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Definition of Disability for Early Distribution Penalty

 

What is the definition of disability for purposes of the early distribution penalty tax?

“How does the IRS define disability for the purposes of allowing a 401(k) plan participant to take a distribution before the age of 59 ½ without a penalty tax?”  

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

Highlights of Discussion

  • Generally, amounts an individual withdraws from an IRA or retirement plan before reaching age 59½ are called ”early” or ”premature” distributions. Beyond including the pretax portion of an early distribution in taxable income for the year taken, the recipient must pay an additional 10% early withdrawal penalty tax, unless an exception applies [Internal Revenue Code Section (IRC §) 72(t)].
  • There are several exceptions to the early withdrawal penalty tax found in IRC §72(t)(2)(A)-(G), including an exception for disability (IRC §72(t)(2)(A)(iii).
  • The IRS defines disability for this purpose in IRC §72(m)(7),  and the definition is quite strict:

 

“… an individual shall be considered to be disabled if he is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration. An individual shall not be considered to be disabled unless he furnishes proof of the existence thereof …”

 

  • Some disabled individuals file IRS Schedule R, Credit for the Elderly or Disabled, with their IRS Form 1040s.  The schedule requires a physician’s certification that a person meets the IRC §72(m)(7) definition of disabled. Alternatively, a physician’s signed statement attesting to an individual’s permanent and total disability can serve as proof of the condition.
  • See the IRS’ Retirement Topics – Exceptions to Tax on Early Distributions for other penalty exceptions.
  • It is important that plan administrators review their disability claims procedures, including acceptable forms of documentation. While the final disability claims regulations and accompanying FAQs (in particular Q&A 9) reference the Social Security Administration or the employer’s long-term disability plan benefit awards as two examples of disability documentation, the rules for pension plans do not seem to preclude other forms, as long as the disability finding is made by a party other than the plan for purposes other than making a benefit determination under the plan. Here is the wording from Q&A 9 of the DOL’s FAQs

 

“However, if a plan provides a benefit the availability of which is conditioned on a finding of disability, and that finding is made by a party other than the plan for purposes other than making a benefit determination under the plan, then the special rules for disability claims need not be applied to a claim for such benefits.”

 

Conclusion

While disability can qualify a distribution recipient for an exception to the early withdrawal penalty tax, the definition of disability for this purpose is rigorous and requires proof.

 

 

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403b plan
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Nonprofit with 401(k) and 403(b)

Can a 403(b) plan merge with a 401(k) plan?

“I have a tax-exempt client that currently offers a 401(k) plan. The group is taking over another IRC Sec. 501(c)(3) tax-exempt entity that has a 403(b) plan.  Can the acquiring entity merge the 403(b) plan into the 401(k) plan?”  

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

Highlights of Discussion

  • No, generally the IRS does not allow mergers or transfers of assets between 403(b) and 401(k) plans [Treasury Regulation 1.403(b)-10(b)(1)(i)]. The IRS has stated in private letter rulings (PLRs) that if a 403(b) plan is merged with a plan that is qualified under IRC Sec. 401(a), the assets of the 403(b) plan will be taxable to the employees PLR 200317022.
  • One option would be to terminate the 403(b) plan, which would allow its participants to receive distributions (See the IRS’ Terminating a 403(b) Plan for more information).
  • The participants in the terminated 403(b) plan who receive eligible rollover distributions from the 403(b) plan would have the option to roll the amounts to the 401(k), provided the 401(k) plan permits rollover contributions (Revenue Ruling 2011-7 and IRS Rollover Chart.)

Conclusion

IRC Sec. 501(c)(3) tax-exempt entities have the ability to maintain both 401(k) and 403(b) plans independently. The IRS does not allow a sponsor to merge the two plan types, however.   A plan termination followed by participant rollovers may be a viable alternative to merging the plans.

