It is important to understand the type of retirement plan you have, the benefits it will provide, and investment alternatives afforded to you. It is often suggested by financial advisors that you maximize the benefits within your retirement plan before establishing supplemental retirement programs.

• A qualified plan is one that conforms to the federal government's requirements and thus makes the participants (the employer and the employees) eligible for favorable federal income tax treatment. An important requirement the federal government imposes on qualified plans is that they not discriminate favorably for the benefit of the highly-paid employees.

• A nonqualified plan is one that fails to meet the federal government's requirements and, therefore, neither the employer nor the employees are eligible to benefit from favorable federal income tax treatment. Nonqualified plans may discriminate in favor of the highly-paid employees.

There are two types of qualified retirement plans: defined-contribution plans and defined-benefit plans.

• A defined-contribution plan establishes, “defines”, the contribution that is to made on the behalf of the employee. In a defined-contribution plan, an individual account is maintained for each employee, showing the required amounts contributed by the employer and interest earnings. The employer's annual contribution is set forth in a formula in the plan document. The employer's contribution is usually specified to be a percentage of the participating employee's compensation.

• A defined-benefit plan establishes ("defines") the retirement benefit the employee is to receive at retirement. Defined-benefit plans do not maintain an individual account for each participating employee. Instead, the employer pools the funds, and the employees are provided statements periodically indicating their accrued retirement benefits. The plan actuary determines each year the amount the employer should contribute to provide the retirement benefits promised to all the employees. The amount of the promised benefit is a specified dollar amount for each retirement year or a percentage of each participating employee's compensation.

Vesting. It is very important to remember that retirement plan benefits or account balances attributable to the employer's contributions belong to the employee only after certain requirements are met. In other words, the benefits or account balances become non-forfeitable or vested (the employee takes the benefit or account balance with him or her if he or she terminates employment with that employer for any reason). The government's obvious purpose in legislating for the vesting of employee pension benefits and account balances was to assure security for the participating employees and their beneficiaries. Thus, if the employer went bankrupt, the employee would still be assured of his or her pension.

There are two types of vesting. Five-year cliff or seven-year graded. In both cases, the number of years is the maximum allowed by law. At the employer’s discretion, the periods can be shorter, including immediate vesting. If 100% immediate vesting is used, the employer can require two years of service before an employee may be eligible to participate in a qualified plan.

• Five-year or "cliff" vesting permits the employer to have no vesting during the first five years of each employee's service but, upon completion of five years of service, the employee must be 100% vested.

• Three-to-seven year graded vesting permits the employer to have no vesting during the first three years of each employee's service but, after completion of three years of service, vesting must occur at least as rapidly as indicated by the following schedule:

  Years of Service	Percentage of Vesting Mandated
  3	20%
  4	40%
  5	60%
  6	80%
  7 or more	100%

Federal Income Tax Implications on Qualified Retirement Plans

An extremely important aspect of establishing a qualified retirement plan is the federal income tax treatment of annual employer contributions. The following is a brief discussion of tax implications for the employer and the employee:

The employer's contribution to a qualified retirement plan on behalf of an employee is currently excluded from the employee's gross income. Any investment earnings or gains from assets owned by a qualified pension are not taxable until such earnings or gains are distributed to plan participants.

Another important aspect of a qualified retirement plan is the tax treatment of retirement distributions to participants. The following is a brief review of the tax treatment of:

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Defined-Contribution Plans

The government has set forth several requirements that all qualified retirement plans must meet to assure retention of their qualified status. Among these government-prescribed requirements is the requirement that a qualified plan must have "definitely determinable benefits." One would logically ask:

Q: How is it possible for a defined-contribution plan to have definitely determinable benefits?

A: By having a definite employer contribution formula in the case of a defined-contribution pension plan, the plan meets the "definitely determinable benefit" requirement.

In a defined-contribution plan, retirement benefits are determined by the amount of dollars that have accumulated in the account of the employee at retirement. This accumulated fund is then used to purchase an annuity for the employee as of his or her retirement age, or the funds are left in the employee's account to provide funds for installment payments. When an annuity is purchased, the benefit payable is a function of the employee's age at retirement, the dollar amount of the fund accumulated in the employee's account, the type of annuity selected (single or joint-life), interest rate assumed, etc. Thus, during the accumulation years, the employee does not know precisely what his or her monthly pension benefit will be, but by making realistic actuarial projections, the plan actuary can predict reasonably accurately what benefit can be paid if contributions continue at the promised level annually.

The rate of return earned on the invested assets of a defined-contribution pension plan affects the employee's retirement benefit directly. The larger the amount of investment income that is earned, the larger the total dollars accumulated in the account of the employee at retirement. The larger the total accumulation of dollars in the account of the employee, the larger the retirement benefit for the employee.

The age of entry of a participant in a defined-contribution pension plan affects the amount available as a retirement benefit in four ways.

1. First, the lower the participant's age when he or she becomes eligible to participate, the longer will be the time period over which investment income may be earned. This longer time period will thus increase the total amount available to fund the retirement benefit.
2. Second, the younger the age of the employee at the time of his or her initial participation, the longer the period is for compounding investment income.
3. Third, the younger the employee's initial age, the longer the period of time that employer contributions will accumulate for the employee.
4. Fourth, the younger the employee's initial age, the larger the dollar amount of the forfeitures that will be allocated to his or her account balance. Obviously, all of this would work in reverse for the older employee. Thus, older employees find defined-benefit plans generally more favorable for them.

Also, older employees generally prefer a defined-benefit pension plan, rather than a defined-contribution plan, because of the lesser risk for the participant. Defined-benefit plans have a certain guaranteed retirement benefit. For defined-contribution plans, the benefit is uncertain because of the uncertainty of the plan's future investment yield. The general rule is that investment risk varies directly with the current yield provided by the asset. Younger participants have a longer time for their investment assets to recover from any adversity in the investment markets. Older employees do not have this luxury of "make-up time." In general, younger employees are more willing to accept the current investment risk of a defined-contribution plan.

The maximum annual addition to a participant's account permitted for a defined-contribution plan is the lesser of $30,000 or 25% of the employee's compensation. The $30,000 limit will be adjusted annually for inflation (in $5,000 increments) when future cost of living adjustments have increased the defined-benefit limit to $160,000. Then, the contribution limit will be the lesser of 25% of the employee's compensation or a dollar maximum that is 25% of the defined-benefit dollar maximum. For 1999, the defined-benefit dollar maximum is $160,000.

Profit-Sharing Plans

A profit-sharing plan is a form of defined-contribution plan. It is distinguished from a pension plan in that the employer's annual contribution to provide future benefits for participating employees is based on the employer's profits. A profit-sharing plan may benefit an employer by providing the firm's employees an incentive to increase productivity and thus increase the employer's profits.

Three different approaches are used for determining the level of an employer's contributions to a profit-sharing plan:

1. The formula approach requires a fixed percentage of the employer's profits to be deposited annually with the trustee of the profit-sharing plan.
2. The discretionary approach permits the employer to vary the annual contributions. The only requirement is that the employer's contribution must be "substantial and recurring."
3. Some combination of 1 and 2.

The maximum deductible employer contribution to a profit-sharing plan is 15% of compensation paid to participating employees. Employer contributions in excess of the amount that can be deducted can be carried over to a later taxable year. A "contribution carry-over" allows the employer to deduct such excess contributions in a succeeding taxable year, provided that the amount of the contribution carry-over, when added to any other employer contributions made during such succeeding taxable year, does not exceed 15% of participating payroll for such succeeding taxable year. Any contribution in excess of the amount that may be claimed as a deduction is subject to a 10% penalty tax.

In the case of an employer who has both a defined-contribution pension plan and a profit-sharing plan, the maximum deductible employer contribution cannot exceed the lesser of 25% of the amount of compensation paid to participating employees.

In a profit-sharing plan, the employer's contributions (as determined by one of the three options) are allocated among the participating employees in the proportion that each employee's earnings bear to total earnings of all participants, or in proportion that each employee's years of service bear to total years of service of all participants, or some combination of relative earnings and relative service.

Investment earnings or losses under a profit-sharing plan are allocated by the ratio of account balances (participant's account balance as a percentage of the account balances of all participants).

