Chapter 13

Retirement Savings and Deferred Compensation

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Learning Objectives
1.

2.

3.

Describe the tax and nontax aspects of employerprovided defined benefit plans from both the employers and employees 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 employers and employees perspective.

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Learning Objectives
4.

5.

6.

Determine the tax consequences of traditional and Roth Individual Retirement Accounts and explain the differences between them. Describe the retirement savings options available to self-employed taxpayers and compute the limitations for deductible contributions to retirement accounts for self-employed taxpayers. Compute the savers credit.

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Employer Provided Plans

Qualified Plans

Must not discriminate between employees Two main types:

Defined benefit plan Defined contribution plan

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Defined Benefit Plans

Standard benefits based on fixed formula

Average compensation Years of service Maximum benefit in 2013 is $205,000

Employers deduct liability as they contribute to plan

Funding requirements based on actuarial assumptions Employer not employee bears investment risk
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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

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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)?

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Defined Benefit Plans Example Solution

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Defined Contribution Plans

Employer specifies up-front contribution on employees behalf

Employers typically match employee contributions Employees may contribute to plan Employees choose how to invest contributions

Alternatives depend on employers plan

401(k), 403(b), and 457

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Defined Contribution Plans

Annual contribution limits for 2013

Employee contributions $17,500 if not 50 years of age by year end $23,000 if at least 50 years old by year end Employer + Employee contributions Limited to lesser of $51,000 ($56,500 if at least 50 years old at end of year) or 100% of the employees compensation.

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Defined Contribution Plan Example

Before Dave retires at the end of 2013 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 employees 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 $22,500 to his 401(k) account. How much would CBA contribute to Daves 401(k) account?

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Defined Contribution Plan Example Solution

Answer: $34,000 [$56,500 (Dave is 50+ years old) minus $22,500 (Daves contribution)]. Without the limitation, CBA would have contributed $36,000 ($450,000 4% 2) to Daves account.

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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.

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Defined Contribution Plans

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Defined Contribution Plans

Distributions

Distributions are ordinary income Early distributions subject to a 10% penalty

Before 59 year of age if still working or Before 55 years old and separated from service (retired)

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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%)?

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Defined Contribution Plans Distributions Example Solution

Answer: $19,800 taxes ($60,000 33%) + $6,000 penalty ($60,000 10%).

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Defined Contribution Plans

Required minimum distributions

For the year in which employee reaches age 70 or when the employee retires, if later (and each subsequent year)

May defer first required distribution to April 1 of next year. Subsequent distributions must be made 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.
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Minimum Distributions Example

Assume that Dave retires from CBA in 2013 at age 72 (age at year end). Also assume that his 401(k) account balance on December 31, 2012 was $3,500,000. What is the amount of minimum distribution he must receive for 2013 and when must he receive it?

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Minimum Distributions Example Solution

Answer: $136,850 by April 1, 2013 ($3,500,000 3.92% from the IRS table).

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Traditional 401k Plans

Contributions are made with before-tax dollars.

Tax deductible Same rules as other defined contribution plans

Distributions:

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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)

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Roth 401k Plans

Qualified distributions

After account open for five years and employee has reached age 59 . Distributions of earnings are taxable and subject to 10% penalty Distributions from contributions are not taxable

Non-qualified distributions

Contributions divided by account balance multiplied by amount of distribution equals distribution from contributions

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Deferred Compensation

Nonqualified plans

May discriminate Generally provided to executives or highly compensated rather than rank and file

Can be used to make employees whole when contributions to qualified plans would be limited Deemed investment choices Risks to employees electing to defer salary?
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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

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Deferred Compensation

Relevant variables

Employer and employee current tax rates Employer and employee future tax rates Employers cost of capital or discount rate Employees cost of capital or discount rate

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Individually Managed Qualified Retirement Plans

IRAs Roth IRAs

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Individual Retirement Accounts (IRAs)

For AGI deduction for contributions

Generally not allowed if participant in employersponsored plan unless For single taxpayers, deduction allowed if participate in employer plan but income is below certain thresholds (2013): Lesser of $5,500 or earned income If 50 years or older at end of year limit is lesser of $6,500 or earned income

Additional $1,000 catch-up contribution

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Individual Retirement Accounts (IRAs)

For AGI deduction for contributions

For married taxpayers deduction is allowed if participate in employer plan but income is below certain thresholds (2013): Lesser of $5,500 or earned income of both spouses reduced by other spouses contributions to IRA or Roth IRA If 50 years or older at end of year limit is lesser of $6,500 or earned income of both spouses reduced by other spouses contributions to IRA or Roth IRA

Additional catch-up contribution

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Individual Retirement Accounts (IRAs)

May make nondeductible contributions

Deductible + nondeductible cannot exceed $5,500 for one taxpayer (plus catch-up)

Must contribute by April 15th of subsequent year

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Individual Retirement Accounts (IRAs)

Distributions taxed as ordinary income

10% penalty if before age 59 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

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Roth IRAs

Nondeductible contributions Contributions to a Roth IRA

Same $5,500 limit ($6,500 if 50 or older at year end) Phase-out based on AGI

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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 to receive qualified distribution or Distributions on death of taxpayer or Taxpayer is disabled or First home purchase (limited to $10,000)

No minimum distribution requirements

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Roth IRAs

Rollover from traditional to Roth

Tax consequences Why roll over?

Marginal tax rates Contribution limits to Roth are effectively higher

$5,500 limit of after tax vs. before-tax dollars

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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?
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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).

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Plans for Self-Employed

SEP IRA Individual 401(k)

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SEP IRA

Contribution limit

Lesser of (1) $51,000 or (2) 20% (net Schedule C income minus deduction for employers portion of self-employment taxes paid).

Employers portion is 50%.

Must provide plan to employees if taxpayer has employees

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SEP IRA Example

Dave (age 64) receives director compensation of $40,000 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)?

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SEP IRA Example Solution

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Individual 401(k)

Contribution limit

Lesser of (1) $51,000 or (2) 20% (net Schedule C income minus deduction for employers portion of self-employment taxes paid) + $17,500 Additional $5,500 if age 50 by year end

Maximum contribution is $56,500 ($51,000 + $5,500)

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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 $40,000 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?

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Individual 401(k) Example Solution

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Savers 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

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Savers Credit

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