 

 

 

 

 

© Copyright 2018 Retirement Learning Center, all rights reserved
retirement pension
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Plan Participation and IRA Contributions

 Plan Participation and IRA Contributions

“A client of mine who participates in a 401(k) plan at work was told by his tax preparer that he cannot make an IRA contribution.  Is that correct?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

  • If your client is under age 70 ½ and has earned income for the year of contribution, he is eligible to make a traditional IRA contribution, provided he does so by the contribution deadline.  But because he participates in a 401(k) plan, the contribution may not be fully tax deductible.
  • Deductibility of a traditional IRA contribution depends on whether the individual (or his or her spouse) is an active participant in an employer-sponsored plan, tax filing status and the amount of modified adjusted gross income (MAGI) for the year (IRC Sec. 219(g).

Deductibility of a 2016 traditional IRA contribution when the individual (or spouse) is covered by a workplace retirement plan

IF your filing
status is …
AND your modified adjusted gross income (modified AGI)
is …
THEN you can take …
single or
head of household
$61,000 or less a full deduction.
more than $61,000
but less than $71,000*
a partial deduction.
$71,000 or more no deduction.
married filing jointly or
qualifying widow(er)
$98,000 or less a full deduction.
more than $98,000
but less than $118,000**
a partial deduction.
$118,000 or more no deduction.
married filing separately2 less than $10,000 a partial deduction.
$10,000 or more no deduction.
Not covered by a plan, but married filing jointly with a spouse who is covered by a plan  $184,000 or less a full deduction.
more than $184,000
but less than $194,000***
a partial deduction.
Source:  IRS 2016 IRA Contribution and Deduction Limits $194,000 or more no deduction.

*$62,000-$72,000 for 2017; **$99,000-$119,000 for 2017; and ***$186,000-$196,000 for 2017

 

Conclusion

If a person meets the age and income requirements for a year, he or she is eligible to make a traditional IRA contribution by the deadline.  But the tax deductibility of the contribution will be affected by participation in a workplace retirement plan, tax filing status and MAGI.

 

 

 

 

 

 

© Copyright 2018 Retirement Learning Center, all rights reserved
money
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Education Policy Statement

Education Policy Statement

“What is an Education Policy Statement for a 401(k) plan and does the Department of Labor (DOL) require a plan have one?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

Highlights of Discussion

  • While the DOL does not requirement qualified retirement plans to have an education policy statement (EPS), it can be a helpful fiduciary liability reduction tool for plan sponsors who offer plan participants the ability to self-direct their account balances. It is often viewed as an extension of a plan’s investment policy statement. The EPS is the blueprint for how the fiduciaries of the plan will implement, monitor and evaluate an employee education program with respect to the plan.

 

  • ERISA 404(c) provides a mechanism for plan sponsors to shift investment responsibility to participants, provided the plan meets certain requirements. Generally, to meet the requirements of ERISA 404(c), participants must have the opportunity to 1) exercise control over their individual account; and 2) choose from a broad range of investment alternatives (DOL Reg. 2550.404c-1). As part of the ability to exercise control participants must have “…the opportunity to obtain sufficient information to make informed investment decisions.” The EPS can be the means by which plan fiduciaries document how this requirement is met.

 

While there is no prescribed format for an EPS, answering the following questions may be helpful in designing the document:

What is the purpose of the EPS?

What are the objectives of the EPS?

What are the educational goals?

Who are the responsible parties and what are their duties?

How will the education be delivered?

How will results be measured?

 

Conclusion

An EPS is a blueprint for how plan fiduciaries will implement, monitor and evaluate an employee education program with respect to a retirement plan. Although not required, an EPS could be a prudent addition to a plan sponsor’s fiduciary fulfillment file.