When an employee terminates employment prior to becoming 100% vested in employer contributions to a profit-sharing plan, the resulting forfeitures may be reallocated among the remaining participants. Because of the potential for discrimination, the Internal Revenue Service is reluctant to allow forfeitures to be reallocated on the basis of participant account balances. The IRS's concern for potential discrimination is explained by the fact that "remaining participants" tend to be the "highly-compensated executives." The usual practice is for forfeitures to be reallocated on the basis of the ratio that each remaining participant's compensation bears to the total compensation of all remaining participants. (Obviously, there is "potential for discrimination" in this arrangement. But, we should note that it is possible to have different allocation formulas for contributions, forfeitures, and investment income; for example, unit allocation, compensation allocation, and account balance allocation, respectively.)

The basic structure of profit-sharing plans makes them particularly suitable for business firms with fluctuating or unstable earnings. With a profit-sharing plan, the employer is not required to make an annual contribution. If earnings are depressed or cash flow is needed for special purposes, the employer need not make a contribution for that year. However, the government requires that contributions must be "recurring and substantial."

Certain basic provisions of profit-sharing plans make them particularly suitable for businesses with young owners or young key employees. Since profit-sharing plans are defined-contribution plans, they have many of the same advantages as defined-contribution pension plans. The young owners will benefit from:

1. The long duration of annual contributions;
2. The long duration of investment income;
3. The long duration of compounding of investment income; and
4. The long participation in annual forfeitures.

Key employees who are beyond the youthful age will also benefit to some extent with respect to each of the four above items, but probably the greatest benefit will be (4), the right to participate in annual forfeitures resulting from termination of employment by employees with non-vested accruals.

Simplified Employee Pension Plans (SEP)

Simplified Employee Pension (SEP) plans are a form of defined-contribution plan in which the employer makes tax-deductible contributions to Individual Retirement Accounts or Annuities for eligible employees. SEP plans provide for employer contributions only, and are intended to eliminate much of the paperwork that is associated with qualified retirement plans. An advantage of a SEP Plan is one of the simplest retirement plans to set up and administer.

Another advantage of a SEP is that employees are 100% vested, and the account benefits are totally portable. Employees own and control their account, and can take it with them after leaving the employment of the company. Because SEPs are individual IRAs, the investment responsibility is that of the employee. A restriction on SEP Plans is that only employers with 100 or fewer employees can establish a SEP.

Since SEPs are funded through IRAs, they have the following similarities to an IRA:

1. The account, or annuity is owned by the employee and the employer can't place any restrictions on the employee's right to withdraw funds at any time,

2. Since the employee is the owner of the account or annuity, the employee is always 100% vested in the contributions made by the employer,

3. Distributions from an IRA used as funding for a SEP are subject to the distribution rules that apply to IRAs; therefore, the favorable tax treatment available for lump-sum distributions from qualified retirement plans is not available for lump-sum distributions from a SEP.

4. Like an IRA, employer contributions to a SEP made on behalf of an employee on or before April 15 may be treated as having been made on the last day of the previous calendar year.

5. A participant in a SEP can treat the SEP as an IRA and make deductible or nondeductible contributions, subject to the rules regarding IRA contributions by an "active participant."

Individual Retirement Accounts (IRAs)

An individual retirement account (IRA) is a personal savings plan to which a working person receiving compensation may make annual tax-deductible contributions. The investment income builds up on a tax-deferred basis. Contributions may be made to a trustee (that is not an individual) or to a custodian that is a bank, a federally insured credit union or a savings and loan association. Nondeductible contributions may also be made to IRAs within the prescribed limits. The nondeductible amounts, upon withdrawal, are free of tax liability but the income derived from these amounts is taxable because this income is accumulated on a tax-deferred basis. However, a person can no longer withdraw just nondeductible amounts. Provided that an IRA contains both nondeductible and deductible contributions, any withdrawal is partly nondeductible and partly deductible (the latter is taxable when withdrawn).

An individual retirement annuity (IRA) is an annuity issued by a life insurance company that is approved as an investment vehicle for IRA tax-deferred plans. The annuity must be non-transferable. Life insurance and endowment policies are not approved for funding an IRA.

The total contributions (deductible plus nondeductible) that can be made to individual retirement accounts are as follows:

1. Single wage earner: 100% of compensation up to $2,000.
2. Married couple: both spouses working, 100% of compensation up to $2,000 for each spouse, for a total of $4,000.
3. Married couple: filing jointly, one spouse working, 100% of the working spouse's compensation up to $2,000, for each spouse, for a total of $4,000.
4. Divorced individual: not working and receiving taxable alimony, 100% of compensation in the form of alimony up to $2,000.

"Compensation" means wages, salary, professional fees, or other amounts derived from, or received for, personal services actually rendered. Compensation also includes alimony paid under a divorce or separation agreement that is includible as income. In the case of a self-employed individual, compensation includes earned income from personal services.

To be deductible for any given tax period, a contribution must be made by April 15, of the following year. Any extension for filing does not mean an extension of the time for contributing to the taxpayer's IRA.

Any distribution of deductible IRA contributions is taxed as ordinary income. No distinction is made between the distribution of investment earnings and the distribution of deductible contributions. Both are taxed as ordinary income, but note that the investment earnings are tax-sheltered until they are paid out. No tax liability is incurred on the payout of the amount of any nondeductible contributions. However, the investment income earned on the nondeductible contributions is taxable income when it is paid out.

The dollar amount of an employee's deductible contribution to an IRA may be limited if he or she is an "active participant" in his or her employer's qualified plan. In the case of a defined-benefit plan, an active participant is any employee who is not excluded from participation for the plan year ending with or within the employee's taxable year. In the case of a money-purchase plan, an active participant is any employee who is entitled to a required employer contribution or forfeiture under the plan. In the case of a profit-sharing plan, an employee is an active participant as soon as an allocation (employer contribution or forfeiture) is made to his or her account during the employee's taxable year.

The active participation of one spouse will not cause the other spouse to be treated as an active participant. For married taxpayers, one spouse’s active participation in an employer retirement plan will no longer make the other spouse ineligible to deduct contributions to an IRA. The spouse who is not an active participant will be able to deduct contributions to an IRA unless the combined AGI for the couple is in the phase-out range of $150,000 to $160,000 or more.

A person is an active participant in his or her employer's qualified retirement plan for a given year if he or she makes either a voluntary or a mandatory contribution to the plan. However, in any given year, a person is not an active participant in his or her employer's qualified plan if only investment income earned on prior employer or employee contributions is allocated to the participant's investment account, but no current year contributions are made.

The full deduction of $2,000 for an IRA contribution can be made by an individual who has $2,000 or more in compensation and (1) is not an active participant in an employer-maintained retirement plan or (2) if an active participant, the taxpayer does not have adjusted gross income (AGI) exceeding a specified amount, namely, $32,000 for a single taxpayer and $52,000 for a married couple filing jointly.

A partial deduction would be available if earned income was less than $2,000 or if AGI for an active participant in an employer's pension plan is between $32,000 and $42,000 for a single individual, between $52,000 and $62,000 for a married couple filing jointly, or between $0 and $10,000 for a married individual filing a separate return.

No deduction is allowed if the employee has no compensation or if AGI for an active participant in an employer’s pension plan exceeds $42,000 for a single taxpayer, $62,000 for a married couple filing jointly, or $10,000 for a married individual filing a separate return. A person can contribute to an IRA up to, but not including, the year in which the IRA owner reaches age 70-1/2. Anyone with compensation, even if he or she has no taxable income or is an active participant with earnings in excess of the AGI limits, may open an IRA in accordance with the usual 100%/$2,000/$2,000 limits. These limits apply to total contributions--deductible plus non-deductible. Thus, the non-deductible amount is limited to the difference between the maximum limit and the amount deducted (for example, $2,000 less deductible amount of $800 leaves $1,200 as the potential non-deductible portion). The income earned by the non-deductible contributions is allowed to accumulate tax-free until time of withdrawal. Upon withdrawal of funds from an IRA that contains nondeductible contributions, each distribution must consist of proportionate amounts of deductible contributions, nondeductible contributions, and earnings on both. The proportionate share is the nondeductible contribution over the total account balance times the withdrawal.

The nondeductible portion is not subject to tax (income tax has already been paid on it); the balance is taxed as ordinary income. Both deductible and nondeductible contributions must be made by the deadline for filing that year's tax return, April 15 for most taxpayers, and must be shown on the tax return.

Excess contributions to an IRA are subject to a non-deductible excise tax of 6% of the dollar amount of the excess. An excess contribution to an IRA is any amount which exceeds the specified limits for deductibility plus nondeductible contributions, namely: single--100% of compensation up to $2,000 maximum; married (spousal) 100% of compensation up to $2,000 maximum; married (both employed), 100% of compensation up to $2,000 maximum for each spouse .

