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Lump-sum payouts and tax implications

February 24th, 2014 No comments

Clark-CharlieOver the past few years, there is evidence to confirm that several employers sponsoring defined benefit (DB) pension plans have been settling their plans’ pension obligation to former employees via a single lump-sum payout. It is commonly referred to as a lump-sum cleanup strategy. Some commenters have said that not only has demand for such a strategy not abated, it has accelerated.

This blog post will remain neutral on the prudence of implementing such a strategy, as each employer’s goal is unique. Recognizing that employers who implement such strategies spend enormous energy and resources to communicate the consequences and financial impact on those electing the lump-sum payout, it’s questionable whether recipients completely understand the individual tax implications it could personally have on them. (And to be clear, this blog post does not implicitly or explicitly render any type of tax advice.)

If a participant chooses to roll over the lump-sum distribution to a personal tax-deferred IRA or to a tax-qualified savings plan of a new employer, the issues below are irrelevant. However, if the lump-sum is received as current income:

• The individual could move into the next higher marginal tax bracket, both federal and state (where there is a state income tax).
• The individual could face a 10% excise tax if that person is younger than age 59½.
• The individual could incur an underwithholding penalty in comparison to their prior year’s tax liability.
• According to the U.S. Department of Health and Human Services (HHS), eligible individuals and families with incomes between 100% and 400% of the federal poverty level (FPL) may receive premium tax credits for purchasing health insurance in the healthcare exchange. The 2013 FPL for a single person is $11,490 and this individual’s healthcare premium payment is capped at $228 per year. A lump-sum of approximately $29,000 would raise that premium cap to $3,816. A lump-sum of approximately $34,000 would raise income above 400% of the FPL and the individual would have to pay the full premium of the healthcare policy selected on the healthcare exchange.

Takeaway: The economic impact of a lump-sum payout must be carefully evaluated by the recipient. It may not be as advantageous as it appears. Plan sponsors implementing this strategy may wish to consider the impacts of the ACA as they draft the communications to the prospective payees.

Managing FICA taxes in the years ahead

November 5th, 2012 No comments

Federal Insurance Contributions Act (FICA) taxes on wages include Social Security’s Old Age, Survivors, and Disability Insurance (OASDI) and Medicare’s Hospital Insurance (HI). Tax rates as a percentage of taxable earnings are set by law and are currently 6.2% for OASDI and 1.45% for HI, payable each by employees and employers. (The 6.2% OASDI employee rate is temporarily reduced to 4.2% for 2011 and 2012.)

As a result of the Patient Protection and Affordable Care Act (PPACA), the employee HI tax will increase by 0.9% beginning January 1, 2013, from 1.45% to 2.35%. This will apply to FICA wages over $200,000 for individuals and $250,000 for married couples filing jointly. The employer tax rate will not change.

Accruals in nonqualified deferred compensation plans are also subject to FICA taxes, although the OASDI tax typically does not apply to these accruals because the non-deferred compensation of highly paid executives in nonqualified plans has usually exceeded the Social Security taxable wage limit ($113,700 in 2013). The HI tax has no maximum wage limit. Before the HI tax rate increase takes effect, executives may have a window of opportunity to save money with respect to taxes on their nonqualified benefits by paying some of the tax at the lower 2012 rates.

In a defined benefit (DB) nonqualified retirement plan (non-account balance plan), participants may voluntarily elect to pay the tax on their vested benefit before they retire. This is called “early inclusion” in the IRC Section 3121(v) regulations. The present value of the nonqualified benefit can be calculated at a date in 2012, and then taxes can be paid on that present value at the 2012 tax rate. When the participant retires in a later year, a “true up” calculation will be done to determine the final present value of the participant’s nonqualified benefit, and the excess of the final value over the originally calculated value is taxed at the rates in effect at the time of retirement.

It is important to note that the employee does face some risk in prepaying FICA taxes on nonqualified benefits. If the benefits decrease between now and retirement (because of growing offsets in the benefit formula, for example), the employee may overpay taxes. A larger risk for the employee is in the possibility that the company enters bankruptcy before he or she retires and the employee loses the nonqualified benefits that he or she has already paid taxes on.

