MGT213 Employee Benefits Chapter 4

Other Types of Retirement Benefits

Aims and Objectives of This Chapter:

Discuss the Cash Balance Pension Plan:

Explore the structure and features of cash balance pension plans.

Understand how these plans differ from traditional retirement plans.

Analyze the advantages and potential challenges associated with cash balance plans.

Introduce the Money Purchase Plan:

Provide an overview of money purchase plans and their key characteristics.

Highlight the contribution and benefit aspects of money purchase plans.

Discuss considerations for employers and employees participating in such plans.

Discuss Issues Related to the Simplified Employee Pension Plan (SEP):

Examine the simplified structure and benefits of SEP plans.

Identify key issues and considerations for employers implementing SEP plans.

Understand the flexibility and advantages offered by SEP plans.

Introduce the 403(b) Plans:

Explore the features and purpose of 403(b) plans, commonly used in the non-profit sector.

Discuss the contributions, investments, and regulatory aspects of 403(b) plans.

Analyze how 403(b) plans cater to the retirement needs of employees in specific industries.

Analyze the Issues Related to a 409A Plan:

Investigate the complexities and compliance considerations associated with 409A plans.

Understand the role of 409A plans in providing nonqualified deferred compensation.

Discuss potential challenges and best practices for implementing 409A plans.

Discuss 457(f) and 457(b) Plans:

Differentiate between 457(f) and 457(b) plans and their respective purposes.

Examine the eligibility, contributions, and benefits under 457(f) and 457(b) plans.

Analyze the significance of these plans in the context of executive compensation and public sector employees.

Chapter Context:

Chapter 5, "Retirement Plans," covered traditional retirement methods. This chapter expands on alternative retirement plans, evolving from the traditional models. It explores cash balance plans, money purchase plans, and simplified employee pension plans, offering a comprehensive understanding of these retirement options. Each plan is dissected to provide clarity on its structure, benefits, and considerations for both employers and employees.

Cash Balance Pension Plans

A cash balance plan represents a unique fusion of both defined benefit and defined contribution retirement plans, seamlessly integrating features from each category. Despite its hybrid nature, the Employee Retirement Security Act (ERISA) categorizes it as a defined benefit plan due to its specification of a monthly retirement benefit.

This innovative retirement vehicle is characterized by two pivotal elements:

Hypothetical Individual Accounts: Departing from the conventional structure of defined benefit plans, a cash balance plan establishes retirement benefits around hypothetical, or notional, individual accounts. Each year, employees in the plan accrue a hypothetical benefit credit linked to a percentage of their normal compensation, accompanied by an interest credit tied to a benchmark rate, often mirroring the yield on 30-year U.S. Treasuries.

Formulaic Benefit Determination: Unlike the traditional defined benefit plan, a cash balance plan employs a formula to ascertain the benefits available upon retirement. This formula combines the annual hypothetical benefit credit and interest credit, providing a clear and predictable mechanism for determining retirement income.

In parallel with defined benefit plans, employees are automatically enrolled in cash balance plans, and the plans are safeguarded by the Pension Benefit Guaranty Corporation. The distinguishing factor lies in the periodic crediting of each employee's account by the sponsoring employer, typically based on a percentage of the individual's salary.

Noteworthy is the divergence in the handling of plan assets. In contrast to defined benefit plans, cash balance plans do not tie individual account values to the performance of underlying plan assets. Contributions and investment earnings are funneled into a collective trust fund for all participants, and benefits are disbursed directly from this communal pool. This characteristic aligns cash balance plans more closely with 401(k) plans, emphasizing portability and presenting benefits in terms of a balance within individual accounts. Importantly, these benefits are rooted in cumulative earnings over the entire duration of plan participation, offering a holistic approach to employee retirement planning.

The computation of benefits in a cash balance pension plan is intricately tied to a formula that factors in wages, pay credit rates, and interest credit rates. Pay credits, denoting contributions allocated by the employer and typically expressed as a percentage of the employee's pay, play a pivotal role in shaping the hypothetical accounts of individuals within the plan.

To illustrate, let's consider a scenario where a cash balance plan assigns a 6% pay credit of an employee's current salary and an interest rate of 5% based on the previous year's balance. In the first year of employment for an individual starting at 28 years old with a $4,000 monthly salary, the pay credit would be $2,880 (6% of $48,000). Given the starting balance of zero, the interest credit for the first year would be nil. In the subsequent year, with a 4.5% salary increase to $4,180, the pay credit for the year would be $3,010 (6% of $50,160). Considering the beginning balance of $2,880, the 5% interest rate would yield a $144 credit. Summing these figures results in an ending balance of $6,034 in the hypothetical account at the end of the second year.

This iterative process continues annually until the employee reaches retirement, producing a hypothetical account balance. The formula for benefits in a cash balance plan is expressed as follows:

\text{Benefits accrued in a year} = \text{Pay credit rate (% of pay)} \times \text{Wage} + \text{Account balance} \times \text{Interest credit rate for the year}

This formula encapsulates the essential elements driving the accumulation of benefits throughout an individual's tenure, providing the basis for calculating the legally required benefit at the time of retirement.

Characteristics of Cash Balance Plans

Distinctive attributes distinguish cash balance plans:

Front-Loaded Benefits for Younger Employees:

Unlike traditional defined benefit plans that often calculate benefits based on an employee's final salary, cash balance plans prioritize younger employees by providing higher benefits early in their career. This approach ensures that younger workers accumulate retirement benefits consistently throughout their tenure, presenting a departure from the reliance on final-year or final-five-year salary averages.

