1. © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Individual Income Taxes 1 Chapter 19 Deferred Compensation

2. 2 The Big Picture Joyce is a junior finance major at State University. Recently, Dr. Sanchez, her finance professor, delivered a lecture on retirement savings that emphasized the need for –A long-term savings horizon, and –Multiple retirement plans. Dr. Sanchez mentioned that she has 4 different retirement plans. Joyce was surprised to hear this because she knows that her father has only a single retirement plan provided by his employer. Joyce drops in on the professor during office hours to find out more about how a person can have multiple retirement plans. Read the chapter and formulate your response.

3. 3 Qualified Plans (slide 1 of 11) Deferred compensation defined: –Payments for services made available to the taxpayer after the period when services were performed

4. 4 Qualified Plans (slide 2 of 11) Tax benefits of qualified deferred compensation plans –Contributions are immediately deductible by the employer –Employees are not taxed on the contributions to the plan or income earned by the plan until payment is made available to them under the plan –Employer contributions to and benefits payable under qualified plans generally are not subject to FICA and FUTA taxes

5. 5 Qualified Plans (slide 3 of 11) A variety of deferred compensation arrangements are offered to employees including: –Qualified profit sharing plans –Qualified pension plans –Cash or deferred arrangement plans –Simple IRAs and § 401(k) plans –Tax-deferred annuities –Incentive stock option plans –Nonqualified deferred compensation plans –Restricted property plans –Cafeteria benefit plans –Employee stock purchase plans

6. 6 Qualified Plans (slide 4 of 11) Pension plans –Provide systematic payments of definitely determinable amounts Employer contributions under a qualified pension plan must not depend on profits Plan normally must pay benefits out as lifetime annuities to provide retirement income to retired employees –2 types of pension plans Defined benefit plan Defined contribution plan

7. 7 Qualified Plans (slide 5 of 11) Defined benefit pension plans –Annual contributions are made by the employer that will provide sufficient amounts to pay specified retirement benefits –Benefits based upon years of service and average compensation –Separate accounts for each employee are not maintained

8. 8 Qualified Plans (slide 6 of 11) Defined contribution pension plans –The annual amount the employer must contribute is defined (e.g., a flat amount or a percentage of compensation) –Separate accounts must be maintained for each employee –The amount received upon retirement is dependent upon amounts contributed and income earned on contributions

9. 9 Qualified Plans (slide 7 of 11) Profit sharing plans –Established to allow employees to participate in the profits of the company –Separate accounts are maintained for each employee

10. 10 Qualified Plans (slide 8 of 11) Profit sharing plans –Definite predetermined formulas must be established for the allocation of contributions to and distributions from the plan –The company is not required to make annual contributions and contributions do not have to come from current profits

11. 11 Qualified Plans (slide 9 of 11) Stock bonus plans –Established so that the employer can contribute shares of its stock –Subject to rules similar to profit sharing plans –Distributions must be in employer’s stock

12. 12 Qualified Plans (slide 10 of 11) Qualification requirements –For a plan to be qualified, it must satisfy the following requirements: Exclusive benefit requirement Nondiscrimination requirements Participation and coverage requirements Vesting requirements Distribution requirements Minimum funding requirements

13. 13 Qualified Plans (slide 11 of 11) Qualification requirements –The qualification requirements are highly technical and numerous Thus, an employer should seek a determination letter from the IRS regarding a plan’s qualified status

14. 14 Tax Consequences to Employee and Employer (slide 1 of 10) Employer contributions to qualified plans are generally deductible immediately Amounts contributed are not taxable to employees until distributed –Tax benefit to the employee amounts to a substantial tax deferral –Another advantage of a qualified plan is that any income earned by the trust is not taxable to the trust Employees are taxed on such earnings when they receive the retirement benefits Taxation of amounts received by employees in periodic or installment payments is generally subject to the annuity rules

15. 15 Tax Consequences to Employee and Employer (slide 2 of 10) Lump-sum distributions-generally taxable in year of distribution –Taxpayers who receive a lump-sum distribution from a qualified plan can roll over the benefits into an IRA or into another qualified plan Defers tax on lump-sum distribution