The taxpayer may correct an excess contribution to an IRA by making appropriate withdrawals on or before the date for filing the federal income tax return. The amount of investment income that has been earned on the excess contribution is includible in the taxpayer's gross income. Also, he or she may have to treat this investment income as a premature distribution from an IRA and pay the 10% premature distribution excise tax on the amount of that investment income.

If the excess contribution is not corrected as described above, it is subject to the 6% excise tax in the year of contribution and the excess contribution is carried over and is subject to the 6% tax each year until the taxpayer corrects the situation in one of the following ways:

1. By reducing his or her contributions in subsequent years.

2. By accepting a distribution of the excess part of a contribution that was less than $2,000, provided that no deduction was allowed for the excess amount. (Under this option, the excess withdrawn is subject to the 6% penalty tax but is not included in income and is not subject to the 10% penalty on premature distributions, and the earnings on the excess need not be withdrawn.)

3. By accepting a distribution of the excess and including such distribution in his or her gross income.

A uniform penalty tax of 10% applies to premature withdrawals from IRAs as well as to withdrawals from most other employer-maintained retirement plans. Withdrawals made after age 59-1/2 are not premature. The 10% penalty imposed on premature withdrawals is avoided when the employee: (1) dies before age 59-1/2; (2) receives the distribution because of permanent disability; (3) is separated from service and takes early retirement after age 55; (4) is separated from service at any age and elects to take equal or substantially equal periodic payments, at least annually, over the employee's life expectancy or over a period not to exceed the joint life expectancy of the employee and his or her spouse; (5) receives a distribution that is used to pay medical expenses in excess of 7½% of AGI; (6) is obligated for a payment to an alternate payee under the terms of a qualified domestic relations order (QDRO); and (7) finally, for individuals who have separated from service with their employer and received unemployment compensation for 12 consecutive weeks under federal or state law, distributions received for the payment of health insurance premiums for the individual and the individual’s spouse and dependents. One of these exceptions to distributions cannot be applied to an IRA, specifically, exception (3), pertaining to early retirement.

The government permits IRA dollars to be invested in any asset except

There are "safe harbors" that many 401(k) plans use to ensure compliance with the government-mandated nondiscrimination requirements. The following are two such safe harbors: :

1. An excess contribution (a contribution in excess of the amount permitted under the ADP test, not to be confused with an excess deferral, which is an amount exceeding the dollar limit on elective deferrals) by a highly-compensated employee may be corrected by re-characterizing the amount of such excess contribution as an after-tax employee contribution; and
2. The employer can make fully vested contributions to eligible employees' accounts, thus making the employer's contribution part of the nondiscrimination test. The objective of such contributions is to reduce the difference between the ADP of highly-compensated employees and the ADP of nonhighly-compensated employees.

In the case of a 401(k) plan that provides for matching contributions or after-tax employee contributions, another nondiscrimination test must be met; this test is called the Average Contribution Percentage test (ACP). The ACP test works in exactly the same manner as does the ADP test (see paragraph #7 above, this assignment), except that the ACP test compares the percentage of matching contributions, after-tax employee contributions, or both, that are credited to the two groups of employees (highly-compensated and nonhighly-compensated). When determining the ACP of each participant, simply divide the matching contribution or after-tax contribution credited to the participant by the participant's compensation. The rest of the test is performed exactly the same as the ADP test discussed above.

Distributions from a 401(k) plan may be permitted in the event of retirement, death, disability, termination of employment, or financial hardship (Note: loans are not technically a distribution, unless the participant defaults on the loan). In the case of financial hardship, the participant will be permitted to withdraw all or part of the elective deferrals, but not the earnings on such deferrals. Proposed hardship regulations require that the hardship be caused by "immediate and heavy financial needs:" (1) that the amount of the hardship distribution be limited to the amount necessary to meet the financial need caused by the hardship; (2) that no other resources are available to the employee to meet the financial need; and (3) that the determination of financial need and the amount that can be distributed to meet that need are made on a nondiscriminatory basis. Finally, hardship distributions are taxable as ordinary income in the year received and hardship distributions made prior to the attainment of age 59-1/2 are subject to the same 10% penalty tax that is assessed on other premature distributions.

There are two methods of granting hardship withdrawals from a 401(k) plan.

Under the first method, a determination of whether or not a participant qualifies for a hardship distribution is made based upon a review of all of the relevant facts and circumstances; this test is known as the facts and circumstances test.

Under the second method, certain types of expenditures and specific requirements set forth in the regulations are deemed to automatically meet the requirements of part (1) of the "immediate and heavy financial needs" requirement described above. This is known as the safe-harbor test and the types of expenditures that qualify are as follows: :

1. Payment of medical fees incurred by the participant, the participant’s spouse or any dependents of the participant (Note: withdrawals made in order to obtain medical care would also qualify);
2. The purchase of the participant’s principal residence (excluding mortgage payments);
3. Payment of tuition, educational fees and room and board expenses related to post-secondary education for the participant, the participant’s spouse or the participant’s children or dependents;
4. Payment of amounts necessary to prevent the eviction of the participant from his or her principal residence or foreclosure on the mortgage of the participant’s principal residence; or
5. Any additional events that may be prescribed by the IRS in the future.

Thrift/Savings Plans

Thrift and Savings plans have many of the same characteristics that are found in profit-sharing plans that include CODA or salary reduction agreements, except that Thrift plans provide for employee after-tax contributions instead of before-tax contributions. There are seven main characteristics of Thrift and Savings plans, and they are as follows: :

1. Employee participation is voluntary, and to participate the employee must agree to make contributions;
2. The employee has the option of selecting the level of contributions within a range established by the plan;
3. Employer matching contributions usually equal a fixed percentage of employee contributions;
4. Employer and employee contributions are usually made to a trust;
5. The employee usually has the option of choosing how his or her contributions will be invested (investment selections are limited to the types of investments permitted by the plan); the employee must have a minimum of three investment options; life insurance may be one of the employee investment options; the employee bears the investment risk.
6. Normal benefits (the distribution of the employee's fully vested account balance, including both employee and employer contributions) are payable in the event of retirement, death, disability or termination of employment; and
7. In-service distributions are usually permitted while the employee is still actively employed (such distributions may be limited in amount or may be subject to some form of penalty).

The typical "qualified" Thrift and Savings plan described above must comply with many of the same rules that apply to "qualified" profit-sharing plans; these rules are as follows: :

1. Eligibility: The plan's service requirement can't exceed one year (two years if full and immediate vesting is provided) and the attainment of age 21;
2. Nondiscrimination: The same nondiscrimination tests that apply to plans that have a CODA or salary reduction agreement also apply to Thrift and Savings plans; this means the ADP and ACP tests, but the ACP test is most pertinent to Thrift and Savings plans since it is the test that deals with after-tax employee contributions and matching employer contributions;
3. Employee Contributions: The plan must specify whether or not supplemental contributions will be permitted, the rules regarding an employee's right to change contribution rates or to suspend contributions, and the after-tax contribution amounts that will be permitted; for example, contributions will be allowed within a range such as 3% to 10%;
4. Employer Contributions: The plan must specify the nature of employer contributions, if any; for example, an employer matching contribution equal to a fixed percentage of employee contributions;
5. Forfeitures: If employer contributions are provided and such employer contributions are not fully vested immediately, the plan must specify how forfeitures will be allocated in the event that an employee terminates prior to being 100% vested in the employer contributions made on his or her behalf; the usual practice is to use forfeitures to reduce future employer contributions. However, if reallocation of forfeitures is permitted, such reallocation is usually based on the ratio of the participant's compensation to the total compensation of all remaining participants (reallocation of forfeitures based on account balances could result in discrimination and the IRS will only issue approvals on account balance reallocations one year at a time);
6. Investment of Funds: The plan must specify how funds are to be invested; typically, funds are not segregated and the plan trustee is responsible for investing funds on behalf of participants. The plan must allow participants to choose how their accounts are to be invested, and the conditions for changing investments;
7. Vesting (also see Forfeitures above): The plan must specify the vesting provisions that apply to employee and employer contributions (employee contributions are always 100% vested and the vesting of employer contributions must follow the same rules that apply to qualified retirement plans); the typical Thrift and Savings plan contains vesting provisions that are more liberal than the vesting provisions identified with the typical profit-sharing plan;
8. Withdrawal Provisions: The plan must specify that funds must accumulate for at least two years; in addition, the plan must specify any other limitations on withdrawals; for example, will withdrawals prior to death, disability, retirement, or termination of employment be limited to employee contributions? Will the plan allow some or all of the participant's vested employer contributions to be withdrawn? The plan must also specify any penalties (such as suspension of participation) that will be imposed if funds are withdrawn for any reason other than one of the normal distributions specified above;
9. Loans: If loans are permitted, the plan must contain the usual limitations that apply to loans from qualified retirement plans, that is, limited to the lesser of $50,000 or 50% of vested interest (except that a minimum $10,000 loan can be made regardless of whether or not it exceeds 50% of the participant's vested interest), and must be repaid within five years (unless the loan is for the purpose of purchasing the principal residence of the participant). The interest rate must be reasonable. Loans must be available to all participants on a nondiscriminatory basis;
10. Distributions: The plan must specify the manner in which distributions will be made, for example, the typical Thrift and Savings plan allows for distributions in the form of cash; however, it is possible for the plan to permit distributions in the form of installments or employer stock.

