Chapter 13

1. Chapter 13 Retirement Savings and Deferred Compensation

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

3. 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.

4. Employer Provided Plans • Qualified Plans • Must not discriminate between employees • Two main types: • Defined benefit plan • Defined contribution plan

5. 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

6. 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

7. 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

8. 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.

9. 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.

10. Defined Contribution Plans

11. 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)

12. 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.

13. Traditional 401k Plans • Contributions are made with before-tax dollars. • Tax deductible • Distributions: • Same rules as other defined contribution plans

14. 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)

15. 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

16. 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?

17. 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

18. 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

19. Individually Managed Qualified Retirement Plans • IRAs • Roth IRAs

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. Plans for Self-Employed • SEP IRA • Individual 401(k)

28. 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

29. 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)

30. 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

31. Saver’s Credit