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2. The Big Picture Joyce is a junior finance major at State University. Recently, Dr. Sanchez, her finance professor, delivered alecture on retirement savings that emphasized the need for A long-term savings horizon, and Multiple retirement plans. Dr. Sanchez mentioned that she has 4 different retirement plans. Joyce was surprised to hear this because she knows that herfather has only a single retirement plan provided by hisemployer. Joyce drops in on the professor during office hours to find outmore about how a person can have multiple retirement plans. Read the chapter and formulate your response.2 3. Qualified Plans (slide 1 of 11) Deferred compensation defined: Payments for services made available to thetaxpayer after the period when services wereperformed 3 4. Qualified Plans(slide 2 of 11) Tax benefits of qualified deferredcompensation plans Contributions are immediately deductible by theemployer Employees are not taxed on the contributions tothe plan or income earned by the plan untilpayment is made available to them under the plan Employer contributions to and benefits payableunder qualified plans generally are not subject toFICA and FUTA taxes 4 5. Qualified Plans(slide 3 of 11) A variety of deferred compensation arrangements areoffered to employees including: Qualified profit sharing plans Qualified pension plans Cash or deferred arrangement plans Simple IRAs and 401(k) plans Tax-deferred annuities Incentive stock option plans Nonqualified deferred compensation plans Restricted property plans Cafeteria benefit plans Employee stock purchase plans5 6. Qualified Plans(slide 4 of 11) Pension plans Provide systematic payments of definitelydeterminable amounts Employer contributions under a qualified pension plan must not depend on profits Plan normally must pay benefits out as lifetime annuities to provide retirement income to retired employees 2 types of pension plans Defined benefit plan Defined contribution plan 6 7. Qualified Plans (slide 5 of 11) Defined benefit pension plans Annual contributions are made by the employerthat will provide sufficient amounts to payspecified retirement benefits Benefits based upon years of service and averagecompensation Separate accounts for each employee are notmaintained 7 8. Qualified Plans (slide 6 of 11) Defined contribution pension plans The annual amount the employer must contributeis defined (e.g., a flat amount or a percentage ofcompensation) Separate accounts must be maintained for eachemployee The amount received upon retirement is dependentupon amounts contributed and income earned oncontributions 8 9. Qualified Plans(slide 7 of 11) Profit sharing plans Established to allow employees to participate inthe profits of the company Separate accounts are maintained for eachemployee 9 10. Qualified Plans(slide 8 of 11) Profit sharing plans Definite predetermined formulas must beestablished for the allocation of contributions toand distributions from the plan The company is not required to make annualcontributions and contributions do not have tocome from current profits 10 11. Qualified Plans(slide 9 of 11) Stock bonus plans Established so that the employer can contributeshares of its stock Subject to rules similar to profit sharing plans Distributions must be in employers stock 11 12. Qualified Plans (slide 10 of 11) Qualification requirements For a plan to be qualified, it must satisfy thefollowing requirements: Exclusive benefit requirement Nondiscrimination requirements Participation and coverage requirements Vesting requirements Distribution requirements Minimum funding requirements12 13. Qualified Plans (slide 11 of 11) Qualification requirements The qualification requirements are highly technicaland numerous Thus, an employer should seek a determination letter from the IRS regarding a plans qualified status13 14. Tax Consequences to Employee andEmployer (slide 1 of 10) Employer contributions to qualified plans aregenerally deductible immediately Amounts contributed are not taxable to employeesuntil distributed Tax benefit to the employee amounts to a substantial tax deferral Another advantage of a qualified plan is that any income earned by the trust is not taxable to the trust Employees are taxed on such earnings when they receive theretirement benefits Taxation of amounts received by employees in periodic orinstallment payments is generally subject to the annuity rules 14 15. Tax Consequences to Employee andEmployer (slide 2 of 10) Lump-sum distributions-generally taxable inyear of distribution Taxpayers who receive a lump-sum distributionfrom a qualified plan can roll over the benefits intoan IRA or into another qualified plan Defers tax on lump-sum distribution15 16. Tax