Defined-Benefit Plans

We have emphasized that one of the important requirements for a retirement plan to be qualified is for the plan to have definitely determinable benefits. "Definitely determinable" for a defined-benefit plan means that the benefit an employee will receive upon retirement must be determinable from a formula set forth in the plan instrument under which the pension plan operates. The benefit may be defined as a specific dollar amount or as a percentage of compensation. Both the employees and the employer can determine the benefit, either directly from the formula specified in the plan or from an actuarial computation.

A pension plan actuary is needed to determine the employer's annual contribution required to assure the accumulation of adequate funding of the employee retirement benefits promised under a defined-benefit plan. The calculation process involves a determination of the amount of money needed at the projected retirement age and date. A single premium to pay the monthly benefit for the assumed lifetime of each participating employee needs to be committed. Thus, the actuary must project the annual employer contribution based upon each participating employee's current age and the assumed investment yield for the committed funds.

To limit the use of qualified retirement plans as a way for highly-paid corporate executives to avoid income taxes, the government has set limits on the maximum annual retirement benefit that currently may be provided from a qualified defined-benefit retirement plan.

The maximum annual retirement benefit that is permitted under a defined-benefit plan at age 65, the normal retirement age, is $160,000 for 1999. The dollar limit on maximum benefits has been increased by cost-of-living adjustments as follows:

When a participant begins to receive retirement benefits prior to attaining his or her Social Security retirement age (SSRA), the dollar limit (indexed for cost-of-living increases) on maximum annual retirement benefits is reduced to the actuarial equivalent of the maximum annual retirement benefit commencing at the participant’s SSRA. In adjusting the benefit limits for payments beginning before SSRA, or for payment in a form other than a straight life annuity, the interest rate assumption cannot be less than the greater of 5% or the interest rate specified in the plan.

When a participant begins to receive retirement benefits after attaining his or her Social Security retirement age (SSRA), the dollar limit (indexed for cost-of-living increases) on maximum annual retirement benefits is increased to the actuarial equivalent of the maximum annual retirement benefit commencing at the participant’s SSRA. In adjusting the benefit limits for payments beginning before SSRA, the interest rate assumption cannot exceed the lesser of 5% or the interest rate specified in the plan.

The amount of contributions that the employer will be able to deduct in a defined-benefit plan is different than in a defined-contribution plan, where the maximum annual addition is the lesser of 25% of the employee's compensation or $30,000. In a defined-benefit plan, the employer deduction is the amount necessary to fund all the plan benefits that are calculated using the stipulated benefit limits. The contribution must be adequate to cover the promised benefits.

The Tax Reform Act of 1986 mandates that maximum retirement benefits for a retiring employee must be reduced by one-tenth (1/10) for each year of the employee's participation that was less than ten (10) years. This government-mandated reduction is known as a "service reduction." To avoid this problem, a defined-benefit plan may set the employee's normal retirement age as the later of age 65 or completion of ten years of participation in the plan.

An important design consideration in a defined-benefit plan formula is the method by which earnings are defined. Benefit calculations are made on the basis of some definition of earnings. There are two basic definitions of earnings used to calculate benefits under a defined-benefit plan formula. Both methods use an average of total compensation over a predetermined number of years.

Career Average Method: This method of determining benefits takes into account the entire history of a person's earnings while the person participated in the plan. When this method is used, an adjustment to the benefit for inflation will be made.

Final Average Method: This method of determining benefits calculates the retirement benefit by using an average of earnings over a specified number of years. The years used to determine the retirement benefit are typically the last three or five years of employment. However, the employee's annual benefit may not be greater than his or her average pay for the 3 highest consecutive years prior to retirement.

The final average method of calculating benefits usually will provide the retiree with a higher pension because the compensation figure used to calculate benefits is typically higher when final years or highest consecutive years of salary are used versus benefits that are based on a person's total career earnings. When career earnings are used, lower salary years are figured into the calculations. The career average method does not reflect the impact of inflation as well as the final average method; however, the career average method does give the employer control in determining when an inflation adjustment will be made. A drawback to the final average method of benefit calculation is that the cost of benefits will be more expensive for the employer. The higher expense is due to inflation and the higher benefit calculations. Higher-paid employees particularly will benefit more from the higher final pay method than the career average method of benefit calculation. This advantage for key employees will offset, at least partially, the disadvantage for the key employees (as corporate stockholders) having to pay the higher cost of the final-average method for the rank-and-file employees.

There are four basic benefit formulas used in defined-benefit plans to determine annual retirement benefits. The four formulas are: :

1. Flat amount formula: Benefits are determined based on a specified stated amount. Length of service is not a factor. For example, the plan formula may state that a flat benefit of $500 per month for a covered employee is provided. This type of formula is usually used in conjunction with another formula. The basic amount may be subject to a benefit reduction if the length of the employee's service is actually less than X number of years. Provided that there are no benefit reductions because of too few years of service, participants in a flat amount formula plan who earn the same compensation are promised the same retirement benefit.

2. Flat percentage of earnings: This formula states that benefits for covered employees are a specified percent of salary. For example, a benefit of 30% of earnings might be provided. This type of formula is used extensively in plans that cover salaried and clerical employees. It is used most frequently in final pay plans. It is not necessary to take an employee's service into account under this type of formula; however, it is common practice to require that an employee complete a minimum period of service prior to normal retirement date and that a proportionate reduction in benefits will occur in the event that the employee completes less than the required minimum service.

3. Flat amount per year of service formula: This formula provides an annual benefit that is a stated dollar amount for each year of covered employment. Under this type of formula, an employee must complete a minimum number of hours of service in a year in order to receive a full benefit credit. Under such plans, it is typical to require significant minimum hour requirements (1,600 and 1,800 are common minimum hour requirements) and an employee who works less than the minimum requirement usually receives a proportionate credit for the actual hours worked. Federal tax law requires that a proportionate credit be given to any employee who completes at least 1,000 hours of service during the plan year. A typical flat amount per year of service formula might be $15 per month for each year of covered service (defined as a year in which the employee works 1,800 hours or more). An employee with 30 years of covered service would receive a monthly pension benefit of $450 ($15 x 30). This type of formula is typically found in union plans.

4. Percentage of earnings per year of service formula: This type of formula gives specific recognition for years of service as well as earnings. This type of formula is often called a unit-credit or unit-benefit formula. Under this type of formula, an employee receives a benefit credit (can be a fixed dollar amount but is usually a percentage of earnings) for each year of service that the employee completes under the plan. In addition to a benefit that is based upon future service, a unit-credit formula can also include a benefit that is based on past service. The amount of benefit credited for past service is usually lower than the amount of benefit credited for future service. For example, a unit benefit formula that recognizes past service might be stated as follows: ½ of 1% of participant's earnings on the effective date of the plan, plus 1% of earnings times each year of service completed while the employee is a participant in the plan. A unit service or unit-benefit formula can be based on either a career average or a final average definition of compensation.

   • The unit-benefit formula favors employees with more years of service. In the unit-benefit formula, credit may be given for years of service that were completed before the plan was established. There may be a maximum number of years that will be counted for annual benefit calculations.

   • If the older employees do not have a significant number of years of service, the unit benefit formula can work against these older employees, who may also be the key employees. When the benefit is based on years of service for these employees, the benefit will be smaller (20 years x 2% is quite different from 5 years x 2%).

The actual experience of a defined-benefit plan will determine the ultimate cost of benefits. The employer's annual contributions, however, will vary based on the funding assumptions used to determine the normal cost of the plan, such as benefit provisions, the age and sex of participants, and the number of years of service. In their attempt to estimate the ultimate number of employees who will eventually be entitled to receive benefits under the plan, actuaries use "actuarial assumptions" such as (a) the mortality rate among active employees, (b) the morbidity (disability) rate among active employees, (c) the turnover rate (employee terminations both voluntary and involuntary), and (d) the ages at which employees will retire (takes into account early and late retirements).

