2013 cch basic principles ch14

Chapter 14

Deferred Compensation and Education Savings

Plans

©2012 CCH. All Rights Reserved.4025 W. Peterson Ave.Chicago, IL 60646-60851 800 248 3248www.CCHGroup.com

CCH Federal Taxation Basic Principles 2 of 61

Chapter 14 Exhibits

1. Investing for the Future: The Grocery Store Analogy

2. Employer-Sponsored Plans: Qualified v. Nonqualified

3. Distributions from Qualified Plans (QPs): Basic Concepts

4. Comparison of Defined Contribution and Defined Benefit Plans

5. Calculating RMDs Using the Uniform Lifetime Table

6. Portability Chart

7. Common Retirement Plans for Large Employers—Eligible Employers

8. Common Retirement Plans for Large Employers—Basic Features

9. Common Retirement Plans for Large Employers— Contribution Limits

10. 401(k) Plans—Lecture Problem on Tax Consequences

11. Common Retirement Plans for Small Businesses—Basic Features

Chapter 14, Exhibit Contents A


Chapter 14 Exhibits

12. Common Retirement Plans for Small Businesses—Contribution and Deduction Limits

13. Personal Retirement Plans for Working Individuals

14. Applying the Two Qualifying Tests to Roth Distributions

15. Employee Stock Purchase Plans—Qualifying Distributions

16. Employee Stock Purchase Plans—Disqualifying Distributions

17. Incentive Stock Options—Qualifying Distributions

18. Incentive Stock Options—Disqualifying Distributions

19. Nonqualified Stock Options (NSOs)—Value Known at Grant Date

20. Nonqualified Stock Options (NSOs)—Value Unknown at Grant Date

21. Restricted Stock Plans—With and Without Section 83(b) Election

22. Savings Plans for Education

Chapter 14, Exhibit Contents B


Investing for the Future: The Grocery Store Analogy

Identify the food to buy

Fruit: Vegetables: Cereal: Coffee: Soup: Bread:

• Apples

• Oranges, etc.

• Carrots

• Celery, etc.

• Fiber

• Frosted, etc.

• Freeze-dried

• Instant, etc.

• Vegetable

• Tomato, etc.

• Rye

• Wheat, etc.

Identify the investments to buy (this is a mere glimpse into the thousands of possibilities)

Stocks:Treasury

Securities:Corporate

Bonds:Real Estate: Commodities:

Highly Liquid Cash

Equivalents:

• S&P 500

• Russell 3000

• Industry-specific (e.g., consumer staples, utilities)

• Geographic-specific (e.g., Pacific rim, Latin America)

• Risk specific (e.g., aggressive growth stocks, “blue chips”)

• Dividend specific (e.g., high yield stocks)

• Market-size specific (e.g., emerging markets), etc.

• T-Bills

• T-Notes

• T-Bonds

• I-Bonds

• EE- Bonds

• TIPS

• etc.

• Risk Specific

• Term Specific

• etc.

• Equity REITS

• Mortgage REITS

• Hybrid REITS

• Foreign Currencies

• Natural Resources

• Industrial Metals

• Precious Metals

• Grains

• etc.

• Interest-Bearing Time Deposits

• Interest-Bearing Demand Deposits

• etc.

Select the grocery store Kroger Whole Foods Costco Farmers Market Walmart 7-Eleven

Select the financial institution Fidelity Bank of America Vanguard 1st Federal S&L E-Trade Prudential

Chapter 14, Exhibit 1a


Investing for the Future: The Grocery Store Analogy

Choose the best food carrier

Paper Plastic Box

Choose the best investment “carrier”

Tax Deferred AccountsTax-free Accounts

Taxable Accounts

Employer-Sponsored Plans:

Educational Savings Plans:

• Traditional IRA

• Roth IRA

• Roth 401(k) plan

Any account maintained at a financial institution that generates:

• Interest

• Dividend income and/or

• Capital gains

that is CURRENTLY TAXABLE

• 401(k) plan

• 403(b) plan

• Employee stock ownership plan (ESOP)

• Solo 401(k) plan (for self-employed taxpayers or single-employee entities)

• Keogh plan

• Simplified employee pension (SEP) IRA

• Savings incentive match plan (SIMPLE)

• DB/K plan

• Nonqualified employer-sponsored plans

• 529 plans

• Coverdell savings account

Choose the type of food packaging Cans Plastic wrappers

Cartons Jugs Jars Rubber bands

Choose the type of investment “packaging” Mutual funds

Exchange-traded funds

Money market funds

Bank certificates of deposit

Savings accounts

Annuity contracts

Chapter 14, Exhibit 1b


Employer-Sponsored Plans: Qualified v. Nonqualified

Qualified Plans 401(k) plans (corporate-styled profit

sharing or stock bonus plans), Roth 401(k) plans (effective January 1,

2006 for amended 401(k) plans), 403(b) plans (i.e., tax-sheltered annuity

arrangements), Employee stock ownership plans

(ESOPs), Solo 401(k) plans (for self-employed

taxpayers or single-employee entities) Keogh plans, Simplified employee pension plans

(SEP IRAs), Savings incentive match plans for

employees (SIMPLE IRAs)

Nonqualified Plans Rabbi Trusts, Employee stock purchase plans, Incentive stock options, Nonqualified stock options, Variable annuity contracts, Restricted stock, Informal short-term arrangements.


Examples of Qualified and Nonqualified Plans:



Tax Advantages (“+”) and Disadvantages (“-”)

Qualified Plans Nonqualified Plans

+ Flexible Rules Governing Tax Deferral of Employer Contributions. Contributions by employers and employees are tax deferred (tax free for employee contributions to Roth 401(k) plans). Taxation generally occurs when the amounts contributed are eventually distributed to participants. Thus, the rules for tax deferral are more flexible for QPs than for NPs. A QP can achieve tax deferral even if the employer contribution has been funded or secured and the employee’s right to that compensation is not subject to a substantial risk of forfeiture.

