Basic Tax Principles
– Income tax world
o sec 61 does not define “income;” but states that all income from all sources is income for tax purposes
– Pension world
o When is income taxable?
§ 404 says ER can deduct contributions to qualified plans
§ 402(a) says EE not taxed until distributions
§ 501(a) trust is exempt from tax on its investment
– “constructive receipt”
o ex. You make 1000 in year 2007, ER puts 200 in pension trust for you. You will be taxed on 12000 because you have constructively received 200 in pension contributions. If you have a legal right to $, you will be taxed on it.
Anti-reduction (204g) and Anti-alienation (206) rules are n/a to welfare benefits!
Parklane Hosiery is the precedent for using a tax court decision to support a civil action
Medicare is Health Insurance for retirees – doesn’t really cover prescriptions or nursing home care
Medicaid is welfare version of Medicare for poor people
– 3 Legged Stool of Retirement Income
o Social security
§ Universal, guaranteed, and indexed to inflation
o Private Pensions / 401k
o Individual Savings (+ earnings if you continue to work)
– Payroll Tax – a dedicated tax for specific purposes
o HI/Medicare
§ 1.45% applied to all wages. ER + EE tax is 7.65%
o FICA (Federal Insurance Contributions Act)
§ Asses taxes for social insurance – (6.2%) – wage base of 95k
§ OASDI (Old Age Survivors & Disability Insurance)
o Payroll tax is regressive – rate is same for everyone
– Income Tax – for general government spending
o income tax is progressive – the more you make, the higher your tax rate is
– DEFINED BENEFIT PLANS – ERISA 3(35) defines a defined benefit plan as a pension plan other than an individual account plan
o DB Plans
§ specifies an output for the participant
· Ex. Retirement income = % of salary X years employed
§ Money is invested in a trust fund supervised by trustees
§ At retirement, fund either pays or purchases annuity for EE
o DB Pensions
§ If funds are inadequate, ER makes up shortfall and thus, ER bears the risk
§ Complexity – DB plans require actuarial calculation of future liabilities and assets
· Note: an actuary is an insurance statistician who calculates insurance premiums, risk, dividends, and annuity rates
§ Regulation – ERISA’s regulatory regime is centered on DB plans
§ Strengths of DB Plans
· If an ER has specific-income replacement objectives in mind, these can be accommodated with a DB plan
· if ER wishes to take SS into account so that the combined levels will produce the desired results, integration of both SS and DB plans can be accomplished
· A more equitable allocation of ER contributions occurs under a DB plan, since the EE’s age, past service, and pay may all be taken into account
· can be structured to provide a benefit that is related to an EE’s final pay, thus protecting the EE against the effects of pre-retirement inflation.
§ Superannuation policy – DB plans have an advantage in facilitating the departure of workers
§ Back-loading – a major theme of ERISA’s regulation is to restrict “backloading,” which is the practice of designing a plan so benefits accrue disproportionately toward the end of the EE’s service. However, plans are intrinsically backloaded, on account of the final career average benefit formulas commonly used.
§ Eliminating moral hazard in the distribution phase – people who prefer annuities tend to be those who have private info suggesting they will live to be relatively old; those expecting relatively early death will take the lump sum. Retirees with average life expectancies therefore are faced with relatively low annuities because the pool is overrepresented by people with long life expectancies.
– DEFINED CONTRIBUTION PLANS (most popular) – ERISA 3(34) defines an individual account plan as “a pension plan which provides for an individual account for each participant and for benefits based solely upon the contributions and investment experience of the participant’s account.”
o Specifies an input for the participant
§ Ex. Plan defines ER’s contribution as % of EE’s salary
o Economic entitlement is amount of defined contribution +/– earnings/losses
o DC plans take the form of ER sponsored pensions (“money purchased pensions”) & profit-sharing arrangements
o ER has fixed annual contribution (% of salary)
o Pension contribution is a fixed cost whereas PS provides flexibility; no profit, no contribution
– Defined Contribution Arrangement/Individual Account Plans (DC)
o Distributes to EE when he leaves employment, regardless of retirement
o Typically, a single lump sum
o No pooling of resources; EEs have individual accounts
o ER contribution + EE contribution +/– earnings/losses
§ No obligation to fund shortfall
§ Risk is on EE; he chooses investment allocation
– Money Purchase Plans
o Traditional money purchase plans (Money Purchase Pension Plans [MPPP])
§ ER or other sponsor creates the plan.
§ Plan mainta
e), (b)(3)
§ Dividends may be paid as cash or used to buy additional stock
o 403(b) Plans
§ IRC § 403(b) – certain tax-exempt organizations and educational institutions are allowed to offer salary reduction plans
§ ER and participant both contribute to the DC account, much like 401k, which is invested
§ purchase annuity for the account owner and spouse, unless another form of distribution is elected
§ Most ERs use TIAA-CREF, the college teacher’s pension fund, as the annuity provider
§ Many also offer option to partially or wholly invest accounts in mutual funds. IRC §403(b)(7)
o Health Savings Accounts (HSA) – p.56
§ Money can be contributed into an account to be used for payment of qualified medical expenses
§ An individual can contribute to an HSA if covered by a health plan (with an annual deductible of at least $1000 for individual coverage and $2000 for family coverage) AND is not eligible for Medicare
§ Annual contributions are limited up to 100% of the deductible up to a maximum of $2600 for an individual and $5159 for a family, with additional contributions permitted for an older EEs
· Contributions to an HAS are tax deductible, but contributions in excess pay 6% excise tax
· Earnings accumulate tax free
· No tax is paid on distributions, so long as they are used for qualified medical expenses
· Distributions not used to pay for qualified expenses are gross income and 10% penalty tax
· Upon death, HAS may be transferred to spouse tax free
o Individual Retirement Accounts (IRAs) – regulated under IRC 408
§ Not ER provided plans, but they are retirement savings incentives
§ Not qualified retirement plans under IRC §401(a)
§ account balances may be rolled-over
§ Roth IRAs – contributions to Roth IRAs are nondeductible, and distributors are wholly untaxed
Progressive benefit – the more money you make, the higher your pension
SSI (Supplemental Security Income) – Welfare benefit and poverty based benefit for elderly; funded by general tax revenue