The employer's annual contributions are determined by the actuary, and these annual contributions by the employer are really the "employer's annual costs." The pattern of these employer contributions (employer's costs) is determined by the actuarial cost method selected, and the actuarial assumptions.

The actuarial funding approach used for defined-benefit plans means that the funding of benefits (employer costs) is incurred during the years that the employee participates in the defined-benefit plan. Thus, the older employees and even the middle-aged employees have a more favorable situation than if their pension benefits were to be funded under a defined-contribution plan. These senior employees have their defined benefits funded over a short period of time because the employer must accelerate the funding process with very generous annual funding payments.

Defined-benefit retirement plans commit the employer to provide each participating employee a future benefit of some specific dollar amount (typically determinable from a formula). To assure that adequate funds will be available to provide these promised benefits, the plan actuary computes the significant variables and determines what the employer should contribute each month (or other time period) so the employer will have enough dollars to pay the promised benefits as each employee reaches retirement age. However, if mortality, investment income, expenses, and other actuarial factors differ from what the plan actuary projected, then the amount of dollars accumulated by the employer may be too little or too much, relative to the retirement benefits to be paid. The government provides a formula to be used by the plan actuary to calculate the minimum amount that the employer must contribute to adequately fund the retirement benefits promised under a qualified defined-benefit pension plan. A qualified pension plan that fails to comply adequately with the government's funding standard will be required to pay a 10% penalty. To help keep things under control, the actuary makes use of the concept of the "funding standard account."

The funding standard account indicates what the account balance would be if all the actuarial factors actually worked out precisely as the actuary projected they would. If there is a difference between projections and results, the pension plan trustee must initiate action to correct any short-fall by requiring increased employer contributions. If there is a surplus of investment assets relative to benefit liabilities, the trustee can have the employer reduce the periodic contribution. The funding standard account is a standard by which the plan actuary can determine the extent to which a pension plan is over- or under-funded in relation to its expected or estimated performance. Thus, it may be possible for the employer to make contributions greater than the required minimum to fund future pension benefits, so that the minimum contributions otherwise required in future years may be reduced.

Qualified retirement plans other than defined-benefit plans that are required to meet the government's "minimum funding standard" each year are money-purchase plans and target benefit plans. The government does not require the employer to meet a "minimum funding standard" for any profit-sharing plan that the employer may have.

It will be helpful to examine some of the actuarial assumptions used by the pension plan actuary to determine the impact of the assumptions on the amount of the employer's annual contribution to a defined-benefit pension plan.

A high interest assumption means that interest is assumed to provide a large percentage of the amount needed at retirement for full funding. A low interest assumption means that interest is assumed to provide a smaller percentage of the amount needed at retirement for full funding. If all other variables remain the same, the lower the assumed rate of interest, the higher the annual contribution required to fund benefits under the plan.

The turnover rate is the probability of termination of employment within a group of employees having certain identifiable characteristics. Age is the characteristic that has the greatest effect on turnover rates. The younger an employee is, the higher is the probability of termination. The turnover rate may also include termination rate estimates based upon morbidity (sickness) and mortality. The higher the estimated termination rate, the fewer the number of employees who are assumed to remain in the group to receive benefits at normal retirement age or whose benefits will vest prior to retirement age. The fewer the number of employees who are expected to remain until vesting occurs or until retirement age, the smaller the amount of funding required.

The increasing of salary levels during certain inflation years has emphasized the need for pension plan administrators to consider the effect of future wage increases during an employee's working life. If the plan's funding assumptions take future wage increases into consideration, the plan is much more likely to avoid future funding inadequacies. Initially, contributions are increased for younger participants because of projected increases in compensation. This allows more time for compound interest to work and, ultimately, the cost of funding benefits for this group is reduced.

Actuarial cost methods are assumptions the actuary uses when calculating the cost of benefits. There are two types of actuarial cost methods.

Accrued Benefit Cost Method: Also referred to as the Unit Credit, Unit Cost, or Single Premium method. Under this type of actuarial cost method, costs are based on those benefits actually earned or accrued as of the date of the cost determination. Unlike the projected method, an accrued benefit cost method only takes into account what has already happened and does not try to estimate or project future costs. An accrued benefit cost method is best suited to plans that provide unit-credit or unit-benefit formulas based on a career average definition of compensation. The normal cost of funding each successive increment of benefit under an accrued benefit cost method increases with the age of the participant because of the fewer years for investment income to be earned. An accrued benefit cost method may also be used in plans that provide a flat dollar amount per year of service benefit formula.

Projected Benefit Cost Method: In contrast to an Accrued Benefit Cost Method, a Projected Benefit Cost Method attempts to project the total benefits that will be paid over some future time and spreads the cost of funding these benefits evenly over that future period of time. A projected benefit cost method differs from the accrued benefit cost method in two important respects: first, the normal cost accrual under a projected benefit cost method is based on total prospective benefits rather than on a specific accrued benefit which may be related to a specific period of service. For example, the actuary estimates that the prospective benefit payable to an employee at normal retirement in 20 years is $1,000 per month. Under a projected benefit cost method, the actuary will estimate the cost of funding that total prospective benefit and spread the cost evenly over twenty years. This is in contrast to an accrued benefit cost method in which a participant, at the end of the current plan year, may earn or accrue a benefit of $50 per month payable at age 65 and the actuary will estimate the cost of funding that specific increment of accrued benefit. Second, all projected benefit cost methods can be characterized as level cost methods, in contrast to accrued benefit cost methods which attribute the cost of funding each increment of benefit to the year in which it was earned. Projected benefit cost methods are divided into individual level cost methods and aggregate level cost methods.

When the corporate employer installs a pension plan for the first time, there may be employees who have already had several years of employment service with this employer. The generous corporate employer may, out of the goodness of the corporate heart (or the pressure of a strong union), agree to give these valued employees credit for their past service in determining the employees' monthly retirement benefit. The cost of providing this past service benefit may be included in the employer's annual cost (and funded) under either the projected benefit cost method or the accrued benefit cost method. Another approach often used by corporate employers is to recognize the obligation to fund this past service benefit by creating on the corporate balance sheet a liability account known as "supplemental liability." The government permits the employer to amortize or fund this supplemental liability over a maximum of 30 years.

It is important to know when the accrued benefit cost method and the projected benefit cost method are used. The accrued benefit cost method is usually used in plans with unit-benefit career average pay formulas but can also be used with flat amount per year of service formulas. The normal cost only reflects benefits earned or accrued in the current year. The normal cost of benefits under the accrued benefit cost method increases each year of the plan because the dollars deposited have fewer years to earn investment income before the dollars are needed to pay benefits. The projected benefit cost method is used with either flat benefit or unit benefit formulas. The normal cost under the projected benefit cost method projects total plan benefits that may be paid (not just currently earned benefits). The normal cost of plan benefits under the projected benefit cost method is more level than under the accrued benefit cost method.

Cash Balance Pension Plans

Cash balance pension plans are defined-benefit plans that also have features usually associated with defined-contribution pension plans. Cash balance pension plans are considered to be defined-benefit plans because the employer guarantees the annual investment return for the employer's annual stated contribution. Thus, the employer guarantees that, at retirement date, the employee will have a specific cash balance that can be used to provide the employee a specific annual retirement benefit for the rest of his or her life. The employer's annual contribution cannot exceed the government's rule for defined-benefit plans: The annual funding must be limited to the amount of dollars needed to provide the employee annually $130,000, as indexed for 1998. The law permits the employer to contribute annually on behalf of each eligible employee a flat dollar amount or a fixed percentage of each eligible employee's compensation. The employer's plan is permitted to vary the amount the employer contributes directly by the employee's age and by length of service. The dollar amount contributed on behalf of each employee may be integrated with Social Security.

Guaranteed Investment Return. The plan document may set forth a fixed investment return that is between 7.5% and 8.5%. Alternatively, the plan document may specify a variable investment rate that varies with the federal government's bond rates or the Pension Benefit Guaranty Corporation's rates. For those years when the investment return is less than the guaranteed rate of return, the employer's contribution must be increased so the accumulating cash balance in the employee's account equals at least the amount that is the product of the specific annual employer contributions and the guaranteed investment return. However, if the actual investment return is greater than the rate guaranteed by the employer, the excess accumulates to the benefit of the employee.

