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NOTE:
The tax regime applying to all fringe benefits is
highly complex, and professional advice should be
taken before planning any scheme designed to minimise
taxation. These notes are intended simply to give
a general overview and should not be relied upon as
a basis for action in any particular case.
Pensions
The statutory
tax treatment of pensions was formally legislated
through the Revenue Act of 1921, which exempted interest
income of stock bonus and profit-sharing plans from
current taxation and deferred tax to employees until
distribution. Statutes enacted since 1921 have permitted
employers to deduct a reasonable amount in excess
of the amount necessary to fund current pension liabilities
(1928); made pension trusts irrevocable (1938); and
established nondiscriminatory eligibility rules for
pension coverage, contributions, and benefits (1942).
These provisions were incorporated into the Internal
Revenue Code (IRC) of 1954 and, along with major modifications
made by the Tax Reform Act of 1986 (TRA '86), constitute
the basic rules governing the tax qualification of
pension plans.
The tax
treatment accorded qualified plans provides incentives
both for employers to establish such plans and for
employees to participate in them. In general, a contribution
to a qualified plan is immediately deductible in computing
the employer's taxes but only becomes taxable to the
employee on subsequent distribution from the plan.
In the interim, investment earnings on the contributions
are not subject to tax. This preferential tax treatment
is contingent on the employer's compliance with rules
set out in the Employee Retirement Income Security
Act of 1974 (ERISA) and administered by the US Department
of the Treasury (under the IRC) and the US Department
of Labor (under ERISA). Plans not meeting ERISA qualification
requirements may also be used to provide retirement
income. Nonqualified plans are generally governed
by trust law rather than the tax code.
Types
of Plans
Defined
Benefit Plans
In a
defined benefit plan, the employer agrees to provide
the employee a nominal benefit amount at retirement
based on a specified formula. The formula is usually
one of three general types: a flat-benefit formula,
a career-average formula, or a final-pay formula.
- Flat-Benefit
Formulas These
formulas pay a flat dollar amount for each year
of service recognized under the plan.
- Career-Average
Formulas There are two types of career-average
formulas. Under the first type, participants earn
a percentage of the pay recognized for plan purposes
in each year they are plan participants. The second
type of career-average formula averages the participant's
yearly earnings over the period of plan participation.
At retirement, the benefit equals a percentage of
the career-average pay, multiplied by the participant's
number of years of service.
- Final-Pay
Formulas
These plans base benefits on average earnings during
a specified number of years at the end of a participant's
career; this is presumably the time when earnings
are highest. The benefit equals a percentage of
the participant's final average earnings, multiplied
by the number of years of service. This formula
provides preretirement inflation protection to the
participant but can represent a higher cost to the
employer.
Flat-benefit
formulas are common in collectively bargained plans
or plans covering hourly paid employees. Career-average
and final-pay formulas are most common in plans covering
nonunion employees. Under pay-related formulas, an
employer has some discretion in defining pay for plan
purposes provided the definition does not discriminate
in favor of highly compensated employees, subject
to the statutory and regulatory definition of compensation
used in testing for nondiscrimination. Under ERISA's
minimum standards, there is also some leeway in determining
what employment period will be recognized in the benefit
formula. The benefit may reflect only the plan participation
period or may be based on the entire employment period.
Defined
Contribution Plans
In a
defined contribution plan, the employer makes provision
for contributions to an account established for each
participating employee. The final retirement benefit
reflects the total of employer contributions, any
employee contributions, and investment gains or losses.
Sometimes the accumulated amount includes forfeitures
resulting from employer contributions forfeited by
employees who leave before becoming vested. As a result,
the level of future retirement benefits cannot be
calculated exactly in advance. Employer contributions
to defined contribution plans are often based on a
specific formula such as a percentage of participant
salary or of company profits.
The plans
may be designed to include pretax or after-tax employee
contributions, which may be voluntary or mandatory.
There are several types of defined contribution plans:
- In
a money purchase plan, employer contributions are
mandatory and are usually stated as a percentage
of employee salary.