For executives with sizeable nonqualified pension benefits, it may be worthwhile to consider taking advantage of the lower tax rates now by paying FICA taxes in 2012 rather than waiting until retirement. When making this decision, employees should consult their tax advisors, bear in mind how their nonqualified benefits may change between now and retirement, and take their companies’ financial stability into consideration. Plan sponsors should also consult with legal counsel before informing participants of the opportunity to pay FICA taxes early.

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Would tax increases prompt small business owners to reevaluate their retirement programs?

October 24th, 2012 No comments

There has been much discussion in the news lately regarding the tax code. Whether the discussion centers around different tax plans proposed by the presidential candidates, the Bush tax cuts set to expire at the end of the year, the fiscal cliff, or Congressional gridlock, it appears small business owners will be adversely affected in some form.

If tax rates increase and small business owners look at different alternatives to manage their tax liabilities, will we see changes to their retirement programs? In particular, will there be interest in adding tax-advantaged cash balance plans to their existing 401(k) profit sharing plans, or perhaps adding newly minted DB(k) plans for those without retirement programs?

For those with 401(k) profit sharing plans, a separate cash balance plan can be established and coupled with the existing plan in order to help small business owners substantially increase contributions to their retirement programs. This allows these small business owners to maximize their tax-deductible contributions and manage their tax liabilities. This type of retirement program is especially feasible for groups of professionals, such as organizations staffed mostly by accountants, lawyers, or doctors.

For those without current retirement programs, the DB(k) may be the way to go. The DB(k) was introduced as part of the Pension Protection Act of 2006. A DB(k) is designed to incorporate the best parts of both a defined benefit (DB) plan and a 401(k) plan into one single plan. These plans provide for a guaranteed income stream at retirement, while allowing for employees to contribute to a 401(k) savings account. Although these plans could be effective January 1, 2010, Congress has not provided any guidance on how they should be operated, leaving employers reluctant to set them up.

It will be important for small business owners to look at all alternatives to manage their tax liabilities. Making a change to their retirement programs may be part of the solution.

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A crystal ball for taxes

October 27th, 2011 No comments

Payroll taxes went down in 2011 from 6.2% to 4.2%, which is due to a one-time change in the law. Ideally, Americans would have used that extra cash to increase their retirement savings, but at this point, it’s hard to tell what they did. Although there is some speculation that the reduction could be renewed in 2012, payroll taxes could go back up to 6.2%. For Americans who were able to save, only time will tell if those who have gotten used to socking away more in their retirement savings will revert back to smaller contributions in 2012 (compared to 2011) because they can’t afford to do it or if it’s too painful.

 

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Social Security’s 2012 makeover

October 21st, 2011 No comments

There are some changes coming for Social Security in 2012 so this week’s poll is a two-parter.

The biggest change is the cost of living increase for Social Security recipients. The 3.6% increase to Social Security is supposed to be a cost of living adjustment to keep seniors up to speed with inflation, but some economists are predicting an increase in consumer spending as a result of this increase.

How is an increase in Social Security benefits possible with the economy in the shape it’s in? Payroll taxes. Everybody’s going to see a payroll tax increase in 2012.

Retirement savings incentives and your taxes

May 26th, 2011 No comments

Charles ClarkIf you ever wondered how much income tax our federal government doesn’t collect by allowing employers to sponsor retirement programs and Americans to defer payment of taxes by contributing to IRAs, the numbers may shock you. In this current fiscal year, it’s $119 billion and that fact is buried in a footnote in a March 2011 report (Report GAO-11-333, page 1 footnote).

U.S. Federal Government FY 2011
Retirement Program Revenue Loss
401(k) plans $62,900,000,000
DB plans $42,200,000,000
IRAs $13,900,000,000
Total $119,000,000,000

It’s no wonder current members of Congress have been considering curtailing these tax-favored plans. In the same report, the GAO presents data that allegedly supports the claim that these tax-favored plans favor Americans with private sector jobs. They’ve titled it “Some Key Features Lead to an Uneven Distribution of Benefits.” What do you think?

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