Presentation on theme: "Retirement Savings and Deferred Compensation"— Presentation transcript:
1 Retirement Savings and Deferred Compensation Chapter 13Retirement Savings and Deferred Compensation
2 Learning ObjectivesDescribe the tax and nontax aspects of employer-provided defined benefit plans from both the employer’s and employee’s perspective.Explain and determine the tax consequences associated with employer-provided defined contribution plans, including traditional 401(k) and Roth 401(k) plans.Describe the tax implications of deferred compensation from both the employer’s and employee’s perspective.
3 Learning Objectives4. Determine the tax consequences of traditional and Roth Individual Retirement Accounts and explain the differences between them.5. Describe the retirement savings options available to self-employed taxpayers and compute the limitations for deductible contributions to retirement accounts for self-employed taxpayers.6. Compute the saver’s credit.
4 Employer Provided Plans Qualified PlansMust not discriminate between employeesTwo main types:Defined benefit planDefined contribution plan
5 Defined Benefit Plans Standard benefits based on fixed formula Average compensationYears of serviceEmployers deduct liability as they contribute to planFunding requirements based on actuarial assumptionsEmployer not employee bears investment risk
6 Defined Benefit Plans Vesting schedules 5-year cliff or7-year gradedDistributions from defined benefit plans are taxable to employee when received.Ordinary incomeEarly distributions subject to 10% penalty
7 Defined Benefit Plans Example CBA provides a defined benefit plan to its employees. Under the plan, employees earn a benefit equal to 2 percent for every year of service of their average salary for their three highest years of compensation. CBA implements a seven-year graded vesting schedule as part of the plan. If Tina works for CBA for four years, earning annual salaries of $60,000, $65,000, $70,000, and $75,000, and then leaves to work for another employer, what benefit would she be entitled to receive (her vested benefit)?
9 Defined Contribution Plans Employer specifies up-front contribution on employee’s behalfEmployers typically match employee contributionsEmployees may contribute to planEmployees choose how to invest contributionsAlternatives depend on employer’s plan401(k), 403(b), and 457
10 Defined Contribution Plans Annual contribution limits for 2011Employee contributions$16,500 if not 50 years of age by year end$22,000 if at least 50 years old by year endEmployer + Employee contributionsLimited to lesser of $49,000 ($54,500 if at least 50 years old at end of year) or 100% of the employee’s compensation.
11 Defined Contribution Plan Example Before Dave retires at the end of 2011 he continues to contribute to his CBA-sponsored 401(k) account. CBA matches employee contributions on a two-for-one basis up to 4 percent of the employee’s salary. Dave is 72 years old at the end of the year and he earned a salary of $450,000 during the year. Dave contributed $22,000 to his 401(k) account. How much would CBA contribute to Dave’s 401(k) account?
12 Defined Contribution Plan Example Solution Answer: $32,500 [$54,500 (Dave is 50+ years old) minus $22,000 (Dave’s contribution)]. Without the limitation, CBA would have contributed $36,000 ($450,000 × 4% × 2) to Dave’s account.
13 Defined Contribution Plans VestingEmployee contributions and earnings on employee contributionsVest immediately.Employer contributions and earnings on employer contributionsMinimum vesting requirements3-year cliff or6-year graded schedule.
15 Defined Contribution Plans DistributionsDistributions are ordinary incomeEarly distributions subject to a 10% penaltyBefore 59 ½ year of age if still working orBefore 55 years old and separated from service (retired)
16 Defined Contribution Plans Distributions Example Assume that when Lisa is 57 years of age and still employed by CBA, she requests and receives a $60,000 distribution from her 401(k) account. What amount of tax and penalty is Lisa required to pay on the distribution (assume her marginal tax rate is 33%)?
17 Defined Contribution Plans Distributions Example Solution Answer: $19,800 taxes ($60,000 × 33%) + $6,000 penalty ($60,000 × 10%).
18 Defined Contribution Plans Required minimum distributionsFor the year in which employee reaches age 70 ½ or when the employee retires, if later (and each subsequent year)May defer first required distribution to April 1 of next year, otherwise distribution must be received by December 31 of current yearBased on applicable percentage of balance at end of prior year50% penalty on undistributed portion of minimum distribution requirement.
19 Minimum Distributions Example Assume that Dave retires from CBA in 2011 at age 72 (age at year end). Also assume that his 401(k) account balance on December 31, 2010 was $3,500,000. What is the amount of minimum distribution he must receive for 2011 and when must he receive it?
