Bryn Mawr, Pa
For advisors who help companies fine-tune their executive and retirement plans, 2006 will be a year of both opportunity and peril. While business owners will be able to avail employees of new retirement planning options–most notably the Roth 401(k)–their nonqualified deferred compensation and defined benefits plans will also face heightened scrutiny.
This was the dual message conveyed during a presentation at The American College, held here Dec. 8 as part of the college’s annual year-end tax conference.
A chief concern of the session’s speaker, John McFadden, a Robert K. Clark chair in executive compensation and benefit planning and professor of taxation and pensions at The American College, were new regulations impacting executive pay. Businesses, he noted, have to be careful not to overstep restrictions that Internal Revenue Code Section 409 imposes on nonqualified deferred compensation. Otherwise, they’ll get hit with an immediate tax on the compensation and a 20% tax penalty.
The 409A rules, which took effect in January 2005, specify events when execs can take distributions on deferred comp (e.g., no sooner than six months after separation of service, death, disability or an unforeseeable financial emergency). And, certain exceptions notwithstanding, the code also prohibits an acceleration of benefits.
Still open to question is whether the acceleration of benefits rule precludes renegotiation of an executive’s contract. McFadden suggested the rule does, in fact, prohibit such contract renegotiations.
“We technically don’t know the answer yet,” he said. “But most practitioners who have considered this issue believe that renegotiation is now out the window. You cannot accelerate payments; nor can you extend payments unless you satisfy the rule.”
Proposed additions to 409A dating from September 2005 would, among other things, also broaden the definition of deferred compensation. Should the additions go into effect, businesses that now legitimately operate beyond 409A’s scope would either have to amend compensation packages to bring them into compliance or terminate them. Example: companies that reimburse executives for post-retirement medical expenses.
The IRS is extending 409A’s reach to still other areas, said McFadden. The Blue Book (a joint congressional committee report) on the American Jobs Creation Act of 2004, of which 409A is an outgrowth, now requires that offshore rabbi trusts and trigger provisions established prior to 2005 be terminated or made 409A-compliant. And, though the courts have ruled otherwise, the IRS has indicated that a SERP-swap–the exchange of a deferred compensation package for a life insurance policy to cover estate planning needs–also falls within 409A’s purview.
“The IRS is on the warpath,” warned McFadden. “It doesn’t accept the idea that a SERP-swap is tax-free.”
While restricting nonqualified compensation packages for top executives, the federal government is broadening them for qualified plans. Starting Jan. 1, 2006, business owners will be able to add the Roth 401(k) to their portfolio of retirement plans.
The vehicle allows plan participants to make Roth contributions up to the elective deferral limit ($15,000 plus $5,000 in catch-up contributions for employees age 50 or over). Eligibility is not restricted by income threshold and, as with the 401(k), employer-matching contributions are pre-tax.
The plans come with caveats. The $15,000/$20,000 limits apply to the total of employees’ elective deferrals (Roth, plus regular 401(k), 403(b), etc.) Contribution amounts are subject to ADP limits. Distributions are limited to regular 401(k) rules (termination, death, disability, etc.). And regular minimum distribution rules apply (i.e., the employee must begin taking distributions after age 70 1/2 ).
The new qualified plan rules, McFadden noted, leave unanswered the question whether a rollover from a Roth 401(k) to a standard IRA eliminates the requirement to take minimum distributions at age 70 1/2 . As to the plan’s merits, he said the Roth 401(k) is superior to the standard 401(k) only if employees take full advantage of the contribution limits, and only if the employer match is “grossed up.” Why? Participants have to pay taxes upfront.
As to the future of the much-battered defined benefit plan, McFadden said pending congressional bills–the Pension Security and Transparency Act of 2005 (S. 1783) and proposed NESTEG legislation–will “hasten termination” of traditional pensions by making them more expensive to fund, though the bills actually seek to strengthen such plans.
The Pension Security and Transparency Act boosts funding requirements for single-employer defined benefit pension plans; creates new rules for multi-employer plans; provides the airline industry and financially troubled plans with special provisions to avoid plan terminations; and enhances financial disclosure requirements for pension sponsors.
The NESTEG legislation incorporates pension-related provisions, including several that aim to codify best industry practices respecting corporate-owned life insurance. The legislation would, however, also preclude companies from offering nonqualified deferred compensation unless their defined benefit plans (assuming they offered one) were at least 80% funded.
“We’re looking at the accelerated death of defined benefit plans,” said McFadden. “The [80% rule] sounds like a nice flag-waving provision that’s good for the little guy. But it’s another reason for a company not to have a defined benefit plan.”
McFadden’s criticism extended beyond legislation before Congress. Administration proposals regarding retirement savings accounts (RSAs) and lifetime savings accounts (LSAs), which aim to supplant existing savings vehicles like IRAs and Roth IRAs, would unnecessarily suppress demand for life insurance, he said.
The problem, he noted, is that the administration–in particular Treasury department officials who write tax policy–wants to move to a regime that would eliminate all tax on investment income. In this scenario, the cash value in life insurance could continue to grow tax-deferred, but the product would be only one among several retirement savings vehicles that would enjoy this advantage.
“Like the French revolutionaries of 1789 who proposed to supplant the existing clock with one that has 10 hours and 100 minutes in each hour, the Ivory-tower guys in Treasury want a perfect world,” said McFadden. “They haven’t heard the old adage, ‘If it ain’t broke, don’t fix it.’ In trying to give us the perfect tax law, they would bring about the disintegration of the $4 trillion reserve now in retirement savings.”
Starting Jan. 1, 2006, business owners will be able to add the Roth 401(k) to their portfolio of retirement plans