- In
a profit-sharing plan, total contributions to be
distributed are often derived from a portion of
company profits.
- Stock
bonus plans are similar to profit-sharing plans
but usually make contributions and benefit payments
in the form of company stock.
-
A target benefit plan is a cross between a defined
benefit plan and a money purchase plan-with a targeted
benefit used to determine the level of contributions
but with contributions allocated to accounts as
in a money purchase plan.
- A
thrift, or savings, plan is essentially an employee
savings account, often with employer matching contributions.
-
In a 401(k) arrangement, an employee can elect to
contribute, on a pretax basis, a portion of current
compensation to an individual account, thus deferring
current income tax on the contribution and the investment
income earned.
-
In an employee stock ownership plan (ESOP), employer
contributions to employee accounts must be primarily
in company stock.
In
December 2004, the Treasury Department and IRS issued
proposed temporary regulations designed to shut down
abusive tax shelter schemes involving ESOP-based pension
schemes.
Section
409(p) of the tax code generally prohibits accruals
or allocations under an employee stock ownership plan
(ESOP) that holds stock of an S corporation, where
the ownership interest in the ESOP or in rights to
acquire the corporation are so concentrated among
10% owners that they hold 50% or more of the interests
in the corporation.
The
regulations replaced proposed temporary regulations
that were issued in 2003 and addressed a wide variety
of issues under section 409(p), including the key
definitions of a prohibited accrual or allocation,
a disqualified person and a non-allocation year.
“These
regulations support our efforts to shut down abusive
schemes, in this case those skirting pension laws,"
IRS Commissioner Mark W. Everson commented at the
time.
The
regulations came into effect for plan years beginning
on or after Jan. 1, 2005, subject to several special
effective date rules.
Pension
plans must satisfy a variety of rules to qualify for
tax-favored treatment. These rules are designed to
protect employee rights and to guarantee that pension
benefits will be available for employees at retirement.
The rules govern requirements for reporting and disclosure
of plan information, fiduciary responsibilities, employee
eligibility for plan participation, vesting of benefits,
form of benefit payment, and funding. In addition,
qualified plans must satisfy a set of nondiscrimination
rules (under IRC sec. 401(a)(4), sec. 410(b), and
in some cases sec. 401(a)(26)) designed to insure
that a plan does not discriminate in favor of highly
compensated employees.
The nondiscrimination
rules are satisfied through a series of complex rules
that must be tested annually to ensure that the classification
of employees who are eligible for participation (i.e.,
covered) is nondiscriminatory, and the proportion
of eligible employees who actually participate in
a plan is nondiscriminatory. In addition, the level
of contributions and benefits under the plan(s) are
tested to ensure that they do not disproportionately
accrue to the highly compensated.
A highly
compensated employee for a particular year is an employee
who is a 5 per cent owner (or who was a 5 per cent
owner in the preceding year), or any employee who
in the prior year had compensation in excess of $95,000
(from 2005) and who, if the employer elects to apply
the top 20 percent rule, was in the top 20 percent
of employees on the basis of compensation for the
prior year.
Pension
plans generally offer retiring participants a choice
between two payment options: an annuity, in which
the benefit is paid out in a stream of regular payments,
usually monthly and usually over the life of the participant
(or lives of the participant and spouse) but sometimes
over some other specified period; or in a lump sum.
The type of distribution and when it is taken determines
the tax treatment.
Benefits
from a qualified plan payable in the form of an annuity
are only included in the employee's income as payments
are received. A portion of any after-tax employee
contribution to the plan is considered a return of
the contribution and therefore is not taxable. An
individual computes the tax-free portion of each year's
distribution by dividing the individual's contributions
and other amounts previously taxed by a specified
factor. This factor is generally tied to the age of
the participant when the payments begin.
The rules
apply to distributions from pension or 401(k) plans,
as well as distributions from sec. 403(b) arrangements.
These rules do not apply to distributions from IRAs.
A lump
sum is commonly offered in defined contribution plans
for distribution at retirement, death, or disability.