20 Minimum Distributions Example Solution Answer:$136,850 by April 1, 2012 ($3,500,000 × 3.92% from the IRS table).
21 Traditional 401k Plans Contributions are made with before-tax dollars. Tax deductibleDistributions:Same rules as other defined contribution plans
22 Roth 401k Plans Contributions made with after-tax dollars. Not tax deductibleEmployer contributions must go into a traditional 401k plan (not a Roth 401k plan)
23 Roth 401k Plans Qualified distributions Non-qualified distributions After account open for five years and employee has reached age 59 ½.Non-qualified distributionsDistributions of earnings are taxable and subject to 10% penaltyDistributions from contributions are not taxableContributions divided by account balance multiplied by amount of distribution equals distribution from contributions
24 Deferred Compensation “Nonqualified plans”May discriminateGenerally provided to executives or highly compensated rather than rank and fileCan be used to make employee’s whole when contributions to qualified plans would be limitedDeemed investment choicesRisks to employees electing to defer salary?
25 Deferred Compensation Employer deducts for tax purposes when paysCompare to financial accountingEmployee includes in income when receivedIf paid after retirement, §162(m) limitation does not apply
26 Deferred Compensation Relevant variablesEmployer and employee current tax ratesEmployer and employee future tax ratesEmployer’s cost of capital or discount rateEmployee’s cost of capital or discount rate
28 Individual Retirement Accounts (IRAs) For AGI deduction for contributionsGenerally not allowed if participant in employer-sponsored plan unlessFor single taxpayers Taxpayer is single, deduction allowed if participate in employer plan but income is below certain thresholdsIn 2011, lesser of $5,000 in 2011 or earned incomeIf 50 years or older at end of year limit is $6,000Additional “catch-up” contribution
29 Individual Retirement Accounts (IRAs) For AGI deduction for contributionsGenerally, not allowed if participant in employer-sponsored plan unlessFor married taxpayers deduction is allowed if participate in employer plan but income is below certain thresholdsIn 2011, lesser of $5,000 in 2011 or earned income of both spouses reduced by other spouse’s contributions to IRA or Roth IRAIf 50 years or older at end of year limit is $6,000Additional “catch-up” contribution
30 Individual Retirement Accounts (IRAs) May make nondeductible contributionsDeductible + nondeductible cannot exceed $5,000 for one taxpayer (plus catch-up)Must contribute by April 15th of subsequent year
31 Individual Retirement Accounts (IRAs) Distributions taxed as ordinary income10% penalty if before 59 ½Certain exceptionsMedical expenses, insurance premiums, first homeSame minimum distributions apply as to qualified contribution plansnontaxable percentage = nondeductible contributions divided by balance of account
32 Roth IRAs Nondeductible contributions Contributions to a Roth IRA Same $5,000 limit ($6,000 if 50 or older at year end)Phase-out based on AGI
33 Roth IRAs Distributions from a Roth Distributions of contributions never taxedQualified distributions of earnings from Roth not taxedAccount must be open for five years before can receive qualified distributions andTaxpayer must be at least 59 ½ to receive qualified distribution orDistributions on death of taxpayer orTaxpayer is disabled orFirst home (limited to $10,000)No minimum distribution requirements
34 Roth IRAs Rollover from traditional to Roth Tax consequences Why roll over?Marginal tax ratesContribution limits to Roth are effectively higher$5,000 limit of after tax vs. before-tax dollars
35 Rollover from Traditional to Roth IRA Example Assume when Tina graduated from college and began working for CBA, Tina made a fully deductible $4,000 contribution to a traditional IRA account. Three years later, when her marginal tax rate is 25 percent, Tina withdraws the $5,000 balance in the account and contributed (rolled over) $3,750 to a Roth IRA. What amount of taxes and penalty is she required to pay on the rollover?
36 Rollover from Traditional to Roth IRA Example Solution She must pay a $1,250 in taxes (25% × $5,000) and $125 penalty. The penalty is 10 percent of the $1,250 that she withdrew from the IRA and did not contribute to the Roth IRA ($5,000 - $3,750).
37 Plans for Self-Employed SEP IRAIndividual 401(k)
38 SEP IRA Contribution limit Lesser of (1) $49,000 or (2) 20% of net earnings from self employmentMust provide plan to employees if taxpayer has employees
39 SEP IRA ExampleDave (age 64) receives director compensation of $30,000 during the current year and is reimbursed for all relevant expenses. Due to the specifics of the work arrangement, Dave is treated as a self-employed sole proprietor for tax purposes. If Dave sets up a SEP IRA for himself, what is the maximum contribution he may make to the plan (assuming he has no other source of employee or self-employment income)?
41 Individual 401(k) Contribution limit Lesser of (1) $49,000 or (2) 20% of net earnings from self employment + $16,500Additional $5,500 if age by year endMaximum contribution is $54,500 ($49,000 + $5,500)
42 Individual 401(k) Example Assume the same facts as in the previous example except that Dave set up an individual 401(k) account. Dave is 64 years old at the end of the year, reports $30,000 of self-employment income, and has no other sources of income. What is the maximum amount he can contribute to his individual 401(k) account?