2. The Big Picture
• Joyce is a junior finance major at State University.
• Recently, Dr. Sanchez, her finance professor, delivered a
lecture 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 her
father has only a single retirement plan provided by his
employer.
• Joyce drops in on the professor during office hours to find out
more 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 the
taxpayer after the period when services were
performed
3
4. Qualified Plans
(slide 2 of 11)
• Tax benefits of qualified deferred
compensation plans
– Contributions are immediately deductible by the
employer
– Employees are not taxed on the contributions to
the plan or income earned by the plan until
payment is made available to them under the plan
– Employer contributions to and benefits payable
under qualified plans generally are not subject to
FICA and FUTA taxes
4
5. Qualified Plans
(slide 3 of 11)
• A variety of deferred compensation arrangements are
offered 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 plans
5
6. Qualified Plans
(slide 4 of 11)
• Pension plans
– Provide systematic payments of definitely
determinable 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 employer
that will provide sufficient amounts to pay
specified retirement benefits
– Benefits based upon years of service and average
compensation
– Separate accounts for each employee are not
maintained
7
8. Qualified Plans
(slide 6 of 11)
• Defined contribution pension plans
– The annual amount the employer must contribute
is defined (e.g., a flat amount or a percentage of
compensation)
– Separate accounts must be maintained for each
employee
– The amount received upon retirement is dependent
upon amounts contributed and income earned on
contributions
8
9. Qualified Plans
(slide 7 of 11)
• Profit sharing plans
– Established to allow employees to participate in
the profits of the company
– Separate accounts are maintained for each
employee
9
10. Qualified Plans
(slide 8 of 11)
• Profit sharing plans
– Definite predetermined formulas must be
established for the allocation of contributions to
and distributions from the plan
– The company is not required to make annual
contributions and contributions do not have to
come from current profits
10
11. Qualified Plans
(slide 9 of 11)
• Stock bonus plans
– Established so that the employer can contribute
shares of its stock
– Subject to rules similar to profit sharing plans
– Distributions must be in employer’s stock
11
12. Qualified Plans
(slide 10 of 11)
• Qualification requirements
– For a plan to be qualified, it must satisfy the
following requirements:
• Exclusive benefit requirement
• Nondiscrimination requirements
• Participation and coverage requirements
• Vesting requirements
• Distribution requirements
• Minimum funding requirements
12
13. Qualified Plans
(slide 11 of 11)
• Qualification requirements
– The qualification requirements are highly technical
and numerous
• Thus, an employer should seek a determination letter
from the IRS regarding a plan’s qualified status
13
14. Tax Consequences to Employee and
Employer (slide 1 of 10)
• Employer contributions to qualified plans are
generally deductible immediately
• Amounts contributed are not taxable to employees
until 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 the
retirement benefits
• Taxation of amounts received by employees in periodic or
installment payments is generally subject to the annuity rules
14
15. Tax Consequences to Employee and
Employer (slide 2 of 10)
• Lump-sum distributions-generally taxable in
year of distribution
– Taxpayers who receive a lump-sum distribution
from a qualified plan can roll over the benefits into
an IRA or into another qualified plan
• Defers tax on lump-sum distribution
15
16. Tax Consequences to Employee and
Employer (slide 3 of 10)
• Limitations on contributions
– Defined contribution plan
• Lesser of $50,000 (in 2012) or 100% of employee’s
compensation
• Employer’s deduction limit cannot exceed 25% of
eligible compensation
16
17. Tax Consequences to Employee and
Employer (slide 4 of 10)
• Limitations on contributions
– Defined benefit plan – max contribution deduction
can 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 costs
17
18. Tax Consequences to Employee and
Employer (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 contributions
18
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 Joyce’s professor, Dr. Sanchez, a
choice between a defined benefit pension plan and a defined
contribution plan.
• Dr. Sanchez expects to work at a number of universities during
her 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 in
making her choice and how much she can contribute annually
to a defined contribution plan.
