2014–15 tax guide: Compensation and benefits

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Compensation and benefits remain some of the trickiest areas for businesses. Benefit plans and employee compensation are big expenses for most employers, but they’re also the key to retaining and attracting top talent. Your first step should be understanding all the requirements, because running afoul of the many restrictions built into compensation and benefits laws can be costly. The second step should be taking a hard look at plan design so you can be sure your plans are cost-effective and attract the right employees.

Retirement plans

Some of the best tax savings offered by the code come in the retirement space, and saving for retirement is fun again. Defined contribution plans let you control how much is contributed. They come in employer-sponsored versions like the 401(k), 403(b), 457, Savings Investment Match Plan for Employees (SIMPLE) individual retirement account (IRA) and Simplified Employee Pension Plans (SEP IRAs), or in nonemployment versions like the IRA.

Tax reference guide

When to choose a Roth version
Four of the defined contribution plans — 401(k)s, 403(b)s, governmental 457(b)s and IRAs — offer Roth versions. The tax benefits of Roth accounts differ slightly from those of traditional accounts. Roth accounts allow for tax-free growth and tax-free distributions, but contributions are neither pretax nor deductible.

The difference is in when you pay the tax. With a traditional retirement account, you get a tax break on the contributions — you pay taxes only on the back end when you withdraw your money. For a Roth account, you get no tax break on the contributions upfront, but you never pay tax again if distributions are made properly.

A traditional account may look like the best approach because it often makes sense to defer tax as long as possible. But this isn’t always the case. Roth plans can save you more if you will be in a higher tax bracket when making distributions during retirement. Plus, there are no required minimum distributions for Roth IRAs. So if you don’t need the distributions, the account continues to grow tax-free for the benefit of your designated beneficiaries. Unfortunately, there is an income phaseout for contributions to a Roth IRA.

Planning tip: Boost tax-protected savings with a Roth rollover
Rollovers into Roth accounts have become very popular since the $100,000 income limitation on conversions to Roth IRAs disappeared in 2010. To convert an IRA into a Roth account, you must pay tax on the investments in your traditional account immediately in exchange for no taxes at withdrawal. But why pay tax now instead of later?

You must pay the tax on your rollover from money outside the account. This has a silver lining. It reduces the cash outside the account, but your full account balance after the rollover becomes tax-free, effectively increasing the proportion of your total wealth in a tax-preferred investment.

There are no required minimum distributions for a Roth IRA, so you can let your money appreciate tax-free as long as you want — or grow tax-free until death (unfortunately, this is not the case with a Roth 401(k) within an employer plan). After your death, the tax-free distributions to your heirs can be made over several years. What’s more, by prepaying the income tax on the account during the conversion, you’ve effectively removed that amount from your estate for estate tax purposes.

If you’re uncertain about a Roth conversion, remember that you can in effect reverse it by “recharacterizing” the rollover as a contribution to a traditional IRA (but this option is not available for rolling over into a Roth 401(k) within an employer plan). This makes it a fairly safe tax play. You have until your extended filing deadline to recharacterize contributions, so you can make a conversion and then reverse it if the value of the assets declines. You can even consider making a series of separate conversions to a Roth IRA with different assets so that you can selectively reverse the conversion for specific assets that decline in value. But there are many reasons to be cautious:

  • The time value of money still makes deferral of taxes a powerful strategy.
  • A large conversion can generate a lot of income, which could affect other tax items tied to adjusted gross income (AGI), including how much of your Social Security benefits are taxed.
  • Paying tax now may not make sense if you’ll be in a lower tax bracket during retirement.
  • Paying tax now may not make sense if you plan on moving to a lower-tax state to retire.

Benefit plans
Lawmakers enacted legislation this past summer that eases short-term pension funding obligations by adjusting the interest rates used to calculate pension liability. Funding obligations are calculated under normal rules using a two-year average of interest rates. The lower the interest rate, the higher the funding obligations — so plan sponsors have faced increased funding obligations with the historically low interest rates over the past several years.

Managing your 401(k) plan

Qualified plans such as a 401(k)s or 403(b)s remain among the most popular retirement plans for employers. But administering them can be costly and complex. Unless you operate your 401(k) plan under a safe harbor, you must perform nondiscrimination testing annually to make sure the plan’s benefits don’t favor highly compensated employees over other employees.

The safe harbors require employer contributions. If you operate under a safe harbor but need to conserve cash and cut costs by ceasing 401(k) contributions, you must amend the plan and give employees advance notice. Employees must have the option of changing their contributions during this advance notice window, and the nondiscrimination test must be performed for the entire year.

New fee disclosure requirements became effective in late 2012, and more are on the way. With the decline of pension plans and the shaky financial outlook for Social Security, policymakers are increasingly trying to make it easier for taxpayers to buy annuities with retirement savings. Regulators may eventually require employers to calculate and disclose how much their retirement plan account value would purchase on the annuity market.

Despite the challenges of a qualified plan such as a 401(k), it is still an attractive option for many reasons:

  • A qualified plan has significant design flexibility to allow sponsors to provide value to their top executives.
  • Nonqualified plans aren’t as tax-effective for plan sponsors as qualified plans, because the employer doesn’t receive a current tax deduction for contributions to a nonqualified plan.
  • Employer contributions to a qualified plan are never subject to Federal Insurance Contributions Act (FICA) tax or other payroll taxes.
  • Distributions can be rolled over on a tax-free basis, so an employee’s taxable event is delayed until the actual payout from a tax-qualified retirement vehicle such as an IRA.
  • The use of qualified retirement plans avoids Section 409A penalty risks.

Privately held business strategies
Privately held businesses often face different executive compensation challenges. Many owners and shareholders want to give key employees and managers the benefits of equity ownership without sacrificing any share of their ownership.

If you have a privately held business, consider a phantom stock plan or a performance-based cash payment plan. They offer opportunities for your company to share the economic value of an equity interest without the equity itself. A typical phantom stock plan simply credits selected employees with stock units that represent a share of the firm’s stock. Essentially, it is a promise to pay the employee the equivalent of stock value in the future. Alternatively, a stock appreciation right (SAR) can be issued to provide an employee with a payment equal to only the appreciation in the stock value between the date the right is granted and some future date, rather than the full value of the stock.  

You can value your stock by a formula or by formal valuation. The phantom stock or SAR can be awarded subject to a vesting schedule, which can be performance- or time-based. A phantom stock plan must comply with restrictions on nonqualified deferred compensation (NQDC) unless the employee is paid for the value of the phantom stock shortly after vesting. The same holds true for SARs. But unlike phantom stock, SARs can meet certain other conditions that exempt them from the restrictions on NQDC.  

Performance-based cash payment plans similarly promise employees a cash bonus in the future if performance goals are met.

Eddie Adkins
+1 202 521 1565

Dustin Stamper
+1 202 861 4144

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