- Restrictive Rules Governing Deferral of Employer Contributions. Employee tax deferral on employer contributions can be achieved only under either of two conditions: (a) the employer’s obligation to pay the benefits remains merely an unfunded and unsecured promise to pay (i.e., no “economic benefit”); or (b) the employer’s obligation is funded or secured but the employee must bear a substantial risk of forfeiture (i.e., no constructive receipt”).

+ Deduction immediately available to employers. Corporate employers, self-employed taxpayers, or individuals (for IRAs) may deduct contributions even though income tax is deferred. For all plans except IRA’s, the contribution may create an NOL.

- No immediate employer tax deduction. An employer is not entitled to a tax deduction until such time as the benefits are actually paid to the employee.






+ Accumulated income tax deferred. Interest, dividends & other income can accumulate tax free until benefits are paid. (With Roth 401(k) plans, accumulated income is intended to be tax-free.)

- Income is taxable to the employer (unless invested in tax-exempt securities).

+ Future payouts with lower tax rates. Tax benefits are typically paid out after retirement when the employee’s effective tax rate is often lower.

+ Same advantage.

+ Payroll tax exemption. Employer contributions (but not employee contributions!) are exempt from FICA and FUTA taxes when paid into and out of a QP.

- No payroll tax exemption. Employer contributions are generally subject to Social Security and Medicare taxes when services are performed or, if later, when a person’s right to receive the compensation no longer is subject to a substantial risk of forfeiture. Sec. 3121(v).

Chapter 14, Exhibit 2c





+ Portability. Tax-free transfers between two QPs and from one QP to a traditional IRAs are permitted, thereby extending tax deferral.

- No Portability.

- Credit to small employers for startup costs. Small employers may be entitled to receive a credit for some of the costs of establishing new QPs see CCH ¶9045).

- No employer tax credit available.

- Credit to employees for contributions. Employees may be entitled to receive a saver’s credit for elective contributions to a QP (see CCH ¶9033).

- No employee tax credit available.

Chapter 14, Exhibit 2d


Employer-Sponsored Plans: Qualified v. NonqualifiedNontax Advantages (“+”) and Disadvantages (“-”)


+ Bankruptcy protection. Plan assets are protected from the employer, employer creditors, and employee creditors. (O.J. Simpson receives $25,000 monthly from his pension plan despite losing a $36 million judgment to the Goldman family.)

- No bankruptcy protection.

+ Employment incentive. QPs can be used to attract and retain employees.

+ Same advantage.

+ Loan option available to employees. Participants may be permitted to borrow up to $50,000 from their QPs.

- No loan option.

Chapter 14, Exhibit 2e




- Nondiscrimination. The plan cannot discriminate in favor of highly compensated employees. Code Sec. 401(a)(4).

+ More flexibility in choosing who participates. NPs are not subject to the same minimum coverage and nondiscrimination requirements as QPs. Therefore, an NP can be designed to cover a limited group of employees.

- Distribution restrictions. Distributions made too soon may be subject to a 10% penalty. If made too late and/or too little in amount, a 50% penalty may be imposed on the recipient.

+ No statutory restrictions on distributions.

- Limitation on annual employee compensation. For most employer-sponsored retirement plans, compensation subject to employer and employee contribution percentages is limited to $250,000 in 2012.

+ Unlimited benefits. An NP can provide benefits in excess of those permitted under QP limits.

Chapter 14, Exhibit 2f



Nontax Advantages (“+”) and Disadvantages (“-”)


- Limitation on contributions. Specified limits apply to how much employees and employers can contribute to a QP. Code Sec. 415.

+ No limitation on contributions.

- Independence of trustee. For most employer-sponsored retirement plans, retirement funds must be held in trust managed by an independent trustee. Exceptions include Keogh plans for self-employed taxpayers.

+ No independent trustee requirement.

- Participation and coverage. Employees meeting certain minimum age and service requirements must be eligible to participate in an employer-sponsored retirement plan. In addition, the plan must generally cover at least 70% of eligible employees on a nondiscriminatory bases. Sec. 410. Exceptions include SIMPLE IRA plans.

+ No participation and coverage requirements..

Chapter 14, Exhibit 2g




- Written and continuous plan. The plan must be in writing and constitute a continuous program.

+ The NP need not be written and continuous.

- Vesting. An employee’s nonforfeitable right to receive future benefits must take effect within a prescribed time frame. Sec. 411.

+ No vesting rules imposed on employer.

- Exclusive benefit of employees. The plan must be created and operated for the exclusive benefit of the employee/participants and isolated from potential misfortunes of the employer.

+ No “exclusive benefit of employees” requirement.

Chapter 14, Exhibit 2h


Distributions from Qualified Plans (QPs): Basic Concepts

“Before-Tax” v. “After-Tax Contributions. Grasping the distinction between “before-tax” and “after-tax” contributions is essential to understanding the distribution rules governing qualified deferred compensation plans. Here’s the distinction: If contributions made to qualified plans such as traditional IRAs or 401(k) plans are deductible, the subsequent withdrawal of these contributions is taxable. Conversely, if the contributions are not deductible, the subsequent withdrawal is tax-free. The rules governing the deductibility of contributions are explained later in this chapter. For now, it’s important to understand why deductible contributions are “before-tax” and why nondeductible contributions are “after-tax.” This distinction is illustrated below.




Illustration of Tax Effect from “Before-Tax” and “After-Tax” Contributions. Assume a taxpayer earns a $100,000 salary and contributes $4,000 into a retirement account such as a traditional IRA or a 401(k). Assume the current tax rate to be 25%.