16. 16 Tax Consequences to Employee and Employer (slide 3 of 10) Limitations on contributions –Defined contribution plan Lesser of $49,000 (in 2011) or 100% of employee’s compensation Employer’s deduction limit cannot exceed 25% of eligible compensation

17. 17 Tax Consequences to Employee and Employer (slide 4 of 10) Limitations on contributions –Defined benefit plan – max contribution deduction can be calculated in one of two ways Aggregate cost method allows an actuarially determined amount, or Normal cost plus up to 10% of past service costs

18. 18 Tax Consequences to Employee and Employer (slide 5 of 10) Limitations on contributions –Defined benefit plan Annual benefit payable under the plan is the lesser of $195,000 (in 2011), subject to certain limitations, or 100% of average compensation for the highest 3 years of employment –Compensation considered in averaging cannot exceed $245,000 (in 2011) –10% penalty tax on excess contributions

19. 19 The Big Picture - Example 7 Defined Benefit Pension Plan vs. A Defined Contribution Plan Return to the facts of The Big Picture on p. 19-2. The university has offered Joyce’s professor, Dr. Sanchez, a choice between a defined benefit pension plan and a defined contribution plan. Dr. Sanchez expects to work at a number of universities during her career. –A colleague has recommended that Dr. Sanchez choose the defined contribution plan because of its mobility She can take the plan with her. She needs to decide if this mobility factor is significant in making her choice and how much she can contribute annually to a defined contribution plan.

20. 20 Tax Consequences to Employee and Employer (slide 6 of 10) Limitations on contributions –Profit sharing plan or stock bonus plan Maximum deduction permitted to an employer each year for contributions to profit sharing and stock bonus plans is 25% of compensation –Maximum compensation considered is $245,000 for 2011 –The maximum deduction allowed is $49,000 in 2011

21. 21 Tax Consequences to Employee and Employer (slide 7 of 10) §401(k) plans –Employee elects to receive cash (taxed currently) or have amount contributed (pretax) to a qualified plan –Limit for 2011 on employee contribution is $16,500 Amount is reduced by other tax-sheltered salary reduction plans Person age 50 or over by year end may make catch-up contributions of up to $5,500 for 2011

22. 22 The Big Picture - Example 14 § 401(k) plan vs. § 403(b) plan Return to the facts of The Big Picture on p. 19-2. Dr. Sanchez is not eligible to participate in a § 401(k) plan. –She does participate in a § 403(b) tax-deferred annuity plan. –A § 403(b) plan is for employees of § 501(c) (3) not-for-profit organizations. Similar in many respects to a § 401(k) plan.

23. 23 The Big Picture - Example 15 § 403(b) Annuity Return to the facts of The Big Picture on p. 19-2. Dr. Sanchez indicates that since she is age 51, she is eligible to make catch-up contributions to her § 403(b) annuity.

24. 24 Tax Consequences to Employee and Employer (slide 8 of 10) SIMPLE Plans –Employers with 100 or less employees and no other qualified plan –In form, §401(k) or IRA –Avoids nondiscrimination rules

25. 25 Tax Consequences to Employee and Employer (slide 9 of 10) SIMPLE Plans –Employees make elective contributions (up to $11,500 in 2011) to plan Contributions made as percentage of compensation Distributions from plan taxed under IRA rules –Employers generally required to match contributions up to 3% of compensation or provide 2% nonmatching contributions –Person age 50 or over by year end may make catch-up contributions of up to $2,500 for 2006 and thereafter

26. 26 Tax Consequences to Employee and Employer (slide 10 of 10) Designated Roth Contributions –Starting in 2006, § 401(k) plans and § 403(b) plans may be amended to permit employees to irrevocably designate some or all of their future salary deferral contributions as Roth § 401(k) or Roth § 403(b) contributions These designated amounts are currently includible in the employee’s gross income and are maintained in a separate plan account The earnings on these elective contributions build up in the plan on a tax-free basis Future qualified distributions made from designated contributions are excludible from gross income

