Taxation chapter 13- retirement savings
and deferred compensation
Congress mandated that employer-provided pension plans receive tax-favored qualified
plan status only if they meet certain requirements (thus ensuring that the plan doesn’t
discriminate against employees)
Employee-provided qualified plans are generally classified as defined benefit plans or
defined contribution plans
Defined contribution plans are much more common
Defined benefit plans- traditional pension plans used by many older and more established
companies and tax exempt organizations, plans provide standard retirement benefits to
employees based on a fixed formula
Amount of compensation taken into account for an employee for a particular year is
subject to an annual compensation limit (285,000 for 2020)
For employees who receiving retirement benefits in 2020- they can receive the begin
LESSER of 100% of the average of the three highest consecutive years of compensation,
limited to annual compensation cap for each of the three years, or 230,000.
Vesting- the process of becoming legally entitled to a certain right or property
Cliff vesting- after a certain period of time, benefits vest all at once.
Graded vesting- vested benefit increases each full year worked for the employer
Distributions from defined benefit plans (and defined contribution plans)- are subject to
early distribution requirements and to minimum distribution requirements (distributions
that violate that are penalized)
A defined benefit plan--- imposes administrative burdens and risks on the employer
sponsoring the plan, a significant amount of work is also required to track employee
benefits and compute required contributions to the plan, and the employer bears the
investment risk associated with investments within the plan.
In a defined contribution plan- employers maintain a separate account for EACH
participating employee, plans specify the up-front contributions the employer will make
to the employees separate account, employees are often allowed to contribute to their
own plan, and employees are generally free to choose how amounts in their retirement
account are invested.
Defined contribution plans shift funding responsibility and investment risk from the
employer to the employee
EMPLOYERS typically contribute to defined contribution plans such as profit-sharing
plans and money-purchase plans. EMPLOYEES typically contribute to 401(k) type plans
For 2020, sum of employer AND employee contributions to a defined contribution
account is limited to the LESSER of 57000 (or 63500 for employees 50+), or 100% of
the employees compensation for the year.
EMPLOYEE contributions to their 401(k) account are limited to 19500 (26000 for 50+).
When they do not maintain separate employee accounts- companies calculate the accrued
benefit from employee contributions by multiplying the total accrued benefit in the
account by the ratio of employee contributions to total contributions to the account
Accrued benefit from employer contributions = total accrued benefit – accrued benefit from
employee contributions
After tax cost of a contribution to a traditional defined contribution plan = contribution amount –
tax savings generated by the deduction from the contribution
Employees effectively deduct their contributions to traditional defined contribution plans
(all plans except Roth 401(k)) because contributions are removed from their taxable
salary (they are still subject to FICA taxes though).
Distributions = taking a withdrawal from the account or retirement plan (taxed as
ordinary income when they do this)
There is a 10% penalty for people who take withdrawals (distributions) before 59 ½ age
if not retired OR before 55 if they already quit or were fired
Required minimum distributions- must receive by April 1 of the LATER of the year after
the taxpayer turns 72 or the year after the employee retires
Retired employees who wait until after turning age 72 to begin receiving distributions
must receive 2 in the first year
The amount of the required minimum distribution is the taxpayers account balance at the
end of the year PRIOR to the year that the distribution will be received * % from life
expectancy table
Taxpayers incur a 50% nondeductible penalty for failing to take the amount of required
minimum distributions when they should have received them
Roth 401(k) plan- employees may elect to contribute to the plan instead of or in addition
to contributing to a traditional 401(k). however, employer contributions to an employees
401k account must go to the employees traditional 401k rather than their roth 401k.
(basically, a persons roth 401k is only their contributions and earnings on the
contributions)
Employers are required to maintain traditional 401k accounts for each employee who
participated in a roth 401k plan
Employee contributions to roth 401k accounts are not deductible and do not produce any
immediate tax savings for employees. (the person has to pay taxes on their contributions
so if they want to contribute 2000, theyd need to have 2564 before tax)
Qualified distributions from roth 401k accounts are excluded from gross income
Before tax rate of return = after tax rate of return for roth 401k accounts
Qualified distributions from roth 401k accounts are those made after the employees
account has been open for five taxable years AND the employee is 59 ½ age.
Taxpayers generally should prefer traditional 401k when their current marginal rate is
HIGHER than they expect it to be in the future. and taxpayers should prefer roth 401k
when their current marginal rate is LOWER than their future rate.