Will the $4,000 contribution be taxable when it is subsequently distributed back to the taxpayer? As illustrated below, the answer depends on whether or not the contribution was deductible.

Will the income accumulating from the $4,000 contribution be taxable when later distributed? Yes, unless the QP is a Roth IRA or a Roth 401(k).




Formula: Description: Before Tax Cont’n After-Tax Cont’n

(a) = Given Contribution $4,000 $4,000

(b) = Given Deductible? (The rules for qualifying for a deduction are explained later in this chapter.)

Assume Yes Assume No

(c) = Given Gross income $100,000 $100,000

(d) = (a) only if(b)=“yes”

Deduction (4,000) 0

(e) = (c)–(d) Taxable income (ignoring other deductions)

96,000 100,000

(f) = Given Tax rate 25% 25%

(g) = (e) x (f) Tax 24,000 25,000

(h) = (d) x (f) Immediate tax savings from the $4m deduction

1,000 0




Formula: Description: Before Tax Cont’n After-Tax Cont’n

(i) = (d) x tax rate in effect in the year of dist’n

Estimated future taxes payable when the $4,000 is subsequently distributed

$1.000(assuming a 25% future tax rate; if

the future tax rate is lower (or higher) due to, say, lower (higher) retirement income, the tax burden will be less (more) than $1m)

$0

If (b) =“yes:”(j) = (a) If (b) =“no:”(j) = (a) [1–

(f)]

Amount of income needed to afford the $4,000 contribution

$4,000(Same as the contribution amount.

This is why the contribution is “before-tax”.)

$5,333(To afford a $4,000

contribution, the taxpayer needs to earn at least $5,333, which, taxed at 25%, would result in $4,000 cash after-tax. This explains why the nondeductible contribution is considered to be “after-tax.”

Proof: 25% x $5,333 = $4,000)



Comparison of Defined Contribution and Defined Benefit Plans

Defined Contribution Plans (DCPs) Defined Benefit Plans (DBPs)

Contributions (a) Fixed percentages; or(b) Flat dollar amounts.

Determined actuarially based on defined benefits.

Contribution Limit Lesser of:(1) $50,000 in 2012, or (2) 100% employee’s gross compensation (25%

for profit sharing, money purchase, or stock bonus plans).

(Note: This limit applies to the aggregate of employer and employee contributions, as well as forfeitures allocated to the employee’s account.)

N/A

Benefits The final benefits depend upon investment performance of the trust account. Upon retirement, an employee is entitled to the account balance, either as a lump-sum or an annuity.

The final benefit is a fixed and pre-determinable lump-sum or annuity.



Comparison of Defined Contribution and Defined Benefit Plans

Defined Contribution Plans (DCPs) Defined Benefit Plans (DBPs)

Benefit Limit N/A Lesser of:(1) $200,000 in 2012(2) Average salary for highest 3 years of

employment(Adjustments based on age, years’ participation

or years’ employment may be required.)

Forfeitures Increase employee benefits, or Reduce future contributions by

employer.

Must reduce future contributions by employer. (Forfeitures cannot increase employee benefits.)

Ideal Employee Targets

More favorable for younger employees since, over a longer period of time, higher benefits may result.

More favorable for older employees at the time the plan is adopted since it is possible to fund higher benefits over a shorter period.

Complexity Less than DBPs Require greater reporting requirements and more actuarial and administrative costs. (This explains why (a) it is impractical for many small businesses and (b) there has been a massive shift away from DBPs over the past decade.)



Calculating RMDs Using the Uniform Lifetime Table

Minimum amount of first distribution = (a) (b), where:

(a) = Accrued benefit or account balance as of December 31 of the year preceding the year in which the taxpayer attains the age of 70 1/2, or retires, if applicable.

(b) = Hypothetical joint life expectancy provided in the Uniform Lifetime table below, that is based on:

(i) the taxpayer’s age on December 31 of the year in which the taxpayer attains the age of 70 1/2, (or retires, if applicable,) and

(ii) a hypothetical beneficiary whose age is exactly ten years younger than the taxpayer’s.




Minimum amount of subsequent distributions = (c) (d), where:

(c) = Accrued benefit or account balance as of December 31 of the year preceding the year in which a distribution must be made (e.g., use the balance as of December 31, Year 1 if a second distribution is due by December 31, Year 2).

(d) = Redetermined joint life expectancy provided in the Uniform Lifetime table below.]




Table 2: Uniform Lifetime Table Age of IRA Owner Distribution Period

Age LifeExp.

Age LifeExp.

Age LifeExp.

Age LifeExp.

Age LifeExp.

70717273747576777879

27.426.525.624.723.822.922.021.220.319.5

80818283848586878889

18.717.917.116.315.514.814.113.412.712.0

90919293949596979899

11.410.810.29.69.18.68.17.67.16.7

100101102103104105106107108109

6.35.95.55.24.94.54.23.93.73.4

110111112113114115

(or older)

3.12.92.62.42.11.9




Eve’s traditional IRA account balances for five years are shown below:

Date Account Balance

December 31, Year 1 $274,000








Eve becomes age 70 on June 1, Year 2, and retires at the end of Year 3. Since Eve’s plan is not employer-sponsored, the retirement date is irrelevant in determining her RMD. The initial RMD (deadline and amount) is based on the year in which she becomes 70 ½ (Year 2). The deadlines and amounts associated with the first four RMDs are shown below.

Distribution: Relevant Relevant Computation of RMD Amt.