 

 

 

 

 

 

© Copyright 2018 Retirement Learning Center, all rights reserved
Compliance Rules Guidelines Regulations Laws
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Rollovers as Business Startups (ROBS)

Rollovers as business startups (ROBS)

“One of my clients, who participates in his employer’s 401(k) plan, asked me about an arrangement whereby he could use a tax-free rollover from the plan to start his own new business?  Are you aware of such a scheme?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

Highlights of Discussion

  • Your client is likely referring to “Rollovers as Business Start-Ups” (ROBS). The IRS has commented that promoters in the industry are aggressively marketing ROBS (described below) as a means for prospective business owners to access accumulated tax-deferred retirement funds, without paying applicable distribution taxes, in order to cover new business start-up costs. While the IRS does not consider all ROBS to be abusive tax avoidance transactions, it has found that some forms of ROBS violate existing tax laws and, therefore, are prohibited.
  • Anyone considering a ROBS transaction should consultant with a tax and/or legal advisor before proceeding as there are several issues the IRS has identified that must be considered on a case-by-case basis in order to determine whether these plans operationally comply with established law and guidance. These issues and guidelines for compliance are detailed in a 2008 IRS Technical Memorandum.
  • Here is an example of a common ROBS arrangement.  An individual sets up a C-Corporation and establishes a 401(k)/profit sharing plan for the business.  The plan allows participants to invest their account balances in employer stock. (At this point the business owner is the only employee in the corporation and the only participant in the plan.)  The new business owner then executes a tax-free rollover from his or her prior qualified retirement plan (or IRA) into the newly created qualified plan and uses the assets from the rollover to purchase employer stock. The individual next uses the funds to purchase a franchise or begin some other form of business enterprise. Note that since the rollover is moving between two tax-deferred arrangements, the new business owner avoids all otherwise assessable taxes on the rollover distribution.
  • The two primary issues that the IRS has identified with respect to ROBS that would render them noncompliant are 1) violations of nondiscrimination requirements related to the benefits, rights and features test of Treas. Reg. § 1.401 (a)(4 )-4; and 2) prohibited transactions resulting from deficient valuations of stock.
  • Other concerns the IRS has with ROBS relate to the plan’s permanency (which is a qualification requirement for all retirement plans, violations of the exclusive benefit rule, lack of communication of the plan when other employees are hired, and inactive cash or deferred arrangements (CODAs).
  • The Employee Plan Compliance Unit of the IRS completed a research project on ROBS in 2010. The research revealed that while some of the ROBS studied were successful, many of the companies in the sample had gone out of business within the first three years of operation after experiencing significant monetary loss, bankruptcy, personal and business liens, or having had their corporate status dissolved by the Secretary of State (voluntarily or involuntarily). The full project summary is accessible here.

 

Conclusion

Caution should prevail when considering a ROBS arrangement. Those interested should seek the guidance of a tax and/or legal advisor, and consider the guidance from the IRS’ 2008 Technical Memorandum.

 

© Copyright 2018 Retirement Learning Center, all rights reserved
Blog: US dollar euro
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Five percent Owner and Stock Options to Consider

Stock Options and Determining a “Five-Percent Owner”

“One of my clients in a 401(k) plan has been given stock options, which have not been exercised.  When determining a five percent owner for plan purposes, does ownership of stock options count?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

Highlights of Discussion

  • The answer to your question is clearly addressed in Internal Revenue Code Sections (IRC) §§416 and 318 and underlying regulations.
  • Under IRC §416(i)(1)(B)(I), the term “five-percent owner” means the following:
  • If the employer is a corporation, any person who owns (or is considered as owning within the meaning of IRC § 318) more than five-percent of the outstanding stock of the corporation or stock possessing more than five-percent of the total combined voting power of all stock of the corporation, or
  • If the employer is not a corporation, any person who owns more than five-percent of the capital or profits interest in the employer.
  • A person might be a more than five-percent owner through the “constructive ownership” rules of IRC § 318. IRC §318(a)(4) states:  If any person has an option to acquire stock, such stock shall be considered as owned by such person. For purposes of this paragraph, an option to acquire such an option, and each one of a series of such options, shall be considered as an option to acquire such stock.

 

Conclusion

When determining ownership for plan purposes, if any participant has an option to acquire stock, such stock shall be considered as owned by such person.