Some defined contribution plans also provide an annuity
option for their participants. However, if such an
alternative exists and the benefit amount exceeds
$3,500, the employer may not cash out the benefit
unilaterally.
In
2005, the maximum contribution to a defined contribution
plan increased to the lesser of 100% of compensation
or $42,000.
The maximum dollar amount will be adjusted upward
for inflation in later years by $1,000 increments
whenever cumulative inflation causes the limit to
exceed the next higher $1,000.
For tax
years beginning prior to January 1, 2000, a lump-sum
distribution may be entitled to special tax treatment
if it is a distribution of an employee's total accrued
benefit from all plans that is paid within a single
tax year and made on the occasion of the employee's
death, attainment of age 591/2, or separation from
the employer's service (separate treatment applies
to money purchase plans). Self-employed individuals
may receive lump-sum distribution treatment only in
the case of death, disability, or the attainment of
age 591/2. A distribution of an annuity contract from
a trust or an annuity plan may be treated as a lump-sum
distribution. The distribution must occur within one
year of the qualified event.
Individual
Retirement Arrangement (IRA).
An
Individual Retirement Arrangement (IRA), commonly
called an Individual Retirement Account, is a personal
retirement savings plan available to anyone, regardless
of age, who receives taxable compensation during the
year. For IRA contribution purposes, compensation
includes wages, salaries, fees, tips, bonuses, commissions,
taxable alimony, and separate maintenance payments.
Husbands
and wives may each have an IRA, even if one person
in that marriage is not working. A person's annual
contribution, whether made to just one or to multiple
IRAs, is limited to the lesser of total taxable compensation
or to the normal yearly amount shown in the following
table. Persons age 50 or older may make an additional
catch-up contribution in the amount indicated for
the year concerned.
Traditional and Roth IRA Annual Contribution Limits
| Year |
Normal
Contribution, US$ |
Catch-Up
Contribution, US$ |
| 2001 |
2,000 |
nil |
| 2002 |
3,000 |
500 |
| 2003 |
3,000 |
500 |
| 2004 |
3,000 |
500 |
| 2005 |
4,000 |
500 |
| 2006 |
4,000 |
1,000 |
| 2007 |
4,000 |
1,000 |
| 2008 |
5,000 |
1,000 |
| 2009 |
indexed* |
1,000 |
| *Normal
contribution limits will increase annually by
$500 whenever cumulative inflation exceeds the
next higher $500 increment |
There is no minimum or required
IRA contribution, and all earnings on the amounts
in an IRA are untaxed until withdrawn. In the case
of the Roth IRA, withdrawals may even be tax-free
provided certain minimum rules are met.
Contributions
to a Roth IRA are never tax-deductible. Contributions
to a traditional IRA may or may not be deductible
in the tax year made, depending on the owner's income
tax filing status, Adjusted Gross Income (AGI), and
eligibility to participate in a tax-qualified retirement
plan through employment. If the traditional IRA owner
participates in an employer's qualified retirement
plan on any day in the tax year, the deductibility
of contributions declines to zero at certain levels
of AGI.
Approved
in August 2006 (by a 93-5 Senate vote), the Pension
Protection Act 2006 attempts to address the estimated
$630 billion in underfunding in pension plans covering
45 million American workers and retirees, and represented
the first major change to America's pension laws for
30 years.
Under the
bill, companies would be required to fund 100% of
their projected pension obligations, an increase from
the 90% requirement under current law. Companies that
do not meet this obligation will be prohibited from
increasing employee benefits and must make accelerated
catch-up payments.
The bill
strengthens disclosure to give workers and retirees
more information about the status of their pension
plan, and restricts 'golden parachute' executive compensation
arrangements.
The bill
also includes $60 billion in tax breaks that permanently
extend pension and savings tax incentives that were
part of the 2001 tax bill. This tax package includes
increased contribution limits to Individual Retirement
Accounts, 401(k) plans and a permanent saver's credit
for lower income workers.
Although
the approved legislation does not go as far as the
White House had wanted, most lawmakers welcomed the
bill as an acceptable compromise.
