SC Lawyer, Nov. 2005, #4. The Estate Planner's Overview of Common Deferred Compensation Issues.

Authorby Eugene Parrs

South Carolina Lawyer


SC Lawyer, Nov. 2005, #4.

The Estate Planner's Overview of Common Deferred Compensation Issues

South Carolina Lawyer November 2005 The Estate Planner's Overview of Common Deferred Compensation Issues by Eugene Parrs Introduction

Estate planners face an increasing number of deferred compensation issues every day. For many of our clients, their deferred compensation, such as pension benefits, IRAs and "non-qualified" arrangements with former employers, constitutes the greatest share of their accumulated wealth.

We have all seen this. Our typical retired physician or businessperson has a balance sheet showing a paid off house, two cars, three educated children, five young grandchildren (still needing educations) and $3 million in a rollover IRA. What's the estate planner going to do with that? And, what do you do if the spouse is a second spouse 20 years younger than the client, perhaps even younger than the client's children?

Deferred compensation, by which I mean qualified and non-qualified retirement plans, is prevalent because that's how our clients got rich. The baby boomers went to medical, law and business schools and earned money from their personal services. They put some of that high income into retirement plans with marvelous tax incentives - full deductions and tax free growth - to get where they are today.

Estate planning attorneys are competent and comfortable when dealing with the garden variety estate planning tools, such as credit shelter and disclaimer trusts, QTIPs, QDOTs and the like. But, when income tax issues on deferred compensation arise, some estate planners get shaky. What do you do when your client has a 457 plan or a 412(i) annuity? What the heck are they, anyway?

What we used to call "estate planning" has become income tax planning. The largest and most complex estate planning problems and mistakes I have seen in recent years have involved a client's or estate's income taxes, most often generated by deferred compensation.

Estate planners must be especially careful when dealing with deferred compensation because it is misunderstood by both clients and their financial advisors. Mistakes are common. Deferred compensation arrangements, such as an IRA or 401(k), are non-probate assets. Clients are often shocked that their deferred compensation is not controlled by their wills. Furthermore, clients receive advice on beneficiary designations, a lot of it wrong, from their well-intentioned financial advisors. For example, naming the estate as IRA beneficiary is almost always bad advice, yet many financial advisors suggest that "to keep things simple."

In this article I will give a three-step strategy for addressing deferred compensation issues that you will encounter in your practice. First, I will give an overview of your client's sources of deferred compensation. This is important because the source of the deferred compensation determines the correct structure in the estate plan. Second, I will explain your planning options with lifetime and post-mortem deferred compensation payouts. Third, I will point out the pitfalls that you must avoid.

Part I: Sources of Deferred Compensation "Deferred compensation" is a label that covers hundreds of arrangements. I will sort them out and give you a framework for analyzing your client's resources. This sorting out process is critical. The first step is determining exactly what kind of deferred compensation the client is bringing to you. The words and labels are often misleading and dangerous. The client says he has a "profit sharing" plan at work, but it may not be so. You must determine exactly what the plan is and what statute controls the plan before you can advise the client on options. Deferred compensation plans fall into one of two categories. Plans are either "qualified" or "non-qualified." Each category is controlled by separate tax rules.

A. Qualified Plans

A plan is qualified if it meets the requirements of Section 401(a) of the Internal Revenue Code. The qualified plans you will encounter include pension plans, 401(k) plans and profit sharing plans. Qualified plans are maintained by employers for their employees. The employer may be a for-profit corporation, partnership, LLC or sole proprietorship. The employer may also be a tax-exempt entity, such as a school district, a hospital or a charity.

Qualified plans have several attractive features. First, the employer receives a dollar for dollar tax deduction for contributions to the plan, but the employee reports no immediate income. Most contributions are not subject to federal payroll taxes. The employee pays the income tax only when distributions are made, oftentimes years later. Second, earnings in the plan are tax-free. Third, the assets are held in a separate trust and are not assets of the employer. Plan assets are not subject to the claims of the employer's creditors or the employee's creditors

As human beings are either male or female, qualified plans fall into two categories. They are either "defined contribution plans" or "defined benefit plans." In a defined contribution plan, the employer contributes an amount for all eligible employees generally based as a percentage of his or her compensation for that year. Contributions for a participant in a defined contribution plan cannot exceed 25 percent of his or her compensation, or more than $41,000. In a defined benefit plan, the employer makes a contribution to fund a predetermined benefit, generally expressed as a lifetime annuity, for the employee at retirement. Actuaries calculate the amount of the contribution to the defined benefit plan. The most attractive feature of defined benefit plans is that annual contributions for each employee can be far greater than those for defined contributions plans. Most of the qualified plans you will encounter are defined contribution plans.

The following are brief descriptions of the plans you will most often encounter.

Pension Plan - A true pension plan is a defined benefit plan that pays the client a fixed annuity payment each month for life. There is generally a continuing benefit for surviving spouses. Benefits stop at the death of the survivor and the spouse.

Profit Sharing Plan - This is a defined contribution plan. Each employee has a separate account in the plan for his or her accumulated benefits. At retirement, the employee may draw on this account until it is exhausted or roll the account into an IRA. If the employee dies during employment, the account is paid to the designated beneficiary.

401(k) Plan - This is a profit sharing plan with a special feature. It allows employees to contribute to their account on a pre-tax basis by salary reductions. When you look under the hood of a 401(k) plan, you will find a profit sharing plan chasis.

Money Purchase Pension Plan - These plans used to be very popular but are now rare. They are defined contribution plans with payout options similar in most respects to profit sharing plans. A "target benefit plan" is a sub-species of the money purchase plan, but these are now almost extinct.

Cash Balance Plan - This plan is a defined benefit plan that has the look and feel of a defined contribution plan. The benefits are generally paid in a lump sum at death and retirement. Many large corporations have tried to convert their conventional defined benefit pension plans into cash balance plans to save money.

412(i) Plan - The 412(i) plan is an obscure type of defined benefit plan. It is funded through an insurance annuity contract. Payments are made from the annuity contract at death or retirement. The 412(i) plan is currently in vogue because of the historically low interest rates.

Age Weighted Profit Sharing Plan - This is a profit sharing plan that skews contributions in favor of older employees.

New Comparability Plan - This is another kind of profit sharing plan that skews contributions in favor of older, higher paid employees.

SEPs - The simplified employee pension plan, or SEP, is technically not a qualified plan because it is authorized by Section 408(k) of the Code, not Section 401. For our purposes, however, we treat it as qualified. The SEP is an employer funded IRA. Annual contributions can be up to 25 percent of compensation, not to exceed $41,000. If your client has a SEP, or SEP-IRA, treat it as just another IRA.

SIMPLE Plan - This is a cousin of the SEP. It is the "junior varsity 401(k) plan." It is a SEP that permits employee contributions. It replaced the SAR-SEP. The SIMPLE plan can be funded through IRAs or it can be set up as a 401(k) plan.

403(b) Plan - This is available only for tax-exempt employers. It is a defined contribution plan. The 403(b) is very similar to the 401(k) plan, as it is funded in most cases by employee pre-tax contributions...

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