 

 

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retirement plan
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Time to Deal with Mergers

Time for Managing a Plan Merger

“My client is working through a business acquisition, which will involve merging two 401(k) plans.  He is concerned about how quickly they will be able to merge the plans.  Are there guidelines on compliance testing for the plans during the merger process?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

Highlights of Discussion

  • A special “transition rule” under Internal Revenue Code Section (IRC §) 410(b)(6)(C) applies for meeting employee coverage requirements in situations where an acquisition involves the merging of two plans. Under these rules, the plan will continue to be considered in compliance with minimum coverage requirements during a “transition period.”
  • The transition period is the period that begins on the date of the transaction and ends on the last day of the first plan year beginning after the date of the transaction.  For example, for an acquisition that takes place on September 1, 2017, the transition period that would apply for a calendar year plan would last until December 31, 2018.
  • The transition rule is only available if 1) both plans satisfy the coverage rules immediately before the acquisition; and 2) there are no significant changes in either the terms of the plan or the coverage of the plans following the transaction.

Conclusion

The merging of two employer plans is a complicated and time consuming process. Fortunately, from an employee coverage perspective, there are transitional rules that give the employer some relief.

 

 

 

© Copyright 2018 Retirement Learning Center, all rights reserved
money
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What is the Definition of Compensation for HCEs

What is the definition of compensation for determining HCEs?

“What definition of compensation is used to determine who is considered an HCE for nondiscrimination testing in a 401(k) plan?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

Highlights of Discussion

A plan must use an Internal Revenue Code Section (IRC §) 415 definition of compensation when determining which employees are HCEs under IRC §414(q).

  • More specifically, according to  Temporary Treasury Regulation 1.414(q)-1T, Q&A 13, the term “compensation” for HCE determination means compensation within the meaning of IRC §415(c)(3) without regard to §§125, 402(a)(8), and 402(h)(1)(B) and, in the case of employer contributions made pursuant to a salary reduction agreement, without regard to § 403(b). Thus, compensation for this purpose includes elective or salary reduction contributions to a cafeteria plan, cash or deferred arrangement or tax-sheltered annuity.

 

  • Only compensation an employee received during the “applicable period” is considered in determining HCE status.  HCE status based on compensation (not on ownership) is determined using compensation earned during the preceding year or 12-month period, referred to as the “look-back year.” If the year for which HCE status is being determined is not a calendar year, the sponsor may make a calendar year election so that HCE status is determined based on compensation earned during the calendar year beginning with or within the look-back year.

 

  • A compensation threshold applies for determining HCE status. This amount is subject to indexing.  When the amount is indexed, the new dollar amount applies to the year in which the compensation is earned, not the year in which HCE status is determined.  For example, when determining HCE status for 2017 based on compensation, plans must use the indexed amount for 2016, which was $120,000.  When determining HCE status for 2018 based on compensation, plans must use the indexed amount for 2017, which is $120,000.

Conclusion

Plans must follow a specific definition of compensation as defined in the IRC and supporting Treasury regulations when determining whether an employee is or is not an HCE.

 

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retirement pension
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Participant in SIMPLE IRA and 401(k) with Separate Employers

Deferral limit involving SIMPLE IRA and 401(k) plans

“I have a client—over age 50—who participates in a savings incentive match plan for employees (SIMPLE) IRA plan with one of his employers and a 401(k) plan with a separate employer. How much can my client defer into the SIMPLE IRA plan and 401(k) plan?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

Highlights of Discussion

  • To determine the answer to your question your client must look at his overall Internal Revenue Code Section (IRC §) 402(g) employee salary deferral limit and the rule that limits employee salary deferrals to the SIMPLE IRA plan under IRC § 408(p)(2)(A)(ii).
  • For each tax year IRC §402(g) limits an individual’s overall employee salary deferrals combined across all eligible plans (e.g., deferrals made to a SIMPLE IRA plan and 401(k) plan) to a set amount. For 2016 and 2017, a person’s 402(g) limit is 100 percent of compensation up to a maximum of $18,000 if he or she is under age 50, and is $24,000 if he or she is age 50 or greater and making catch-up contributions.
  • The maximum amount that a SIMPLE IRA plan participant may defer into the SIMPLE IRA plan is limited to 100 percent of compensation up to a maximum of $12,500 for 2016 and 2017 or, if he or she is age 50 and over, to $15,500 (which includes catch-up contributions of $3,000).
  • Therefore, your client, being over age 50, could choose to make employee salary deferral contributions to the SIMPLE IRA plan in any amount as long as he does not exceed 100 percent of compensation up to $15,500. He could defer the balance of his 402(g) limit up to 100 percent of compensation up to $24,000 to the 401(k) plan IRS Publication 560 and IRS Notice 98-4, Q&A C-3.

