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Now that we have a new president, many business owners and executives are wondering what a Barack Obama administration will mean to their families and their wallets. While President Obama did mention changes to the tax code during his campaign, he doesn”™t appear to be an advocate for the kinds of fundamental tax reform that would scrap the tax code and replace it with a national sales tax or flat tax.
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Although Obama has yet to offer a comprehensive tax plan, he has offered a number of clues that provide some indication of the changes he would support. One item that has quickly caught the attention of business owners, executives and compensation planners is the restoration of the top income tax rates of 36 and 39.6 percent for the so-called “high-income” taxpayers. In the Obama administration, high-income taxpayers would be defined as those with adjusted gross incomes of $250,000 for married couples and $200,000 for other taxpayers, both of which would be indexed for inflation.
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The Obama plan is consistent with the view held by Democratic leadership in the Senate and House, for example, the tax code should be progressive, with those earning more having a greater ability and responsibility to pay more. As a result, it appears as if high-income taxpayers will soon lose more of their income to increased income taxes. What can business owners and executives do about this?
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In the face of these tax increases, a frequently used compensation planning strategy may see renewed interest in 2009 and beyond ”“ deferring income in a salary reduction deferred compensation plan. As soon as there is a concrete proposal to hike tax rates, CPAs and other tax advisers will start to have conversations with their clients making $200,000 or more on the merits of deferring income. As a result, human resource departments may have to field questions about the availability of a deferred compensation program.
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Higher-paid executives have long found that the benefits from qualified pension, profit-sharing and 401(k) plans are, in many cases, significantly reduced and insufficient. For example, if a company”™s 401(k) plan has low participation rates by rank-and-file employees, the ability of key executives to make pre-tax contributions can be significantly reduced. Highly paid executives are also surprised to learn that their qualified retirement plan benefits may be insufficient at retirement to meet the lifestyle to which they are accustomed. As a result, many businesses need to seek alternative arrangements to retain their most talented executives.
And, of course, with higher income tax rates, business owners and executives may wish to bet on the possibility that, when they are ready to retire, there may be a presidential administration in place with a different outlook on income taxes, and that the income tax rates may be lower. Wage deferrals into a salary reduction deferred compensation plan have the effect of lowering the amount that would be reported as “gross income” on line 1 of a Form 1040. Thus, salary reduction plans are a very attractive alternative for business owners and executives who find themselves suddenly bumped into a 36 percent or 39.6 percent bracket.
Non-qualified deferred compensation (NQDC) arrangements are one of the most common and attractive plans for businesses seeking to reward and retain their top performers because they are flexible and customizable to the executive. NQDC plans come in two basic forms. The first is often referred to as a supplemental executive retirement plan or SERP. As the name implies, a SERP is an agreement where the business promises to supplement the executive”™s income at retirement.
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The second form of NQDC plan is commonly referred to as a salary reduction/deferral plan. As the name implies, the executive defers his or her own salary to fund the plan. The salary amounts deferred are not currently taxable to the executive, but will be at retirement and then deductible by the business. A common variation of a salary reduction plan mirrors the company”™s 401(k) plan and provides matching contributions.
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Salary reduction plans offer advantages to the business that sponsors the plan as well as the participants. From the business”™ perspective, it has the flexibility to decide who, among its executives and highly compensated employees, are allowed to participate. Likewise, the business can better attract new talent and retain current executives. Salary reduction plans coordinate with existing qualified plans and can be individually tailored to complement other benefit programs. The benefits are tax deductible to the business when paid at retirement. Finally, where corporate-owned life insurance is used to informally fund the plan, tax-deferred accumulation and high early cash value can offset the impact to earnings charges. In addition, policy cash values are controlled by the business and can be used for general business purposes.
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For the participant, salary reduction plans allow the participant to reduce their taxable income. At retirement, the executive may be in a lower tax bracket when the benefits are received. A key downside to salary reduction plans is that, for the tax deferral to be effective, the funds deferred must remain “at risk” ”“ thus, the participant is a general creditor of the employer and of its ability to pay the deferred compensation. Nevertheless, the benefits of tax-deferred growth can result in increased retirement income, and a pre-retirement death benefit can be provided for designated beneficiaries. With the proper planning, a participant”™s retirement income shortfall can be reduced or eliminated.
Joe Biegel works with Associated Benefit Consultants and is a financial adviser of Park Avenue Securities in Rye Brook. Reach him at JBiegel@AssociatedBenefit.com.