Enhanced Portability for Short-Term Employees:

The formula employed in cash balance plans facilitates more portable benefits, particularly beneficial for individuals with a history of short-term employment. Comparable to 401(k) plans, cash balance plans appeal to workers who frequently change jobs, offering them the flexibility to carry their cash balance benefits seamlessly from one employer to another.

Lump-Sum Distribution Option Similar to 401(k) Plans:

In a parallel feature with 401(k) plans, cash balance plans allow beneficiaries to opt for a lump-sum distribution either before or at the normal retirement age. This feature provides individuals with greater control over their retirement funds, aligning with the flexibility often associated with 401(k) plans.

While the option for lump-sum distributions in cash balance plans presents a positive aspect, the practical implications of individual financial decisions can paint a less favorable picture. In reality, there is a risk that individuals may exhaust their lump-sum amounts before retirement, potentially leaving them in a less advantageous position compared to counterparts with traditional defined benefit plans. Unlike many traditional pension plans, cash balance plans permit cashing out, introducing a dynamic that demands thoughtful consideration in financial planning.

For a comprehensive overview, Table 6.1 provides a side-by-side comparison of traditional pension plans, 401(k) plans, and cash balance plans, shedding light on the nuanced features that distinguish these retirement options.

Table 6.1:

Table 6.1 Comparison of Defined Benefit, 401(k), and Cash Balance Plans

The transformation of traditional defined benefit plans into cash balance plans has undergone a remarkable surge in the past decade, particularly among major employers. A December 2012 article published in the Bureau of Labor Statistics Monthly Labor Review unveiled a significant shift in pension plan strategies. The adoption of a cash balance plan formula skyrocketed from a modest 3% in 1995 to a substantial 36% by 2010. In stark contrast, the utilization of defined benefit-based plan formulas, relying on a percentage of terminal earnings or career earnings, followed a descending trajectory, plummeting from 69% in 1996 to 43% in 2010. The trend is unequivocal: an increasing number of companies are opting for the flexibility and advantages presented by cash balance plans.

Why Employers Are Converting to Cash Balance Plans

Employers are increasingly opting to convert their traditional defined benefit plans into cash balance plans, a strategic move driven by several compelling factors. Firstly, this transition is motivated by the desire to attract and retain a younger, more mobile workforce by offering enhanced pension benefits early in employees' careers. The shift aligns with the evolving preferences of new talent and provides employers with a competitive edge in the dynamic job market.

Additionally, employers are drawn to cash balance plans as a means of sidestepping reversion taxes, a financial burden associated with terminating overfunded defined benefit plans. Terminating such plans triggers stringent Pension Benefit Guaranty Corporation (PBGC) termination procedures, requiring the inclusion of recovered plan assets (employer reversion) into corporate income. This process subjects employers to a minimum 20% excise tax, potentially escalating to 50%. To circumvent these tax implications, many employers choose the route of converting to cash balance plans, a streamlined process involving a plan amendment rather than a complete termination and the establishment of a defined contribution plan.

Amidst the retirement wave of the Baby Boomer generation, employers are grappling with a surge in pension obligations. Opting for cash balance plans over terminating traditional defined benefit plans allows employers to eliminate formula-based commitments inherent in the latter, offering a strategic solution to navigate the financial landscape.

While employers have the flexibility to make changes to their plans, federal law imposes certain restrictions. Notably, advance notice is mandated if amendments significantly reduce the rate at which employees may earn future benefits. Legal requirements, including anti-discrimination measures based on age, must also be meticulously adhered to. Importantly, while employers can amend plans to cease or reduce future benefits, retroactively reducing benefits already earned by employees is generally prohibited. This safeguard ensures that employees receive no less than their accrued benefits under the plan formula as of the effective date of the amendment, emphasizing the importance of fairness and adherence to established commitments.

Assume, for instance, that a plan’s benefit formula provides a monthly pension at age 65 that equals 1.5% for each year of service multiplied by the monthly average income of a given employee’s highest three years of compensation. Further assume that the plan is amended to change the benefit plan’s formula. If a hypothetical employee has completed 10 years of service at the time of the amendment, that employee will have the right to receive a monthly pension (as of age 65) equal to 15% of the monthly average income of the employee’s highest three years of compensation once the amendment is in effect. This pre-amendment benefit amount (including related early-retirement benefits) is protected by law and cannot be reduced.

Also, additional restrictions apply, specifically in the case of an amendment that converts a plan formula to cash balance plan formula. Specifically speaking, employees must receive the sum of their pre-amendment benefit amount plus any benefits under the new cash balance formula; as a result of this arrangement, there cannot be a “wear-away” period during which the employee does not accrue additional benefits, which could occur if the employee were merely entitled to the greater of the two amounts. Furthermore, all benefits under a cash balance plan, including benefits accrued prior to a conversion, must be fully vested after three years of service.

Whenever a sponsoring employer amends its pension plan to convert its traditional defined benefit plan formula to a cash balance plan formula, the plan’s assets remain intact and will continue to back all pension benefits under the plan; employers cannot remove funds from the plan unless the plan has been terminated and has remaining assets after all benefits have been paid out.

Money Purchase Pension Plans

A money purchase pension plan operates as a defined contribution strategy where the sponsoring employer commits a predetermined cash amount, distinct from shares of stock or a percentage of company profits. It bears resemblance to a profit-sharing plan, albeit with a distinctive feature—the contribution amounts are fixed and predetermined. While akin to profit-sharing plans, money purchase plans possess a characteristic rigidity in their contribution structure.

In contrast to profit-sharing plans, money purchase plans necessitate mandatory contributions; employers are obliged to make yearly contributions to each employee's account, irrespective of the company's profitability in a given year. These contributions can reach up to 25% of the total annual compensation for all plan participants, capping at either 100% of each participant's salary or a specified limit, such as $51,000 (as of 2013), whichever is less.

