Tax Guide: Long-Term Savings

Table 5-1 showed the benefits of deferring income over long periods of time. Figure 6-1 below shows very simply the power of long-term deferral, comparing the first alternative (receiving income, paying tax, and investing the after-tax proceeds for 10 years) with the second (deferring income, receiving credit for annual income on the whole amount, and paying tax at the end of the 10-year period). Even in this situation, in which the tax rates are the same in the current

If you participate in a qualified retirement plan (or plans), you have a significant opportunity to help provide for your eventual retirement security and for the security of your survivors. Consequently, one very important aspect of your participation in a plan is designating a beneficiary to receive the proceeds of the plan when you die. This designation should be made only after you carefully review your overall estate plan to ensure the coordination of assets, including employee benefit plan balances. In general, you may want to designate your spouse, your children, other family members, your estate, and often a trust.

Qualified Retirement Plans: Most employees have the opportunity to participate in some form of qualified retirement plan, typically a pension, profit-sharing, or savings plan. Generally, a plan is "qualified" if it provides for participation in a nondiscriminatory manner and complies with certain restrictions. The restrictions are mainly limits on employer and employee contributions and distributions from the plans.

Defined Benefit Pension Plans: If you have a defined benefit pension plan, you are generally entitled to an annual pension when you retire. The benefits are typically based on a formula that considers your length of service with the employer, your age at retirement, your annual social security income, your preretirement earnings, the period over which you elect to take benefits (that is, your life expectancy), and whether you elect survivor benefits. Figure 6-2 below shows you the most common distribution options available under most qualified plans. In some cases, you may be able to take a lump-sum distribution at retirement instead of taking annual amounts.

FIGURE 6-2
Common Distribution Options

Single Life. A monthly annuity will be paid to the retired employee for life. This is usually the basic form of benefit under a pension plan.
Joint and Survivor. A reduced monthly annuity will be paid to the retired employee for life, with a percentage of that reduced benefit paid to the surviving spouse or other beneficiary. The larger the continuing percentage, the smaller the initial benefit.
Term Certain. Based on a single life or joint life annuity, a reduced monthly annuity will be paid for life (or joint life), coupled with a guaranteed minimum payment period, such as five, 10 or 15 years.
Lump Sum. A single sum, rather than an annuity, will be paid to the retired employee. This amount is a present-value equivalent of the stream of otherwise available annuity payments in a pension plan or, in the case of a defined contribution plan, simply the balance accumulated in the retiree's account at the time of distribution.

Nonqualified Retirement Plans: Generally, nonqualified plans are available only to more highly compensated employees. Nonqualified plans are not subject to the same tax and labor law restrictions as qualified plans, such as limitations regarding discrimination in contributions and distributions or funding requirements. However, since these plans generally either are not currently funded or are tied to the performance of employer stock, they can be much riskier than qualified plans.

Almost any plan designed to increase an employee's retirement income or savings available for retirement can be considered a nonqualified retirement plan. These plans can be provided by an employer or established by an employee. Because these plans are nonqualified, employers who provide them do not receive any income tax deduction until the funds are actually paid to employees, and there is some risk that the funds will not be available to the employee at retirement. If you participate in this type of plan, you may want to consider this risk when determining your projected retirement income.

There may be less risk with employee-funded nonqualified retirement plans, but there is still generally some risk. For example, if you purchase a deferred annuity or a cash value life insurance contract for tax-deferred growth, there is still some investment risk, as well as the risk that the company selling the product will not perform as expected.

Stock Option Plans: Stock options are often granted to executives as incentive compensation and to encourage and assist in the ownership of stock in the employer company. Stock appreciation rights (SARs) accomplish much the same results by rewarding executives with the increase in stock value, paid in cash or shares of stock or both.

These plans typically provide for the options/SARs to vest from one to five years following the date of grant and to expire, if unexercised, ten years from the date of grant. Employee stock options generally are not taxable at the time of grant, but instead at the time of exercise and at the time of sale of the acquired stock.

Nonqualified stock options are subject to income tax at the time of exercise; the difference between the fair market value on the date of exercise and the grant price (the bargain element) is treated as additional compensation and taxed as ordinary income. Incentive stock options (ISOs) provide a major benefit because there is no ordinary income taxation at date of grant or date of exercise. However, the ISO bargain element is an adjustment for alternative minimum tax. You are allowed long-term capital gain treatment for the entire option gain (initial spread at exercise plus any subsequent appreciation) if you hold the stock for at least two years from the date of grant and at least one year from the date of exercise.