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,

IRS Gives Additional Time for Roth Amendments and Lots of Other Roth Guidance

Note:  You can find my earlier blog post on the subject here:
http://johnhlowell.blogspot.com/2010/11/in-plan-roth-conversions.html


In Notice 2010-84, the Internal Revenue Service provided lots of needed guidance on in-plan (withing a 401(k) plan) Roth conversions (converting traditional 401(k) money to Roth money). Probably the most important guidance extended the deadline for adopting conforming plan amendments until the close of the 2011 plan year. For companies that may have been struggling to get these amendments done in time, this is very good news.

You can find the text of the Notice here: http://benefitslink.com/IRS/notice2010-84.pdf

Here is a summary of some of the other key guidance contained in the Notice:

• In order to be eligible to do an in-plan Roth conversion, a participant must be at least age 59 1/2, dead or disabled, or receive a qualified reservist distribution.
• Plan loans are not considered new loans.
• Spousal consent is not required.
• Roth conversions may be allowed by a plan even if the plan does not allow in-service distributions. If you are a participant who is at least 59 1/2, this could be very valuable.
• For 2010 conversions only, the participant can make an irrevocable election to not include that income for 2010 tax purposes, but split it evenly between his or her 2011 and 2012 tax years. This could be crucial for tax planning. Note, however, that employers will not withhold for in-plan Roth conversions. So, if you are doing a large in-plan conversion, you need to be careful to not under-withhold.

Think Tank Recommends Decreases in Tax-Favored Retirement Contributions

The Bipartisan Policy Center (supported by the Economic Policy Institute) recently unveiled a proposal, that among other things, would decrease the total amount that could be contributed to tax-favored, or qualified, retirement plans to $20,000 or 20% of pay, whichever is smaller. (You can read the full report here: http://www.bipartisanpolicy.org/sites/default/files/FINAL%20DRTF%20REPORT%2011.16.10.pdf . The section referenced above can be found on page 39 of the 140 page document.)

This would serve to make many Americans even less prepared for retirement than they are currently. Companies with defined benefit plans and defined contribution plans (yes, there still are a few) could be limited in their contributions. Even participants in 401(k) plans would often see their deferrals reduced.

This is lunacy (assuming that the income tax is continued). In a day where 'leakage' (losses in 401(k) accumulation due to loans, hardship withdrawals and discontinuity in employment among other things) is commonplace, workers who would like to retire someday need to be able to catch up during good times. The Congress and President saw this in 2001 with the passage of EGTRRA in 2001 which allowed for "catch-up" contributions for those at least age 50.

It seems to this writer that under that structure, the two groups of people who will likely be able to retire are those with ultra-high income and those with very low income. The first do not have costs that tend to obliterate their incomes (unless they choose to live that high off the hog). The latter will live off of Social Security and Medicare or Medicaid and have a lifestyle similar to what they had when they were working (or not). For the rest, costs like education for their children, energy, housing, and taxes will diminish their abilities to save for their own retirement. Being deemed redundant in the workplace may result in layoffs that further cut into any savings they may have.

This proposal is akin to classism -- a stratification of classes where in this case, the true upper class are fine, the lower class may be better off in retirement and the middle class will work forever (if they can) in order to not become the lower class.

Ultra-High Earners, How Much Can You Really Defer?

A lot of what we might describe as ultra-high earners (say $500,000 US per year or more) would love to have more tax-favored savings. Physicians, attorneys, and others who are owners of their businesses struggle with this.

In a fairly common design scenario, here is what they can defer into a qualified retirement plan (tax-favored, secure from creditors):

• $16,500 ($22,000 if they reach age 50 or older during the year) to a 401(k) plan
• $22,050 in a profit sharing plan. This is 9% of $245,000 (pay cap). We use 9% because by contributing 3% of pay on behalf of nonhighly compensated employees (NHCEs), the owners are usually able to contribute 9% (3 times 3) to their own accounts
• Perhaps a matching contribution (not more than about $11,000) in the 401(k) plan, but only if they make similar percentage of deferral matches for NHCEs, and the NHCEs participate in the plan to a great enough extent.

Suppose someone told you that by putting aside a little bit more for your NHCEs (generally tax deductible, but you should seek appropriate legal or tax counsel before proceeding), you could quintuple your own deferrals if you are at least age 62 (the numbers are smaller for younger ages, but can triple as early as your 40s). Go through the math, or trust me. Because of the tax deductibility of all these contributions (if you can afford to make them), your income plus deferrals less taxes will often increase ... and you get the benefit of tax-deferred buildup, secure from creditors.

The mechanics aren't that simple, but that's why there are experts. From your standpoint, you just need the willingness to do this, good advisors, and proper counsel.