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Nonqualified Deferred Compensation--"Rabbi
Trusts"
There are annual compensation limits
that must be taken into account for each employee in determining
contributions or benefits under qualified retirement plans. For 2005, the
limit is $210,000. However, there is a way to avoid this limitation.
Benefits that are not subject to the
qualified plan limitations can be provided through nonqualified deferred
compensation agreements and a related "rabbi trust"--so-called
because one of the favorable IRS letter rulings in this area involved a trust
established by a congregation for its rabbi. These agreements are
basically contracts between an employer and employee for the payment of
compensation in the future--after a specified number of years, at
retirement, or on the occurrence of a specific event, such as a corporate
take-over, in consideration of continued employment by the employee.
Unlike a qualified plan, these
"rabbi trusts" are funded at the discretion of the employer and
are subject to the claims of creditors. Essentially, the trust is under
the employer's control, and, if structured properly, will result in a
deferral of income taxes for the employee on the amount of compensation
deferred. Moreover, unlike contributions to a qualified plan, employer
contributions to a "rabbi trust" are deductible only when
amounts attributable to those contributions are distributed to the
employee.
One of the important considerations is
that "rabbi trusts", as nonqualified plans, are not subject to
the nondiscrimination rules under which qualified plans must operate.
This means that you are free to provide this benefit to selected
management or executive employees even though you exclude rank- and-file
employees.
The IRS has laid down guidelines for
these arrangements and related trusts, which can be structured to assure
tax deferral for key employees you may want to cover. Generally, for
amounts deferred after 2004, a deferred compensation plan must meet
certain distribution, acceleration of benefits, and election
requirements, and limitations apply for offshore rabbi trusts and
nonqualified deferred compensation plans where funding restrictions are
triggered by changes in the employer's financial health.
Such arrangements should be considered
in the appropriate situations. They can provide a powerful benefit not
otherwise available under the strictly regulated qualified plan rules.
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Quick Links...
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Dear Reader,
After a
brief respite, we are back with more tax planning ideas and strategies.
Although recipients of our tax newsletters have provided us with great
feedback, we also welcome any suggestions regarding topics of interest
that you would like discussed in future issues.
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· Health Savings Accounts
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Health
savings accounts (HSAs) are another health insurance option available to
businesses and individuals. HSAs can be set up only by those who have
policies with high deductibles. The minimum allowable deductible is
$2,000 for family coverage and $1,000 for self-only coverage. HSAs must
also limit co-payments on covered benefits to $10,200 a year for marrieds
and family coverage and $5,100 for individual coverage.
HSAs
are tapped to pay what basic coverage would have paid. Disability,
dental, vision and long-term care insurance are permitted. Seniors
covered by Medicare can't have HSAs; nor can persons who can be claimed
as someone's dependent.
Contributions
by individuals to their HSAs are deductible up to the deductible on the
associated insurance policy. Annual pay-ins are limited to $5,250 for
family coverage and $2,650 for self-only coverage. Participants born
before 1951 can put in an extra $600 for 2005. The deductible can be
claimed by both itemizers and non-itemizers. Contributions can be funded
through salary reduction.
Income
earned within an HSA is not taxed to the HSA owner. Withdrawals are not
taxed if used to pay for medical treatment of someone covered by the
plan. Payouts for other purposes are taxed and hit with a 10% penalty,
unless made on or after reaching age 65 or because of death or disability.
Unused amounts in HSA accounts are carried over to the following year.
Individuals with medical savings accounts can roll them over tax-free
into HSAs.
Payins
to HSAs are fully deductible by employers that make them on behalf of
employees who do not have basic medical insurance protection.
Contributions that are made by employers are tax-free to employees.
Employers who offer HSAs must do so for all of their eligible employees.
HSA
plans are worth considering, especially by healthy individuals, who can
benefit from the tax-free compounding of their unused HSA payins.
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· Wash Sales
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One needs to be aware of the
"wash sale" rules in connection with stock and securities
transactions.
If one sells stock or securities
for a loss and buy substantially identical stock or securities within the
30-day period before or after the sale date, the loss cannot be claimed
for tax purposes. This rule is designed to prevent taxpayers from using
the tax benefit of a loss without parting with ownership in any
significant way. Note that the rule applies to a 30-day period before or
after the sale date to prevent buying the stock back before it is even
sold. If you participate in any dividend reinvestment plans, the wash
sale rules may be inadvertently triggered when dividends are reinvested
under the plan, if you have separately sold some of the same stock at a
loss within either of those 30-day periods.
Although the loss cannot be
claimed on a wash sale, the disallowed amount is added to the cost basis
of the new stock. Therefore, the disallowed amount can be claimed when
the new stock is finally disposed of.
Note that while wash sales losses
cannot be claimed, gains cannot be avoided. That is, if you sell stock
for a gain and buy it right back, you must, of course, report the gain
and pay any tax due--no special rule applies.
One must keep the wash sale in
mind so as to not lose a tax loss inadvertently--it can easily be avoided
with a little planning.
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· QTIPing an IRA
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Like many people, you may have
substantial sums invested in individual retirement accounts (IRAs). In
fact, it is quite common for a rollover IRA-one holding distributions from
a qualified retirement plan-to be a family's most important asset.
However, without proper planning,
this wealth could be reduced drastically by income and/or estate taxes.
If you take the money out of the IRA, you must pay income tax. If you
leave the funds in the IRA until death, the date-of-death account balance
will be subject to estate tax. Further, your beneficiaries will still
have to pay income tax on what's left.
By making the IRA payable to a
qualified terminable interest property (QTIP) trust, you can postpone
paying estate taxes on the property and provide for your spouse during
his or her lifetime. You can do this while protecting the property for
ultimate distribution to your children.
An IRA-to-QTIP arrangement can
minimize your taxes and meet your non-tax objectives. But, the
arrangement must be carefully structured, or your spouse and children may
lose the benefit of income and estate tax deferral. Payout of an IRA must
comply with technical provisions of the income tax laws. QTIP trusts must
satisfy estate tax requirements. Meshing the two sets of rules is tricky
and requires careful planning.
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· Tax Deadlines
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The June 15th deadline is
relevant for those corporations with a March 31st year-end and those with
a September 30th year-end and on a 6-month extension. Further, the 2004
income tax returns for nonresident individuals (who were not subject to
US wage withholding) are on automatic extension from April 15th to June
15th.
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