The cash balance pension plan is being used by employers to modify an existing defined-benefit plan without having to incur the cost of actually terminating the existing defined-benefit plan. The employees have the security of the guaranteed annual investment return and the guarantees of the PBGC. Because the plan does not guarantee a specific defined benefit for the employee at normal retirement age, the plan is not as favorable for the older employee as a conventional defined-benefit plan. However, the plan treats younger employees more favorably than the older employees because the younger employees have a longer period of time to benefit from the many years of employer contributions and the guaranteed investment return. This eliminates the investment risk for the employee, which is the great disadvantage of a defined-contribution plan for an employee. An unfavorable feature of the cash balance plan for the employer is the need to perform the actuarial calculations and to fulfill the annual administrative requirements for a cash balance plan.

403 (b) Plans, Tax-Sheltered Annuities (TSA)

A tax-sheltered annuity (TSA) is a Section 403(b) retirement plan that is given favorable federal income tax treatment. Such plans are limited to employees of public school systems and to employees of qualified tax-exempt (501(c)(3)) organizations, which include both public charities and private non-operating foundations. An important decision for the employee and the employer is whether the TSA plan is to be elective, non-elective, or both. If the plan is employee-elective, the employee is permitted to make salary-reduction contributions. When the contribution is made as part of a salary-reduction agreement, the contribution is excluded, within limits, from the employee's taxable income. The annual elective (salary-reduction) contribution limit for a TSA is $10,000. Excess contributions in any year are included in the employee's gross income. Payments made to a TSA by payroll deduction, instead of salary reduction, are not excludible from the employee's income.

If the employee elects to use the salary reduction method for a TSA, the reduction must be made under a legally binding agreement between the employer and the employee. Also, the agreement must be irrevocable as to salary earned while the agreement is in effect. For years beginning after 1996, a participant in a TSA plan may enter into more than one salary reduction agreement with his or her employer. However, the employee may terminate any agreement at any time with respect to amounts not yet earned. The salary reduction may be a fixed dollar amount or a percentage. Participants may continue to accept tax deferred salary reductions after age 70-1/2, but are subject to minimum distribution rules.

Amounts paid for a TSA by a salary reduction are still subject to Social Security (FICA) taxes. This is so even though the salary reduction is not includible in taxable income. If the plan is set up so the amount is paid by the employer (not a salary reduction plan), those dollars are not subject to the FICA tax.

403(b) plans which permit salary reduction contributions only are subject to one nondiscrimination requirement. This rule stipulates that, if the plan permits all employees (excluding certain employees, such as those who are participants in a Section 457 deferred compensation plan of the employer, a qualified cash or deferred Section 401(k) plan of the employer or another 403(b) plan of the employer) the right to elect to have the employer make contributions to a 403(b) plan under a salary reduction agreement, the plan will be automatically classified as nondiscriminatory. A 403(b) plan is permitted to deny participation to any employee who is unwilling to make a minimum annual salary reduction contribution of $200.

There are limits on the amounts that may be excluded from income by an employee participating in a TSA plan. There are three types of limits to be considered: (a) the "exclusion allowance," (b) the overall section 415 limit on annual additions which includes the special "catch-up" contribution elections, and (c) the limit on elective or salary reduction contributions.

The exclusion allowance for annual contributions to a TSA salary reduction plan is calculated as follows: (a) multiply the employee's current year includible compensation by 20% (Prior to 1998, “includible compensation” was the employee’s compensation net of any salary reduction contribution to a TSA; beginning in 1998, “includible compensation” will include salary reduction contributions to a TSA plan); (b) multiply the result calculated in (a) above by the number of years of the employee's service; (c) subtract from the result in (b) above the total excludible prior years' contributions. The remainder after this subtraction is the employee's exclusion allowance for the current taxable year. Only compensation from the current employer may be used. Compensation received from other prior employers must be ignored.

An employee of an educational organization, hospital, home health service agency or a health and welfare service agency may elect to have a his or her exclusion allowance computed in the same manner as the maximum annual additions to the account of a participant in a defined contribution plan. In general, this election permits the employee to use the maximum annual additions limitation (the lesser of $30,000 or 25% of compensation as his or her exclusion allowance). Note: Don’t forget that the annual dollar limit on salary deferral contributions must also be taken into consideration. See Section 25 for special elections that a TSA participant may use to increase the overall Section 415 limitations on annual additions.

The maximum annual salary reduction for TSAs is limited to $10,000 beginning in 1998. The $10,000 limit is now subject to annual cost-of-living increases. The $10,000 limit is also the maximum aggregate limit on amounts that can be excluded from income by a participant who makes contributions under a TSA plan sponsored by an employer plus any other plan sponsored by the same employer, including a 401(k), SARSEP established prior to 1997, or a Simple IRA plan. For example, if $7,000 is contributed under a 401(k) plan, only $3,000 could be contributed under a TSA plan (See Assignment 8, paragraph 15). Employer contributions are not affected by this limit.

Employees who have completed 15 years or more of service with an educational organization, hospital, home health service agency, church, association of churches or a health and welfare service agency may elect a special catch-up rule to increase the maximum dollar limit on salary reduction contributions. If the special catch-up rule is elected, the salary reduction dollar limit is increased by the least of: :

1. $3,000 annual limit
2. Lifetime limit of $15,000 minus amounts not included in income for prior taxable years by reason of this rule.
3. $5,000 multiplied by the number of years of service by the employee, reduced by the elective deferrals made on behalf of the employee.

The overall limit on the annual amount ("annual additions") that may be contributed to a TSA is the lesser of 25% of the employee's compensation or $30,000. The "annual additions" are composed of:

1. Employer contributions (including salary reduction amounts), and (b) nondeductible (voluntary) employee contributions.

   Employees of an educational organization, hospital, home health service agency, health and welfare service agency or church organization may elect one of three alternatives in order to increase their overall annual additions limit under Section 415.

   The three alternative limitations are as follows: :

   1. The first alternative limitation is available only once and only in the employee’s year of separation from service. Using this special election, the employee’s exclusion allowance may be calculated as the limitation on annual additions but without the 25% of compensation limit. The $30,000 limit, adjusted for inflation, would continue to apply and the exclusion allowance would be modified to include only years of service and employer contributions during the ten-year period ending upon the date of separation. Presumably, the employee’s annual earnings would be at their highest during those last ten years of employment and an annual exclusion allowance calculated on the basis of those years should produce a higher exclusion allowance. Note: If the contribution for that last year is an elective deferral, the dollar limit on elective deferrals will continue to apply.

   2. The second alternative limitation substitutes the least of the following for the annual additions limitation: :
      1. $4,000, plus 25 percent of the employee’s includible compensation for the taxable year with or within which the limitation year ends;
      2. The exclusion allowance for the taxable year with or within which the limitation year ends; or
      3. $15,000.
   3. The third alternative limitation is the same as the normal overall limitation found in Section 415 (the lesser of $30,000 or 25% of compensation). This alternative allows the employee to use the annual addition limitation of Section 415 as his or her exclusion allowance. See Section 22.

   Only one alternative limitation may be elected in any given year; once an election has been made, it may not be changed in any subsequent year.

   The following special rules may be used to calculate the exclusion allowance for members of the clergy and other church employees: :

   1. In determining the exclusion allowance, the person may count all years of service with the organizations that are part of a particular church as years of service with one employer. This is a great advantage in many cases. If public school teachers change from one public school district to another, it is considered a change of employer. Public school teachers and other non-church employees can no longer use their past service credit, after they change employers.
   2. If an employee's adjusted gross income is $17,000 or less, he or she may elect as an alternative exclusion allowance the lesser of $3,000 or his or her "includible compensation."
   3. Church employees may use any one of the three special "catch up" provisions described in paragraph 25(b) above.

      Also, church employees can catch up by electing annual additions of a maximum $10,000 in any one year (subject to a $40,000 lifetime maximum). The $10,000 exception may not be used in the same year the employee elects the (1) alternative described in paragraph #25(b) above, this assignment.

   An excess contribution to a TSA must be included in the employee's gross income. Excess contributions that are used to purchase an annuity policy escape the excess contributions tax. Excess contributions to a custodial account that are used to purchase stock of a regulated investment company are subject to a 6% tax.

   In addition, even though an excess amount contributed to a TSA plan has been included back in the employee’s taxable income, such excess contribution must be considered for purposes of computing the employee’s exclusion allowance for future taxable years. This means that the excess TSA contribution will have the effect of reducing the employee’s exclusion allowance even though the excess was added back to the employee’s taxable income.

