To Defer or Not to Defer, That is the Question

Last week, I wrote about the American Taxpayer Relief Act more commonly referred to as the Fiscal Cliff deal. While it avoided reversion to the pre-Bush era marginal tax rates for most Americans, it certainly included a lot of tax increases. Here we will focus on nonqualified deferred compensation (NQDC). Does it make more sens to defer or less sense to defer?

First, the withholding rate on supplemental wages in excess of $1 million in the aggregate increased to 39.6%. For supplemental wages up to $1 million, the withholding rate remains at 25%, What are supplemental wages? Generally, they are pay to an employee that is not part of a regular wage. They include overtime, bonuses, and distribution of nonqualified deferred compensation among other things. Ultimately, the taxes that a taxpayer pays are determined based on a number of factors, but the amount that they will see in a check for supplemental wages will decrease for particularly high recipients of supplemental wages.

Second, the OASDI portion of Social Security tax returned to 6.2% after being at 4.2% for a few years. This is the percentage of your paycheck that goes to Social Security on earnings not in excess of the Social Security Wage Base ($113,700 for 2013). The employer portion of OASDI remains at 6.2% of pay. For participants on NQDC plans, this is may be important because Social Security taxes are paid on NQDC generally in the year that such compensation is both vested and reasonably ascertainable. For most plans, that is the date when vested. For certain more complex plans such as DB SERPs, the amount may not be reasonably ascertainable until the participant terminates employment.

Third, the Medicare or HI portion of Social Security taxes has increased largely to pay for the ACA or ObamaCare if you prefer. For single filers with wages in excess of $200,000 or those filing jointly with income in excess of $250,000, the amounts above those thresholds will see an increase in HI tax from 1.45% of excess wages to 2.35% of excess wages. Additionally, there is a new 3.8% surtax on investment income such as capital gains from the sale of stock.

So, how do you know whether to defer or not to defer? It's a difficult question and the math is not as easy as we might like. Generally, the higher the marginal tax rate that you are paying, the more useful tax deferral is. Of course, there are many other factors that may influence your decision including your view of future tax rates, your need for the money in the short term, the investment return you can achieve and other factors that may be particularly germane to you as an individual.

Best of all will likely be compensation deferred in qualified plans such as 401(k), other defined contribution, and defined benefit if you are fortunate enough to have those opportunities.

In any case, for high earners, the new tax rates are more confiscatory than were the old ones, but your guess is as good as mine with respect to where they will be in the future.

We Have a Fiscal Cliff Deal

It had to happen. If it didn't, the sun might not have risen. Perhaps it's what the Mayans anticipated so many years ago -- the fiscal cliff. Well, through the last-ditch efforts of Congress (you do know that a collection of baboons is called a congress, don't you?), we have 157 pages of legislative contortion that keeps the country from plunging off that cliff.

Who gets helped? Who gets hurt? Well, they say that if nobody is happy, then there really was compromise. In this particular case, the compromise was a combination of tax cut extenders and a few spending cuts. Most of what's in the bill doesn't matter to my typical reader. In fact, most of it doesn't apply to any reader that I know. But, since you're here and reading, I'll let you in on a few things that might.

• FICA taxes (the OASDI part) are going back up to 6.2% of pay up to the wage base. For those who are counting, that's a 2% additional tax compared to last year on the entire income of most working Americans. But, if we kept it at 4.2% of pay, Social Security was going to run out of money really quickly.
• Most Americans have no increase in their marginal tax rates. Unless you are (depending upon your filing status) a single person with adjusted gross income (AGI) in excess of $400,000, a head of household with AGI more than $425,000, or a couple filing jointly with AGI exceeding $450,000, you still benefit entirely from the Bush era cuts in marginal income tax rates.
• If you are fortunate enough to be a beneficiary of the estate of someone who is unfortunate enough to die, estate tax rates are higher than they have been the last few years, but not as high as they were prior to 2001.

These were all considered to be tax increases by those who were worried about counting tax increases versus spending cuts. But, then there's this beauty for people who are wondering where the spending cuts are coming from. The ability to convert traditional IRA, 401(k), 403(b), etc. accounts to the Roth variety has been made permanent, or at least until a future law makes this ability disappear. 

This is a savings? Of course it is. Readers of this blog know of my dislike for the required methodology used to score bills by the Congressional Budget Office (CBO). They look at the next ten years on a static economic basis. Since you have to pay taxes on the converted amount when you convert your Roth, and the taxes that you would have paid upon retirement on the traditional account would often have not been paid for more than years into the future, this is scored as a money-saver.

The message here is that when you read in the media that there are spending cuts in this bill, take it with a grain of salt.

Oh yeah, there are also tax cut extenders for some of the usual suspects: Hollywood, NASCAR, and green energy among them. 2013 is off to a rousing start.

Unsure About Tax Rates Rising, Defer Anyway!

Where do you think your marginal tax rate will be in 2011? How about in 2012? 2013? You don't know? You're not sure? If you're a high earner, let's say $500,000 or more, are you concerned? Of course you are.

Should rising tax rates changes your deferral behavior? To the extent that you will have less take-home pay, perhaps it should. To the extent that you have a fear of deferring at a lower marginal rate and later being taxed at a higher marginal rate, the answer may surprise you.

Here is an article written by a few former colleagues of mine that I reviewed : http://tinyurl.com/24bfyhy 


To quote from the article, "As shown above, the advantage of deferred compensation is impacted by changing tax rates. Although it may seem counter-intuitive, a long-term increase in tax rates during the deferral period actually provides the greatest relative advantage for deferred compensation."


Let me re-phrase: when marginal tax rates are rising over time, there is more advantage to deferring compensation (assuming security of course) even on a nonqualified basis. In a qualified plan, there is even more advantage.


So, put your intuitive thinking aside, take a look at the article and consider deferring what you can,