27. 27 Retirement Plans for Self-Employed Individuals (slide 1 of 2) H.R. 10 (Keogh) plans –Retirement plans for self-employed and their employees –Plan rules are similar to corporate provisions –Plan must be established before the end of the tax year, but contributions may be made up to the due date of the return

28. 28 Retirement Plans for Self-Employed Individuals (slide 2 of 2) Keogh (H.R. 10) plans (cont’d) –Contribution limitations Defined contribution plan –Lesser of $49,000 (in 2011) or 100% of earned income –Profit sharing plans and stock bonus plan are limited to 25% –Defined benefit plans limit the annual benefit payable to the lesser of $195,000 (in 2011) or 100% of average compensation for 3 highest years

29. 29 The Big Picture - Example 19 Keogh Plan Return to the facts of The Big Picture on p. 19-2. Joyce’s professor, Dr. Sanchez, has a forensic consulting practice in addition to her position at the university. –Also, she receives book royalties from a textbook. Since she is self-employed (she will report her earnings on a Schedule C), she is able to establish a Keogh plan.

30. 30 Individual Retirement Accounts (slide 1 of 15) Contribution ceiling is lesser of $5,000 ($10,000 for spousal IRAs) or 100% of earned income Person age 50 or over by year end may make catch-up contributions –Max contribution limit is increased by $1,000 for 2006 and thereafter Deductible IRA contribution may be reduced if taxpayer is an active participant in another qualified plan To extent individual is ineligible to make deductible contributions, a nondeductible IRA contribution may be made –Income accrues on account tax deferred

31. 31 Individual Retirement Accounts (slide 2 of 15) If taxpayer is covered by a qualified plan, IRA deduction is phased out within the AGI ranges listed below: Phase-out begins Phase-out ends Single & HH $56,000 $66,000 MFJ 90,000 110,000 MFS 0 10,000

32. 32 Individual Retirement Accounts (slide 3 of 15) For distributions made in 2006 through 2011, an exclusion from gross income is available for traditional IRA distributions made to charity –The amount of the distribution that is eligible for this beneficial exclusion treatment is limited to $100,000

33. 33 Individual Retirement Accounts (slide 4 of 15) Roth IRA –Contributions are nondeductible Maximum allowable annual contribution is the smaller of –$5,000 ($10,000 for spousal IRAs) or –100% of the individual’s compensation for the year –Qualified distributions are tax-free after an initial five year holding period if: Made on or after age 59 ½ Made to beneficiary on or after participant’s death Participant becomes disabled Used to pay for qualified first-time home buyer’s expenses ($10,000 limit)

34. 34 Individual Retirement Accounts (slide 5 of 15) Roth IRA (cont’d) –Other distributions may be taxable Distributions first treated as nontaxable return of capital to extent of contributions Remaining distribution treated as taxable payout of earnings

35. 35 Individual Retirement Accounts (slide 6 of 15) Roth IRA (cont’d) –Annual contributions are subject to phase out within the AGI ranges listed below: Phase-out begins Phase-out ends Single $ 107,000 $122,000 MFJ 169,000 179,000 MFS 0 10,000

36. 36 The Big Picture - Example 29 Roth IRAs Income Limits Return to the facts of The Big Picture on p. 19-2. Joyce’s professor, Dr. Sanchez, also contributes annually to a traditional IRA. –She would prefer a Roth IRA, but her AGI exceeds the phaseout limit.