Within a money purchase plan, the plan document explicitly outlines the required percentage of contributions. For instance, a plan might mandate a 5% contribution of each eligible employee's pay. In adherence to this stipulation, the employer must contribute 5% of each eligible employee's pay to their respective individual accounts. At the point of retirement, an employee's benefits are contingent upon the accumulated contributions to their account and the associated gains.

A key distinction from profit-sharing plans lies in the allocation process. In a profit-sharing plan, the sponsoring employer has flexibility in determining the contribution amount (e.g., $10,000), which is then apportioned to the separate accounts of eligible employees based on the plan's contribution formula. Notably, while money purchase plans historically featured higher deductible limits than profit-sharing plans, this distinction no longer holds true in contemporary settings.

These plans can be strategically employed in tandem with profit-sharing plans to optimize the utilization of allowable contribution levels within a given year.

Employer contributions, within the specified annual limits, enjoy tax deferral. Similar to other defined contribution plans, employees witness the tax-deferred accumulation of funds until they opt for withdrawal. Noteworthy is the absence of an option for employees to make additional contributions to their own accounts. Nevertheless, they typically retain the prerogative to select the investments included in their accounts.

Vesting schedules, often instituted by employers, delineate when an employee gains the right to claim funds from their plan. Upon achieving full vesting, employees can initiate withdrawals without incurring tax penalties once they cross the age threshold of 59.5. In certain circumstances, employees may also be eligible to borrow from their plans before reaching this age, provided specific qualifying events are identified as defined in the plan's documentation.

Distribution from these plans can occur through various channels, including plan loans, hardship distributions, in-service distributions, required minimum distributions, or distributions prompted by termination or retirement. Of these, retirement remains the preferred mode of distribution, offering a structured and anticipated approach to accessing accumulated funds.

Withdrawals from money purchase pension plans are subject to taxation as ordinary income and become mandatory when the account holder reaches the age of 70.5 years. These withdrawals can be structured either as a lump sum or as minimum annual installments based on life expectancy, offering flexibility to the account holder.

To ensure compliance and adherence to regulatory standards, money purchase pension plans are obligated to have a meticulously crafted written plan document. This document is typically prepared by a third-party administrator and formally executed by the employer. Furthermore, the plan undergoes annual testing to verify its conformity with all nondiscrimination rules outlined in the Internal Revenue Code. Alongside this, an annual electronic filing of Form 5500 with the Department of Labor is mandatory. In cases where the sponsoring employer boasts more than 100 plan-eligible employees, an annual audit of the plan is an additional requisite, contributing to the robust regulatory framework governing money purchase pension plans.

Employer Advantages with Money Purchase Plans

Sponsoring employers can leverage several advantages with money purchase plans, including the following:

Competitive Edge for Small Businesses:

Small business owners can strategically establish money purchase plans to enhance their competitiveness when vying for top-tier talent. This serves as an effective tool for attracting and retaining high-quality employees, allowing smaller enterprises to rival larger businesses in the recruitment landscape.

Tax Deductibility for Employer Contributions:

The contributions made by the employer to a money purchase plan offer a tax advantage. All contributions, within predetermined allowable limits, are tax-deductible for federal and, in most instances, state income tax purposes. This favorable tax treatment not only supports the financial health of the plan but also translates into a potential reduction in the company's current tax liabilities.

Simplified Employee Pension Plans

A Simplified Employee Pension (SEP) plan stands out as a straightforward and efficient retirement savings program, offering a simplified alternative compared to other plans discussed in this context. SEPs empower employers to make tax-favored contributions to individual retirement accounts (IRAs) held by plan participants, thereby serving as a valuable means for accumulating retirement income for both employers and their workforce. This simplicity makes SEPs particularly well-suited for mid-size companies seeking an uncomplicated yet effective retirement savings solution.

Within the framework of a SEP, employees are required to establish an IRA to receive employer contributions. In cases where an employee is either unwilling or unable to set up a traditional IRA, the employer assumes the responsibility of processing the necessary documentation and establishing an account on behalf of the employee.

Contributions to eligible employee accounts must be made equally by the employer. While SEPs generally allow all employees to participate, employers retain the discretion to exclude certain individuals, including those under the age of 21, those who have not worked in three of the past five years, certain union and nonresident alien employees, and employees not meeting the minimum annual earnings threshold (e.g., $550 for 2013).

The maximum annual contributions are determined by a per-employee limit, calculated as the lower of two options: 25% of the employee's compensation up to a defined compensation cap (e.g., $225,000 for 2013) or a set dollar amount (e.g., $51,000 for 2013). These figures are subject to annual adjustments for cost-of-living considerations. It's important to note that SEPs exclusively receive contributions from employers, distinguishing them from plans where employee contributions are also a component.

Effectively, a Simplified Employee Pension (SEP) operates as an enhanced IRA, affording employers the flexibility to contribute a predetermined percentage up to a specified maximum amount each year. This percentage can be adjusted annually, allowing for reduced or even zero contributions during periods of constrained resources. Importantly, employees are fully vested in all funds associated with SEP-IRAs, adding to the attractiveness of this retirement savings vehicle. SEPs offer several compelling advantages:

No Filing Requirement for Employers:

Employers are exempt from filing requirements, streamlining administrative obligations.

Cost-Effective Setup and Operation:

SEPs incur lower start-up and operating costs compared to conventional plans, making them a financially efficient choice.

Applicability to Businesses of Any Size:

SEPs are accessible to businesses of all sizes, ensuring broad applicability.

Low Administrative Costs:

The plan entails minimal administrative costs, contributing to its efficiency.