   The two types of funding vehicles approved for TSAs are: (a) annuity contracts (either fixed dollar or variable), and (b) the stock of regulated investment companies. Face amount certificates issued by a few mutual funds are considered to be annuity contracts. Also treated as annuity contracts are life insurance policies that provide only incidental life insurance protection (retirement income policies).

   Tax consequences of including life insurance protection in a TSA are as follows: the employee must include in gross income each year the one-year term cost of the pure protection provided by the employer. Thus, the PS 58 rates are applicable. The sum of these annual costs will be considered as part of the employee's cost basis in determining the employee's taxable income after retirement.

   Under Section 72(p) of the IRC, loans may be made up to the lesser of 50% of the present value of a participant's vested interest (subject to a minimum $10,000 loan) or $50,000, and such loans are not treated as a taxable distribution, provided that the loan is paid back within five years or, in the case of loans used to acquire a principal residence, the loans are paid back within a reasonable period of time. If the loan does not meet the 5-year or principal residence requirement, the entire loan is a taxable distribution. If the loan meets the requirement but exceeds the dollar limit, the amount in excess of the dollar limit is treated as a taxable distribution. The determination of the dollar limit is related to the participant's outstanding loans from the plan and to his or her vested interest in the plan. The loan must be paid off with level amortization payments over the period of the loan, with quarterly payments as a minimum.

   Early withdrawals from TSAs, whether invested in annuity contracts or mutual fund custodian accounts, are not allowed unless the withdrawal comes under the age, death, disability, or severance from service exceptions. Early withdrawals from TSAs for hardship reasons will be limited to dollars that already were in the participant's account on 12/31/88 and to contributions (but not investment income) made under a salary-reduction program after 12/31/88. Earnings from salary-reduction contributions do not qualify for withdrawal. Early withdrawals will be subject to federal income taxes. The withdrawals also will be subject to the 10% penalty tax unless they qualify under one of the exceptions.

   Distributions from TSA plans are taxed in much the same way as distributions from pension or profit-sharing plans. Any TSA contributions on which income tax has already been paid, for example, accumulated PS 58 costs, and contributions in excess of the employee's exclusion allowance, constitute a cost basis which may be recovered free from income taxation. The remaining TSA contributions and earnings are subject to ordinary income taxation.

   An exception to the normal pension and profit-sharing distribution rules is made in the case of a lump-sum distribution from a TSA plan. The special averaging treatment available to other qualified plans is not available to lump-sum distributions from a TSA. For annuity payments, the split between taxable and non-taxable distributions is determined using the conventional Section 72 annuity rules (tax-free portion of annuity income is spread evenly over the annuitant's life expectancy). Annuity payments received after the annuitant's life expectancy is reached are fully taxable.

   The required beginning date for distributions from a TSA, a qualified pension or profit sharing plan or a governmental plan (Section 457) is April 1 of the calendar year following the later of the calendar year in which an employee, other than a 5% owner, attains age 70½ or actually retires. Participants in qualified pension or profit sharing plans who are 5% owners and participants in IRA, SEP, SARSEP or Simple IRA plans are required to commence receiving benefits not later than April 1 of the calendar year following the year in which the participant attains age 70½.

   Upon the employee's or ex-employee's death, the value of the annuity or other payment receivable under the terms of the TSA is included in the annuitant's gross estate.

Section 457 Plans

A Section 457 plan is a deferred compensation plan that allows the employees of state and local governments to make tax-deferred salary reduction contributions. Such contributions are limited to a maximum of 33-1/3% of includible compensation or $7,500 ($8,000 as of 1998), whichever is less. Distributions from a Section 457 plan may be deferred until the employee attains age 70-1/2.

The organizations that may sponsor a Section 457 plan are state and local governments, a political subdivision of a state, or any agency or instrumentality of a state or municipality. Section 457 plans may also be sponsored by tax-exempt organizations. For taxable years beginning after December 31, 1987, churches may not sponsor Section 457 plans for the benefit of their employees. Participation in a Section 457 plan is restricted to employees or independent contractors. Any amount of compensation, up to the limits discussed in paragraph #36 above, may be deferred under a Section 457 plan for any calendar month, but only if an agreement to defer such compensation was in effect before the beginning of the month.

Distributions under 457 plans are prohibited prior to age 70-1/2, unless there is separation from service or an unforeseen emergency. Distributions under nongovernment plans are controlled by the same rules that apply to TSAs and qualified plans as to beginning dates for distributions and minimum amounts to be distributed annually. Government plans are not required to conform to these distribution rules.

The term "includible compensation" is defined in Section 457 plans in much the same way as it is in TSA plans. In a Section 457 plan, includible compensation means compensation for services performed for the employer which is currently subject to income taxation. Includible compensation does not, therefore, include amounts that have been deferred as a contribution to the plan. Note that 25% of compensation before a salary reduction under a Section 457 plan is the same as 33-1/3% of compensation after the salary reduction. Assume employee's compensation before salary reduction was $32,000. A 25% salary reduction would mean an $8,000 salary reduction. This $8,000 reduction is 33-1/3% of $24,000 ($32,000 minus $8,000 salary reduction).

Section 457 plans are not required to include provisions that prohibit discrimination. In addition, the assets of a Section 457 plan (including all salary deferrals and any earnings on such deferrals) must be owned by the employer and must be subject to the claims of the employer's general creditors.

A Section 457 plan may provide for catch-up contributions which allow participants who contributed less than the maximum amount in previous years to make up for some of the lost deferrals. In each of the last three years prior to the normal retirement age specified in the plan, the catch-up rules permit a participant to defer a maximum of $15,000. Basically, this amounts to an additional $7,500 deferral on top of the $7,500 cap on normal deferrals to a Section 457 plan. For purposes of the catch-up rules, the 33-1/3% limit is ignored.

Amounts deferred from compensation under a Section 457 plan are not subject to income taxation until the year in which such deferrals are paid or otherwise made available to the participant. Amounts deferred from compensation under a Section 457 plan are, however, subject to FICA and FUTA taxation at the time of deferral.

Benefit payments from Section 457 plans represent wages and are subject to ordinary income taxation; in addition, the regular income tax withholding rules apply. Lump-sum distributions are also taxed as ordinary income and there is no special tax treatment available for such distributions from a Section 457 plan.

SIMPLE Plans

The Small Business Job Protection Act of 1996 introduced Simple Plans (Savings Incentive Match Plans for Employees). A Simple Plan can be structured as either a Simple IRA or a Simple 401(k) plan. These new plans may be funded with individual retirement accounts and annuities, the same as permitted with SEPs.

The government has prescribed the following requirements for SIMPLE: (a) full vesting immediately, (b) neither life insurance nor collectibles may be used for funding, (c) participants are not permitted plan loans, (d) only employers with 100 or fewer employees are eligible for a SIMPLE (an eligible employee must receive $5,000 or more compensation in any two prior years and must reasonably expect to receive at least $5,000 in compensation during the current year), (e) eligible employers are forbidden to have any qualified plan, SEP or 403(b) plan, (f) employees may elect to contribute up to $6,000 annually before taxes (to be indexed in $500 increments in future years), (g) nondiscrimination testing is not imposed and top-heavy rules do not apply, (h) mandatory employer contributions are subject to the following requirements: (i) the employer can match dollar for dollar the first 3% of compensation the employee elects to defer, or (ii) the employer may make an annual nonelective contribution of 2% of compensation for all eligible employees. Note that those employers who elect to make matching contributions may reduce the 3% to as little as 1% if the participants are informed of the reduction a reasonable time prior to the beginning of the calendar year. The reduction to a low of 1% is permitted only for 2 of any 5-year period.

Simple IRA’s are employee salary reduction programs combining employee contributions with employer matching or nonelective contributions. The limit on contributions to SIMPLE IRAs was increased to the limit that applies to a qualified salary reduction arrangement, the lesser of 15% of compensation or $30,000. The employee’s annual contribution limit is $6,000, plus the employer’s contribution. The employee contribution limit is lower than the employee contribution limit for a 401(k), $10,000.

The following rules apply to distributions from SIMPLE IRAs: :

1. Ordinary income tax rates apply to withdrawals.
2. A participant is permitted to have rollovers from a SIMPLE IRA to another SIMPLE IRA or (after participating in a plan for two years) to an individual IRA or SEP outside the SIMPLE plan.
3. The SIMPLE IRA is treated as an individual IRA, if participation is terminated after a minimum of two years' participation.
4. If a premature distribution (prior to age 59½) is made within the two-year period beginning on the date on which the employee first participated in any Simple IRA sponsored by his or her employer, the penalty tax is increased from 10% to 25%.
5. Borrowing is prohibited.
6. No protection is provided for SIMPLE IRA plans under the anti-creditor provisions.
7. The government’s simplified reporting requirements apply to SIMPLE IRA plans.