Consequences to Employee andEmployer (slide 3 of 10) Limitations on contributions Defined contribution plan Lesser of $50,000 (in 2012) or 100% of employees compensation Employers deduction limit cannot exceed 25% of eligible compensation 16 17. Tax Consequences to Employee andEmployer (slide 4 of 10) Limitations on contributions Defined benefit plan max contribution deductioncan be calculated in one of two ways Aggregate cost method allows an actuarially determined amount, or Normal cost plus up to 10% of past service costs17 18. Tax Consequences to Employee andEmployer (slide 5 of 10) Limitations on contributions Defined benefit plan Annual benefit payable under the plan is the lesser of $200,000 (in 2012), subject to certain limitations, or 100% of average compensation for the highest 3 years of employment Compensation considered in averaging cannot exceed$250,000 (in 2012) 10% penalty tax on excess contributions18 19. The Big Picture - Example 7 Defined Benefit Pension Plan vs.A Defined Contribution Plan Return to the facts of The Big Picture on p. 19-1. The university has offered Joyces professor, Dr. Sanchez, achoice between a defined benefit pension plan and a definedcontribution plan. Dr. Sanchez expects to work at a number of universities duringher career. A colleague has recommended that Dr. Sanchez choose the defined contribution plan because of its mobility She can take the plan with her. She needs to decide if this mobility factor is significant inmaking her choice and how much she can contribute annuallyto a defined contribution plan. 19 20. Tax Consequences to Employee andEmployer (slide 6 of 10) Limitations on contributions Profit sharing plan or stock bonus plan Maximum deduction permitted to an employer each year for contributions to profit sharing and stock bonus plans is 25% of compensation Maximum compensation considered is $250,000 for 2012 The maximum deduction allowed is $50,000 in 201220 21. Tax Consequences to Employee andEmployer (slide 7 of 10) 401(k) plans Employee elects to receive cash (taxed currently)or have amount contributed (pretax) to a qualifiedplan Limit for 2012 on employee contribution is$17,000 Amount is reduced by other tax-sheltered salary reduction plans Person age 50 or over by year end may make catch-up contributions of up to $5,000 for 2012 21 22. The Big Picture - Example 14 401(k) plan vs. 403(b) plan Return to the facts of The Big Picture on p. 19-1. Dr. Sanchez is not eligible to participate in a 401(k) plan. She does participate in a 403(b) tax-deferred annuity plan. A 403(b) plan is for employees of 501(c) (3) not-for-profit organizations. Similar in many respects to a 401(k) plan.22 23. The Big Picture - Example 15 403(b) Annuity Return to the facts of The Big Picture on p. 19-1. Dr. Sanchez indicates that since she is age 51,she is eligible to make catch-up contributionsto her 403(b) annuity. 23 24. Tax Consequences to Employee and Employer (slide 8 of 10) SIMPLE Plans Employers with 100 or less employees and noother qualified plan In form, 401(k) or IRA Avoids nondiscrimination rules24 25. Tax Consequences to Employee andEmployer (slide 9 of 10) SIMPLE Plans Employees make elective contributions (up to $11,500 in2012) to plan Contributions made as percentage of compensation Distributions from plan taxed under IRA rules Employers generally required to match contributions up to3% of compensation or provide 2% nonmatchingcontributions Person age 50 or over by year end may make catch-upcontributions of up to $2,500 for 2006 and thereafter25 26. Tax Consequences to Employee andEmployer (slide 10 of 10) Designated Roth Contributions Starting in 2006, 401(k) plans and 403(b) plans may beamended to permit employees to irrevocably designatesome or all of their future salary deferral contributions asRoth 401(k) or Roth 403(b) contributions These designated amounts are currently includible in the employees gross income and are maintained in a separate plan account The earnings on these elective contributions build up in the plan on a tax-free basis Future qualified distributions made from designated contributions are excludible from gross income26 27. Retirement Plans for Self-Employed Individuals (slide 1 of 2) H.R. 10 (Keogh) plans Retirement plans for self-employed and theiremployees Plan rules are similar to corporate provisions Plan must be established before the end of the taxyear, but contributions may be made up to the duedate of the return 27 28. Retirement Plans for Self-EmployedIndividuals (slide 2 of 2) Keogh (H.R. 10) plans (contd) Contribution limitations Defined contribution plan Lesser of $50,000 (in 2012) or 100% of earned income Profit sharing plans and stock bonus plan are limited to 25% Defined benefit plans limit