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Show How Retirement Plans Affect Taxes Using Tax Planning Software

A lot hinges on your client’s retirement plan decisions. The type of plan (or plans) they select will affect how satisfied their employees are with their benefits packages, and it will help determine how attractive the business is to new talent. Each plan will have different administrative needs, and managing certain plans will be more costly than others. But their chosen retirement plan will also affect taxes, both for the business and the plan’s participants. Fortunately, with good tax planning software at your side, you can help your clients navigate the tax aspects of their decision.

Business Taxes

The first determination you’ll need to make is if your client’s retirement plan is a qualified plan or a non-qualified plan. Qualified plans are governed by the Employee Retirement Income Security Act of 1974 (ERISA) and must meet certain criteria. For example, ERISA-qualified plans must:

  • Supply information about the plan’s framework and investment options to participants on a predetermined basis or on request.
  • Adhere to nondiscrimination policies so that all classes of employees are given the same investment opportunities.
  • Follow certain guidelines on participation, like requiring participants to meet certain age or service requirements.
  • Operate in accordance with the plan document.
  • Abide by annual contribution limits as established by ERISA for that plan year.
  • Conform to other expectations as outlined by ERISA.

ERISA-qualified plans face more scrutiny and oversight from the Department of Labor (DOL) than non-qualified plans, but the tradeoff is that qualified plans tend to be more tax-favorable.

Qualified Plans

ERISA-qualified retirement plans have a few different tax advantages. First, contributions to qualified plans are deductible. In defined benefit plans (i.e. pension plans), the business is solely responsible for funding the participant’s retirement plan. All contributions to defined benefit plans are deductible alongside other employment costs like payroll and healthcare benefits. The same is true for defined contribution plans (e.g. 401(k)s, 403(b)s, etc.). Although businesses are not typically required to contribute to defined contribution plans, many choose to do so with employer matches. If they do, those contributions are deductible.

Second, earnings within the plan are not taxable to the business. As the plan sponsor, the employer is a fiduciary to the plan’s assets but has no rights to the assets themselves, therefore the earnings grow tax-free within the plan. Only when those earnings are withdrawn do taxes become a concern. And even then, the earnings, if taxable at all, are taxable to the beneficiary rather than the business.

Non-Qualified Plans

Non-qualified plans have markedly different tax implications. In most cases, the business is not permitted to deduct contributions they make to non-qualified plans – at least not presently. Consider, for instance, an unfunded deferred compensation (NQDC) plans, one of the most common types of non-qualified plans. In NQDC plans, participants can elect to defer a portion of their compensation until retirement. Businesses typically place these deferred amounts into a separate trust to be held for the benefit of the employee at retirement, but those assets are never truly segregated from assets of the business. Because the business still has ownership over those assets, they cannot take a present tax deduction when they fund the trust. They can only deduct those amounts – their “contribution” to the retirement plan – when the compensation is paid out at retirement.

Sponsors of NQDC plans also need to think about payroll taxes. Because the plan is funded with deferred compensation, the deferred amounts will be subject to payroll taxes. The business may be required to pay payroll taxes before they distribute the funds to the participant. The dollar amounts won’t change – all compensation will be subject to payroll tax whether it is deferred or paid out – but it can be burdensome if payroll taxes become due before the business can take a deduction for compensation.

Income tax deductions are important to most businesses because deductions effectively subsidize the cost of funding a retirement plan. Without those deductions, many businesses cannot justify them, which is why many non-qualified plans are only reserved for executives. While non-qualified plans can be simpler in many ways (fewer reporting requirements, no discrimination clauses, more favorable contribution limitations, etc.), they simply aren’t feasible for most businesses to use on their entire workforce.

Participants’ Taxes

Before your client selects a retirement plan, they will likely consider how appealing certain plans are to their employees. Taxes are going to be a major concern for participants, and for good reason: the tax consequences of each plan varies.

Qualified Plans

No matter what type of qualified plan your client selects, one maxim holds true: the retirement funds grow tax-deferred for the beneficiary. This tax-deferred growth is why most individuals want their employer to offer a retirement plan in the first place.While growth may be tax-deferred, the tax consequences of contributions and withdrawals differ based on the type of plan. Take, for instance, 401(k)s. Most 401(k)s are funded with pre-tax dollars, which means that employees will not pay income taxes on their contributions. When their funds are withdrawn at retirement, they will pay income tax on the amounts they initially contributed and on the plan’s growth. But some employers offer a different type of 401(k): a ROTH-401(k). In these plans, employees contribute to their plan after income taxes have already been withheld. When employees withdraw from their ROTH-401(k) accounts at retirement, their withdrawals will not be taxed. In ROTH-401(k)s, the growth that occurred within the account is never taxed.

Non-Qualified Plans

Non-qualified plans can take many forms, but let’s review the most common one: NQDC plans where employees can elect to defer a portion of their salary. If done correctly, the growth within a NQDC plan grows tax-deferred, just like growth within a qualified plan. Participants will not pay income taxes on their deferred salary until they withdraw the benefits at retirement. Many high earners assume they will be in a lower tax bracket at retirement, so deferring taxes until later in life can be a mechanism to pay fewer taxes over time.

But other non-qualified plans are less beneficial from a tax standpoint. Consider executive bonus plans. These plans are life insurance policies for the participant (typically an executive) where the premiums are paid for by the company. Premium payments are treated as deductible compensation payments to the business and are taxable as compensation to the employee. In this instance, the employee does not get to defer taxes at all.

Making the Right Choice

If your client is considering opening a new retirement plan, make sure they know what options are available to them. To help them fully grasp how taxes come into play, rely on a quality tax planning software like ours at Corvee. With our tax planning software, you can show your client how each type of plan will affect their taxes. By changing an assumption or two within our software, you can get detailed reports that project your client’s tax liabilities years into the future. Seeing their taxes from a multi-year standpoint can help them make the decision that is best for their business in the long run.

Want to learn more about Corvee Tax Planning Software? Schedule a Demo Today.

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