37. 37 Individual Retirement Accounts (slide 7 of 15) Coverdell Education Savings Account –Distributions to pay for qualified education expenses (QEE) are tax-free Exclusion may be available in year American Opportunity credit or lifetime learning credit is claimed –Maximum annual nondeductible contribution for a beneficiary is $2,000 No contributions allowed after beneficiary reaches 18 years of age No contribution allowed in year contribution made to qualified tuition program for same beneficiary

38. 38 Individual Retirement Accounts (slide 8 of 15) Coverdell Education Savings Account (cont’d) Annual contributions are subject to phase out within the AGI ranges listed below: Phase-out begins Phase-out ends Single $95,000 $110,000 MFJ 190,000 220,000

39. 39 Individual Retirement Accounts (slide 9 of 15) Coverdell Education Savings Account (cont’d) –Distributions in excess of QEE are treated, pro rata, as a return of capital and a distribution of earnings The exclusion for the distribution of earnings is calculated as follows: Exclusion = (QEE/Total Distributions) × Earnings –Qualified higher education expenses (QEE) include: Tuition, fees, books, supplies and equipment Room and board if enrolled for at least one-half of full-time course load

40. 40 Individual Retirement Accounts (slide 10 of 15) Simplified employee pension (SEP) plans –Employer contributes to employee’s IRA Contribution limited to lesser of $49,000 (in 2011) or 25% of compensation Subject to most restrictions of qualified plans –Elective contributions by employee are limited to $16,500 in 2011

41. 41 Individual Retirement Accounts (slide 11 of 15) Spousal IRAs –If both spouses have earned income, ceiling on deductible contributions is $10,000 or combined earned income –If only one spouse has earned income, ceiling is $10,000 or earned income of that spouse –Must file jointly to use spousal IRA rules

42. 42 Individual Retirement Accounts (slide 12 of 15) Alimony is considered to be earned income for purposes of IRA contributions –Thus, a person whose only income is alimony can contribute to an IRA Timing of Contributions –Contributions (both deductible and nondeductible) can be made to an IRA anytime before the due date of the individual’s tax return (without extensions)

43. 43 Individual Retirement Accounts (slide 13 of 15) Taxation of Benefits –A participant has zero basis in deductible contributions to a traditional IRA because the contributions were deducted Therefore, all withdrawals from a deductible IRA are taxed as ordinary income in the year of receipt –A participant has a basis equal to the contributions made for a nondeductible traditional IRA Therefore, only the earnings component of withdrawals is included in gross income Such amounts are taxed as ordinary income in the year of receipt

44. 44 Individual Retirement Accounts (slide 14 of 15) Distributions before age 59 1/2 subject to 10% penalty tax except to pay for: –Medical expenses in excess of 7.5% AGI –Qualified higher education expenses –Qualified first-time home buyer expenses up to $10,000 –Health insurance premiums for person (and family) who has received unemployment comp for at least 12 consecutive weeks

45. 45 Individual Retirement Accounts (slide 15 of 15) Rollovers –Distribution from qualified plan transferred within 60 days to IRA (or another qualified plan) not includible in gross income –One tax-free rollover from IRA within 12-month period Direct transfers not subject to this limitation –Employer must withhold 20% of any lump-sum distribution that is not a direct transfer

46. 46 The Big Picture - Example 37 Tax-free Rollover Return to the facts of The Big Picture on p. 19-2. Dr. Sanchez withdraws $15,000 from her traditional IRA on May 2, 2011, but she redeposits it in the same IRA on June 28, 2011. –Although the withdrawal and redeposit was a partial rollover and Dr. Sanchez may have used the funds for a limited time. –This is a tax-free rollover.

47. 47 Nonqualified Deferred Compensation Plans (slide 1 of 3) New rules apply after 2004 to nonqualified arrangements that defer the receipt of compensation income –If the plan does not meet certain conditions in § 409A, all amounts deferred under the arrangement may be included in the participant’s gross income to the extent they are not subject to a substantial risk of forfeiture –In addition, a 20% penalty tax is imposed on such income along with interest at the underpayment rate plus 1% In general, a § 409A deferral occurs where an employee has a legally binding right to compensation that has been deferred to the future

48. 48 Nonqualified Deferred Compensation Plans (slide 2 of 3) Golden parachutes –Defined: Excess severance payments –Employer is denied deduction for golden parachute payments if Payment is contingent on change of ownership through a stock or asset acquisition Aggregate present value of payment equals or exceeds three times the employee's average annual compensation –Disallowed amount is excess of payment over statutory base (five-year average taxable compensation) and a 20% excise tax is imposed on the recipient