No. RMDDate

Acct. Bal. Date (12/31)

Age onDec. 31 of:

(refer to the UniformLifetime Table above)

RMDAmount

1st 4/1 Yr 3 Yr 1 Yr 2: 70 $274,000 27.4 $10,000

2nd 12/31, Yr 3 Yr 2 Yr 3: 71 [$296,200 - $10,000] 26.5 $10,800

3rd 12/31, Yr 4 Yr 3 Yr 4: 72 $320,000 25.6 $12,500

4th 12/31, Yr 5 Yr 4 Yr 5: 73 $345,800 24.7 $14,000

Chapter 14, Exhibit 5e


Portability ChartELIGIBLE ROLLOVER TO RECIPIENT PLAN? (Yes v. No)

TO: 401(k)Roth

401(k)/403(b)

403(b)Plan

Gov't.457(b)

KeoghPlan

SEPIRA

SIMPLEIRA

Trad’lIRA

RothIRA

FROM:

401(k) - Other Than Roth 401(k)

Yd N Yc Yc Yd Y N Y Y

403(b) - Other Than Roth 403(b)

Y N Y Y Y Y N Y Y

Roth 401(k)/ 403(b) by Direct Rollover

N Y N N N N N N Y

Governmental 457(b) Y N Y Y Y Y N Y Y

Keogh Yd N Yc Yc Yd Y N Y Y

SEP IRA Ya N Ya Ya Ya Y N Y Y

SIMPLE IRAb Y N Y Y Y Y Y Y Y

Traditional IRA Ya N Ya Ya Ya Y N Y Y

Roth IRA N N N N N N N N Y

Superscript Notes:

a Only pretax amounts from a traditional IRA or SEP IRA may be rolled to these plans.

b Rollovers from SIMPLE IRAs are prohibited until after 2 years of participation.

c Pretax amounts only.

d After-tax amounts may be received only by direct transfer or direct rollover.

Chapter 14, Exhibit 6


Characteristics: 401(k) 403(b) (“Tax Sheltered

Annuity” Plan)

457(b) (Governmental)

457(b) (Nongovernmental)

Description of Eligible Employers:

Taxable entities

Tax-exempt organizations

Public school systems

State and local governments

Tax-exempt organizations

Examples of eligible employers:

For-profit employer formed as a C or S corporation, partnership, LLC, or proprietorship

Yes No No No


Common Retirement Plans for Large Employers—Eligible Employers




Annuity” Plan)



Examples of eligible employers (contd.):

Federal government No No No No

State and local governments

No No(unless it’s an

educational institution)

Yes No

Schools (K to university level)

No(unless it’s a

for-profit business)

Yes for both governmental (state & local) or 501(c)(3) tax exempt organizations

Yes for governmental (state & local) employers

Yes for 501(c)(3) organizations





Annuity” Plan)



Examples of eligible employers (contd.):

Hospitals No(unless it’s a

for-profit business)




Museums that are tax-exempt

No Yes for 501(c)(3) organizations



Libraries that are tax-exempt

No Yes for 501(c)(3) organizations



Private research foundations

No Yes No Yes

Labor unions No Yes No Yes

Private clubs No Yes No Yes



Common Retirement Plans for Large Employers—Basic Features

Features: 401(k) 403(b) (“Tax Sheltered Annuity” Plan)



Plan type Qualified Qualified Nonqualified Nonqualified

Able to discriminate? No No Yes Yes

Loans up to $50,000 OK? Yes Yes Yes No

Subject to 10% penalty on premature withdrawals?

Yes Yes No (unless the distribution consists of an amount previously rolled over from another type of plan)

No

Subject to 50% penalty on late RMDs?

Yes Yes Yes No

Subject to $5,000 mandatory cash-out rules?

Yes Yes Yes No



Common Retirement Plans for Large Employers—Basic Features

Features: 401(k) 403(b) (“Tax Sheltered Annuity” Plan)



Portable with other employer-sponsored plans and IRAs?

Yes Yes Yes No

Subject to statutory vesting rules for employer contributions?

Yes Yes No No

Must be for exclusive benefit of employees?

Yes Yes for retirement income accounts;

No, for annuity contracts and custodial accounts.

Yes No

Protection from creditors of employer?

Yes Yes Yes No



Common Retirement Plans for Large Employers—Contribution Limits

Limits: 401(k) 403(b) (“Tax Sheltered

Annuity” Plan)



Are employee elective deferral contributions allowed?

(“GC” is defined below)

Yes, limited to the lesser of:

(1) = 17,000; (2) = 100% GC* + $5,500 if age

50+


(1) = 17,000; (2) = 100% GC* + $5,500 if age 50+ + $3,000 (max.) if

completed 15 years of service


(1) = 17,000; (2) = 100% GC* + $5,500 if age

50+OR + $15,000 (max.) if

within 3 years of retirement


(1) = 17,000; (2) = 100% GC+ $15,000 (max.) if

within 3 years of retirement

(The 50 + catch-up contribution is not permitted.)

Aggregate Limit on Employer and Employee Contributions

Lesser of:(1) = $50,000 or (2) = 100% GCplus catch-up

contributions

Lesser of:(1) = $50,000 or (2) = 100% GCplus catch-Up

contributions

Same as employee elective deferral contribution limit above.

Same as employee elective deferral contribution limit above.

“GC:” Gross compensation is equal to the employee’s salary plus any qualified benefits such as medical insurance premiums under a cafeteria plan.



Common Retirement Plans for Large Employers—Contribution Limits

Limits: 401(k) 403(b) (“Tax Sheltered

Annuity” Plan)


457(b) (Nongovernmental

)

Are contributions subject to FICA or FUTA?

No for employer contributions;

Yes for employee contributions.

Same as 401(k) Same as 401(k) Yes

Are employee supplemental after-tax contributions allowed?