 

EXAMPLE

Seth, age 53, participates in a SIMPLE IRA plan with Employer A and a 401(k) plan with Employer B.  Based on his compensation he decides to defer $15,500 to his SIMPLE IRA plan ($3,000 of which is considered a catch-up contribution).  In order to stay within his 402(g) annual limit across all eligible plans in which he participates, Seth may only defer up to $8,500 to his 401(k) plan.  Note that Seth’s overall 402(g) limit of $24,000 could be allocated as he wishes between the two plans, as long as his deferrals do not exceed $15,500 to the SIMPLE IRA plan.

 

Conclusion

An individual who participates in a SIMPLE IRA plan and a 401(k) plan of a different employer must look at his or her overall 402(g) employee salary deferral limit and the rule that limits employee salary deferrals to the SIMPLE IRA plan in order to determine the amount that can be deferred into each plan.

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pension benefits
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401(k) and Nonqualified Deferred Compensation plans

 

“My client has a 401(k) excess contribution as a result of a failed actual deferral percentage (ADP) test.  However, he was told he could roll over the excess contribution to another of his employer’s plans.  How could that be; I thought excess contributions were ineligible for rollover?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

Highlights of Discussion

  • You are correct; 401(k) excess contributions are not eligible to be rolled over to an “eligible retirement plan” pursuant to Internal Revenue Code Section (IRC §) 402(c)(8)(b). The term eligible retirement plan is defined as an individual retirement account under IRC §408(a); an individual retirement annuity under IRC § 408(b); a qualified trust; a qualified annuity plan under IRC § 403(a); a governmental plan under IRC §457(b); and an IRC §403(b) plan.
  • However, it is possible that, in addition to the 401(k) plan, your client’s employer maintains a plan that is not an eligible retirement plan, such as a nonqualified deferred compensation plan (NQDC) under IRC §409A.
  • An NQDC plan is an agreement, method, or arrangement between an employer and an employee (or service recipient and service provider) to pay the employee or independent contractor compensation in the future for service presently performed. NQDC plans allow employees to defer compensation until retirement or some other predetermined date. A thorough discussion of NQDC plans is beyond the scope of this writing.
  • NQDC plans are an attractive benefit for highly paid employees because they are free from the contribution limits, participation requirements and nondiscrimination restrictions that apply to qualified plans. Because NQDC plans are not subject to the limitations of qualified retirement plans, they can allow some executives and high-level managers to defer a much larger portion of their compensation than permitted under qualified plans.
  • If permitted under the terms of the plan document, participants may have the option to contribute to the NQDC their excess contributions that occurred in their 401(k) plans. These NQDC plans may be referred to as “401(k) excess plans” or “401(k) wrap plans.” The contribution to the NQDC plan is not a rollover, but is considered an additional type of permissible deferral under the NQDC plan.
  • A best practice would be to get a copy of the NQDC plan document and check to see if there is language in the plan that addresses the ability of participants to defer excess contributions. The consultants at the Learning Center review NQDC plans documents, as well as other types of plan documents, daily.

 

Conclusion

While 401(k) participants may not roll over excess contributions to another eligible retirement plan, it may be possible for them to defer their excesses into a NQDC or 401(k) wrap plan, if one exists. Check the NQCD plan document for accommodating language.

 

 

© 2017 Retirement Learning Center, LLC

© Copyright 2018 Retirement Learning Center, all rights reserved