Financial & Estate Planning for Retirement Plan Assets & Executive Compensation

Transcription

1 Financial & Estate Planning for Retirement Plan Assets & Executive Compensation 2012 FPA of Charlotte Annual Symposium September 13 & 14, 2012 Presented by James E. Hickmon, JD, MBA, CFP Hickmon Law, PC 6135 Park South Drive, Suite 510 Charlotte, North Carolina These seminar materials and the seminar presentation are intended to stimulate thought and discussion and to provide those attending the seminar with useful ideas and guidance in the areas of financial and estate planning and estate and trust administration. The materials and comments made by the presenter during the seminar or otherwise do not constitute and should not be treated as legal advice regarding the use of any particular financial or estate planning or other technique, device or suggestion or any of the tax or other consequences associated with them. Although he has made every effort to ensure the accuracy of these materials and the seminar presentation, Mr. Hickmon does not assume any responsibility for any individual s reliance on the written or oral information presented in association with the seminar. Each seminar attendee should verify independently all statements made in the materials and in association with the seminar before applying them to a particular fact pattern and should determine independently the tax and other consequences of using any particular device, technique or suggestion before recommending the same to a client or implementing the same on a client s or his or her behalf.

2 ABOUT THE SPEAKER: Jim Hickmon is a Charlotte, North Carolina estate planning, fiduciary law, employee benefits and executive compensation attorney. In his practice, Jim assists clients with estate planning, trust, tax and probate law issues. He also works with clients to resolve trust and estate disputes. He is a member of the American Bar Association s Committees on Estate Planning and Employee Benefits and the North Carolina Bar Association s Section on Estate Planning and Fiduciary Law where he is a member of that body s Legislative Committee and Ethics Committee. Jim was a member of the North Carolina Bar Association s Legislative subcommittee that drafted and submitted to the North Carolina General Assembly revisions to North Carolina s probate statutes which became effective January 1, Jim is also a contributing author to the Seventh Supplemented Edition of the North Carolina Estate Administration Manual, published by the North Carolina Bar Association Foundation. He regularly contributes articles to the NC Bar Association s estate planning professional journal, The Will & The Way, and has authored a number of professional articles published by the Bureau of National Affairs in its Tax Management & Compensation Planning Journal. In addition to his extensive trusts and estates experience, Jim brings many years of business experience to his practice. Prior to attending law school, he worked as a trust officer for two national banking corporations. He also earned the designation of Certified Financial Planner (CFP) from the Certified Financial Planner Board of Standards. Jim holds an undergraduate degree in finance from the University of North Carolina, Wilmington, an MBA from East Carolina University and his law degree from the Wake Forest University School of Law. Jim has involved himself in a number of charitable and community service organizations at the local, state, and national levels. His fellow members of the North Carolina Bar selected Jim for inclusion in Business North Carolina magazine s Legal Elite in the field of Tax and Estate Planning Law in 2010 and Jim is a member of the Charlotte chapter of the Financial Planning Association and the Charlotte Estate Planning Council. Jim is rated AV Preeminent 5.0 out of 5.0 by Martindale-Hubbell as judged by his fellow lawyers and has received a Superb rating from the AVVO independent attorney rating service.

3 I. Introduction. This presentation is intended to familiarize the Certified Financial Planner professional with estate and financial planning considerations relating to distributions from qualified retirement plans and individual retirement accounts ( IRAs ). This outline and the accompanying live presentation include a general discussion of qualified retirement plans, IRAs, and nonqualified deferred compensation plans. The CFP professional should be familiar with the gift, estate, and generation skipping transfer tax issues that arise with respect to qualified retirement plan benefits and IRAs. In addition, a CFP needs more than a basic understanding of the income tax considerations, including the income taxation of distributions, the special income tax treatment of employer securities received as part of a distribution, and income in respect of a decedent issues that arise when plan benefits and IRAs are paid to the beneficiaries of a deceased participant or account holder, and the ability to roll over distributions from qualified retirement plans into IRAs and other qualified retirement plans. This presentation will examine the various penalty taxes that may apply to a distribution from a qualified retirement plan or IRA, including the 10% additional income tax on premature distributions and the 50% excise tax on the amount of a minimum required distribution that is not made to a qualified plan participant or IRA owner. Lastly, this presentation will explain planning opportunities for the receipt of qualified retirement plan benefits and IRA distributions, including the naming of a beneficiary while the participant is still active, the optimum method of receiving distributions from a qualified retirement plan or IRA once the participant reaches his or her required beginning date, and the various options available to the executor or beneficiary of a deceased participant or account holder's estate to reduce or defer taxes. (1)