Yes if written into the plan

Same as 401(k) No No

“GC:” Gross compensation is equal to the employee’s salary plus any qualified benefits such as medical insurance premiums under a cafeteria plan.



401(k) Plans—Lecture Problem on Tax Consequences

Facts: ABC Corp’s 401(k) plan provides that employees may elect to contribute 100% of their

“gross” compensation, up to $17,000, the elective deferral limit. ABC will match employee contributions up to 6% of “net” compensation. Cy elects to contribute 10% of his $25,000 salary in 2012.Explain the tax consequences.

Tax consequences:

Employee elective deferral contribution: $2,500 (= 10% x $25,000)

Employer contribution: $1,350 (= 6% x [$25,000 - $2,500])

Amt. of salary subject to employee FICA:

$25,000 (i.e., elective employee contributions, but not employer contributions, are subject to FICA tax.)

Amt. of salary currently subject to federal income tax:

$22,500 (= $25,000 - [10% x $25,000])

Amt. of salary currently escaping federal income tax:

$3,850 (= $2,500 + $1,350)

Note: If ABC’s plan had been a 403(b) or 457, the tax consequences would have been the same.



Common Retirement Plans for Small Businesses—Basic Features

Features Solo 401(k) Keogh SEP SIMPLE

Form of plan: 401(k) Pension, profit-sharing, or both

IRA IRA or 401(k)

Self as trustee OK?

Yes Yes No No

Permitted legal entity type:

LLCs, Partnerships Sole props. C or S

corporations

LLCs, Partnerships Sole props.

LLCs, Partnerships Sole props.

LLCs, Partnerships Sole props. C or S corps.,

Limit on number of employees:

Must not exceed 1 owner-employee (except for spouse)

No limit No limit Must not exceed 100 employees





Annual filing requirements:

Annual IRS Form 5500-EZ or Form 5500 once balance exceeds $250,000 (by last day of 7th month after year-end)

Annual IRS Form 5500-EZ or Form 5500 once balance exceeds $100,000, or $250,000 for a one-participant plan (by last day of 7th month after year-end)

None.(although certain

W-2 reporting is required.)

None.(although certain W-

2 reporting is required.)

Statutory establishment deadline (financial institutions may set earlier deadlines):

By December 31 of the current year.

By December 31 of the current year.

By extension due date of employer return.

By October 1 of current year.





Statutory contribution deadline:

Employee: By Dec. 31 of current year;

Employer: By extension due date.




Vesting requirements:

None(since no employee

other than spouse may be employed)

Regular vesting rules (e.g., 3-yr. cliff or 6-yr. graded) apply

None(Employer

contributions are always nonforfeitable)

None(Employer

contributions are always nonforfeitable)

Plan loans ok? Yes, up to $50,000 Yes, up to $50,000 No No





Participation requirements:

Only owner-employee (and spouse) may participate

Each employee: age 21 or

over; & with 1 year of

service (2 years with 2-year vesting).

Each employee: age 21 or over; who performed

services in current year and in 3 out of past 5 years;

who earned at least $550 for current year.

SIMPLE IRA:Each employee: Any age limit; Earn at least $5K

for any past 2 years and be expected to do so in current year.

SIMPLE 401(k):(same as Keogh)

Rollovers permitted?

Yes Yes Yes Yes, but rules are very restrictive for SIMPLE IRAs



Common Retirement Plans for Small Businesses—Contribution and Deduction Limits


Contribution limits for employees (or “deemed employees”) (see “Terms” below):

Lesser of:(1) = 17,000;(2) = 100% GC or

gross SEI

N/A N/A Lesser of:(1) = 100% GC (or gross SEI), or(2) = $11,500

Contribution limits for employers (or “deemed employers”)

(See aggregate contribution limit on the

next slide.)

(See aggregate contribution limit on the next slide.)

(See aggregate contribution limit on the next slide.)

Elective contributions:Lesser of (a) or (b): (a) = Employee (or “deemed”

employee) contributions (from above), or

(b) = 3% GC (or gross SEI) for each participating employee

Nonelective contributions:2% GC for each eligible employee

Terms: “GC” mean gross compensation, i.e., salary paid or accrued to employees. “Gross SEI” refers to (a) – (b) – (c) where (a) = self-employed taxpayer’s gross income from the business; (b) = business deductions;(c) = 1/2 x self-employment tax actually paid (for Keoghs and SEP IRAs); or [(a) – (b)] x .9235 (for solo 401(k)s & SIMPLE IRAs). “Net SEI” is equal to gross SEI – the actual retirement plan deduction.




Aggregate contribution limit for employers and employees

Lesser of:(1) = $50,000 or (2) = 25% GC (or

20% gross SEI)

Lesser of:(1) = $50,000 or (2) = 100% GC

or net SEI (25% for single- profit sharing plans)

Lesser of:(1) = $50,000 or (2) = 25% GC (or

20% gross SEI)

(Separate employee and employer limits apply—see

preceding slide)

$50,000 (of GC or net SEI) limit in contribution formula?

Yes Yes Yes For SIMPLE 401(k)s: YesFor SIMPLE IRAs: No,

except for nonelective contributions






Age 50+ catch-up contributions:

Yes, $5,500 for 2012. (This is in addition to the $50,000 aggregate limit.)

No Yes, $5,500 for 2012. (This is in addition to the $50,000 maximum limit.)

Yes, $2,500 for 2012

Minimum contribution limits

None 1% to 3%, depending on the form of Keogh

None The 3% employer contribution percentage shown above may be reduced to 1% in any 2 out of 5 years.






Deduction limit for owner-employees

Same as aggregate contribution limit (see preceding slide)

Lesser of:(1) = $50,000

or (2) = 25% GC

or net SEI

Same as aggregate contribution limit (see preceding slide)

For corporate employers: Same as employer limit above.