the annual benefitpayable to the lesser of $200,000 (in 2012) or100% of average compensation for 3 highest years 28 29. The Big Picture - Example 19 Keogh Plan Return to the facts of The Big Picture on p. 19-1. Joyces professor, Dr. Sanchez, has a forensic consultingpractice in addition to her position at the university. Also, she receives book royalties from a textbook. Since she is self-employed (she will report her earnings on aSchedule C), she is able to establish a Keogh plan.29 30. Individual Retirement Accounts(slide 1 of 15) Contribution ceiling is lesser of $5,000 ($10,000 forspousal IRAs) or 100% of earned income Person age 50 or over by year end may make catch-upcontributions Max contribution limit is increased by $1,000 for 2006 and thereafter Deductible IRA contribution may be reduced iftaxpayer is an active participant in another qualifiedplan To extent individual is ineligible to make deductiblecontributions, a nondeductible IRA contribution maybe made Income accrues on account tax deferred30 31. Individual Retirement Accounts(slide 2 of 15) If taxpayer is covered by a qualified plan,IRA deduction is phased out within the AGIranges listed below:31 32. Individual Retirement Accounts(slide 3 of 15) For distributions made in 2006 through 2012,an exclusion from gross income is availablefor traditional IRA distributions made tocharity The amount of the distribution that is eligible forthis beneficial exclusion treatment is limited to$100,00032 33. Individual Retirement Accounts (slide 4 of 15) Roth IRA Contributions are nondeductible Maximum allowable annual contribution is the smaller of $5,000 ($10,000 for spousal IRAs) or 100% of the individuals compensation for the year Qualified distributions are tax-free after an initial five yearholding period if: Made on or after age 59 Made to beneficiary on or after participants death Participant becomes disabled Used to pay for qualified first-time home buyers expenses ($10,000 limit)33 34. Individual Retirement Accounts (slide 5 of 15) Roth IRA (contd) Other distributions may be taxable Distributions first treated as nontaxable return of capital to extent of contributions Remaining distribution treated as taxable payout of earnings 34 35. Individual Retirement Accounts(slide 6 of 15) Roth IRA (contd) Annual contributions are subject to phase outwithin the AGI ranges listed below:Phase-out beginsPhase-out ends Single $ 110,000 $125,000 MFJ 173,000 183,000 MFS010,000 35 36. The Big Picture - Example 29 Roth IRAs Income Limits Return to the facts of The Big Picture on p. 19-1. Joyces professor, Dr. Sanchez, alsocontributes annually to a traditional IRA. She would prefer a Roth IRA, but her AGI exceeds the phaseout limit.36 37. Individual Retirement Accounts (slide 7 of 15) Coverdell Education Savings Account Distributions to pay for qualified educationexpenses (QEE) are tax-free Exclusion may be available in year American Opportunity credit or lifetime learning credit is claimed Maximum annual nondeductible contribution for abeneficiary is $2,000 No contributions allowed after beneficiary reaches 18 years of age No contribution allowed in year contribution made to qualified tuition program for same beneficiary 37 38. Individual Retirement Accounts (slide 8 of 15)Coverdell Education Savings Account (contd) Annual contributions are subject to phase out within the AGI ranges listed below: Phase-out beginsPhase-out endsSingle $95,000 $110,000MFJ190,000220,00038 39. Individual Retirement Accounts(slide 9 of 15) Coverdell Education Savings Account (contd) Distributions in excess of QEE are treated, pro rata, as a return of capital and a distribution of earnings The exclusion for the distribution of earnings is calculated asfollows:Exclusion = (QEE/Total Distributions) Earnings Qualified higher education expenses (QEE) include: Tuition, fees, books, supplies and equipment Room and board if enrolled for at least one-half of full-time courseload 39 40. Individual Retirement Accounts(slide 10 of 15) Simplified employee pension (SEP) plans Employer contributes to employees IRA Contribution limited to lesser of $50,000 (in 2012) or 25% of compensation Subject to most restrictions of qualified plans Elective contributions by employee are limited to$17,000 in 201240 41. Individual Retirement Accounts (slide 11 of 15) Spousal IRAs If both spouses have earned income, ceiling ondeductible contributions is $10,000 or combinedearned income If only one spouse has earned income, ceiling is$10,000 or earned income of that spouse Must file jointly to use spousal IRA rules 41 42. Individual Retirement Accounts (slide 12 of 15) Alimony is considered to be earned income forpurposes of IRA contributions Thus, a person whose only income is alimony cancontribute