49. 49 Nonqualified Deferred Compensation Plans (slide 3 of 3) Compensation limitations –Publicly traded companies have a limitation of $1 million on deductible compensation for each of the top 5 executives Limit may be reduced to $500,000 under TARP –Certain types of compensation are not subject to the limit e.g., Commissions, certain performance-based amounts, qualified retirement plan contributions, and excludible amounts such as employee fringe benefits

50. 50 Restricted Property Plans (slide 1 of 2) Restricted property plan defined: –Generally, an incentive compensation arrangement where the employee receives property (e.g., stock in the employer) at little or no cost –Time for inclusion in income is the earlier of: When the property is no longer subject to substantial risk of forfeiture, or When the property is transferable by the employee

51. 51 Restricted Property Plans (slide 2 of 2) Employee can elect to recognize any ordinary income from the restricted property immediately Employer is allowed a tax deduction at the same time the employee includes the compensation in income

52. 52 Stock Options (slide 1 of 5) Stock option defined: –The right to purchase a stated number of shares of stock at a certain price within a specified time period

53. 53 Stock Options (slide 2 of 5) Incentive stock options (ISO) –No tax consequences to issuer or recipient when granted The spread between FMV and option price at exercise date is a tax preference item for AMT

54. 54 Stock Options (slide 3 of 5) Incentive stock options (ISO) –Employee will qualify for long-term capital gain treatment on the sale of stock received by exercising the option if stock is held more than 2 years after the option is granted, or 1 year after the option is exercised –May produce no compensation deduction for employer

55. 55 Stock Options (slide 4 of 5) Nonqualified stock options (NQSO) –NQSO are stock options that do not qualify as ISO –If the NQSO has an ascertainable value at the date of grant, it is included in the employee’s income on that date

56. 56 Stock Options (slide 5 of 5) Nonqualified stock options (NQSO) –If the NQSO does not have an ascertainable value at date of grant, employee will recognize ordinary income at the exercise date equal to the difference between FMV and the option price –Employer receives a deduction for the same amount as is included in the employee’s income

57. 57 Refocus On The Big Picture (slide 1 of 4) From her discussion with Dr. Sanchez, Joyce learns that her professor has the following retirement plans: –Defined contribution plan - The university offered its faculty members a choice between a defined benefit pension plan and a defined contribution plan. Dr. Sanchez expects to work at a number of universities during her career, so she chose the defined contribution plan because of its mobility. The maximum annual contribution the university could make to the plan is $49,000 for 2011. Since the university contribution rate is 15%, the actual contribution is $22,500($150,000 X 15%).

58. 58 Refocus On The Big Picture (slide 2 of 4) § 403(b) annuity - Dr. Sanchez makes contributions to a § 403(b) annuity –This is the equivalent of a § 401(k) plan, but available to educators. –She has the university deduct the maximum annual contribution in 2011 of $16,500. –In addition, because she is at least age 50, she has the university deduct an additional $5,500 as a catch-up contribution.

59. 59 Refocus On The Big Picture (slide 3 of 4) Keogh (H.R. 10) plan - Dr. Sanchez also has a forensic consulting practice. –Since she is self-employed, she is able to establish a Keogh plan. –She makes contributions of 20% of her net earnings from the consulting practice, about $8,000 per year ($40,000 X 20%), to the plan.

60. 60 Refocus On The Big Picture (slide 4 of 4) IRA - Dr. Sanchez also contributes annually to a traditional IRA. –She would prefer a Roth IRA, but her AGI exceeds the $122,000 phaseout limit. –Likewise, she cannot deduct her IRA contribution of $5,000 (the maximum) because her AGI is above the limit. Since she cannot deduct her contributions, her basis in the IRA is equal to the amount of her contributions. –The $15,000 that Dr. Sanchez withdrew from her traditional IRA is not subject to current taxation and does not reduce her basis for the IRA. This result occurs because Dr. Sanchez successfully recontributed the $15,000 to her IRA within 60 days.

61. © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 61 If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA trippedr@oneonta.edu SUNY Oneonta