For owner-employees:Sum of the separate

contribution limits for deemed employees and deemed employers





Features: Traditional IRA Roth IRA

Ideal Investor Time Frame

Shorter time horizon Longer time horizon

Age of Contributor

Must be age 18 but not 70 ½ or older No age restrictions.

Minimum Compensation Requirement?

Yes Yes

Establishment Deadline

By filing due date (April 15 of following year). Same deadline

Contribution Deadline

By filing due date (April 15 of following year). Same deadline

Maximum Contribution Amount

$5,000 ($6,000 if age 50+) aggregate limit for traditional IRAs, deemed IRAs (SEP or SIMPLE), and Roth IRAs

Same limit


Personal Retirement Plans for Working Individuals


Personal Retirement Plans for Working Individuals

Features: Traditional IRA Roth IRA

Contribution Phase-Out (MAGI Limits)

None MFJ: $173,000 – 183,000Single: $110,000 - $125,000

Deduction Phase-Out (MAGI Limits)

For active participants: MFJ: $92,000 – $112,000 Single: $58,000 – $68,000 For nonparticipant spouses of active

participants: $173,000- $183,000) For nonparticipants (including married

taxpayers who are both nonparticipants): Contributions are fully deductible

Never deductible

IRA Earnings Taxed when withdrawn Tax exempt if conditions are met

Penalty for Early Withdrawals

10% 10%

Penalty for Late Withdrawals

50%(distributions to begin no later than April 1

after the year in which the participant becomes 70 ½)

None(no minimum distribution rules apply while participant is living)



Applying the Two Qualifying Tests to Roth Distributions

TaxableTax-freeTax-freeIf No:

Tax-freeTax-freeTax-freeIf yes:

(2) Has the age 59 ½, death, disability, or 1st time home buying requirement been satisfied?

10% penalty10% PenaltyPenalty-freeIf no:

Penalty-free only if (2) below is also met

Penalty-freePenalty-freeIf yes:

(1) Has the five-year holding period requirement been met?

4th Earnings

2nd Taxable

Portion of Rollover

Contributions

1st Direct

ContributionsTests:

Ordering of Roth IRA Sources


Tax-free

3rd Nontaxable Portion of Rollover

Contributions

Penalty-free

Tax-free

Penalty-free


Employee Stock Purchase Plans—Qualifying Distributions

Consider an ESPP with a 10% discount, a look-back provision, and a 6-month offering period. Assume Avery Cobb is paid $90,000 annually and (on an after-tax basis) contributes 5% of gross pay to purchase stock, or $4,500. Let the share price be $50 on the first day of the offering period and $200 on the last day of the offering period. With the discount and look-back, Avery gets to purchase stock at a per share price of $45, which is equal to 85 percent of the lesser of (a) the offering price ($50) or (b) the purchase price ($200). The total number of shares purchased with the $4,500 contributed is thus 100 ($4,500 $45). Assume first that Avery holds the shares 18 months for a qualified disposition. If the price per share at disposition is $250, the total gain per share is $250 - $45 = $155. The discount at the start of offering period was $5 per share ($50 × 10% ). This is less than the $155 per share total gain on sale, so $5 per share is taxed as ordinary income and is subject to FICA and FUTA taxes; the remainder, $150 per share, is taxed as a long-term capital gain. Furthermore, because the shares were held for a qualified disposition, the employer gets no corporate tax deduction. See per share computations below.



Employee Stock Purchase Plans—Qualifying Distributions

Formula Description Per Share Amt.

(a) = Given Grant price (FMV at beginning of offering period)

$50

(b) = Given Purchase price (FMV at end of offering period) $200

(c) = Given Sale price (upon disposition of stock) $250

(d) = Given Employee purchase discount % 10%

(e) = (d) x [the lesser of ( a) or (b)] Employee purchase discount amount:10% x $50 = $5

$5

(f) = [the lesser of ( a) or (b)] – (e) Actual cost to employee: $50 – $5 = $45

$45

(g) = the lesser of: (c) - (f); (a) x (d)

Ordinary income = the lesser of: $250 - $45 = $205 $50 x 10% = $5

$5

(h) = (f) + (g) Tax basis for computing capital gain:$45 + $5 = $50

$50

(i) = (c) – (h) Capital gain: $250 - $50 = $200 $200



Employee Stock Purchase Plans—Disqualifying Distributions

Referring to the preceding example, assume that the shares were disposed of immediately after purchase in a same-day sale. The sale would be a disqualifying disposition for either of two reasons: Avery would have sold the stock (1) within one year or less from the exercise (purchase) date and (2) less than two years after the offering (grant) date. In this case, the disposition is $200 per share and the gain per share is $200 - $45 = $155, all of which is taxed as ordinary income and is subject to FICA and FUTA taxes. Because the shares were sold in a disqualifying disposition, the employer gets a corporate tax deduction for the compensation amount of $155 per share. The employer’s statutory FICA and FUTA taxes on the $155 per share ordinary income are deductible as well. The formula for disqualifying dispositions is provided in the computations in the next slide.



Formula Description Per Share Amt.