4 II. Qualified Retirement Plans and Individual Retirement Accounts ( IRAs ). A. Advantages of Qualified Plans Qualified retirement plans offer both an employer and an employee a number of tax benefits. An employer is allowed a current deduction for its contributions to the plan. Contributions for a plan year are allowed for the taxable year in which the plan year ends if they are made by the due date (including extensions) of the employer's tax return for that tax year. Participants are not taxed until they actually receive payments from the plan. The trust or other investment vehicle used by the plan to accumulate assets is generally tax-exempt. Finally, participants may receive favorable tax treatment for distributions from the plan or may defer current tax by rolling their distributions into an IRA or a qualified retirement plan of their new employer. (1) Planning for Self-Employed Client. A qualified retirement plan offers a number of advantages over an IRA for certain individuals. For example, Code Sec. 401 provides an exemption from the required minimum distribution rules (the RMDs ) for employees over age 70-½ who remain in the employ of the employer sponsoring the qualified plan. An employee otherwise subject to the RMD rules is not required to begin taking his or her minimum distributions until the participant experiences a separation from service with the sponsoring employer. However, if an individual remains employed with qualified plan sponsoring employer beyond age 70-½ he or she will continue to be required to take annual required minimum distributions from IRAs and any other qualified plan where the participant s assets remain in the custody of a former employer s qualified plan trustee. If the client does not need his or her RMDs and would like to defer the recognition of taxable income for as long as possible the client may wish to consider one of the following alternatives: (a) Rollover to Existing Employer s Qualified Plan. Many, but not all, employers qualified plans will permit a currently employed plan participant to transfer assets (2)

5 held in a former employer s qualified plan or from the employee s own IRA. Therefore, if an employee is over age 70-½ and prefers to defer receipt of taxable income from a qualified plan or IRA, he or she may wish to consider transferring his or her account balances from a former employer s plan or from an IRA into a plan sponsored by the client s current employer. The client will thereafter not be required to withdraw RMDs until the participant experiences a separation from service from the current employer. (2) Asset Protection Considerations. With rare exceptions, almost all employer sponsored qualified retirement plans are governed by the Employee Retirement Income Security Act of 1974, as amended ( ERISA ). A significant advantage ERISA governed plans enjoy over IRAs and other non-employer sponsored retirement vehicles is the absolute protection ERISA governed assets from the claims of the participant s creditors, including the bankruptcy court and tax liens. IRAs do enjoy some protection from the account owner s judgment creditors. In most jurisdictions, including North Carolina, a $1 million exemption exists to protect an IRA account owner s IRA balance from the claims of his judgment creditors. However, to the extent an IRA owner s judgment creditors assert claims in excess of $1 million the excess IRA balance is subject to the claims of the account owner s creditors. In addition, a bankruptcy trustee and certain taxing authorities may also be able to exert an effective claim against IRA assets where they would have no such ability with respect to assets held in an ERISA governed plan. B. Types of Qualified Plans. (1) In General. There are two basic types of qualified retirement plans, a defined contribution plan and a defined benefit plan. A defined contribution plan provides for an individual account for each participant. Under such a plan, a participant's benefit is based solely on the amount in the participant's account. The participant's account consists of allocations of employer (3)

6 and employee contributions and forfeitures, and income, expenses, gains and losses attributed to the assets held in the account. The participant bears the investment risk. A defined benefit plan provides for definitely determinable benefits to be paid in the future, usually at normal retirement age. The employer contributes an amount necessary to fund benefits, determined on an actuarial basis annually. Because the amount of the employee's benefit is not dependent on the income, gain, expenses and losses of the trust assets, the employer bears the investment risk. The ERISA rules and the Department of Labor regulations and other guidance issued thereunder, relating to reporting and disclosure, funding and the maximum contribution and benefit limits differ between defined benefit plans and defined contribution plans. Defined benefit plans are covered by the Pension Benefit Guaranty Corporation ( PBGC ) termination insurance (Title IV of ERISA) while defined contribution plans are covered by no insurance or other guarantee. (2) Types of Defined Contribution Plans. There are a number of types of defined contribution plans. Some types of defined contribution plans, such as most profit-sharing plans, do not require the employer to make contributions, while other types of defined contribution plans, such as money purchase pension plans, require the employer to make an annual contribution. Some types of defined contribution plans, such as standard money purchase pension and profit-sharing plans, allocate the employer's contribution based on the employee's salary, while other types of defined contribution plans, such as age-weighted profit-sharing plans and target benefit pension plans, take into account the participant's age as well. (a) Profit-Sharing Plans. A profit-sharing plan is a discretionary defined contribution plan that permits an (4)

