McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 13

Retirement Savings and Deferred Compensation

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Learning Objectives

1. Describe the tax and nontax aspects of employer-provided defined benefit plans from both the employer’s and employee’s perspective.

2. Explain and determine the tax consequences associated with employer-provided defined contribution plans, including traditional 401(k) and Roth 401(k) plans.

3. Describe the tax implications of deferred compensation from both the employer’s and employee’s perspective.

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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.

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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

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 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

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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.

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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 ½ year of age if still working or Before 55 years old and separated from service

(retired)

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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.

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Traditional 401k Plans

Contributions are made with before-tax dollars. Tax deductible

Distributions: Same rules as other defined contribution plans

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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 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

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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 employee’s 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 Employer’s cost of capital or discount rate Employee’s 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 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

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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

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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

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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

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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

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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 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

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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

$5,000 limit of after tax vs. before-tax dollars

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Plans for Self-Employed

SEP IRA Individual 401(k)

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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

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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)

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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

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Saver’s Credit