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Several years ago a wealthy investor stated that he had experienced two types of tax problems. The first was having to pay too much in taxes because he had too much income. The second was paying too little in taxes because he had too little income. He went on to state that having to pay too much in taxes is always preferable to having too little income.
Most highly compensated executives realize that company sponsored 401(k) plans and defined benefit plans are not going to provide them an adequate income replacement ratio at retirement. The solution to this deficient income replacement ratio is to defer pre-tax income into a company sponsored non-qualified deferred compensation plan even if income taxes increase in the future. Remember paying too much in taxes is always preferable to having too little income.
The current income tax environment continues to breed uncertainty. Income taxes on the highly compensated may increase in two years, but no one can say with certainty if they will. It is known with relative certainty that Republicans will attempt to block any future tax increase. An executive who attempts to develop a personal investment portfolio with personal after-tax money will incur taxable income each year on realized gains. Invested assets in a non-qualified deferred compensation plan avoid all of these taxes until there is a plan distribution. These advantages continue during the retirement payout period. The longer the payout period of the deferred compensation account, the greater the advantages become.
Consider the following situation with a rising tax bracket in 2013:
Current tax bracket: 33% federal, 7% state
Tax bracket at payout: 40% federal, 10% state
Current age: 50
Retirement Age: 65
Distribution period: 20 years
An executive who is currently age 50, has a 40% tax bracket increasing to 50% in 2013, will have an after-tax annual deferred compensation payout of
Tax deferred compounding works, even in a rising tax bracket. Income deferral and residence in a state with no income tax provides an 88% increase in after-tax annual income over not deferring, while residence in other states provides a 57% increase, still substantial. (Watch a 5 minute video on the value of deferred compensation here.)
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