19
20. Tax Consequences to Employee and
Employer (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 2012
20
21. Tax Consequences to Employee and
Employer (slide 7 of 10)
• §401(k) plans
– Employee elects to receive cash (taxed currently)
or have amount contributed (pretax) to a qualified
plan
– 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 contributions
to 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 no
other qualified plan
– In form, §401(k) or IRA
– Avoids nondiscrimination rules
24
25. Tax Consequences to Employee and
Employer (slide 9 of 10)
• SIMPLE Plans
– Employees make elective contributions (up to $11,500 in
2012) to plan
• Contributions made as percentage of compensation
• Distributions from plan taxed under IRA rules
– Employers generally required to match contributions up to
3% of compensation or provide 2% nonmatching
contributions
– Person age 50 or over by year end may make catch-up
contributions of up to $2,500 for 2006 and thereafter
25
26. Tax Consequences to Employee and
Employer (slide 10 of 10)
• Designated Roth Contributions
– Starting in 2006, § 401(k) plans and § 403(b) plans may be
amended to permit employees to irrevocably designate
some or all of their future salary deferral contributions as
Roth § 401(k) or Roth § 403(b) contributions
• These designated amounts are currently includible in the
employee’s 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 income
26
27. Retirement Plans for Self-Employed
Individuals (slide 1 of 2)
• H.R. 10 (Keogh) plans
– Retirement plans for self-employed and their
employees
– Plan rules are similar to corporate provisions
– Plan must be established before the end of the tax
year, but contributions may be made up to the due
date of the return
27
28. Retirement Plans for Self-Employed
Individuals (slide 2 of 2)
• Keogh (H.R. 10) plans (cont’d)
– 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 benefit
payable to the lesser of $200,000 (in 2012) or
100% 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.
• Joyce’s professor, Dr. Sanchez, has a forensic consulting
practice 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 a
Schedule 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 for
spousal IRAs) or 100% of earned income
• Person age 50 or over by year end may make catch-up
contributions
– Max contribution limit is increased by $1,000 for 2006 and thereafter
• Deductible IRA contribution may be reduced if
taxpayer is an active participant in another qualified
plan
• To extent individual is ineligible to make deductible
contributions, a nondeductible IRA contribution may
be made
– Income accrues on account tax deferred
30
31. Individual Retirement Accounts
(slide 2 of 15)
• If taxpayer is covered by a qualified plan,
IRA deduction is phased out within the AGI
ranges listed below:
31
32. Individual Retirement Accounts
(slide 3 of 15)
• For distributions made in 2006 through 2012,
an exclusion from gross income is available
for traditional IRA distributions made to
charity
– The amount of the distribution that is eligible for
this beneficial exclusion treatment is limited to
$100,000
32
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 individual’s compensation for the year
– Qualified distributions are tax-free after an initial five year
holding period if:
• Made on or after age 59 ½
• Made to beneficiary on or after participant’s death
• Participant becomes disabled
• Used to pay for qualified first-time home buyer’s expenses
($10,000 limit)
33
34. Individual Retirement Accounts
(slide 5 of 15)
• Roth IRA (cont’d)
– 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 (cont’d)
– Annual contributions are subject to phase out
within the AGI ranges listed below:
Phase-out begins Phase-out ends
Single $ 110,000 $125,000
MFJ 173,000 183,000
MFS 0 10,000
35
36. The Big Picture - Example 29
Roth IRAs Income Limits
• Return to the facts of The Big Picture on p. 19-1.
• Joyce’s professor, Dr. Sanchez, also
contributes 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 education
expenses (QEE) are tax-free
• Exclusion may be available in year American
Opportunity credit or lifetime learning credit is claimed
– Maximum annual nondeductible contribution for a
beneficiary 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 (cont’d)
Annual contributions are subject to phase
out within the AGI ranges listed below:
Phase-out begins Phase-out ends
Single $95,000 $110,000
MFJ 190,000 220,000
38
39. Individual Retirement Accounts
(slide 9 of 15)
• Coverdell Education Savings Account (cont’d)
– 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 as
follows:
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 course
load
39
40. Individual Retirement Accounts
(slide 10 of 15)
• Simplified employee pension (SEP) plans
– Employer contributes to employee’s 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 2012
40
41. Individual Retirement Accounts
(slide 11 of 15)
• Spousal IRAs
– If both spouses have earned income, ceiling on
deductible contributions is $10,000 or combined
earned 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 for
purposes of IRA contributions
– Thus, a person whose only income is alimony can
contribute to an IRA
• Timing of Contributions
– Contributions (both deductible and nondeductible)
can be made to an IRA anytime before the due date
of the individual’s 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 as
ordinary 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 included
in gross income
• Such amounts are taxed as ordinary income in the year of receipt
43
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 least
12 consecutive weeks
44
45. Individual Retirement Accounts
(slide 15 of 15)
• Rollovers
– Distribution from qualified plan transferred within
60 days to IRA (or another qualified plan) not
includible in gross income
– One tax-free rollover from IRA within 12-month
period
• Direct transfers not subject to this limitation
– Employer must withhold 20% of any lump-sum
distribution that is not a direct transfer
45
46. The Big Picture - Example 37
Tax-free Rollover
• Return to the facts of The Big Picture on p. 19-1.
