Tax Facts

J—Deferred Compensation


In allowing selected management or highly compensated employees to defer income until after retirement, deferred compensation offers multiple tax advantages to both the employer and the participant.





CORPORATE OBLIGATION. To illustrate, assume we have a key corporate manager who is currently age 45. Under its terms, the plan would provide for retirement payments, at age 65, of $10,000 per year for 10 years. These payments would be tax-deductible to the corporation when made, and, although taxable to the retired employee, presumably he would pay less in taxes due to a reduced retirement income and resulting lower marginal tax bracket.





Typically, such plans also provide for survivor payments if the employee dies prior to retirement. For example, should the employee die at age 55, a typical plan might pay his surviving family $10,000 per year for 10 years. Since these payments would be tax-deductible to the corporation, each $10,000 payment would cost only $7,900 (assuming a 21 percent corporate marginal tax bracket). However, these payments would be taxable income to the family. Life insurance cash values grow on an income tax-deferred basis and death benefits are ordinarily received on an income tax-free basis – making life insurance a common and tax-effective method of funding deferred compensation obligations.





The plan can also be structured to provide disability benefits to the employee. To assure itself of funds to meet its obligation, the employer could purchase a disability income contract, or it could partially protect itself by adding a waiver of premium rider to any life insurance contract on the employee’s life. Although standards for disability, long-term care, chronic illness, and critical illness differ – today it is common to see plans created with pre-retirement payouts based on a standard that is consistent with the payout language on a hybrid life insurance policy offering a lifetime benefits rider.













 


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