7 employer to make contributions whether or not it has current or accumulated profits. The employer has complete discretion as to the amount of contribution it makes each year to the plan. For example, the plan may state: The employer shall contribute each year such amount as the Board of Directors shall determine. Forfeitures resulting from participants' termination of employment before they are 100% vested in their accrued benefits are usually reallocated to other participants' accounts. The maximum deductible contribution that an employer may make each year to a profitsharing plan is an amount equal to the greater of 25% of the total compensation of all participants or the amount it is required to contribute pursuant to Section 401(k)(11) of the Internal Revenue Code of 1986, as amended (the Code ). If the employer contributes more than the maximum deductible amount for a year, the excess may be carried over and deducted in a succeeding year (subject to the 25% limitation). However, the excess is subject to a nondeductible 10% excise tax. A profit-sharing plan must contain a definite formula for allocating employer contributions among the accounts of plan participants. The allocation formula usually provides for an allocation based on participants compensation. It is possible for an allocation formula to be weighted for age and/or years of service. If allocations are weighted for age or years of service, the average rate of allocations for highly compensated employees cannot exceed the average rate of allocations for non-highly compensated employees. A profit-sharing plan may permit distributions to be made from the plan after a participant reaches a specified age or after a fixed number of years of service. For example, a profit-sharing plan may permit participants to withdraw from their accounts employer contributions that have been held in the plan for at least two years. The qualified joint and survivor annuity ( QJSA ) and qualified preretirement survivor annuity ( QPSA ) rules do not apply to profit-sharing plans that meet certain requirements. (5)

8 (b) Money Purchase Pension Plans A money purchase pension plan must specify a stated contribution that the employer must make each year. The contribution is usually defined as a percentage of participants' compensation. For example, the plan may state: The employer shall contribute each year an amount equal to 10% of each participant's compensation. A money purchase pension plan is subject to the minimum funding standards of Code Sec Forfeitures may be either applied to reduce the employer's contribution or reallocated to other participants. Contributions may be made to the money purchase pension plan and deducted by the employer up to the annual addition limits of Code Sec Code Section 415 limits the amount of employer contributions, forfeitures and employee contributions allocated to a participant's account each year to the lesser of $50,000 in 2012 (as indexed) or 100% of that participant's compensation. Distributions generally may not be made from a money purchase pension plan before the earlier of the participant's retirement date or separation from service with the employer. The QJSA and QPSA rules apply to money purchase pension plans. The chief advantage of a money purchase pension plan over a profit-sharing plan is the increased amount of contributions that can be deducted by the employer. Although the same annual addition limit (100% of compensation or $50,000 in 2012 (as indexed), if less) applies to profit-sharing plans and money purchase pension plans, the employer sponsoring a profit-sharing plan is limited to deducting 25% of the total compensation of all participants, while no deduction limit applies to contributions to a money purchase pension plan, as long as the Code Section 415 limits on annual additions are satisfied. However, the money purchase pension plan requires a fixed contribution and is subject to the qualified survivor annuity rules. (c) Target Benefit Pension Plans A target benefit pension plan is a money purchase pension plan under which the employer's contribution is an amount actuarially determined to be needed to produce a stated benefit (the target benefit ) upon retirement. The plan defines a target benefit to be provided to (6)

9 each participant at retirement. For example, the plan may state that it will provide an annual benefit for the participant's lifetime equal to 30% of the participant's final average compensation commencing on the participant's normal retirement date. The employer makes a contribution each year in an amount determined by an actuarial formula, and the amount contributed is allocated to a separate account for the participant on the books of the plan. At retirement, the participant receives the balance in the account, which may be greater or less than the target benefit. A target benefit plan has the same advantages and disadvantages as a money purchase plan but permits larger annual additions to the accounts of older participants at a cost of more complex contribution calculations. (d) Stock Bonus Plans A stock bonus plan is a discretionary defined contribution plan the assets of which are invested in employer stock. Benefits under a stock bonus plan are distributed in the form of employer stock, except to the extent that the plan permits a participant to elect to receive cash instead of employer stock. A participant who receives employer stock that is not readily tradable on an established securities market must be given a put option that permits him or her to sell the employer stock to the employer. An employer that has a registration-type class of securities must permit plan participants to direct the manner in which employer securities allocated to their accounts are to be voted on all matters. An employer that has no registration-type class of securities must permit participants to vote shares that are allocated to their accounts with respect to approval or disapproval of any corporate merger or consolidation, recapitalization, reclassification, liquidation, dissolution, sale of substantially all the assets of a trade or business, or such similar transaction as the IRS may prescribe in regulations. (e) Employee Stock Ownership Plans An employee stock ownership plan ( ESOP ) is a stock bonus plan or a combination (7)

