ObamaCare and Nonqualified Deferred Compensation

Sunday, July 1, 2012
The importance of Executive Nonqualified Deferred Compensation in a second Obama administration with the proposed increased taxes.

Fasten your seatbelt and get ready to get ready because your taxes are going up. You do, however, have the option to do something about it, but you and your employer need to take action. The proposed tax increases include:

  1. The previous top income tax rates of 36% and 39.6% will be restored.
  2. Capital gains rates will increase from 15% to 20% in 2012 and 23.8% in 2013 for joint filers with income over $250,000.
  3. In 2013, all or part of the net investment income for individuals earning over $250,000 will have an additional 3.8% "Medicare contribution tax". Therefore, the maximum rate on dividends will be 43.4% (39.6% + 3.8%) versus the current rate of 15%.
  4. In addition, many state income taxes, tied to the federal tax rate, will increase automatically. While other states, feeling considerable fiscal pressure, have already increased their tax rate or are currently giving it consideration. All of these tax increases, depending on the state of residence, will put many high earners in a marginal tax bracket in excess of 50%.

The table below summarizes the proposed changes:

 

  Current Top Marginal Income Tax Rates 2013 Top Marginal Income Tax Rates (Per Current Law) 2013 Additional ACA Taxes 2013 Additional Taxes from Reinstatement of Itemized Deduction Limits 2013 Top Combined Marginal Tax Rate Difference (%) Between Current & 2013 Tax Rates
Long Term Capital Gain 15% 20% 3.8% 1.2% 25% 66.7%
Qualified Dividends 15% 39.6% 3.8% 1.2% 44.6% 197.3%
Interest, Rents, Royalties, etc. 35% 39.6% 3.8% 1.2% 44.6% 27.4%
Wages (Incl. ACA Taxes) 36.45% 41.05% 0.9% 1.2% 43.15% 18.38%

For those higher earners who are corporate executives Nonqualified Deferred Compensation, regulated by IRC 409(A), offers an opportunity for current income tax reduction. It also offers the opportunity to avoid capital gains taxes on investment changes and possible state tax exemption when the funds are distributed.

IRC 409(A) provides detailed guidance concerning the structure of a Nonqualified Deferred Compensation Plan. Some of the more important provisions are as follows:

  1. Plans may permit the pre-tax deferral of up to 100% of base and bonus compensation.
  2. The election to defer base compensation must be made before the compensation is earned.
  3. The election to defer bonus compensation must be made 6 months before the end of the bonus performance period, i.e., June 30th for calendar year bonus plans.
  4. Plans may include investment options similar to those offered by 401(k) plans.
  5. Investment gains, if any, are tax deferred.
  6. Investment reallocations do not generate income tax or capital gains tax to the executive.
  7. All distributions from the plan are taxed as ordinary income.
  8. A federal tax statute permits deferred compensation payments of 10 years or greater to be taxed in the state of residence at the time they are paid.
  9. The executive is a general creditor of the sponsoring corporation.

Residence in a state with no income tax (i.e., Florida) would avoid a state tax on deferred compensation payments.

The following table illustrates the tax efficiency of a Nonqualified Deferred Compensation Plan:

  Without Income Deferral With Income Deferral With Income Deferral & No State Income Tax in Retirement State of Residence
Annual Savings $60,000 $60,000 $60,000
Net After-Tax Savings $36,000 $60,000 $60,000
Earnings Rate 6% 6% 6%
Net After-Tax Rate 3.6% 6% 6%
Accumulation at Retirement $591,132 $1,480,352 $1,480,352
Net After-Tax Annual Benefit $75,770 $110,604 $132,506
Increase in Annual After-Tax Income   46% 75%

This is a hypothetical illustration and not indicative of the performance of any particular investment.

Assumptions:

Above illustration is based on an executive currently age 50, deferring/saving for 15 years and electing a 10-year payout at age 65.

Current Tax Brackets:   Years 2013 forward tax brackets:  
Federal 33% Federal 39.5%
State 7% State 10%
Total 40% Total 49.5%

This table compares the retirement funds accumulated by an executive with an after-tax strategy vs. a deferred compensation strategy. The deferred compensation strategy creates 46% more annual after-tax income than the after-tax strategy and if the retirement state of residence (Florida, New Hampshire, etc.) does not have a state income tax, the deferred compensation strategy creates 75% more annual after-tax income. The payout period must be ten (10) years or greater to avoid state income tax in the state where the funds were deferred.

About Us

At American Benefit Corporation, we design, fund and manage executive non-qualified benefit plans for highly compensated corporate executives who wish to reduce current income taxes and form personal capital on a tax efficient basis. Established more than 30 years ago, we serve the unique needs of executives in numerous corporations with their personal capital formation objectives.

This material is intended for informational purposes only and is not intended to replace the advice of a qualified tax advisor. Investments in securities involve risks, including the possible loss of principal. When redeemed, shares may be worth more or less than their original value.