Flexible Annual Employer Contributions:

Employers benefit from the flexibility of adjusting annual contributions, aligning with cash-flow considerations.

Minimal Paperwork:

Administrative requirements are kept to a minimum, streamlining the management of SEPs.

Full Employer Funding:

Employees are not obligated to contribute to SEPs; employers bear the entire cost of the plan.

Exemption from Annual Government Reports:

SEPs eliminate the need for annual government reports, reducing administrative burdens.

Management Simplicity with Significant Contributions:

SEPs are as manageable as deductible IRAs but allow for more substantial contributions, enhancing their appeal.

When establishing a SEP, specific steps must be undertaken:

Adoption of a Formal Agreement:

Select and adopt a formal written agreement using options such as the IRS model SEP (Form 5305), an IRS-approved prototype SEP from plan providers, or an individually designed SEP plan document.

Employee Communication:

Provide each employee with pertinent information about the SEP, including a copy of Form 5305 if applicable, or equivalent information for prototype or individually designed SEPs.

Plan Setup for Eligible Employees:

Establish the SEP for each eligible employee with a qualified financial institution, such as a bank, insurance company, or another suitable entity. This ensures proper implementation and management of the plan.

SEPs have specific features and tax considerations:

No Employee Loans or Collateral Use:

SEPs do not facilitate employee loans, and plan assets cannot serve as collateral, maintaining a clear boundary on the use of plan funds.

In-Service Withdrawals:

While in-service withdrawals are permissible, they come with tax implications. Withdrawals are included in the employee's income and are subject to an additional tax of 10% if the employee is under the age of 59 years.

Tax Characteristics:

The tax characteristics of a SEP are structured as follows:

Tax-Deductible Employer Contributions:

Employer contributions to a SEP are tax-deductible, providing a favorable incentive for employers to contribute to the retirement savings of their employees.

Tax Credits for Start-Up Costs:

Employers may be eligible for tax credits to offset start-up costs associated with implementing a SEP, further encouraging the adoption of these plans.

Tax-Deferred Asset Growth:

Assets within a SEP remain tax-deferred until distribution, allowing for potential growth without immediate tax obligations.

Taxation of Distributions:

Distributions from a SEP are taxed as ordinary income when received, aligning with the standard tax treatment for retirement plan withdrawals.

403(b) Plans

A 403(b) plan, commonly known as a tax-sheltered annuity (TSA), serves as a retirement plan designed for specific groups of employees, including those working in public schools, certain tax-exempt organizations, and qualifying ministers. This plan encompasses various account types:

Annuity Contract:

Provided through an insurance company.

Custodial Account:

Invested in mutual funds.

Retirement Income Account:

Established for church employees, with the flexibility to invest in either annuities or mutual funds.

Eligible participants in a 403(b) plan include:

Employees of Tax-Exempt Organizations (Section 501(c)(3)):

Commonly referred to as Section 501(c)(3) organizations.

Public School System Employees:

Involved in the day-to-day operations of a school.

Employees of Cooperative Hospital Service Organizations:

Civilian faculty and staff of the Uniformed Services University of the Health Sciences.

Employees of Public School Systems Organized by Indian Tribal Governments.

Certain ministers are also eligible participants:

Ministers Employed by Section 501(c)(3) Organizations.

Self-Employed Ministers:

Treated as employed by a qualified employer, which is a tax-exempt organization.

Ministers (Chaplains) Who Meet Specific Criteria:

Employed by organizations not qualified as Section 501(c)(3) organizations.

Function as ministers in their day-to-day professional responsibilities.

Individuals cannot establish their own 403(b) accounts; only employers can initiate these plans. Additionally, a self-employed minister cannot set up a 403(b) account for personal benefit; the associated organization (denomination) must establish the account on behalf of the minister. This structure ensures that 403(b) plans are administered through employers and qualified organizations, promoting regulatory adherence and proper oversight.

Typically, only employers have the authority to contribute to a 403(b) account. However, certain plans allow employees to make after-tax contributions, subject to yearly contribution limits.

403(b) accounts can receive the following types of contributions:

Elective Deferrals:

These contributions arise from a salary reduction agreement. In this arrangement, the employer withholds a portion of the employee's salary, directing it into the 403(b) account.

With the exception of Roth contributions, these deferrals are not subject to income taxes upon withdrawal. Roth contributions, however, are taxed upon contribution, but qualified distributions from the Roth account remain tax-free.

Nonelective Contributions:

These are employer contributions not tied to a salary reduction agreement. Examples include matching, discretionary, and mandatory contributions by the employer.

Income taxes on nonelective contributions are deferred until the funds are withdrawn from the account.

After-Tax Contributions:

Employees can make non-Roth after-tax contributions using income that has already been taxed, such as funds from a salary payment with withheld income taxes.

Unlike other contributions, after-tax contributions are not excluded from the employee's income. Additionally, employees cannot claim deductions for these contributions on their tax returns.

Understanding these contribution types is crucial for both employers and employees participating in 403(b) plans, as they provide insight into the tax implications and benefits associated with each contribution method.

In the case of a self-employed minister serving as both an employee and an employer, they have the unique ability to contribute to a retirement income account on their own behalf.

Typically, employees, except in the case of Roth contributions, are not required to report contributions made to their 403(b) account on their tax returns. Instead, it is the employer's responsibility to report these contributions on Form W-2. Specifically, elective deferrals are detailed in Box 12, with the Retirement Plan Box indicated in Box 13. This reporting structure simplifies the tax process for employees, ensuring that the necessary information is conveyed accurately through their employer's reporting mechanisms.