10 stock bonus and money purchase pension plan that is designed to invest primarily in qualifying employer securities. The term qualifying employer security means, for purposes of an ESOP, either any readily tradable common stock of the employer (or certain affiliated corporations), or if the employer has no readily tradable common stock, common stock of the employer (or of certain affiliated corporations) that has a combination of voting power and dividend rights equal to or in excess of (1) that class of common stock that has the greatest voting power, and (2) that class of common stock that has the greatest dividend rights. The term employer security also includes non-callable preferred stock that is convertible into common stock. An ESOP may permit the plan trustee to borrow money to purchase employer stock, provided various requirements are met. For example, the ESOP trustee may borrow funds from a bank and use the loan proceeds to purchase employer stock from the employer. The loan from the bank may be guaranteed by the employer. If certain requirements are met, the loan is exempt from the prohibited transaction rules. Under this type of leveraged transaction, the employer will make tax-deductible contributions to the ESOP in an amount sufficient to amortize the loan. The ESOP trustee will use the employer contributions to repay the loan. A leveraged ESOP may be used in a leveraged buy-out or as a way of transferring ownership of a business to employees. ERISA Sections 408(b)(3) and 4975(d)(3), and the regulations thereunder, describe the requirements of a leveraging transaction. An ESOP can, under limited circumstances, be the qualified remainder beneficiary of a testamentary charitable remainder trust, entitling the decedent's estate for an estate tax charitable deduction for the value of the remainder interest in the trust. The qualification requirements are so strict and time-limited, however, that very few transfers may qualify for this beneficial treatment. (f) Section 401(k) Plans A Code Sec. 401(k) plan is a profit sharing plan or stock bonus plan that contains a qualified cash or deferred arrangement ( CODA ). Under a CODA, a participant elects to have (8)

11 the employer reduce his or her salary and contribute that amount to the plan on his or her behalf. The amount of the salary reduction is not included in the employee's compensation for income tax purposes, although it is subject to social security ( FICA ) and unemployment ( FUTA ) taxes. A participant's salary reduction elective deferrals are limited each year to a specific dollar amount (adjusted annually for the cost of living), and any excess deferrals must be distributed to the employee no later than April 15 of the following calendar year. Code Sec. 402(g) limits the deferral amount for 2012 to $17, A 401(k) plan must meet special nondiscrimination requirements. The actual deferral percentage ( ADP ) during a plan year for highly compensated employees cannot exceed the ADP of non-highly compensated employees for the preceding plan year by more than a specified percentage. The ADP for each relevant group (highly compensated employees and non-highly compensated employees) is the average of the ratios (calculated separately for each employee in each group) of the elective contributions (plus any qualified non-elective contributions QNEC ) for each eligible employee for a plan year to such employee's compensation for that plan year. The nondiscrimination tests set forth in Code Sec. 401(k)(3) result in the following limitations on the ADP of the highly compensated employees: If the ADP of eligible nonhighly compensated employees is: The ADP of eligible highly compensated employees may not exceed: 0% 0% 1% 2% 2% 4% 3% 5% 4% 6% 5% 7% 6% 8% (9)

12 7% 9% 8% 10% 9% 11.25% 10% 12.50% 11% 13.75% 12% 15% If a CODA fails the nondiscrimination tests, the employer may either: (1) make additional contributions that meet the requirements of a qualified non-elective contribution ( QNEC ) on behalf of non-highly compensated employees to the point where the ADP test is passed; or (2) return deferrals to highly compensated employees within two and one-half months after the end of the plan year in an amount sufficient to meet the test. Elective deferral salary reduction contributions and any employer contributions that are used in computing the ADPs must be 100% vested. In addition, benefits derived from salary reduction contributions may not be distributed to participants or other beneficiaries earlier than upon a severance from employment (whether or not the employee continues to perform the same duties for a different employer following the liquidation, merger, or consolidation of the former employer), death, disability, termination of the plan without the establishment of a successor plan, the attainment of age 59-1 / 2, financial hardship, or qualified reservist status. Despite the additional administrative burden involved in keeping track of the various types of contributions, a Code Sec. 401(k) profit-sharing plan enables the highly compensated employees to defer a somewhat greater proportion of their current income than the non-highly compensated employees. This benefit can only be achieved to the extent that the non-highly compensated employees make significant salary reduction contributions. The employer can encourage non-highly compensated employees to make such contributions by matching such contributions with employer contributions. Since 1998, an employer has been able to avoid the ADP test by maintaining a safe (10)

13 harbor Code Sec. 401(k) plan. A safe harbor Code Sec. 401(k) plan will automatically satisfy the nondiscrimination tests if the plan satisfies one of two contribution requirements and a notice requirement. The safe harbor contribution requirement can be satisfied by making a matching contribution to the Code Sec. 401(k) plan of 100% of employee contributions to the extent they do not exceed 3% of compensation, and 50% of employee contributions to the extent that they exceed 3% but do not exceed 5% of the employee's compensation. Alternatively, the safe harbor contribution requirement can be met by making a non-elective contribution to a defined contribution plan of at least 3% of an employee's compensation on behalf of each non-highly compensated employee who is eligible to participate in the Code Sec. 401(k) plan without regard to whether the employee actually makes elective contributions under the arrangement. The notice requirement is met if each employee eligible to participate is annually given a written notice of his or her rights under the plan. (3) Types of Defined Benefit Pension Plans A defined benefit pension plan promises to pay participants a pension upon retirement equal to a stated amount. Under a defined benefit pension plan, the plan administrator retains an actuary to compute the amount of annual contribution that is needed to fund the benefits to be paid under the plan. A defined benefit pension plan is subject to the minimum funding standards of Code Sec. 412 and is also subject to the QJSA and QPSA requirements. There are several types of defined benefit plans, which differ with regard to the method of determining the participant's benefit. (a.) A Fixed Benefit Plan is a defined benefit plan in which the benefit payable at retirement is a stated dollar amount. For example, the plan may provide an annuity payable for the participant's lifetime equal to $200 per month; (b.) A Flat Benefit Plan is a defined benefit plan in which the benefit payable at retirement is a stated percentage of compensation, which may be career average compensation (the average annual compensation received from the sponsoring employer (11)

