owns 7% of company stock.  The Company adopted a 401(k) Plan with a Profit Sharing element in 2006 and all employees are eligible to participate after 6 months of service.  Employees may contribute from 1% to 10% of their covered compensation.  The Company contributes 100% on the first 3% of pay that employees contribute, and then, subject to annual profits, 100% on the next 2% of pay that an employee contributes.

18. Assignment - Facts Employee Compensation Deferral % 1 $200,00010% 2 $158,000 9% 3 $ 107,000 8% 4 $ 80,000 7% 5 $ 75,000 6% 6 $ 71,000 6% 7 $ 58,000 6% 8 $ 51,000 5% 9 $ 45,000 6% 10 $ 40,000 5% 11 $ 35,500 4% 12 $ 32,000 0% 13 $ 30,000 0% 14 $ 28,000 1% 15 $ 25,700 0%

19. Please answer these questions and provide your calculations  Who are the HCEs? Specify by Employee #.  What is the actual ADP of the HCEs?  What is the actual ADP of the non-HCEs?  What is the allowable deferral rate for HCEs?  Does this plan qualify as a “safe harbor” plan?  Give two examples of how any plan could be considered a “safe harbor” plan.