Many attorneys and accountants have asked just the question if it makes sense to voluntarily defer compensation. Understanding the complexity of the answer can help make a better policy decision, that results in a better outcome for the policy owners. In most cases, the answer is a very emphatic “YES!”
Here are some of the factors to consider:
- Corporate tax rates may go up. When tax rates go down, the value of a corporate-level tax deduction and the leverage it can produce when benefits are paid out is reduced. However, when rates go up, so does the employer’s leverage. Higher tax brackets at distribution mean more benefits can be paid with the same post-deduction outlay, or that the same payments can be paid out at a lower net corporate cost.
- A reduction in tax rates reduces the value of tax deferral to participating employees. However, when rates go up, so does the value of deferring next year’s bonus.
- The value of tax deferral is lower at a 36 percent bracket than at a 50 percent bracket. But as personal rates rise, so does the value of a deferral. From the employee’s standpoint, deferral is advantageous even if rates rise to 40 percent (or even 45 percent), provided that the deferral period is long enough.
- In a few situations, the employee may be better off taking the money, paying tax on it and investing on his own rather than risking being a general creditor of the employer for many years. But few employees would, year after year, invest the after-tax difference. If they did, and if they never touched the investment, and if it never suffered a capital loss, and if it always earned a specified after tax rate of interest, then they might be better off.
- The mathematics of the deferral issue show that the benefit of deferral varies according to three factors: (a) the tax rate when the funds are distributed (if rates increase, the value of the interest-free loan from the government is offset by the amount of the increased tax that must be paid); (b) the length of the deferral; and (c) the interest rate that the deferred funds earn. At what point will the deferral of current taxation offset the increase in tax rates? Under almost any scenario, a key employee is better off deferring compensation, assuming that tax rates will increase, if the deferral period exceeds six years and the interest rate is 6 percent or greater.
- When top corporate rates drop, the employer’s cost of deferral can still be significant. In fact, the cost of deferral to the corporate employer can actually be greater than the value of deferral to the employee.
On the other hand, the employer can use the money it has on hand but is not paying out. It can put the earmarked investments to work at the corporation’s earnings level, both during the accumulation period and during the distribution period. It could earn a rate of return sufficient not only to put the employee in a better position than he would have been had he taken current salary and invested it, but it can also retain a portion of the earnings to offset the cost of deferral.
With a salary continuation plan, the corporate client can set up the plan so that the employer maintains control and achieves its business purpose, or else it gets its money back. And, unlike the current payment of a salary, earmarked funds can be available for a corporate emergency or opportunity.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM