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Case Study – Savings

You are a newly hired analyst at a top company

Your starting salary is $80,000 year

You are attempting to save about 10% of your income

You have the following options for savings and investment.
1. A Company 401K Plan that matches the first 6% Pretax Contributions at a 50%
Match rate
2. Your own Individual Retirement Account (IRA) with a balance of $5,500.
3. Your own Roth IRA with a balance of $1,250.
4. Your brokerage account with a balance of $2,500
Based on information in the course, how much would you save each
year and in which savings options would you put the money?
Profit Sharing and
Savings Plans
March 7, 2019
Instructor : Vincent Walker
Email: [email protected]
• Profit Sharing Plans
• 401K Plans
• Individual Retirement Accounts
• Common Misconceptions about 401Ks
The 401K Plan
• A 401(k) plan is a qualified plan with a cash-or-deferred arrangement
• CODAs are permitted with profit sharing plans, including stock bonus
plans and ESOPs.
• Prior to the establishment of 401(k) plans, employees did not have
the option of deferring compensation into a retirement plan on a
pretax basis
• Retirement plans were funded almost entirely by employers
• Some companies offered “thrift” plans, which allow employee
contributions of after-tax dollars, not pretax dollars as with 401(k)
• A salary reduction agreement is one type of cash or deferred
election, and allows a participating employee to contribute future
compensation into a 401(k) plan
The 401K Plan
• You often hear individuals refer to their “401(k) plan,” but in reality
401(k) provisions must be combined with either:
• A profit sharing plan (including stock bonus plans and ESOPs), or
• A “SIMPLE” plan.
• Currently, these are the only two plans that offer 401(k) provisions
• In a nutshell, a profit sharing 401(k) plan is characterized by:
• The ability of employees to make voluntary contributions of pretax
dollars up to a certain amount ($18,500 in 2018, plus $6,000 catch-up if
over age 50).
• These are, in effect, deferrals of compensation that are not taxed until
they are distributed from the plan.
The 401K Profit Sharing Plan
• Individual accounts for participants, who usually are responsible for
making investment decisions regarding the assets in those accounts
• Matching contributions from employers (called 401(m) contributions);
employers can match employee contributions in whole or in part
• These matching contributions are tax deductible for the employer to the
extent that they do not exceed certain limits (25% of participating
employees’ payroll)
• Plan loans and opportunities for hardship withdrawals
• A plan may be established as part of a profit sharing plan so that
non-401(k) profit sharing contributions may be made to participants’
The 401K Profit Sharing Plan
1. Employer discretionary contributions
• This is your “traditional” profit sharing part of the plan, and it is
entirely funded by employer contributions
• The employer is in effect “sharing profits” with its employees, and
allocating a certain amount to each employee
• There is often a vesting schedule associated with this section of the
The 401K Profit Sharing Plan
2. Employee elective deferrals
• This is the 401(k) part of the plan, allowed because of the 401(k)
• It is in this part of the plan that the employee is able to defer some of
her compensation, pretax
• Employees are always 100% vested in what they have deferred, since
it is part of their compensation and they have elected to have it go
into the plan rather than currently receiving it
The 401K Profit Sharing Plan
3. Employer matching or non elective contributions
• This is also in the 401(k) part of the plan, and comes into play when
the employer decides to either match a portion of the employee’s
elective deferral or decides to make a non elective contribution on
behalf of all employees in the plan, whether they make a deferral or
• The vast majority of employers prefer the matching contribution
since it encourages employees to save for their retirement
• The matching or nonelective contributions may or may not have a
vesting schedule, but they often do not if the employer wants to have
a “safe harbor” plan in order to pass nondiscrimination tests.
The 401K – Eligible Employers
• All organizations, with the exception of state and local governments,
can currently establish 401(k) plans
• Those include:
• Sole proprietors. The sole proprietor, or self-employed person, is
treated as his own employee.
• Partners. If the self-employed individual is a partner, he is treated as an
employee of the partnership.
• Special rules apply to a partnership’s profit sharing plan if it includes a CODA.
• Corporations. Regular (or C), S, and limited liability corporations (LLCs)
are eligible.