(a) = Given Grant price (FMV at beginning of offering period) $50

(b) = Given Purchase price (FMV at end of offering period) $200

(c) = Given Sale price (upon disposition of stock) $200

(d) = Given Employee purchase discount % 10%

(e) = (d) x [the lesser of ( a) or (b)] Employee purchase discount amount: 10% x $50 = $5

$5

(f) = [the lesser of ( a) or (b)] – (e) Actual cost to employee: $50 – $5 = $45

$45

(g) = (b) - (f) Ord. income: $200 - $45 = $155 $155

(h) = (f) + (g) Tax basis for computing capital gain: $45 + $155 = $200

$200

(i) = (c) – (h) Capital gain: $200 - $200 = $0 $0


Employee Stock Purchase Plans—Disqualifying Distributions


Incentive Stock Options—Qualifying Distributions

ABC Corp. grants George Willingham 1,000 ISOs on January 1, Year 1 (the “grant” date). On this date, the stock’s fair market value is $10 per share and each ISO entitles the holder to buy one share of ABC stock for $10 (the exercise price). George can exercise the ISO after one year of employment but not more than 10 years after the grant date and not more than three months after the effective severance date in the event his employment is terminated. George exercises the ISOs on December 31, Year 2 (the “exercise” date) when the stock is worth $200 per share. He sells the stock on January 1, Year 4 (the “sale” date) for $250 per share. Neither the granting nor exercising of the stock will have regular tax consequences to George in a qualifying disposition (but see discussion on AMT below). In the year of sale, George will report a $240 per share long-term capital gain. ABC is not allowed any deduction in connection with the ISOs, since no ordinary income was recognized by George. See per share computations in the next slide.



Incentive Stock Options—Qualifying Distributions

Key Dates Qualifying Disposition

Jan. 1, Year 1(ISO is granted.)

No ordinary income (OI); ISO’s tax basis = $0 per ISO ISO tax basis = $0 cost + $0 ordinary income

Dec. 31, Year 2(ISO is exercised.)

No ordinary income (OI); stock basis = $10 per share Stock basis = $10 cost + $0 ordinary income

Jan. 1, Year 4(Stock is sold.)

$240 per share long-term capital gain (LTCG) $240 LTCG = $250 sale price - $10 stock basis The holding period begins on January 1, Year 3, the day after

the exercise date; therefore, the holding period is long-term.



Incentive Stock Options—Disqualifying Distributions

Referring to the foregoing example, suppose that George Willingham sold his shares on June 30, Year 3. Because the stock was not held for one year from the exercise date, December 31, Year 3, George made a disqualifying disposition of the stock. As before, George will recognize no income on the grant date or on the exercise date. On June 30, Year 3 (the sale date) however, George will recognize $190 per share in ordinary income ($200 - $10) and $50 per share short-term capital gain ($250 - $200). The holding period of a disqualified ISO begins on the day after the exercise date; thus, George’s holding period is short-term (from January 1, Year 3, the day after the exercise date, to June 30, Year 3, the sale date). ABC is allowed a corresponding deduction of $190 per share for its tax year which includes December 31, Year 3, George’s year-end.



Incentive Stock Options—Disqualifying Distributions

Key Dates Disqualifying Disposition

Jan. 1, Year 1(ISO is granted.)

No ordinary income (OI); ISO’s tax basis = $0 per ISO ISO tax basis = $0 cost + $0 ordinary income

December 31, Year 2(ISO is exercised.)

No tax effect; stock basis = $10 per share Stock basis = $10 cost + $0 ordinary income

June 30, Year 3(Stock is sold.)

(a) $190 per share ordinary income (OI) $190 OI = $200 exercise price - $10 stock basis(b) $50 per share short-term capital gain (STCG) $50 STCG = $250 sale price - $200 FMV at exercise date The holding period begins on January 1, Year 3, the day

after the exercise date; therefore, the holding period is short-term.



Nonqualified Stock Options (NSOs)—Value Known at Grant Date

XYZ Corp. grants Wesley Bloeme 1,000 NSOs on January 1, Year 1 (the “grant” date). Each NSO grants the holder the right to buy 1 share of XYZ stock for $10. Wesley can exercise the NSO after one year of employment. The stock’s readily ascertainable fair market value on the grant date is $50 per share. (Note that with NSOs, the exercise price may be below the market value of the stock since the Code Sec. 422(b)(4) pricing rules do not apply as they do for incentive stock options.) Wesley exercises the NSO on December 31, Year 2 (the “exercise” date) when the stock is worth $200 per share. He sells the stock on January 1, Year 4 (the “sale” date) for $250 per share. Wesley must recognize $50 per share ordinary income on the grant date and XYZ is allowed a corresponding deduction of $50 per share for its tax year which includes December 31, Year 1, Wesley’s year-end. Wesley must also report a $190 per share long-term capital gain in the year of sale. See per share computations in the next slide.



Nonqualified Stock Options (NSOs)—Value Known at Grant Date

Key Dates Readily Ascertainable Value at Grant Date

Jan. 1, Year 1(NSO is granted.)

Ordinary income (OI) = $50 per share $50 OI = $50 NSO market value - $0 costNSO tax basis = $50 per NSO $50 NSO tax basis = $0 cost + $50 OI

Dec. 31, Year 2(NSO is exercised.)

No ordinary income (OI); stock basis = $60 $60 stock basis = $10 cost + $0 OI + $50 NSO basis


$190 per share long-term capital gain (LTCG) $190 LTCG = $250 selling price - $60 stock basis The holding period begins on January 2, Year 1, the day

after grant date; therefore, the holding period is long-term.



Nonqualified Stock Options (NSOs)—Value Unknown at Grant Date

Referring to the foregoing example, suppose that the XYZ stock had no readily ascertainable value on the grant date. Wesley recognizes no taxable income on the grant date. He recognizes $190 per share of ordinary compensation income on December 31, Year 2, when he exercises the NSO. XYZ will be allowed a deduction of the same $190 per share for its taxable year which contains December 31, Year 2, Wesley’s year-end. Wesley will also recognize a $50 per share long-term gain upon the sale of the stock on January 1, Year 4, since his holding period was more than twelve months (January 1, Year 3 – January 1, Year 4.



