1. Lecture 25 401(k) and Other Tax Deductible Salary Savings Plans Tax treatment Illustration of the tax deferral advantage Basic characteristics of 401(k) plans Actual Deferral Percentage test SIMPLE/IRAs 403(b) plans 457 plans

2. Tax Treatment Employees elect whether to participate and how much to contribute to the plan Employee contributions reduce taxable income for income tax purposes, but not for Social Security taxes Investment income is not currently taxable Employee is taxed when the funds are withdrawn from the plan Some plan withdrawals are eligible for income averaging

3. Illustration of the Tax Deferral Advantage Assumptions: $2000 per year in contributions for 40 years Tax rates: 28% while working 15% after retirement Interest rate: 8% (5.76% after-tax) Annuity rate: $9.50 per $1 annual income Calculations: 401(k):$2000 per year at 8% Other:$1440 per year at 5.76%

4. Illustration of the Tax Deferral Advantage (cont.) Accumulations*: 401(k) $559,562 Other $221,941 Annual retirement income: 401(k)$50,066 (559,626/9.5)x.85 Other$23,362(221,941/9.5) *Annuity due factor: [(1+i) n+1 - (1+i)]/ i For n = 40 and i =.08: 279.781 For n = 40 and i =.0576:154.126

5. Basic Characteristics of 401(k) Plans Private employers Maximum contribution: –15% of compensation subject to $9500 (indexed) maximum Voluntary participation Matching contributions allowed Vesting –Employee contributions: immediate –Employer contributions:standard rules Distribution restrictions

6. Actual Deferral Percentage Tests A qualified 401(k) plan must meet one of the following two tests: 1ADP for HCE must not be more than 125% of the ADP for non-HCE 2ADP for HCE must not exceed the lesser of: a) 200% of the ADP for non-HCE b) ADP for non-HCE + 2%

7. ADP Test Example 10 employees in company A and B earn $100,000 per year (HCEs) –A contributes 10% –B contributes 6% –ADP of HCE = 8% other 8 are non-HCEs –4 of non-HCE contribute 6% –other 4 do not participate –ADP of non-HCE = 3% Plan fails, since ADP of HCE cannot exceed: –Test 1: 3.75% –Test 2: Lesser of a)6% b)5%

8. Designing a Plan to Meet the ADP Tests Mandatory deferral Limiting the deferral by the HCE Encouraging non-HCE to participate

9. SIMPLE/IRAs (Savings Incentive Math Plans for Employers) Eligibilty –Fewer than 100 employees –No qualified plan Employer contributes to employees’ IRA –Employees contribute up to $6,000 to IRA –Employer matching contributions Advantages –Simple –Portable Disadvantages –Benefits may not be adequate –Lower limits than 401(k)

10. 403(b) Tax-Deferred Annuity Plans Similar to 401(k) plans Eligible employers –Tax exempt under section 501(c)(3) –Educational organization Limits on contributions –403(b) Annual exclusion allowance 20% of compensation multiplied by Total years of service minus Amounts contributed in prior years –415 annual additions limit and catch-up 25% of compensation or $30,000 –Salary reduction limitation $9,500 –Salary reduction catch-up (if 15 years of service)

11. Section 457 Plans Similar to 401(k) plans Eligible employers –Government Limitations –Lessor of: $7500 (indexed) or 1/3rd compensation