Deferred compensation plans permit employees to defer (or contribute) current salary in
exchange for a future payment from the employer
Employee contributions to nonqualified deferred compensation (NQDC) plans reduce the
employees taxable income in the year of the contribution, distributions from NQDCs are
taxed as ordinary income
Employers may discriminate in terms of who they allow to participate in a NQDC
Employers also are not required to fund nonqualified plans, typically they retain funds
deferred by employees to the plan, use the funds for business operations and pay the
deferred compensation out of their general funds when it becomes payable
Employers are allowed to deduct only actual payments of deferred compensation to
employees under NQDCs
Should employees participate in nonqualified plans--- employees must decide whether
the benefits they expect to receive from qualified retirement plans will be adequate to
provide for their expected costs during retirement, employees should consider whether
they can afford to defer current salary, also employees should consider the expected after-
tax rate of return on the deferred salary relative to what they could earn by receiving that
salary and personally investing it.
An employees after tax rate of return on deferred compensation depends on their
investment choices AND on the employees marginal tax rates at the time of the
contribution and at the time of the distribution
Employers can benefit from nonqualified plans if they are able to earn a better rate of
return on the deferred compensation than the rate of return they are required to pay
employees participating in the plan, employers can also use nonqualified plans to achieve
hiring objectives.
Individual retirement accounts (IRAs)- divided into traditional IRAs and Roth IRAs (for
the most part, traditional and roth IRAs have the same characteristics as traditional and
roth 401ks)
Deductible contributions to IRAs are FOR AGI deductions, max deductible contribution
– 6k if person is 49 or less, 7k if person is 50 plus.
Deductible contribution limit may be further restricted depending on the taxpayers
participation in an employer sponsored retirement plan, their filing status, their earned
income, their modified AGI.
Unmarried taxpayers not participating in an employer-sponsored plan may deduct IRA
contributions up to the LESSER of 6k (7k for people 50+) or earned income.
Married taxpayers can make deductible contributions to separate IRAs- however, the max
deduction for the spouse with the HIGHER amount of earned income is 6k (7k if 50+) or
earned income, but for the spouse with the LOWER amount of earned income, the
deduction is limited to 6k (7k if 50+) or total earned income of both spouses reduced by
contributions
Spousal IRA- deduction to the lesser-earning spouses IRA
Deductions for IRA contributions are phased out (see textbook for details)
Taxpayers can still make nondeductible contributions- however, it is limited to 6k per
year (7k if 50+)
Distributions from traditional IRAs are taxed as ordinary income to the taxpayer
Contributions to a roth IRA are NOT deductible, qualifying distributions from a roth IRA
are NOT taxable
Whether taxpayers participate in an employer-sponsored retirement plan or not, the roth
IRA contribution limitation phases out based on modified AGI
Qualified distributions (distribution from funds or earnings from funds in a roth IRA if
the distribution occurs at least five years after the taxpayer opened the roth IRA and
meets at least one of several requirements *see page 13-24*) from roth IRAs are not
taxable
Nonqualified distributions of the earnings of a roth IRA are taxable as ordinary income.
Taxpayers can convert a traditional IRA to a roth IRA through a rollover- when they do
this, the entire amount coming out of the traditional IRA Is taxed at ordinary rates.
Roth IRAs have two main advantages over traditional IRAs--- the minimum distribution
requirements for traditional IRAs do not apply to roth IRAs, and taxpayers can withdraw
their roth contributions tax-free at any time without paying tax or a penalty
For self-employed people, simplified employee pension (SEP) IRAs and individual (or
self employed) 401(k) plans are the most popular. (for these plans, amounts contributed
are deducted from income, earnings are free of tax until distributed, and distributions
from the plan are fully taxable)
For a SEP IRA- contributions are limited to the LESSER of 57k or 20% of schedule C net
income, after reducing net income by the deduction for the employers portion of self-
employment taxes paid
Individual 401(k) plans are strictly for sole proprietors (and their spouses) with no
employees
For individual 401ks- people can contribute the LESSER of 57k (63.5k if 50+) or 20% of
schedule C net income, after reducing net income by the deduction for the employers
portion of self employment taxes paid
Congress provides an additional savers credit for an individuals elective contribution of
up to 2k to any of the qualified retirement plans
The savers credit is provided in addition to any deduction the taxpayer is allowed for
contributing to a retirement account (calculated by multiplying the taxpayers contribution
[max 2k] by the applicable % depending on the taxpayers filing status and AGI