to an IRA Timing of Contributions Contributions (both deductible and nondeductible)can be made to an IRA anytime before the due dateof the individuals tax return (without extensions)42 43. Individual Retirement Accounts(slide 13 of 15) Taxation of Benefits A participant has zero basis in deductible contributions to a traditional IRA because the contributions were deducted Therefore, all withdrawals from a deductible IRA are taxed asordinary income in the year of receipt A participant has a basis equal to the contributions made for a nondeductible traditional IRA Therefore, only the earnings component of withdrawals is includedin gross income Such amounts are taxed as ordinary income in the year of receipt43 44. Individual Retirement Accounts(slide 14 of 15) Distributions before age 59 1/2 subject to 10%penalty tax except to pay for: Medical expenses in excess of 7.5% AGI Qualified higher education expenses Qualified first-time home buyer expenses up to$10,000 Health insurance premiums for person (and family)who has received unemployment comp for at least12 consecutive weeks44 45. Individual Retirement Accounts (slide 15 of 15) Rollovers Distribution from qualified plan transferred within60 days to IRA (or another qualified plan) notincludible in gross income One tax-free rollover from IRA within 12-monthperiod Direct transfers not subject to this limitation Employer must withhold 20% of any lump-sumdistribution that is not a direct transfer45 46. The Big Picture - Example 37Tax-free Rollover Return to the facts of The Big Picture on p. 19-1. Dr. Sanchez withdraws $15,000 from her traditionalIRA on May 2, 2012, but she redeposits it in the sameIRA on June 28, 2012. The withdrawal and redeposit was a partial rollover and Dr. Sanchez may have used the funds for a limited time. This is a tax-free rollover. 46 47. Nonqualified Deferred Compensation Plans(slide 1 of 3) New rules apply after 2004 to nonqualifiedarrangements that defer the receipt of compensationincome If the plan does not meet certain conditions in 409A, all amounts deferred under the arrangement may be included in the participants gross income to the extent they are not subject to a substantial risk of forfeiture In addition, a 20% penalty tax is imposed on such income along with interest at the underpayment rate plus 1% In general, a 409A deferral occurs where anemployee has a legally binding right to compensationthat has been deferred to the future47 48. Nonqualified Deferred Compensation Plans(slide 2 of 3) Golden parachutes Defined: Excess severance payments Employer is denied deduction for golden parachutepayments if Payment is contingent on change of ownership through a stock or asset acquisition Aggregate present value of payment equals or exceeds three times the employees average annual compensation Disallowed amount is excess of payment over statutorybase (five-year average taxable compensation) and a 20%excise tax is imposed on the recipient48 49. Nonqualified Deferred Compensation Plans (slide 3 of 3) Compensation limitations Publicly traded companies have a limitation of $1million on deductible compensation for each ofthe top 5 executives Limit may be reduced to $500,000 under TARP Certain types of compensation are not subject tothe limit e.g., Commissions, certain performance-based amounts, qualified retirement plan contributions, and excludible amounts such as employee fringe benefits 49 50. Restricted Property Plans (slide 1 of 2) Restricted property plan defined: Generally, an incentive compensation arrangementwhere the employee receives property (e.g., stockin the employer) at little or no cost Time for inclusion in income is the earlier of: When the property is no longer subject to substantial risk of forfeiture, or When the property is transferable by the employee 50 51. Restricted Property Plans (slide 2 of 2) Employee can elect to recognize any ordinaryincome from the restricted propertyimmediately Employer is allowed a tax deduction at thesame time the employee includes thecompensation in income 51 52. Stock Options(slide 1 of 5) Stock option defined: The right to purchase a stated number of shares ofstock at a certain price within a specified timeperiod 52 53. Stock Options(slide 2 of 5) Incentive stock options (ISO) No tax consequences to issuer or recipient whengranted The spread between FMV and option price at exercise date is a tax preference item for AMT 53 54. Stock Options(slide 3 of 5) Incentive stock options (ISO) Employee will qualify for long-term capital gaintreatment on the sale of stock received byexercising the option if stock is held more than 2 years after the option is granted, or 1 year after the option is exercised May produce no compensation deduction foremployer 54 