14 while the employee was a participant in the plan) or final average compensation (generally the average annual compensation during the employee's last five years of participation in the plan). For example, the plan may provide an annual annuity payable for the participant's lifetime equal to 30% of the participant's final average compensation. (c.) A Unit Benefit Plan is a defined benefit plan in which the benefit payable at retirement is based on the participant's years of service with the employer. For example, the plan may provide an annual annuity payable for the participant's lifetime equal to 1% of the participant's final average compensation, multiplied by the participant's years of service. Defined benefit pension plans are generally covered by the PBGC insurance provisions of Title IV of ERISA. The plan sponsor must pay annual premiums to the PBGC. These premiums have a fixed and a variable component. The fixed component is $30 per participant; the variable component generally applies only to underfunded plans. A professional service employer that has never had more than 25 employees at any time after September 2, 1974, is not subject to the PBGC insurance provisions. Because a defined benefit plan can permit the largest contribution for an older participant, an employer may want to adopt a defined benefit plan if its key employees are older and its rank and file employees are younger. The decision to adopt a defined benefit plan must take into account the additional administrative costs involved, including actuarial services, as well as the PBGC premium. Also, the employer will be assuming a fixed liability to make the necessary contributions each year, despite the financial condition it might then be in. (4) Other Plan Categories (a) A Keogh Plan is simply a qualified retirement plan with at least one self-employed participant. Self-employed participants include partners in a partnership and sole proprietors. A Keogh plan may be a defined contribution plan, such as a profit-sharing or (12)

15 money purchase pension plan, or a defined benefit plan. (b) A Top-Heavy Plan is a qualified plan that provides over 60% of the benefits under the plan to key employees (certain owners and officers of the sponsoring employer). Such plans are subject to certain additional requirements. (c) Technically not a qualified retirement plan, an IRA is maintained by an individual, not an employer, to provide for the individual's retirement. A simplified employee pension plan ( SEP ) is essentially an employer-sponsored retirement plan using IRAs as funding vehicles. An employer may make deductible annual contributions under the SEP to each employee's IRA up to the lesser of $50,000 in 2012 (as indexed) or 25% of the employee's compensation. Any excess contribution over the lesser of $50,000 in 2012 (as indexed) or 25% of the employee's compensation is included in the employee's income and treated as if contributed by the individual. The SEP contributions made to an IRA by an employer are not generally subject to withholding for FICA, FUTA or income tax, provided there is reason to believe that no amount is includible in the employee's income. Under a SEP, the employer must make a contribution for the benefit of each employee who has reached age 21, has received at least a certain dollar amount in compensation for the year (adjusted annually for inflation) and worked for the employer during at least three of the preceding five calendar years. The allocation of contributions cannot discriminate in favor of highly compensated employees and must be made in accordance with a definite written formula. Employers cannot require participants to leave money in their IRAs and cannot condition contributions on employees doing so. All contributions to a SEP are 100% vested. (d) For plan years beginning before 1997, employers with 25 and fewer employees could establish SEPs with qualified CODAs, known as SARSEPs. SARSEPs were replaced by the Small Business Job Protection Act of 1996 with a simplified retirement plan for small businesses known as a savings incentive match plan for (13)

16 employees ( SIMPLE plan). A SIMPLE plan, which can be maintained in either an IRA or Code Sec. 401(k) form, can be adopted by employers who, in the preceding year, employed 100 or fewer employees receiving at least $5,000 in compensation and who do not maintain another employer-sponsored retirement plan. In addition to employer contributions, a SEP may receive employee contributions, provided the combined contributions of the employer and employee do not exceed the overall limits discussed above, and the employee's contributions (including deemed contributions of excess employer contributions as noted above) do not exceed the limits applicable to individual contributions to traditional IRAs, including the additional deduction for catch-up contributions by individuals over age 50 but subject to the deduction phase-out for active participants in qualified retirement plans. Similarly, for SARSEPs and SIMPLE plans, an employee aged 50 or older by the end of the tax year may elect to defer additional amounts from his or her salary beyond the limits set forth in Code Secs. 408(k)(6) and 408(p)(2). Such catch-up contributions are not subject to any otherwise applicable limit on contributions to such plans. (5) IRAs Prior to the Economic Growth and Tax Relief Reconciliation Act of 2001 (2001 EGTRRA), an individual was entitled under Code Sec. 219 to deduct up to $2,000 annually for contributions made to an individual retirement account (IRA). Beginning January 1, 2002, this amount increased steadily and an additional deduction for catch-up contributions is permitted for individuals age 50 or older as follows: in 2002 through 2004, the deductible amount increased to $3,000; in 2005 through 2007, the amount increased to $4,000; and after 2007, the amount increases to $5,000, which is adjusted annually for the cost of living thereafter. If the individual is over age 50 as of the end of the tax year, the deductible amount is further increased by $500 for years 2002 through 2005, and by $1,000 for years after There is no indexing of this additional amount. The income from the assets in the IRA is not currently subject to tax; rather, the (14)