409A Plans

A nonqualified deferred compensation (NQDC) plan is subject to the guidelines outlined in Section 409A, along with its final regulations. This encompasses any contractual agreement, method, program, or arrangement designed for the deferral of compensation.

It's important to distinguish that, strictly speaking, a deferred compensation plan is not a retirement plan but a capital accumulation plan. Despite this distinction, it finds mention in this chapter due to the common perception among participants that it serves as an additional tool for funding retirement income, akin to a 401(k) plan. Notably, Section 409A does not apply to tax-qualified retirement plans (e.g., 401(k) plans, 403(b) plans, 457(b) plans, or similar tax-favored plans), even though both types of plans involve delaying taxation.

For a NQDC plan to be valid, it must be documented in writing and adhere to the requirements specified in Section 409A. These requirements mandate that the company establishes the material terms of the plan, covering crucial aspects such as:

The amount of deferred compensation payable to an employee (or an objective nondiscretionary formula to determine this amount).

The payment schedule or events triggering payment to an employee.

Conditions governing an employee's initial and subsequent deferral elections.

In certain cases, conditions allowing the acceleration of deferred compensation payments.

If the company is publicly traded, adherence to the six-month delay rule applicable to specific employees, necessitating a delay in payment.

Employees making compensation deferral elections under a 409A plan must also specify the time and form of payment. Alternatively, the plan must outline the time and form of payment, permitting disbursement no earlier than specified events, such as: [Include specific events as per the text.]

• Separation from service

• Disability

• Death

• Change of control

• Unforeseeable emergency

• At a fixed date or according to a fixed schedule specified by the plan or an employee’s irrevocable election

In specific scenarios, diverse forms of payment may be chosen for distinct payment events. For instance, an employee can opt for a lump-sum payment in the event of disability, while selecting installment payments for both separation from service and, alternately, death. Once the timing and form of payment for deferred compensation have been established by either the employee or the 409A plan, acceleration of payment is precluded.

When it comes to death or survivor benefits payable to a beneficiary, the time and form of payment election typically align with the employee’s payment election. This involves decisions such as whether the beneficiary will receive a lump sum or an annuity. Nevertheless, Section 409A's regulations do permit employees to change beneficiaries, provided such changes do not impact the predetermined time or form of payment. This flexibility allows for adjustments in beneficiary designations without altering the fundamental structure of when and how deferred compensation will be disbursed.

To effectuate alterations in payment options, a minimum notice period of 12 months preceding the initial payment is mandated, with the inaugural payment deferred for at least five years. Consider, for instance, an employee who initially opts for a lump-sum deferred compensation at age 65 but desires a modification to installment payments. The employee must finalize the payment deferral election by age 64, and the commencement of the first installment payment is deferred until reaching the age of 70.

In certain instances, 409A plans may interconnect with qualified plans. Employees possess the flexibility to adjust deferrals (inclusive of other pre-tax contributions) within qualified plans, respecting the 401(k) salary reduction limit, independently of Section 409A regulations. However, elective deferrals or contributions under a qualified plan leading to compensatory changes exceeding the salary reduction limit must adhere to Section 409A's compensation deferral and anti-acceleration rules.

Notably, an employer upholding a 409A plan is prohibited from funding the plan for its top five officers or specified key employees during periods of "at-risk" status of any qualified defined benefit plan, whether due to underfunding or the employer's bankruptcy. This funding restriction extends to six months before or after the termination of an underfunded, qualified, defined benefit plan. Furthermore, the restriction encompasses amounts allocated in a "rabbi trust," whose assets remain susceptible to the employer's creditors during bankruptcy.

Enhanced Termination and Exceptions in Section 409A:

Terminating a 409A plan by employers without incurring adverse tax consequences under Section 409A is permissible, provided such termination is not closely associated with a downturn in the employer's financial health. To ensure compliance, the employer concludes all similar 409A plans, and payments under the terminated plan occur no sooner than 12 months and no later than 24 months after the requisite steps for termination are taken. Additionally, the employer commits to refraining from adopting another akin 409A plan for a duration of three years.

Numerous exceptions are integral to Section 409A regulations, outlined as follows:

Short-Term Deferral Exception: This exception exempts deferred compensation that is disbursed within 2.5 months following the employee's or sponsoring employee's tax year in which the compensation is earned, or, if later, when it becomes vested.

Severance Pay Exemption: Section 409A does not govern severance pay (referred to as separation pay in the regulations) under specific conditions. Eligibility hinges on the employee's separation from service being either involuntary or voluntary for a compelling reason. The remuneration is capped at two times the employee's annualized compensation rate for the year before separation or, if lower, two times the compensation limit for qualified retirement plans in the year of separation. Payments must conclude by the end of the second year commencing after the employee's separation from service.

Enhanced Explanations on Restricted Stock and Stock Options under Section 409A:

Restricted Stock:

Employees receiving restricted property, such as employer stock, tied to service performance, find respite from Section 409A's regulations, even when taxation is deferred under Section 83. The value of restricted stock generally remains excluded from an employee's gross income, provided the stock's restrictions subject it to a substantial risk of forfeiture.

Stock Options:

a. Employee Stock Purchase Plan (ESPP) and Incentive Stock Options (ISO):

Section 409A does not govern options granted under an ESPP or statutory incentive stock options. These options remain exempt from its regulations.

b. Nonstatutory Stock Options and Stock Appreciation Rights (SARs):

Nonstatutory stock options and SARs escape Section 409A scrutiny if granted or awarded at fair market value and lack additional tax deferral features post-exercise. Notably, extending the exercise period for terminated employees is not considered an additional deferral feature, as long as the extension aligns with or is less than the original exercise period, and does not surpass ten years from the grant date.

c. Fair Market Value Determination:

In publicly traded companies, fair market value is typically derived from market prices in actual transactions. For non-public entities, a valuation professional must determine fair market value, considering pertinent information such as anticipated cash flows, recent arm’s length transactions, control premiums, and lack of marketability discounts. This meticulous approach ensures a comprehensive and accurate assessment of fair market value for companies not traded publicly.

