1. Retirement Savings and Deferred Compensation
Chapter 13
Retirement Savings and Deferred Compensation

2. Learning Objectives
Describe 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 Objectives
4. 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 Plans
Must not discriminate between employees
Two main types:
Defined benefit plan
Defined contribution plan

5. Defined Benefit Plans Standard benefits based on fixed formula
Average compensation
Years of service
Employers deduct liability as they contribute to plan
Funding requirements based on actuarial assumptions
Employer not employee bears investment risk

6. Defined Benefit Plans Vesting schedules
5-year cliff or
7-year graded
Distributions from defined benefit plans are taxable to employee when received.
Ordinary income
Early 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)?

8. Defined Benefit Plans Example Solution

9. Defined Contribution Plans
Employer specifies up-front contribution on employee’s behalf
Employers typically match employee contributions
Employees may contribute to plan
Employees choose how to invest contributions
Alternatives depend on employer’s plan
401(k), 403(b), and 457

10. Defined Contribution Plans
Annual contribution limits for 2011
Employee contributions
$16,500 if not 50 years of age by year end
$22,000 if at least 50 years old by year end
Employer + Employee contributions
Limited 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
Vesting
Employee contributions and earnings on employee contributions
Vest immediately.
Employer contributions and earnings on employer contributions
Minimum vesting requirements
3-year cliff or
6-year graded schedule.

14. Defined Contribution Plans

15. Defined Contribution Plans
Distributions
Distributions are ordinary income
Early distributions subject to a 10% penalty
Before 59 ½ year of age if still working or
Before 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 distributions
For 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 year
Based on applicable percentage of balance at end of prior year
50% 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 deductible
Distributions:
Same rules as other defined contribution plans

22. Roth 401k Plans Contributions made with after-tax dollars.
Not tax deductible
Employer 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 distributions
Distributions of earnings are taxable and subject to 10% penalty
Distributions from contributions are not taxable
Contributions divided by account balance multiplied by amount of distribution equals distribution from contributions

24. Deferred Compensation
“Nonqualified plans”
May discriminate
Generally provided to executives or highly compensated rather than rank and file
Can be used to make employee’s whole when contributions to qualified plans would be limited
Deemed investment choices
Risks to employees electing to defer salary?

25. Deferred Compensation
Employer deducts for tax purposes when pays
Compare to financial accounting
Employee includes in income when received
If paid after retirement, §162(m) limitation does not apply

26. Deferred Compensation
Relevant variables
Employer and employee current tax rates
Employer and employee future tax rates
Employer’s cost of capital or discount rate
Employee’s cost of capital or discount rate

27. Individually Managed Qualified Retirement Plans
IRAs
Roth IRAs

28. Individual Retirement Accounts (IRAs)
For AGI deduction for contributions
Generally not allowed if participant in employer-sponsored plan unless
For single taxpayers Taxpayer is single, deduction allowed if participate in employer plan but income is below certain thresholds
In 2011, lesser of $5,000 in 2011 or earned income
If 50 years or older at end of year limit is $6,000
Additional “catch-up” contribution

29. Individual Retirement Accounts (IRAs)
For AGI deduction for contributions
Generally, not allowed if participant in employer-sponsored plan unless
For married taxpayers deduction is allowed if participate in employer plan but income is below certain thresholds
In 2011, lesser of $5,000 in 2011 or earned income of both spouses reduced by other spouse’s contributions to IRA or Roth IRA
If 50 years or older at end of year limit is $6,000
Additional “catch-up” contribution

30. Individual Retirement Accounts (IRAs)
May make nondeductible contributions
Deductible + 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 income
10% penalty if before 59 ½
Certain exceptions
Medical expenses, insurance premiums, first home
Same minimum distributions apply as to qualified contribution plans
nontaxable 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 taxed
Qualified distributions of earnings from Roth not taxed
Account must be open for five years before can receive qualified distributions and
Taxpayer must be at least 59 ½ to receive qualified distribution or
Distributions on death of taxpayer or
Taxpayer is disabled or
First home (limited to $10,000)
No minimum distribution requirements

34. Roth IRAs Rollover from traditional to Roth Tax consequences
Why roll over?
Marginal tax rates
Contribution 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 IRA
Individual 401(k)

38. SEP IRA Contribution limit
Lesser of (1) $49,000 or (2) 20% of net earnings from self employment
Must provide plan to employees if taxpayer has employees

39. SEP IRA Example
Dave (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)?

40. SEP IRA Example Solution

41. Individual 401(k) Contribution limit
Lesser of (1) $49,000 or (2) 20% of net earnings from self employment + $16,500
Additional $5,500 if age by year end
Maximum 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?

43. Individual 401(k) Example Solution

44. Saver’s Credit Credit for taxpayers contributing to qualified plans
Credit in addition to deduction for contribution
Available to lower income taxpayers
Depends on filing status and AGI

45. Saver’s Credit