17 individual pays tax when he or she withdraws amounts from the IRA. Distributions from, and accumulations in, an IRA are generally subject to the same penalty and additional income taxes that apply to distributions from, and accumulations in, qualified retirement plans. Distributions from an IRA are not entitled to favorable averaging or capital gain treatment that may apply to lump-sum distributions from qualified retirement plans. Withdrawals from an IRA may be rolled into another IRA, if the withdrawal is not a required minimum distribution, the rollover is done within 60 days, and the individual has not had another rollover within the prior year. Before 2002, if the IRA was composed entirely of assets previously rolled from a qualified retirement plan, it could also be rolled into a qualified retirement plan. Under the 2001 EGTRRA, rollovers from an IRA may be made to a qualified retirement plan, Code Sec. 403(b) annuity, or Code Sec. 457 plan under certain circumstances. A spouse with little or no compensation may nevertheless make deductible contributions to an IRA, provided the couple files a joint return for the year and the amount of the contribution does not exceed the lesser of: (1) the deductible amount then in effect under Code Sec. 219(b)(1)(A); or(2) the combined compensation of both spouses, less the working spouse's IRA contributions for the year. An individual may make an annual nondeductible contribution to an IRA to the extent his or her deductible contributions for the year are in fact less than the maximum contribution permitted, for example, because of the application of the phase-out limits under Code Sec. 219(g). The benefit of making nondeductible contributions is that earnings on the contributions are not subject to current income tax. However, any distributions from the individual's IRAs will be treated as a pro rata distribution of deductible and nondeductible contributions. This prevents an individual from withdrawing a portion of his or her IRA and treating it entirely as a nontaxable return of nondeductible contributions. For example, if an individual has made $10,000 of nondeductible contributions, $40,000 of deductible contributions, and the earnings on all of the contributions equal $10,000, one-sixth of any distribution to the individual ($10,000/$60,000) will be nontaxable. The balance will be taxable income and also may be subject to the 10% additional income tax on premature distributions. (15)

18 The 1997 TRA established a new type of nondeductible IRA called the Roth IRA. The maximum contribution to a Roth IRA is limited to the amount that can be contributed to a regular IRA (disregarding the regular IRA phaseouts), reduced by the amount contributed to such IRAs for the taxable year. This contribution amount is phased out for individuals with AGI between $95,000 and $110,000 and for joint filers with AGI between $150,000 and $160,000. Effective for taxable years beginning after 2006, the $150,000 and $95,000 AGI limits in Code Sec. 408A(c)(3)(C)(ii) are subject to an adjustment for inflation in increments of $1,000. Although no deductions are allowed for a contribution to a Roth IRA, distributions from the account are tax-free if special distribution requirements are met. Tax-free distributions may be made from a Roth IRA beginning on the date on which the individual turns age 59 1 / 2, provided that it is made after the fifth taxable year following the taxable year of the contribution. In addition, tax-free distributions may be made on account of disability, for the purchase of a first home (but subject to a lifetime limit of $10,000), or following the individual's death, provided the same five-year requirement is satisfied. Unlike a traditional IRA, an individual is not required to begin taking distributions from his or her Roth IRA upon attaining age 70 1 / 2. After death, however, minimum distributions are required to be paid in the same manner as a regular IRA where the owner died prior to the required beginning date. III. Nonqualified Deferred Compensation Plans A. In General (1) Definitions A nonqualified deferred compensation plan ( NDC ) is a plan or arrangement providing for the payment of compensation for services to an employee (or to a director who is not also an employee of the corporation or to an independent contractor) after the year in which the individual performs the services, regardless of whether the plan or arrangement involves a voluntary decision by the individual to defer the receipt of the compensation. While an NDC plan may be subject to ERISA, it is not designed to qualify for favorable income tax benefits (16)

