Chapter 23 Review Questions & Answers

Chapter 23 Answers to Study Questions / Page PAGE 2 Chapter 23 401(k) and Other Salary Savings Plans Answers to Study Questions A Sec. 401(k) plan allows employees to in effect make before-tax contributions to the plan, generally through a salary reduction election. In many plans, the employer also contributes, either through matching or through discretionary or formula contributions. The advantage of such a plan is that it allows the participant full qualified plan tax deferral, at least up to the salary reduction limit of $15,500 annually (2007), as indexed. (Additional deferrals are available for employees who are aged 50 or over.) Elective deferrals must always be fully vested; employer contributions may be subject to graduated vesting. Elective deferrals by highly compensated employees may be further reduced by the actual deferral percentage (ADP) testing requirements. 2. To perform the ADP test it is first necessary to determine who is a member of the highly compensated employee group and who is a member of the non-highly compensated group. Highly compensated employees include (1) more-than-five-percent owners and (2) those whose compensation is in excess of $100,000 (2007 indexed figure). Under these rules Drs. Able, Baker, and Resident would be highly-compensated, and Dr. Intern, nurses Marmer and Devries, and receptionist Smith would be non-highly-compensated. The next step is to determine the deferral percentage for each group by adding up the actual percentage deferred for each group and dividing by the number of participants in the group. Dr. Able 8% Dr. Intern 8% Dr. Baker 8% Nurse Marmer 5% Dr. Resident 8% Nurse Devries 5% Total 24% Receptionist Smith 0% Total 18% Divided by three members = Divided by four members = 8% average 4.5% average The Fixemup plan does not meet the requirements of the ADP test. Under part 1 of the test, eight percent is more than 125 percent of 4.5 percent. Under part 2 of the test, the 200 percent requirement is satisfied, but the two percentage point differential is not met (there is a difference of 3 1/2 percent). It is interesting to note that the ADP requirement might have been met if the Fixemup plan had had a matching contribution scheme that could have acted as an incentive for receptionist Smith to contribute. 3. Like a 401(k) plan, a SIMPLE provides for employee salary reduction contributions and employer matching contributions. However, salary reductions are limited to $10,500 (2007 figure) while 401(k) salary reductions can be as high as $15,500 (2007 figure). The catch-up contribution for SIMPLEs for participants aged 50 or over is $2,500 (2007) as compared with $5,000 (2007) for 401(k) plans. 4. The employer must contribute either (a) a dollar-for-dollar matching contribution up to three percent of the employee?s compensation (the employer can elect a lower percentage of compensation, not less than one percent, in not more than two out of the past five years); or (b) two percent of compensation for all eligible employees earning at least $5,000 (whether or not they elected salary reductions). 5. Sec. 403(b) plans are available to employees of tax-exempt Sec. 501(c)(3) organizations and public schools and colleges. 6. The salary reduction limit (and 50-or-over catchup limit) is the same for 403(b) plans as for 401(k) plans. That is, for 2007, $15,500/$5,000. 7. Sec. 401(k) plans and 403(b) plans evolved out of totally different statutory arrangements and there are therefore many differences. Many of the differences can be summarized simply by noting that 401(k) plans are ?qualified? plans subject to all of the qualified plan rules, and 403(b) plans are not qualified plans. The qualified-plan like features applicable to 403(b) plans are (1) nondiscrimination rules if the plan features employer contributions; (2) tax deferral for employees for both employer contributions and employee salary reductions (but special 10-year averaging is not available); (3) loans to participants are available. 9. Sec. 457 applies to tax-exempt and governmental employers. Except for the use of employee salary reductions, 401(k) plans and 457 plans are quite dissimilar in their technical rules, although they provide somewhat similar benefits for employees. 401(k) plans are funded, qualified plans, while 457 plans are unfunded (except for governmental employers) and not subject to the qualified plan rules. Salary reductions are subject to the same dollar limits in both plans.