The American Taxpayer Relief Act of 2012, while keeping federal income tax rates the same for almost all Americans, significantly increased ordinary income and capital gains rates for executives and other high earners. By raising the threshold at which top rates apply, the Act makes deferring compensation attractive, because there is more likelihood the compensation may be subject to tax at lower marginal rates when it is received, a PwC HRS Insights report says.
“Qualified plans are the most beneficial vehicle for deferring compensation from a tax benefits perspective,” Joe Olivieri, a managing director in PwC’s Human Resource Services practice, PLANADVISER. There is no tax at the time of deferral, the amount is taxed upon distribution, and there is flexibility for when an executive can take his money from the plan. In addition, employers get a deduction for contributions.
Olivieri explained that if the deduction is attractive for an employer, it may want to consider bumping up its company match contribution to help executives—as well as other employees—accumulate more retirement income that will be taxed at a lower rate.
Under prior law, taxpayers were subject to a maximum tax rate at incomes of $250,000 and above, but now the maximum federal income tax rate increases to 39.6% for joint filers with adjusted gross income (AGI) above $450,000. Many executives expect to continue receiving income of at least $250,000 during retirement because of income available to them from sources such as their retirement plans, board service or consulting opportunities. With the maximum tax rate at that level, deferral of compensation until retirement would have provided only limited tax savings because the compensation would likely be taxed at the same rate at the time of receipt as at the time of deferral.
Olivieri said most executives who receive compensation above $450,000 do not expect to receive that much in retirement, making deferral more attractive. Employers might be more willing to provide forms of compensation that allow employees some choice as to when they will take the amount into income, and to adopt and expand other deferred compensation programs. In the past, rather than deferring compensation, executives frequently chose strategies to recognize income earlier, and then convert it to tax-advantaged investments.
In cases where qualified plans are utilized to the maximum extent possible and executives desire further deferral opportunities, nonqualified deferred compensation (NQDC) plans are still a good idea, but Olivieri pointed out that these plans do not offer as much flexibility for timing of distributions, and the tax deduction for deferred amounts is delayed.
The PwC paper suggests employers may also consider forms of compensation that allow for more of a deferral opportunity, such as restricted stock units (RSUs) rather than restricted stock. Unlike restricted stock, which is taxed at vesting (unless the employee made an 83(b) election to be taxed at grant), RSU programs may allow the employee to timely elect to delay payment (and income tax) until retirement or until a year when they expect their marginal tax rate to be lower. However, any deferral of the tax event for the employee would correspondingly delay the tax deduction for the employer. Still, deferring execution of RSUs could be beneficial to executives, Olivieri said.
The HRS Insight report is here.