Nonqualified Stock Options (NSOs)—Value Unknown at Grant Date

Key Dates No Readily Ascertainable Value at Grant Date

Jan. 1, Year 1(NSO is granted.)

No ordinary income (OI); NSO tax basis = $0 per NSO NSO tax basis = $0 cost + $0 ordinary income

Dec. 31, Year 2(NSO is exercised.)

Ordinary income (OI) = $190 per share $190 OI = $200 stock value - $10 cost]Stock basis = $200 per share $200 stock basis = $10 cost + $190 OI


$50 per share long-term capital gain (LTCG) $50 LTCG = $250 selling price - $200 stock basis The holding period begins on January 1, Year 3, the day

after exercise date; therefore, the holding period is long-term.



Restricted Stock Plans—With and Without Section 83(b) Election

CTK Corp. transfers one hundred shares of its common stock to Matt Andres, an executive of CTK on January 1, Year 1. On the date of the transfer, the stock has a market value of $50 per share. Matt’s cost of the shares is discounted to $10 per share. The stock is intended as a bonus for Matt’s work for the year, but is issued with the restriction that if Matt leaves CKS’s employment within the next two years, he must return the shares to the corporation. On December 31, Year 2, when the restrictions expire, the stock is trading publicly at $200 per share. On January 1, Year 4, Matt sells the stock for $250 per share. Matt will recognize $40 per share ordinary income in Year 1 under the special Code Sec. 83(b) election, or he may postpone recognizing any ordinary income until the expiration of the restriction in Year 2. However, his recognized ordinary income would be $150 per share more. One of the principal advantages of the Code Sec. 83(b) election is the conversion of what would be ordinary income into a more favorable capital gain. For example, if Matt had sold the stock at its market value on the date of the lapse of the restrictions, December 31, Year 2, the entire gain of $190 would have been taxed as ordinary income without the election. With the election, he would have converted $150 per share of ordinary income into long-term capital gain. Since the ordinary tax rate can be substantially higher than the long-term capital gain rate, the Code Sec. 83(b) may be advantageous, despite accelerating the recognition of a portion of the income. See per share computations in the next slide.



Restricted Stock Plans—With and Without Section 83(b) Election

Dates: Without Sec. 83(b) Election With Sec. 83(b) Election

Jan. 1, Yr. 1(Stock is issued.)

No ordinary income (OI)Stock basis = $10 per share Stock basis = $10 cost + $0 OI

Ordinary income (OI) = $40 per share $40 OI = $50 stock value - $10

stock cost]Stock basis = $50 per share $50 stock basis = $10 cost + $40 OI

Dec. 31, Yr. 2(Restriction is

lifted.)

Ordinary income (OI) = $190 per share $190 OI = $200 stock value - $10 stock

cost]Stock basis = $200 per share $200 stock basis = $10 cost + $190 OI

No ordinary income (OI)Stock basis = $50 per share (Unchanged

from above)

Jan. 1, Yr. 4(Stock is

sold.)

$50 per share long-term capital gain (LTCG)

$50 LTCG = $250 selling price - $200 stock basis

The holding period begins on January 1, Year 3, the day after the restriction is lifted; therefore, the holding period is long-term.

$200 per share long-term capital gain (LTCG)

$200 LTCG = $250 selling price - $50 stock basis

The holding period begins on January 2, Year 1, the day after the stock is issued; therefore, the holding period is long-term.



Savings Plans for EducationItem: Coverdell ESA 529 Prepaid Tuition Plan 529 Savings Plan

Purpose: Tax-exempt accumulation of income to pay for the qualified kindergarten through postsecondary education expenses of a beneficiary under age 30.

Tax-exempt accumulation of income to pay for the qualified postsecondary education expenses of a beneficiary.

Tax-exempt accumulation of income to pay for the qualified postsecondary education expenses of a beneficiary.

Age Restrictions: For qualified contributions: the beneficiary must not be over age 18 at the end of the contribution year.

For qualified distributions: the beneficiary must not be more than age 30 at the end of the distribution year.

None None

Establishment Deadline:

By December 31 of current year.

Depends on the plan Depends on the plan



Savings Plans for Education

Item: Coverdell ESA 529 Prepaid Tuition Plan 529 Savings Plan

Contribution Deadline

By filing due date (April 15 of following year).

Depends on the plan Depends on the plan

Maximum Contribution Amount

$2,000 per beneficiary (not per contributor) per year

Determined by each state Determined by each state

Contribution Phase-Out (MAGI Limits)

MFJ: $190,000- $220,000Other: $95,000 - $110,000

None None

Control of the Account:

In most states, account assets become property of the beneficiary at age 18.

In most states, control of the account will always remain with the contributor.

In most states, control of the account will always remain with the contributor.

Assignability to Other Relatives:

Immediate family of beneficiary, including cousins, step-relatives, and in-laws

Same as CESA Same as CESA



Item: Coverdell ESA 529 Prepaid Tuition Plan 529 Savings Plan

Earnings: Tax exempt if conditions are met.


Penalty for Non-Qualified Withdrawals:

Earnings are taxed as ordinary income to contributor, plus a 10% penalty.


Effect on Financial Aid Calculation:

Considered to be an asset of the beneficiary, which means a large portion of the assets will be considered in the financial aid calculation.

Considered to be the student’s resource and thus reduces financial aid dollar-for-dollar.

Assets are considered to be property of the account owner, which—unless the owner is also the beneficiary—means only a small portion of the assets will be considered in the financial aid calculation.

Coordination with Hope and Lifetime Learning Credits

Credits can be claimed in the same year as tax-free withdrawals provided that the distribution is not used for the same expenses for which a credit is claimed.




Savings Plans for Education

2013 cch basic principles ch14

Economy & Finance

Transcript of 2013 cch basic principles ch14