SIMPLE 401(k)

The eligibility requirements for SIMPLE 401(k) plans are approximately the same as for other “qualified” plans. But a different set of nondiscrimination tests must be passed than are applicable to qualified 401(k) plans. Basically, a SIMPLE 401(k) plan complies with the nondiscriminatory tests by complying with the same “safe harbor” requirements mandated for the SIMPLE IRA, except the option to reduce the employer’s match to less than 3% is not available to the SIMPLE 401(k) plan.

As the result of the Small Business Job Protection Act of 1996, a special set of contribution and nondiscriminatory rules were made applicable to SIMPLE 401(k) plans. :

1. The elective deferral for each participating employee does not exceed $6,000;

2. The employer matches employee elective deferrals dollar for dollar, up to 3% of each employee’s compensation, or the employer makes a nonelective contribution equal to 2% of the compensation of each eligible employee who received at least $5,000 in compensation from the employer in the current year;

Since distribution from SIMPLE 401(k) plans are treated generally in accordance with qualified plan rules, distribution rules differ from SIMPLE IRA rules in the following respects: :

1. In-service withdrawals are possible under conditions of hardship.
2. Borrowing is permitted.
3. The usual anti-creditor (anti-garnishment) provisions apply as for other qualified plans.

Pension Law Changes

It is important for you to keep up with changes in the pension laws. With the increased Congressional attention to individual retirement savings, several potential changes will most likely occur. Specifically, the trend is to permit individuals to save larger amounts through elective retirement plans.

Both the House of Representatives and the Senate are considering increasing the annual contribution to individual IRA accounts from $2,000 to $5,000. The contribution limit to a 401(k), currently $10,500, would also be increased to $15,000.

Legislation would also permit individuals over 50 years of age contribute additional funds, in excess of the $15,000 annual limit, to their 401(k) plans. The House of Representatives “catch up” provision would allow older individuals to contribute $5,000 per year in addition to the annual limit. The Senate provision would allow an additional 50% of the annual contribution limit. Catch up provisions currently are available in 403(b) plans, but were never available to participants in 401(k) plans.

There are also provisions in the pending legislation to permit individuals to elect to have all, or part of their 401(k) contributions treated the same as Roth IRAs. The contributions would not reduce the current years taxable income, but all distributions would be tax-free.

Integration of the Qualified Plan with Social Security

Since Social Security contributions and benefits are intentionally skewed in favor of lower-income employees, the IRS allows the employer to offset this discrimination by integrating his or her qualified retirement plan with Social Security. Any type of qualified plan except an ESOP may be integrated with Social Security. The effect will be to provide, through the combination of both Social Security and the qualified plan, the same overall percentage of benefits and contributions to all employees relative to their income levels. The integration rules are very complex, however, and are designed to prevent the retirement plan from becoming excessively discriminatory in favor of the highly-compensated employees.

Integration Level: In a qualified retirement plan that is integrated with Social Security, the term "integration level" refers to the level of participant compensation specified in the plan at or above which the pension plan's contribution or benefit rate is increased, compared to the rate applied to the level of participant compensation below this specified level. In the case of defined-contribution plans, the employer may not select an integration level that exceeds the Social Security taxable wage base that was in effect on the first day of the plan year. In addition, if the employer selects an integration level that is lower than the current Social Security taxable wage base, the amount of the maximum excess contribution percentage must be reduced. In the case of defined-benefit plans, the integration level is each employee's covered compensation for Social Security purposes.

Covered compensation represents the average level of compensation upon which Social Security benefits are based. Covered compensation is the average of the maximum Social Security taxable wage bases for the 35-year period ending with the last day of the calendar year in which an individual attains Social Security retirement age. In plan years beginning before 1995, qualified plans may use the 35 calendar years ending on the last day of the calendar year preceding the year in which the individual attains Social Security retirement age.

The taxable wage base is the maximum amount of compensation on which Social Security taxes (other than for Medicare) are paid. This amount is indexed each year ($72,600 in 1999). The Social Security tax rate for retirement, disability, and survivorship benefits is 6.2% of the taxable wage base. The rate for the Medicare portion is 1.45% of all earned income. These rates are paid both by the employer and by the employee.

For that portion of an employee's compensation that falls below the integration level, the employer will contribute a base contribution percentage. For that portion of an employee's compensation that exceeds the integration level, the employer will contribute the base contribution percentage plus an excess contribution percentage. In the case of an integrated defined-contribution plan, the "permitted disparity" rules require that the excess contribution percentage may not exceed the base benefit percentage by more than the lesser of (1) the base contribution percentage, or (2) 5.7%.

In the case of an integrated defined-benefit plan, a base benefit percentage will be applied to the amount of each employee's compensation that is below the plan's integration level. A base benefit percentage plus an excess benefit percentage not to exceed 26.25% will be applied to the amount of each employee's compensation that exceeds the plan's integration level. (At the heart of this integration rule is the assumption that Social Security benefits paid to a retired worker equal 26.25% of the worker's covered compensation.) As a result, the permitted disparity between the base benefit percentage and the excess benefit percentage may not exceed the lesser of (1) the plan's base benefit percentage, or (2) 3/4 of 1% for each year of service with the employer, up to a maximum of 35 years. This means that the permitted disparity may not exceed (35 x .75), or 26.25%. Thus, one example of an acceptable integrated defined-benefit formula would be 26.25% of a worker's compensation below the plan's integration level, plus 52.50% of the worker's compensation above the plan's integration level.

In a defined-benefit plan, a second method of integration is allowed, called the offset method. This method allows a reduction in the plan benefits for an employee by a percentage of the Social Security retirement benefits he or she will receive at age 65. Although the details differ for unit-benefit plans vs. flat benefit plans, in no case may the reduction exceed 50% of the employee's benefits from the qualified plan.

Investment Suitability for Qualified Retirement Plans

Once the type of qualified plan has been selected and implemented, the investment process begins. Special care must be taken in the selection of an investment manager. Strict ERISA guidelines must be followed when investing plan assets. Certain fiduciary responsibilities are given to the investment manager. The manager must make prudent investments and avoid any "prohibited transactions."

Any person who has any control over plan assets is considered a "fiduciary" of the pension plan. These people must act in the best interest of the plan and plan participants. People who simply perform accounting or actuarial services for the plan trustee (or fiduciary) for a fee are not fiduciaries.

When constructing a portfolio for a pension plan, you go through a construction process similar to the process that would take place for an individual portfolio. The factors to consider include time horizon, liquidity, marketability, diversification, risk tolerance and any possible tax consequences.

Pension portfolios must be diversified to maximize performance at a low level of risk of benefit loss. The portfolio should be reviewed on a regular basis and changes made to the investment allocation according to market conditions.

Investments that are suitable for pension plans must be selected. Some types of investments are definitely not suitable for qualified plans. For example, a tax-free municipal bond would not fit into a pension portfolio because of the qualified status of the plan. The income earned by pension plan investments is deferred from taxation until distributed. Therefore, there is no reason to accept the lower annual yield associated with municipal bonds.

Liquidity is an important consideration and necessary in qualified plans. The conversion of assets into cash may be necessary to pay annuity benefits and lump-sum settlements, as well as withdrawals and participant borrowing. However, the transaction expense of short-term liquid investments drives up investment expenses.

A properly diversified portfolio will have some assets placed in higher risk investments (for example, 20% of assets) in order to maximize return. The higher risk investments are generally securities that provide good return, keep pace with inflation, but have considerable volatility with respect to market value.

The Ibbotson & Singuefield investment return study notes the importance of proper investment analysis for pension plans. The major requirements of pension plan investments are: (a) stability in price, (b) an inflation hedge and adequate purchasing power, and (c) liquidity. This study examined the real rates of return for common investments in pension plans. The study found that, for the period 1926-1995, common stocks showed a real rate of return of 7.2%, while U.S. Treasury bills showed only a real rate of return of 0.6%. Obviously, the lack of any capital gain from owning U.S. Treasury bills made the impact of inflation a significant deflater of real return.

Ignoring the impact of inflation, for the period 1926-1978, common stocks achieved an impressive 10.3% rate of return, as compared to only 3.7% for U.S. Treasury bills. However, in some years, common stocks registered severe declines in market value. For example, in 1974, the S&P 500-stock average declined 26 percent. For the period 1926-199