457 Plans

This chapter delves into the intricacies of the 457 retirement plan, as outlined by the Internal Revenue Code (IRC) Section 457. This section specifically addresses the federal tax treatment of deferred compensation or retirement plans applicable to state and local government employees, as well as employees of various tax-exempt organizations.

The genesis of IRC Section 457 lies in recognizing the unique tax-exempt status of the aforementioned employers, relieving them from the usual tax considerations and timing of deductions. The tax treatment under Code Section 457 hinges on whether the plan falls into the category of a 457(b) or 457(f) plan.

In essence, Section 457 plans are nonqualified, unfunded, deferred compensation plans established by state and local governments and tax-exempt employers falling within the ambit of IRC 501(c). These entities can opt for either eligible plans, falling under 457(b), or ineligible plans, covered by 457(f), each subject to specific requirements and limitations outlined in Section 457 of the Internal Revenue Code of 1986.

Eligible plans under 457(b) empower employees to defer income taxation on their retirement savings. In contrast, ineligible plans, covered by 457(f), may trigger varying tax treatments under IRC 457. Notably, 457 plans operate under different, often less stringent regulations compared to their funded, qualified counterparts. While qualified plans adhere to complex rules ensuring parity among covered employees and limiting deferral amounts, Section 457 plans offer flexibility with potentially less stringent security measures.

Participants in 457 plans can defer their compensation on a before-tax basis through regular payroll deductions. The funds deposited in these accounts grow on a federally tax-free basis until they are eventually withdrawn, providing a distinct advantage for retirement savings.

The burgeoning interest in 457 plans can be traced back to the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), a legislative landmark that ushered in significant changes in the treatment of such plans. Notably, employers eligible to participate in these plans encompass state and local government agencies, enjoying federal income tax exemption. Additionally, other nonchurch organizations exempt from such taxes are eligible participants, including:

Educational organizations

Charitable organizations

Hospitals

Charitable foundations

Labor unions

Trade associations

This diverse array of eligible participants highlights the inclusivity of 457 plans, extending their reach beyond government agencies to encompass various tax-exempt entities. As elucidated earlier, there exist two distinct categories of 457 plans: those tailored for government agencies and a counterpart tailored for nongovernmental and tax-exempt agencies.

457(f) Plans

A tax-exempt organization navigating the landscape of 457(f) plans must carefully structure participation, confining it to a top-hat group comprising select management or highly compensated employees. This strategic limitation is essential to sidestep the entanglements of participation, vesting, and funding requirements imposed by the Employee Retirement Income Security Act (ERISA).

Of paramount importance for a 457(f) plan is the evasion of ERISA's funding obligations. Any infusion of funds into the plan would render interests taxable for participants, aligning with the stipulations in Sections 83 and 402(b) of the Internal Revenue Code. Furthermore, the advantageous tax treatment of earnings, which participants enjoy, would be forfeited.

In a contrasting scenario, governmental plans enjoy an automatic exemption from ERISA. Consequently, a governmental employer possesses the flexibility to include any employee or group of employees in its 457(f) plan without being encumbered by ERISA constraints.

According to Code Section 457(f), benefits become taxable to the employee in the first calendar year when there is no substantial risk of forfeiture. Despite this immediate tax liability upon vesting, any earnings accrued on these benefits after the vesting date retain the privilege of accumulating on a tax-deferred basis, contingent upon meeting specified conditions. Treasury Regulation Section 1.457-11(a)(3) specifies that taxation of earnings credited on vested benefits occurs only upon disbursement or when made available to the employee. This condition, however, assumes that the employee's interest in any assets of the employer, including amounts deferred under the plan, does not take precedence over the claims of the employer's creditors.

Section 457(f) plans offer flexibility in design, allowing for various configurations that cater to the preferences and needs of both employees and employers. One approach involves enabling employees to make pretax payroll contributions, which can be complemented by nonelective employer contributions. Alternatively, these plans can be structured to solely accommodate nonelective employer contributions or to provide specifically defined benefits. Importantly, there are no stipulated contribution or benefit limits imposed under the Internal Revenue Code for 457(f) plans.

In instances where a plan entails a deferral of compensation, as delineated by Section 409A, any pretax deferral elections made by participants must adhere to the requirements of Section 409A. This necessitates employees making compensation deferral elections generally prior to the year in which the relevant compensation is earned. Newly eligible participants are afforded a 30-day window, commencing from their eligibility, to make their initial compensation deferral elections. It's crucial to note that these rules are not applicable to a 457(f) plan exempt from the purview of Section 409A. Such exemption liberates the plan from the procedural constraints imposed by Section 409A, providing additional flexibility in plan administration.

457(b) Plans

The distinction between governmental and tax-exempt 457(b) plans is notable in their participant inclusivity. A governmental 457(b) plan possesses the flexibility to encompass any employee or group of employees without constraints. Conversely, the landscape for a tax-exempt organization's 457(b) plan is more nuanced, necessitating a limitation of participation to a top-hat group, as previously described. This strategic restriction is imperative to circumvent the funding requirements mandated by the Employee Retirement Income Security Act (ERISA).

The significance of steering clear of ERISA's funding obligations is particularly pronounced for a 457(b) plan, given that Section 457 explicitly prohibits the funding of such plans maintained by tax-exempt organizations. This underscores the critical role of adherence to these regulations, ensuring the seamless operation and compliance of 457(b) plans within the framework of tax-exempt entities.