• Tax-exempt organizations
• Indian tribal governments
The 401K – Eligible Employers
• State and Local Governments, as well as non-profits, may establish
403(b) plans, which are very similar to 401(k) plans
• Although state and local governments may not establish new 401(k)
plans, they may continue to administer grandfathered 401(k) plans
established under prior law
The 401K – Eligible Employees
• A 401(k) plan must allow plan participation to any employee who
• Has completed one year of service and has worked a minimum of
1,000 hours
• Is at least 21 years old.
• These are the basic ERISA eligibility requirements, referred to as “21
and 1.”
• A 401(k) plan may require employees to work for up to one year before
they can make elective contributions (usually called “deferrals”), but
many plans may allow elective deferrals upon employment or within
several months of employment.
• Even if the employer allows deferrals prior to one year of service,
oftentimes employer matches or non elective contributions will not
begin until the employee has completed at least one year of service
The 401K – Eligible Employees
The 401K – Limits on Contributions
• Section 401(k) plans are subject to the same “annual additions”
limits that apply to other defined contribution plans
• Additions to a participant’s account cannot exceed the lesser of
$55,000 or 100% of compensation (maximum for 2018).
• Additions Include all contributions, including
• Elective contributions (but not catch-up contributions);
• Matching contributions (401(m))
• Employer non elective contributions
• After-tax employee mandatory and voluntary contributions
• Employer contributions to another defined contribution plan the
employer may have, including money purchase plans, ESOPs, and
profit sharing plans
The 401K – Limits on Contributions
• Additions Include all contributions, including
• Forfeitures allocated to a participant’s account from terminated
• Amounts allocated to a Section 401(h) individual medical account,
which is part of a qualified pension plan maintained by the employer
• Employer contributions for a key employee allocated to a separate
account under a welfare benefit plan for postretirement medical
• Note that the $55,000 annual limit does not include the age
50 catch-up of $6,000
The 401K – Elective Deferrals
• Eligible employees may make an election to defer a portion of their
compensation prior to actually earning the money that is going to be
• If the employee makes a deferred election, then elective deferrals will
come out of the employee’s pay and will be applied to her 401(k)
balance instead of being received as cash.
• The Internal Revenue Code limits the level of pretax contributions to
a maximum of $18,500 per year in 2018
• Subject to the previous limitations, elective deferrals are excluded
from the employee’s gross income for the year in which they are
made and are not subject to income taxation until distributed.
• However, deferrals still remain subject to FICA (Social Security and
Medicare) and FUTA (federal unemployment) taxes
• Note that FUTA is paid by the employer, not the employee.
The 401K – Elective Deferrals
Catch-up contributions
• Catch-up contributions are additional elective deferrals (up to $6,000
in 2018) that may be made by individuals who are at least age 50 by
the end of the plan or calendar year
• Catch-up contributions are unique because they are not subject to
certain limitations, including:
• The IRC Section 402(g) limitation on elective deferrals (see prior
• The IRC Section 415(c) annual additions limitation of $55,000 (2018)
Maximum Elective Deferrals (2018)
Elective Deferral Limit for
Individuals under Age 50
Elective Deferral Limit for Individuals
Age 50 and Older (includes catch-up
$24,500 ($18,500 + $6,000)
The 401K – Non Deductible Contributions
• Some 401(k) plans may allow employees to make additional
contributions on an after-tax or nondeductible basis.
• Also, 401(k) plans may re-characterize elective deferrals as
nondeductible employee contributions to satisfy the 401(k) ADP test.
• Plan documents will specify whether this option is available to
• Nondeductible, or after-tax, employee contributions are subject to a
nondiscrimination requirement known as the actual contribution
percentage (ACP) test
• They must be monitored on an ongoing basis to ensure that highly
compensated employees do not contribute such significant
nondeductible amounts that the plan falls out of compliance.
