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myNQDC.com Alert (Jan. 16, 2013): Tax Act’s Impact On Nonqualified Deferred Compensation

For nonqualified deferred compensation, the American Taxpayer Relief Act has some impacts. In general, these enhance the appeal of deferring income into the future through nonqualified plans. The following potential tax increases apply to nonqualified deferred compensation with effect from January 1, 2013.

  • The top federal withholding rate on supplemental income rose to 39.6%. The withholding rates on supplemental income apply to current and former employees at the distribution of deferred compensation. The higher of two flat federal rates for withholding from supplemental income changed under the new tax law, as the rates are tied to income tax brackets. For aggregate supplemental wage payments totaling up to $1 million during the year, the rate is unchanged at 25% (the rate of the third income tax bracket). For aggregate supplemental wage payments that exceed the level of $1 million in a calendar year, the rate is now 39.6% (the new rate of the highest income tax bracket).
  • The Social Security rate returned to 6.2%. At the time of your compensation deferral or the vesting of a company match or contribution, you pay Social Security tax. In 2013, the Social Security tax rate returned to 6.2% from the reduced rate of 4.2% that applied in 2011 and 2012, as the new tax law did not extend the reduction in payroll tax. Social Security tax applies up to a certain amount of yearly income ($113,700 in 2013) and not to yearly income above that threshold.
  • At deferral or vesting, you also pay Medicare tax. Separately from the American Taxpayer Relief Act, in 2012 the Affordable Care Act increased the Medicare tax rate on compensation income for high-income taxpayers from 1.45% to 2.35%. In addition, a new 3.8% Medicare surtax now applies to investment income, such as capital gains from stock sales or dividend income, though it is unlikely that this 3.8% surtax will apply to distributions from nonqualified plans. Both of these tax changes became effective on January 1, 2013.

Advantages Of Nonqualified Plans

Generally, the rise in tax rates increases the attractiveness of deferring income into the future through nonqualified plans.

  • Deferrals can keep your yearly taxable income below the thresholds for the new top tax rates on ordinary income (39.6%) and capital gains and dividends (20%). These top rates are triggered for single filers with yearly taxable income of more than $400,000 and for married joint filers with yearly taxable income of more than $450,000.
  • Deferrals can also lower your modified adjusted gross income (MAGI) below the thresholds for the increases in Medicare tax detailed above. These new Medicare tax provisions apply to single filers with yearly MAGI of more than $200,000 and to married joint filers with yearly MAGI of more than $250,000.
  • Deferrals can help to keep your adjusted gross income (AGI) below the threshold for phaseouts on personal exemptions and itemized deductions, which under the new law have returned for single filers with AGI of $250,000 and married joint filers with AGI of $300,000.

Each person’s situation is different, however, and you should make projections involving various factors:

  • your calculation of current and future tax rates for both ordinary income and capital gains
  • the investment return on the compensation you defer
  • the growth of alternative investment(s) for the after-tax amount of the compensation without deferral

To make simple projections with these factors, try the calculator at myNQDC.com.

As explained in an FAQ at myNQDC.com, even though you may want to defer this year’s expected income into the future, when your tax rates may be lower, you cannot change your deferral election for this year’s compensation. Similarly, given the restrictions on redeferrals, you cannot move an income distribution that is scheduled for this year.

Further Reading

We are in the process of updating our content for recent tax-law changes (the calculator is fully updated). For additional coverage of tax changes taking effect in 2013, see the following FAQs on myNQDC.com:

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