This plan facilitates pretax payroll deferrals for employees, offering a strategic avenue for financial planning. The 457(b) plan, in its design, allows for the inclusion of nonelective employer contributions, providing a comprehensive framework for retirement savings. However, it's crucial to note that the aggregate of pretax payroll deferrals and contributions for a given calendar year is subject to the IRS annual limit, which stood at $17,500 in 2013. This annual limit encompasses both elective and nonelective contributions, prompting many 457(b) plans to exclusively permit elective contributions to align with this constraint. According to Section 457(b)(4), compensation can only be deferred for a specific month if a deferral agreement has been established prior to the commencement of that month.

In the three calendar years leading up to an employee's normal retirement age under a 457(b) plan, the catch-up limit can be elevated by utilizing any unused annual limit from prior active plan years. This adjustment can amount to double the IRS annual limit, reaching $35,000 in 2013. Specifically for governmental 457(b) plans, employees aged 50 or older have the provision to make catch-up contributions in accordance with Section 414(v). In cases where an employee is eligible for both the catch-up limit and contributions under this section, the employee can leverage the higher of the two limits, which cannot be combined.

Vesting in 457(b) plans typically follows a policy of full and immediate vesting for all elective deferrals, as well as any nonelective contributions. The absence of vesting requirements for such contributions is essential to avoid contravening the IRS limit. Contributions and their earnings that vest in the same year must be aggregated and counted against the IRS annual limit as dictated by the rules of Section 457. This adherence ensures compliance with IRS regulations and the seamless operation of the 457(b) plan.

This particular section of the code imposes distinct requirements based on the nature of the 457(b) plan. In the case of governmental 457(b) plans, there is a mandate for funding and trusteeship, ensuring that the assets are held in trust exclusively for the benefit of participants. In sharp contrast, plans maintained by tax-exempt organizations must maintain a legal status of being unfunded. This implies that contributions and investment earnings remain the exclusive property of the employer, subject to the claims of the employer's creditors until they are disbursed to an employee. Notably, a non-governmental 457(b) plan may opt for informal funding through a rabbi trust, as outlined previously.

To align with the stipulations of Section 457, a 457(b) plan must not extend benefits to employees before the calendar year in which the employee reaches 70.5 years of age, unless separation from employment triggers a financial hardship amounting to an unforeseeable emergency.

The initiation of minimum distributions under these plans is governed by the precise requirements of Section 401(a)(9). Additionally, governmental 457(b) plans are subject to the stipulations of Section 401(a)(31) concerning eligible rollover distributions. Contrastingly, benefits under a 457(b) plan maintained by a tax-exempt organization are taxed at the time of distribution or when made available, whichever comes first. In contrast, benefits under a governmental plan are specifically taxed at the point of distribution. These intricacies underscore the nuanced compliance measures required for both governmental and non-governmental 457(b) plans.

Summary:

This chapter delved into various retirement plans that offer unique benefits for both employers and employees, setting them apart from traditional retirement options. Cash balance pension plans, combining elements of both defined benefit and defined contribution plans, were explored in terms of key characteristics, calculations, and advantages. This alternative to traditional pension plans proves valuable for attracting mobile workforce talent and helps employers sidestep reversion tax.

Money purchase plans, as a defined contribution alternative, were highlighted for their tax benefits, particularly beneficial for small business owners. The simplified employee pension plan (SEP) emerged as a straightforward retirement savings program with enticing tax advantages.

The discussion expanded to the 403(b) plan, tailored for specific employees of public schools, tax-exempt organizations, and certain ministers. In addition to these, critical issues surrounding 409A, 457(f), and 457(b) plans were addressed, covering their features, eligibility criteria, and pertinent accounting and tax considerations.

Key Concepts in This Chapter:

Cash balance pension plan

Cash balance formula

Reversion tax

Money purchase pension plans

Simplified employee pension plans (SEPs)

Individual Retirement Accounts (IRAs)

403(b) plans

Tax-sheltered annuity (TSA) plans

409A plans

457(f) plans

457(b) plans

This comprehensive exploration equips readers with a nuanced understanding of a diverse array of retirement plans, empowering informed decision-making based on specific organizational and individual needs.

Unit 4 Discussion 

Who is most responsible for funding your retirement...you, your employers, the government? Explain your answer.

When it comes to retirement the main person that’s responsible for that is going to be you since when it comes to what you want in the future the one that looks out for you the best will always be yourself. But with a large portion of your time spent working and contributing to the successes of a business a good company should offer some sort of 401k match plan which helps contribute to your future since you will likely be spending at least 5 to 6 days a week and at the minimum 8 hours a week working for them. Of course that isn’t always the case and as your own self advocate you should always be thinking about your future and how to get to your retirement. As for the government we pay social security benefits when we are employed which should be there for retirement for the future if they didn’t go and keep borrowing from that fund it would be there for the people in the future for retirement. The government borrowed 1.7 trillion from social security yet the government can’t even handle its own debt it just keeps raising the debt ceiling putting us farther and farther into the red while it continues to print more money and inflation keeps growing. The bottom line though if you don’t take care of yourself outside of relying on the government and the company you work on you might never get to retirement. Even if you contribute to a 401k plan or have a pension you should always take more and put it aside for your own portfolio that way you won’t be surprised or feel too badly when social security doesn’t exist to help you with your bills at 65.

Unit 4 Assignment - Other Types of Retirement Plans

Referring to Unit 4 Readings and Resources, write a 4-5 page paper explaining the benefits of simplified employee retirement plans, 401K plans, and 403B plans.