• This is often the case unless the company has a “safe harbor” 401(k)
The 401K – Employer Contributions
• Employers can deduct 401(k) profit sharing plan contributions of up
to 25% of the participating employees’ payroll
• “Payroll” includes the elective deferrals and catch-up contributions
of those employees
• For purposes of calculating the 25% deduction limit, employer
contributions are defined as non elective contributions, matching
contributions, and discretionary profit sharing contributions only
• Employee elective deferrals and catch-up contributions are not
considered to be employer contributions for this purpose
• This is an advantage for an employer that wants to maximize
deductible contributions to a 401(k) plan
• Plus, it works in favor of employee-participants who want to maximize
their plan contributions
The 401K – Employer Contributions
Matching contributions
• Matching contributions are employer contributions made in
proportion to a participant’s elective deferrals or, less typically, a
participant’s after-tax voluntary contributions
• An employer may elect a formula for making matching contributions
to a 401(k) plan on behalf of employees making elective deferrals
• Plan documents state the formula by which matching contributions, if
any, are determined
• For example, the formula may have an employer make a qualified
matching contribution that is equal to 50% of a participant’s deferral
into the plan of up to 6% of the participant’s pay
• Typically, matching contributions are 100% vested at all times
• However, some 401(k) plans make these contributions subject to a
graded vesting schedule
The 401K – Self Employed Plans
• While 401(k) provisions are generally tied to profit sharing plans they
may also take the form of a solo (or Keogh) 401(k), a 401(k) stock
ownership plan (KSOP), or Roth 401(k)
Solo 401(k) Plans (Keogh)
• A self-employed individual can make deductible employer
contributions and elective deferrals to a 401(k) profit sharing Keogh
• A self-employed individual can maximize his contributions to a
defined contribution Keogh plan
• Let’s consider the advantages of a solo 401(k) profit sharing Keogh
plan for Shawn.
Schedule C net profit (business profit)
Less income tax deduction allowed (1/2 selfemployment tax)
Net earnings from self-employment
Multiply by .2
(maximum amount allowable for owner)
Owner’s contribution =
x .2
In summary, Shawn can make an $18,587 deductible employer contribution and
an $18,500 elective deferral (deductible as an ordinary and necessary business
expense) to his solo 401(k) profit sharing plan for 2018, a total of $36,587. A
shortcut that will allow you to estimate the Keogh contribution is to multiply the
net profit by 18.59% (for a 20% contribution) or 12.12% (for a 15%
contribution). Note: The further you go above the wage base, the less accurate
this method becomes.
If Shawn is age 50 or older, he can make an additional $6,000 (2018 limit)
catch-up contribution to a 401(k) Keogh profit sharing plan, for a total
contribution of $42,587.
Sole proprietors or partners, such as Shawn, will find it easier if they commit to
making elective contributions during the plan year. Of course, this will require
Individual Retirement Accounts (IRAs)
• The individual retirement account (IRA) was first introduced in 1974,
and there are now two general types of IRA accounts
• Traditional IRAs (typically funded with pretax dollars)
• The Roth IRA account (always funded with after-tax dollars).
• In addition, there are also two employer-sponsored retirement plans
that involve setting up IRA accounts for each of the eligible
• The simplified employee pension (SEP-IRA) plan and
• The SIMPLE IRA plan
• IRA accounts are not considered to be qualified plans, but rather
simply “tax advantaged” plans
• Since they are “individual” plans they are not subject to ERISA
requirements and have their own rules and requirements
Qualified and Nonqualified Plans, and IRAs
Qualified Plans
Nonqualified Plans
Pension Plans
Profit Sharing
Plans (DC)
Defined benefit (DB)
Profit sharing
Traditional IRA
Section 457 plans
Cash balance (DB)
Thrift plan
Roth IRA
Stock bonus
Money Purchase (DC)
Target Benefit (DC)
Age weighted
403(b) (TSA)
401(k) plan
SIMPLE 401(k)
• An IRA is a trust or custodial account set up for the exclusive benefit
of its owner and/or his named beneficiaries
• IRAs were introduced as a means of supplementing retirement
income after Congress realized that personal savings, payments from
employer-sponsored plans, and Social Security benefits were
insufficient to meet the financial needs of many Americans at
• Over the years, IRAs have grown in popularity, and Congress has
expanded the types of IRAs available and the contribution limits,
making it possible for more people to enjoy their benefits
• IRAs are not qualified plans and are not covered by the Employee
Retirement Income Security Act (ERISA)
• However, they are subject to a number of restrictions designed to
preserve the assets for retirement by impeding unencumbered
access to an IRA’s assets.