55. Stock Options(slide 4 of 5) Nonqualified stock options (NQSO) NQSO are stock options that do not qualify as ISO If the NQSO has an ascertainable value at the dateof grant, it is included in the employees income onthat date 55 56. Stock Options(slide 5 of 5) Nonqualified stock options (NQSO) If the NQSO does not have an ascertainable valueat date of grant, employee will recognize ordinaryincome at the exercise date equal to the differencebetween FMV and the option price Employer receives a deduction for the sameamount as is included in the employees income56 57. The Big Picture - Example 47Stock Options (slide 1 of 2) Return to the facts of The Big Picture on p. 19-1. Dr. Sanchez is on the board of directors of WrenCorp. Wren Corp. granted an ISO for 100 shares of its stock to Dr. Sanchez on March 18, 2011. The option price was $100 and the FMV was $100 on the date of the grant. Dr. Sanchez exercised the option on April 1, 2011, when the FMV of the stock was $200 per share. She sells the stock on April 6, 2012, for $300 per share. 57 58. The Big Picture - Example 47Stock Options (slide 2 of 2) Return to the facts of The Big Picture on p. 19-1. Dr. Sanchez did not recognize any ordinary incomeon the grant date or the exercise date. The option qualified as an ISO. Wren received no compensation deduction. Dr. Sanchez has a $10,000 tax preference item on theexercise date. She has a long-term capital gain of $20,000 on thesale of the stock in 2012 [($300 $100) 100]. The one-year and two-year holding periods and other requirements have been met. 58 59. The Big Picture - Example 48 Stock Options Return to the facts in Example 47, except that Dr.Sanchez was not an employee of Wren Corp. for 6months before she exercised the options. Dr. Sanchez must recognize $10,000 [($200 $100) 100] of ordinary income on the exercise date, to the extent of the spread. She was not an employee of Wren Corp. at all times during theperiod beginning on the grant date and ending three months beforethe exercise date. Wren is allowed a deduction at the same time Dr. Sanchez reports the ordinary income.59 60. The Big Picture - Example 49 Stock Options Assume the same facts as in Example 47,except that Dr. Sanchez sells the stock onMarch 22, 2012, for $290 per share. Because Dr. Sanchez did not hold the stock formore than one year, $10,000 of the gain is treatedas ordinary income in 2012. Wren Corp. is allowed a $10,000 compensationdeduction in 2012. The remaining $9,000 is short-term capital gain ($29,000 $20,000). 60 61. Refocus On The Big Picture (slide 1 of 4) From her discussion with Dr. Sanchez, Joyce learnsthat her professor has the following retirement plans: Defined contribution plan - The university offered its faculty members a choice between a defined benefit pension plan and a defined contribution plan. Dr. Sanchez expects to work at a number of universities during hercareer, so she chose the defined contribution plan because of itsmobility. The maximum annual contribution the university could make to theplan is $50,000 for 2012. Since the university contribution rate is 15%, the actualcontribution is $22,500($150,000 X 15%). 61 62. Refocus On The Big Picture (slide 2 of 4) 403(b) annuity - Dr. Sanchez makescontributions to a 403(b) annuity This is the equivalent of a 401(k) plan, butavailable to educators. She has the university deduct the maximum annualcontribution in 2012 of $17,000. In addition, because she is at least age 50, she hasthe university deduct an additional $5,500 as acatch-up contribution. 62 63. Refocus On The Big Picture (slide 3 of 4) Keogh (H.R. 10) plan - Dr. Sanchez also hasa forensic consulting practice. Since she is self-employed, she is able to establisha Keogh plan. She makes contributions of 20% of her netearnings from the consulting practice, about$8,000 per year ($40,000 X 20%), to the plan. 63 64. Refocus On The Big Picture (slide 4 of 4) IRA - Dr. Sanchez also contributes annually to atraditional IRA. She would prefer a Roth IRA, but her AGI exceeds the $125,000 phaseout limit. Likewise, she cannot deduct her IRA contribution of $5,000 (the maximum) because her AGI is above the limit. Since she cannot deduct her contributions, her basis in the IRA isequal to the amount of her contributions. The $15,000 that Dr. Sanchez withdrew from her traditional IRA is not subject to current taxation and does not reduce her basis for the IRA. This result occurs because Dr. Sanchez successfully recontributedthe $15,000 to her IRA within 60 days. 64 65. If you have any comments or suggestions concerning thisPowerPoint Presentation for South-Western FederalTaxation, please contact:Dr. Donald R. Trippeer, [email protected] Oneonta 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 65