19 under the Code. For example, a supplemental executive retirement plan ( SERP ) is a type of NDC plan that is designed to supplement the retirement income an executive receives from qualified retirement plans (i.e., plans qualified under Code Sec. 401(a)). A SERP that is designed solely to provide benefits in excess of those permitted in a qualified retirement plan because of the Code Sec. 415 limitations is referred to as an excess benefit plan under ERISA Code Sec. 3(36). An NDC plan designed to benefit only a select group of management and highly compensated employees is often referred to as a top-hat plan. (2) Reasons for Using NDC Plans There are several reasons why an employer may want to establish an NDC plan for certain of its employees. A SERP may be adopted to supplement a highly compensated employee's pension under a qualified retirement plan when his or her benefit under the plan is capped because of Code Sec. 415 limitations. An employer may also adopt a SERP to provide benefits to highly compensated employees in amounts that would violate the nondiscrimination rules under Code Sec. 401(a)(4) applicable to qualified retirement plans. A SERP may also be used when the compensation cap under Code Sec. 401(a)(17) increases the cost of providing the maximum dollar benefits to highly compensated employees because the testing for nondiscrimination is based on the capped compensation of the highly compensated employee. Finally, a SERP permits highly compensated employees to defer additional compensation when they are limited by the actual deferral percentage test or dollar limit on annual deferrals under a Code Sec. 401(k) cash or deferred plan. In addition to providing benefits to executives to supplement benefits provided under qualified retirement plans, there are other reasons for using NDC plans. For example, an NDC plan is generally not subject to the spousal consent rules under Code Sec. Code Sec. 401(a)(11) and 417 that apply to qualified retirement plans. Those rules require that a participant's spouse be entitled to receive a survivor annuity or the participant's vested accrued benefit if the participant dies before his or her annuity starting date (the date the participant begins to receive benefits). Also, except for certain defined contribution plans, a participant's spouse is entitled to have the (17)

20 participant's benefit paid in the form of a joint and survivor annuity once the participant reaches his or her annuity starting date. A participant's spouse may consent to waive these rights only during periods specified in the Code and regulations thereunder. NDC plans are often used to defer the receipt of bonuses or portions of compensation increases because the employee has greater need for the funds at a later time, the employee believes the tax rate may be lower after retirement, or the build-up of the fund on a pre-tax basis is considered to provide a greater benefit than receiving current compensation. NDC plans can be used to replicate benefits of stock ownership if the corporation wants to remain closely held. Under such a plan, often referred to as a phantom stock or shadow stock plan, the employee's benefit is equal to the appreciation in the value of the corporation's stock from the date the phantom stock is credited to the employee's account. These plans can provide benefits similar to stock options. Stock appreciation rights may also be viewed as a variation of either stock options or NDCs. An NDC plan can provide benefits to independent contractors (or to directors who are not also employees) who cannot be covered by a qualified retirement plan since qualified retirement plans can only benefit employees and their beneficiaries. Such NDC plans may be desired for many of the same reasons that an employee might wish to defer compensation. NDC plans usually involve lower administration costs than qualified retirement plans, because they generally are required to comply only with minimal reporting and disclosure requirements, rather than the annual filings imposed on qualified retirement plans. NDC plans can also be used to encourage employees to retire early during an early retirement window program. Such programs are used by employers wishing to reduce their labor force without involuntary layoffs. Under such programs, employees over age 50 are typically given incentives to encourage them to retire voluntarily. An NDC plan can replace benefits that a highly skilled employee often forfeits when transferring from one employer to another. (18)

21 An employer can also use an NDC plan as a golden handcuff to retain key employees. Under such a plan, an employee would forfeit benefits if he or she terminated employment before a certain age. On the other hand, an NDC plan can be used to provide key employees with some security against the possibility of a change of ownership or control that may result in their premature dismissal. Payments under these plans are often referred to as golden parachute payments. Finally, an NDC plan can be used to encourage performance by conditioning the payment and amount of benefits under the plan on the achievement of certain earnings objectives. (3) Types of NDC Plans An NDC plan may be either employee-motivated or employer-motivated. An employeemotivated plan usually involves a deferral of income that the executive would receive in the current taxable year but for his or her decision to defer. Because the employee would have been entitled to the compensation in the current year absent the deferral, it is not customary for such a plan to contain forfeiture provisions. Such a plan usually has the characteristics of a defined contribution plan, such as a money purchase pension plan, since the deferred income is credited to an account that is held for eventual distribution to the employee. In some cases, the employer may credit interest to the balance in the account until the entire amount is paid out. Rather than crediting interest to the account, the account could be adjusted using other indices of investment earnings, such as the Standard and Poor's 500 Stock Index or the performance of a designated fund in which the employer will invest, although the employee has no rights to the fund. In other cases, the value of the account may be determined as if the deferred amount were invested in stock of the employer. To protect itself from unanticipated appreciation in the index used to determine the employee's benefit, the employer will normally invest the deferred income in the investment being used as the index. Although the account may be only a book entry on the employer's books, the deferred income may instead be placed in a separate trust, such as a rabbi trust or a secular trust. The (19)