• The owner may not, for example, borrow from his IRA, and most
withdrawals made before the owner reaches age 59½ are penalized
IRAs – Statutory Requirements
• To comply with the Internal Revenue Code (IRC), every IRA plan must
adhere to the following requirements:
• An individual (taxpayer) must have compensation (earned income or
alimony) and be under age 70½ to be eligible to establish a non-Roth
• However, an individual who has compensation (earned income or
alimony) and is under or over age 70½ is eligible to establish a Roth
• It must be established for the exclusive benefit of an individual (IRAs
cannot be established as joint accounts) and the individual’s
• It must be established as a custodial account or a trust set up in the
United States
• Documents must be set in writing
IRAs – Statutory Requirements
• Contributions (other than rollovers) must be made in cash
• For example, the IRA owner cannot take shares of stock from her safe deposit
box, use them to fund the IRA, and then take a deduction for the value of those
• Contributions for 2018 cannot exceed 100% of an individual’s earned
income up to $5,500 a year per individual (or $11,000 for a married
couple filing a joint return, both of whom are under age 50)
• Individuals who are at least age 50 by the end of the year may also
make an additional $1,000 catch-up contribution (discussed below) for
• Note: Rollovers are not considered “contributions” and can exceed
$5,500 per year.
IRAs – Statutory Requirements
• IRA contributions for a given tax year must be made by the income tax
filing deadline for that year, which is April 15th. Extensions are not
• Individuals are immediately and fully vested in their contributions; IRA
owners always have full control of their accounts and the assets in
• Funds cannot be invested in life insurance policies or in collectibles—
with the exception of certain coins and bullion and shares of a publicly
traded, stock-exchange-listed investment trust invested in gold or silver
bullion (e.g. GLD).
• Prohibited transactions between an IRA and its owner will result in the
penalties and income taxation of the entire fair market value of an IRA.
• Loans to an IRA owner or a “disqualified person” (certain related
parties such as family members) are prohibited transactions.
IRAs – Statutory Requirements
• The use of an IRA by its owner as security for a loan is a prohibited
• Assets cannot be commingled with other property
• Distribution of IRA accumulations must begin by April 1 of the year
following the year in which the owner reaches age 70½
• If an excess contribution is made to an IRA, then a 6% penalty tax
will apply
• If the excess contribution is withdrawn, no penalty will apply if the
withdrawal is made by the tax return filing due date (including
extensions) and if the withdrawal includes any income earned on the
excess contribution.
IRAs – Traditional vs Roth IRAs
• There are currently two types of IRAs: traditional and Roth IRAs
• Traditional IRAs may be tax deductible or nondeductible
• In a tax deductible IRA, contributions are deductible from current
income and earnings are tax- deferred until they are distributed and
taxed as ordinary income
• In a nondeductible IRA, contributions are made on an after-tax basis
and earnings accrue tax-deferred
• Upon distribution, all earnings are fully taxable as ordinary income;
however, distributions of after-tax contributions are nontaxable
• In contrast, contributions to a Roth IRA are always nondeductible
(after tax) and earnings accrue tax-deferred
• However, distributions that are considered “qualified” are tax-free.
Traditional IRAs – Contributions
• In 2018, individuals who are under age 70½ and have earned income
can contribute to an IRA
• Contributions are limited to the lesser of $5,500 or earned income
• In addition, individuals who have attained age 50 before the end of the
tax year are eligible to contribute an additional $1,000, bringing the
annual total contribution to $6,500
• Earned income, according to the IRC definition, includes the
• Salaries, fees, bonuses, and commissions an individual receives as a
result of services performed (W-2 income)
• Schedule C (Self-Employment) net income
• K-1 income from a partnership (if the partner is a material participant)
• Taxable alimony
Traditional IRAs – Contributions
• Earned income does not include the following:
• Unemployment compensation
• Passive income, such as interest, dividends, and pension distributions
• Capital gains
• Deferred compensation (until it is taxed)
• Amounts received as a pension or annuity
• Social Security income
• Workers’ compensation
• Income from the sale …
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