To Defer or Not? Part 2: Unlocking the Possibilities

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A unique “loan enhanced” after tax plan can deliver participants all the economic advantage of a pre-tax plan along with added security, no worries about tax increases eroding their benefits, and no concerns about 409A restrictions on deferrals and distributions.   Bob Birdsell shows us how this can work when a sponsor provides a loan to the participant to cover the taxes on his after tax investment.

This is the  second in a series of 2 articles and videos on the subject of “Pre-Tax Saving” and “After-Tax Savings”.  This article was published in the September issue of PSX: The Exchange for People Strategy.    You can  watch the video here.

The first article and video “To Defer or Not? What are My Options?” is available in the August issue of PSX.

Essentially, if the sponsor provides a Pre-Tax deferred compensation plan for the executives it is similar to providing an informal loan to the participant. This is true because the participant does not pay current income taxes on the amount deferred. For example, assuming a tax rate of 40%, for every $50,000 of Pre Tax savings, it is comparable to giving the participant an annual loan of $20,000. (After tax savings would be only $30,000 since taxes need to be paid before the dollars are invested). The value of this informal loan can be measured in economic terms. If the assumed earnings rate on the deferral is 6%, the value of the “informal loan” is $1,200 in year one ($20,000 x 6%). By the 10th year of the loan the value is $12,000 and rises to $24,000 by the 20th year.

As presented above, the economic advantage of the deferred compensation plan over the personal after-tax savings account is approximately 16% over a 20 year period. This suggests that pre-tax savings are preferable to after-tax savings to the tune of approximately 16%. This 16% advantage, however, does not take into consideration other issues associated with pre-tax deferrals such as the prospect of higher taxes in the future, security concerns, contribution limitations, and restrictions imposed by 409A. Contemporary executive benefit programs were designed for a different age, an age that was not concerned with these issues that have become commonplace on the modern marketplace.

The question then becomes: “Is it possible to replicate the traditional deferred compensation plan using After Tax savings and deliver the same economic value while eliminating some or all of the issues?” The answer is yes if loans are made available to participants in the After Tax plan and the proceeds of the loan are invested along with the after tax dollars. Although there are various types of loans that could be employed to accomplish this objective, this discussion and video (which you can access here ) examines only one: a special insurance loan. This type of insurance loan addresses and eliminates issues with taxes, security and complications arising from 409A.

In summary, the sponsor provides a loan to the participant to cover the taxes on his after tax investment. (i.e., $20,000 per the example above). The sponsor will recover the loan provided to the participant at termination or retirement and would hold an assignment of the policy to guarantee the recovery of such dollars.

With the “loan enhanced” after tax plan, the participant will have no worries about security, no worries about tax increases eroding their benefits, no concerns about 409A restrictions on deferrals and distributions. Additionally, no taxes would be due on any gains during the accumulation program and the program can decide to provide tax-free distributions at retirement.

It’s a true win win!

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