"This
bill that passed in both the House and the Senate
includes about 95 percent of the compromise language
we developed in the Conference Committee. It’s
a package that will significantly strengthen pension
funding rules, help curb record pension failures and
better protect the retirement dreams of 45 million
Americans," commented Sen. Mike Enzi, (R-Wy),
Chairman of the Senate Health, Education, Labor and
Pensions (HELP) Committee.
"Although
we didn’t get everything we wanted in this bill,
I am pleased the Congress will not leave this critical
job unfinished as we adjourn for the August recess.
The 45 million Americans directly affected by this
bill deserve a greater sense of security about their
retirements as we head into the end of summer,"
he added.
Senate
Majority Leader Bill Frist (R-Tenn) also welcomed
the bill, saying that the legislation will shield
taxpayers from a possible multi-billion dollar taxpayer
bailout of the federal Pension Benefit Guaranty Corporation,
the institution that guarantees pension benefits for
workers and retires from covered pension plans.
“Promises
made to the American worker will be promises kept
with the passage of this pension bill. We have protected
the interests of retirees by strengthening pensions
funding rules and making permanent the retirement
security provisions from the 2001 tax bill, which
is a major step toward making the president’s
tax cuts permanent," Frist stated.
The bill
is due to come into effect on January 1, 2008.
Meanwhile,
in December 2006, the IRS announced that individuals
and businesses making contributions to charity should
keep in mind several important tax law changes made
by the Pension Protection Act.
The new
law offers older owners of individual retirement accounts
a new way to give to charity. It also includes rules
designed to provide both taxpayers and the government
greater certainty in determining what may be deducted
as a charitable contribution.
Giving
details of a new tax break for older IRA holders,
the IRS revealed that individuals aged over 70 ½
can directly transfer tax-free, up to $100,000 per
year to an eligible charitable organization. This
option is available in tax years 2006 and 2007. Eligible
IRA owners can take advantage of this provision, regardless
of whether they itemize their deductions. Distributions
from employer-sponsored retirement plans, including
SIMPLE IRAs and simplified employee pension (SEP)
plans are not eligible.
To qualify,
the funds must be contributed directly by the IRA
trustee to the eligible charity. Amounts so transferred
are not taxable and no deduction is available for
the amount given to the charity.
However,
not all charities are eligible under this provision.
For example, donor-advised funds and supporting organizations
are not eligible recipients.
Transferred
amounts are counted in determining whether the owner
has met the IRA’s required minimum distribution
rules. Where individuals have made nondeductible contributions
to their traditional IRAs, a special rule treats transferred
amounts as coming first from taxable funds, instead
of proportionately from taxable and nontaxable funds,
as would be the case with regular distributions.
Unveiling
new general guidlines for monetary donations, the
IRS revealed that in order to deduct any charitable
donation of money, a taxpayer must have a bank record
or a written communication from the charity showing
the name of the charity and the date and amount of
the contribution. A bank record includes canceled
checks, bank or credit union statements and credit
card statements. Bank or credit union statements should
show the name of the charity and the date and amount
paid. Credit card statements should show the name
of the charity and the transaction posting date.
Donations
of money include those made in cash or by check, electronic
funds transfer, credit card, and payroll deduction.
For payroll deductions, the taxpayer should retain
a pay stub, Form W-2 wage statement or other document
furnished by the employer showing the total amount
withheld for charity, along with the pledge card showing
the name of the charity.
Prior law
allowed taxpayers to back up their donations of money
with personal bank registers, diaries or notes made
around the time of the donation. Those types of records
are no longer sufficient.
This provision
applies to contributions made in taxable years beginning
after Aug. 17, 2006. For taxpayers that file returns
on a calendar-year basis, including most individuals,
the new provision applies to contributions made beginning
in 2007.
The new
law does not change the prior-law requirement that
a taxpayer get an acknowledgement from a charity for
each deductible donation (either money or property)
of $250 or more. However, one statement containing
all of the required information may meet the requirements
of both provisions.
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