22 employee may have a right under certain circumstances, such as if he or she is in financial difficulty, to withdraw some or all of the account before the date the benefit is otherwise to be distributed. An employer-motivated plan usually involves an additional economic benefit provided by the employer to the employee. An employer-motivated plan is often used when the purpose of the plan is to serve as a golden handcuff to retain a key employee or to encourage the employee to achieve certain earnings objectives. Employer-motivated plans may contain vesting or forfeiture provisions, because it is the employer's money that is being used to fund the benefit. An employer-motivated plan is usually designed as either a defined benefit plan or a money purchase pension plan. (4) Goals The employee's primary nontax goal is likely to be to provide for forced savings for retirement. An employee needs to consider whether he or she can forgo current income and whether the tax benefits or detriments and the compensation for deferral of receipt is more advantageous than an individual savings program. The employer's goal may be to provide some golden handcuffs. A general nontax goal is to avoid the requirements imposed by ERISA. Under ERISA, a pension plan must satisfy certain reporting requirements to the IRS, Department of Labor ( DOL ), and PBGC, as well as disclosure requirements to participants and their beneficiaries. A plan subject to ERISA must also meet minimum funding, participation and vesting requirements. Fortunately, if an NDC plan covers only a select group of highly compensated or management employees and is unfunded, most of the requirements of ERISA can be avoided. An unfunded plan that meets the requirements of an excess benefit plan is exempt from ERISA entirely, regardless of whether it happens to cover nonhighly compensated employees and nonmanagement personnel. An unfunded plan that meets the requirements of a top-hat plan, by covering only a select group of management or highly compensated employees, is exempt (20)

23 from ERISA's funding, participation and vesting requirements. Top-hat plans are subject to simplified DOL reporting requirements. The goal from a tax standpoint is usually to defer the recognition of income by the employee until payment is made to the employee from the plan. The employer forgoes an immediate deduction for the amount set aside to fund the employee's benefit but will be entitled to a deduction when the payments are includible in the employee's gross income for federal income tax purposes. While the amount of deferral is currently subject to Social Security and Medicare tax if there is no risk of forfeiture, most individuals covered by NDC plans will have other current taxable income in excess of the Social Security wage base. B. Tax Considerations (1) In General In the case of an employer-motivated arrangement containing a forfeiture provision, the employee should not be taxed on the economic benefit until there is no substantial risk that he or she will forfeit the benefit, regardless of whether the benefit is funded. If there is no substantial risk that the employee will forfeit his or her benefit, the deferred income may be currently taxable to the employee under one of the following doctrines or Code provisions: the constructive receipt doctrine; the economic benefit doctrine; Code Sec. 83, dealing with transfers of property for services; or Code Sec. 402(b), dealing with the taxability of a beneficiary of a nonexempt trust. As part of the economic stabilization legislation enacted in October 2008, the Tax Extenders and Alternative Minimum Tax Relief Act of 2008 enacted Code Sec. 457A, which is generally applicable to amounts deferred that are attributable to services performed after Section 457A(a) requires compensation deferred under a NDC plan of a nonqualified entity to be included in gross income when there is no substantial risk of forfeiture of the rights to such compensation. Code Section 457A(b) defines a nonqualified entity as:(1) any foreign corporation unless substantially all of its income is (a) effectively connected with the conduct of a U.S. trade (21)

24 or business or (b) subject to a comprehensive foreign income tax; and (2) any partnership unless substantially all of its income is allocated to persons other than (a) foreign persons for whom the income is not subject to a comprehensive foreign income tax and (b) tax-exempt organizations. Generally, under Code Sec. 457A(d)(1)(A), compensation is considered subject to a substantial risk of forfeiture only if a person's rights to the compensation are conditioned upon the future performance of substantial services by any individual. Section 457A applies in addition to Code Sec. 409A and incorporates many of the specific provisions of Code Sec. 409A. (2) Constructive Receipt Under the constructive receipt doctrine, a taxpayer will be taxed on income that he or she is entitled to receive regardless of whether he or she actually reduces the income to his or her possession. The simplest example is interest credited to a bank account. A controlling shareholder of a corporation may be in constructive receipt of bonuses declared by the corporation in one year but not paid until the following year if the corporation had the funds to pay the bonus in the earlier year. The IRS's advance ruling position on the application of the constructive receipt doctrine to unfunded NDC plans before the enactment of Code Sec. 409A was set forth in two revenue procedures. According to these procedures, the decision to defer had to occur before the beginning of the period of service for which the compensation was payable, regardless of the existence in the plan of forfeiture provisions. The period of service for purposes of this requirement generally was the calendar year for cash basis taxpayers. If an employee could make additional elections after the initial election to defer the payment of income, the payment had to be subject to a substantial forfeiture provision. A substantial forfeiture provision had to impose upon the employee a significant limitation or duty requiring meaningful effort on the part of the employee to avoid the forfeiture, and there had to be a definite possibility that the forfeiture could occur. Two exceptions to the requirement that the decision to defer occur before the period of (22)