• Dr. Sanchez withdraws $15,000 from her traditional
IRA on May 2, 2012, but she redeposits it in the same
IRA 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 nonqualified
arrangements that defer the receipt of compensation
income
– If the plan does not meet certain conditions in § 409A, all
amounts deferred under the arrangement may be included
in the participant’s 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 an
employee has a legally binding right to compensation
that has been deferred to the future
47
48. Nonqualified Deferred Compensation Plans
(slide 2 of 3)
• Golden parachutes
– Defined: Excess severance payments
– Employer is denied deduction for golden parachute
payments 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 employee's average annual compensation
– Disallowed amount is excess of payment over statutory
base (five-year average taxable compensation) and a 20%
excise tax is imposed on the recipient
48
49. Nonqualified Deferred Compensation Plans
(slide 3 of 3)
• Compensation limitations
– Publicly traded companies have a limitation of $1
million on deductible compensation for each of
the top 5 executives
• Limit may be reduced to $500,000 under TARP
– Certain types of compensation are not subject to
the 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 arrangement
where the employee receives property (e.g., stock
in 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 ordinary
income from the restricted property
immediately
• Employer is allowed a tax deduction at the
same time the employee includes the
compensation in income
51
52. Stock Options
(slide 1 of 5)
• Stock option defined:
– The right to purchase a stated number of shares of
stock at a certain price within a specified time
period
52
53. Stock Options
(slide 2 of 5)
• Incentive stock options (ISO)
– No tax consequences to issuer or recipient when
granted
• 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 gain
treatment on the sale of stock received by
exercising 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 for
employer
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 date
of grant, it is included in the employee’s income on
that date
55
56. Stock Options
(slide 5 of 5)
• Nonqualified stock options (NQSO)
– If the NQSO does not have an ascertainable value
at date of grant, employee will recognize ordinary
income at the exercise date equal to the difference
between FMV and the option price
– Employer receives a deduction for the same
amount as is included in the employee’s income
56
57. The Big Picture - Example 47
Stock 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 Wren
Corp.
– 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 47
Stock Options (slide 2 of 2)
• Return to the facts of The Big Picture on p. 19-1.
• Dr. Sanchez did not recognize any ordinary income
on 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 the
exercise date.
• She has a long-term capital gain of $20,000 on the
sale 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 6
months 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 the
period beginning on the grant date and ending three months before
the 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 on
March 22, 2012, for $290 per share.
– Because Dr. Sanchez did not hold the stock for
more than one year, $10,000 of the gain is treated
as ordinary income in 2012.
– Wren Corp. is allowed a $10,000 compensation
deduction 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 learns
that 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 her
career, so she chose the defined contribution plan because of its
mobility.
• The maximum annual contribution the university could make to the
plan is $50,000 for 2012.
• Since the university contribution rate is 15%, the actual
contribution is $22,500($150,000 X 15%).
61
62. Refocus On The Big Picture (slide 2 of 4)
• § 403(b) annuity - Dr. Sanchez makes
contributions to a § 403(b) annuity
– This is the equivalent of a § 401(k) plan, but
available to educators.
– She has the university deduct the maximum annual
contribution in 2012 of $17,000.
– In addition, because she is at least age 50, she has
the university deduct an additional $5,500 as a
catch-up contribution.
62
63. Refocus On The Big Picture (slide 3 of 4)
• Keogh (H.R. 10) plan - Dr. Sanchez also has
a forensic consulting practice.
– Since she is self-employed, she is able to establish
a Keogh plan.
– She makes contributions of 20% of her net
earnings 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 a
traditional 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 is
equal 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 recontributed
the $15,000 to her IRA within 60 days.
64