Your paper should include:

Cover page

4-5 pages of content

Reference page

Proper formatting per APA 7th edition.

Other Types of Retirement Plans

 

            Retirement plans come in many different forms but today we will cover simplified employee retirement plans also known as SEP plans as well as 401k plans and 403B plans in a greater detail to outline what makes these plans different than the ones we went over last week and explain any pros and cons they might have.

            With a simplified employee pension or (SEP) this type of plan can help out during retirement by letting the employee set money aside that gets allocated to retirement accounts for employees. This plan type doesn’t require the company to have any start-up costs and doesn’t have operating costs like most other retirement plans have. And it can allow contribution of 25% of each employee’s pay. The other great feature of the plan is that the size of the business doesn’t matter and any business size can take advantage of it. Implementation of a SEP plan can be done by making use of form 5305-SEP but if a company does use this form other forms of retirement plans can’t be used unless they are also SEP related plans. A SEP plan also doesn’t require filing like most other plans for the employer. Employee’s that are in the program are always 100% vested for all the SEP-IRA money. And the employer contributes to the SEP plan. Another positive is for years that a company doesn’t do as well as a business they can make smaller contributions towards the employee’s SEP fund and during good years they can contribute a larger portion towards SEP allowing flexibility during financial hardship situations. SEP plans are easy to setup and operate and have low administrative costs, flexible annual contributions, and require that the employer equally contributes to all of the eligible employees. On the cons side loans can’t be taken against the plan and they cannot be used as a collateral for loans unlike some of the other types of retirement plans. Withdrawals done at an in-service base can be done but are subject to an additional 10% tax while the employee is under the age of 59 ½.  In order for an employee to be eligible to participate in a SEP plan they need to be at least 21 years old and must have worked for the employer 3 of the last 5 years. They also must have received at least $750 in compensation for 2023 or $650 for 2021 or 2022 from the employer. Of course those requirements can differ based on the employer they can set less strict requirements but cannot set requirements more restrictive ones then the ones above. The employer can also exclude employees from being able to participate in SEP plan based on either employee’s that are foreign from the U.S and don’t have U.S. wages or salaries and don’t receive compensation such as work visa individuals from other countries and also employees that are covered by a union agreement that had specific benefits bargained for from a union. Another downside that can affect plans that use SEP is employee retention because employees know that the SEP balance won’t be transferred with them if they leave the company. And also SEP plans don’t offer a catch-up contribution for new employees that are over the age of 50 which can also affect retention of the company when people realize that as well.

            With 401k plans employees can decide for themselves whether they want to contribute to the 401k or not based on choosing an amount of percentage of their paycheck into the specific 401k plan. With this plan type the employee can have other plan types aside from this one and the business can be any size. But the employer must annually file a form 5500 unlike SEP plan which has no filing requirements. The employer can decide how simple or complex it wants to make a 401k plan but by using a pre-approved plan from the IRS it can cut down on different problems or expenses from an administrative point of view. 401k plans can have employer match and also offer employees with more options when it comes to a 401k plan such as the ability to borrow against the money for loan purposes and hardship withdrawals which allows employees much more freedom compared to SEP plans. On the downside the administrative costs might be higher on this type of plan. There can also be issues such as testing to make sure discrimination in favor of higher compensated employees doesn’t arise and that in itself can make testing a complicated process. Also the additional withdraw and loan flexibility of a 401k can also cause a higher administrative burden compared to a SEP plan. The deferral limitations for 401k plans can differ based on the 401k's type traditional plans limit employees a maximum of 22,500 for 2023 for simple 401k's that deferral is 15,500 for 2023. On a positive 401k plans have catch-up contributions and participating individuals who are over 50 are able to make more contributions 7,500 for traditional and 3,500 for simple 401k's plans.

            The 403b plan also called Tax-Sheltered Annuity plans are plans with a much more limited company application these are often used by 501© tax-exempt organizations and also by public schools and offer employees a way to save for retirement while contributing to individual accounts. These are often used by certain charities and it works similar to a 401k plan and allows employees the ability to defer salary into the plan. The money that is deferred into a 403b plan isn’t subject to state or federal tax until after it’s distributed. But 403b plans can also offer ROTH accounts which are taxed but when distributed they will be considered tax-free then. Most companies don’t qualify for this type of plan but the ones that do are public schools, university, college, church, and any charity entity that falls under 501© of the IRS.  A positive of this plan is flexibility in contributions and of course that most companies will not be able to access the ability to use this type of plan. Some negatives of it is that the plan can have high administrative costs the investment options are limited to what the employer picks meaning that if the investment plan is bad then the rate of return can be low or it can have low growth rate. But it also has the optional loan and hardship benefits that a 401k plan has making it a very flexible plan for employees. The plan also is subject to in service withdrawals like the 401k plan in that if the employee is under the age of 59 ½ then a 10% penalty is possible. And the terms of the loan situation are up to what the plan allows. This plan has a universal availability rule which states that if one employee is able to defer salary into the 403(b) then it has to be extended to all employees in the organization. But the employer can exclude individuals based on Visa workers that are non U.S residents, employees that work less than 20 hours per week, employee’s that participate in another 401k plan or 457(b) plan or have a 403(b) plan with a different employer or employees that have a contribution of $200 or less annually.

            As stated above 457(b) plans would leave individuals exempt and those plans specifically are only available to state and local government organizations or tax-exempt organizations under IRC 501(c). They also work similar to 403(b) plans just for local government and state.

            So as we can see the plan types above can differ when it comes to specific organization’s as well as be open to all or most companies based on the type of plan. The 403(b) and 457(b) plans don’t affect people outside the respective organization types while SEP and 401k plans are available for a wider range of companies and organizations.