Lower Your Tax Bill By Directing Your Mandatory IRA Distributions To Charity
When you turn 70 1/2, you will have the option to process Qualified Charitable Distributions (QCD) which are distirbution from your pre-tax IRA directly to a chiartable organizaiton. Even though the SECURE Act in 2019 changed the RMD start age from 70 1/2 to age 72, your are still eligible to make these QCDs beginning the calendar year that you
When you turn 70 1/2, you will have the option to process Qualified Charitable Distributions (QCD) which are distribution from your pre-tax IRA directly to a chartable organization. Even though the SECURE Act in 2019 changed the RMD start age from 70 1/2 to age 72, your are still eligible to make these QCDs beginning the calendar year that you turn age 70 1/2. At age 72, you must begin taking required minimum distributions (RMD) from your pre-tax IRA’s and unless you are still working, your employer sponsored retirement plans as well. The IRS forces you to take these distributions whether you need them or not. Why is that? They want to begin collecting income taxes on your tax deferred retirement assets.
Some retirees find themselves in the fortunate situation of not needing this additional income so the RMD’s just create additional tax liability. If you are charitably inclined and would prefer to avoid the additional tax liability, you can make a charitable contribution directly from your IRA and avoid all or a portion of the tax liability generated by the required minimum distribution requirement.
It Does Not Work For 401(k)’s
You can only make “qualified charitable contributions” from an IRA. This option is not available for 401(k), 403(b), and other qualified retirement plans. If you wish to execute this strategy, you would have to process a direct rollover of your FULL 401(k) balance to a rollover IRA and then process the distribution from your IRA to charity.
The reason why I emphases the word “full” for your 401(k) rollover is due to the IRS “aggregation rule”. Assuming that you no longer work for the company that sponsors your 401(k) account, you are age 72 or older, and you have both a 401(k) account and a separate IRA account, you will need to take an RMD from both the 401(k) account and the IRA separately. The IRS allows you to aggregate your IRA’s together for purposes of taking RMD’s. If you have 10 separate IRA’s, you can total up the required distribution amounts for each IRA, and then take that amount from a single IRA account. The IRS does not allow you to aggregate 401(k) accounts for purposes of satisfying your RMD requirement. Thus, if it’s your intention to completely avoid taxes on your RMD requirement, you will have to make sure all of your retirement accounts have been moved into an IRA.
Contributions Must Be Made Directly To Charity
Another important rule. At no point can the IRA distribution ever hit your checking account. To complete the qualified charitable contribution, the money must go directly from your IRA to the charity or not-for-profit organization. Typically this is completed by issuing a “third party check” from your IRA. You provide your IRA provider with payment instructions for the check and the mailing address of the charitable organization. If at any point during this process you take receipt of the distribution from your IRA, the full amount will be taxable to you and the qualified charitable contribution will be void.
Tax Lesson
For many retirees, their income is lower in the retirement years and they have less itemized deductions since the kids are out of the house and the mortgage is paid off. Given this set of circumstances, it may make sense to change from itemizing to taking the standard deduction when preparing your taxes. Charitable contributions are an itemized deduction. Thus, if you take the standard deduction for your taxes, you no longer receive the tax benefit of your contributions to charity. By making IRA distributions directly to a charity, you are able to take the standard deduction but still capture the tax benefit of making a charitable contribution because you avoid tax on an IRA distribution that otherwise would have been taxable income to you.
Example: Church Offering
Instead of putting cash or personal checks in the offering each Sunday, you may consider directing all or a portion of your required minimum distribution from your IRA directly to the church or religious organization. Usually having a conversation with your church or religious organization about your new “offering structure” helps to ease the awkward feeling of passing the offering basket without making a contribution each week.
Example: Annual Contributions To Charity
In this example, let’s assume that each year I typically issue a personal check of $2,000 to my favorite charity, Big Brother Big Sisters, a not-for-profit organization. I’m turning 70½ this year and my accountant tells me that it would be more beneficial to take the standard deduction instead of itemizing. My RMD for the year is $5,000. I can contact my IRA provider, have them issuing a check directly to the charity for $2,000 and issue me a check for the remaining $3,000. I will only have to pay taxes on the $3,000 that I received as opposed to the full $5,000. I win, the charity wins, and the IRS kind of loses. I’m ok with that situation.
Don’t Accept Anything From The Charity In Return
This is a very important rule. Sometimes when you make a charitable contribution, as a sign of gratitude, the charity will send you a coffee mug, gift basket, etc. When this happens, you will typically get a letter from the charity confirming your contribution but the amount listed in the letter will be slightly lower than the actual dollar amount contributed. The charity will often reduce the contribution by the amount of the gift that was given. If this happens, the total amount of the charitable contribution fails the “qualified charitable contribution” requirement and you will be taxed on the full amount. Plus, you already gave the money to charity so you have spend the funds that you could use to pay the taxes. Not good
Limits
While this will not be an issue for many of us, there is a $100,000 per person limit for these qualified charitable contributions from IRA’s.
Summary
While there are a number of rules to follow when making these qualified charitable contributions from IRA’s, it can be a great strategy that allows retirees to continue contributing to their favorite charities, religious organizations, and/or not-for-profit organizations, while reducing their overall tax liability.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
Tax Reform: At What Cost?
The Republicans are in a tough situation. There is a tremendous amount of pressure on them to get tax reform done by the end of the year. This type of pressure can have ugly side effects. It’s similar to the Hail Mary play at the end of a football game. Everyone, including the quarterback, has their eyes fixed on the end zone but nobody realizes that no
The Republicans are in a tough situation. There is a tremendous amount of pressure on them to get tax reform done by the end of the year. This type of pressure can have ugly side effects. It’s similar to the Hail Mary play at the end of a football game. Everyone, including the quarterback, has their eyes fixed on the end zone but nobody realizes that no one is covering one of the defensive lineman and he’s just waiting for the ball to be hiked. The game ends without the ball leaving the quarterback’s hands.
The Big Play
Tax reform is the big play. If it works, it could lead to an extension of the current economic rally and more. I’m a supporter of tax reform for the purpose of accelerating job growth both now and in the future. It’s not just about U.S. companies keeping jobs in the U.S. That has been the game for the past two decades. The new game is about attracting foreign companies to set up shop in the U.S. and then hire U.S. workers to run their plants, companies, subsidiaries, etc. Right now we have the highest corporate tax rate in the world which has not only prevented foreign companies from coming here but it has also caused U.S. companies to move jobs outside of the United States. If everyone wants more pie, you have to focus on making the pie bigger, otherwise we are all just going to sit around and fight over who’s piece is bigger.
Easier Said Than Done
How do we make the pie bigger? We have to lower the corporate tax rate which will entice foreign companies to come here to produce the goods and services that they are already selling in the U.S. Which is easy to do if the government has a big piggy bank of money to help offset the tax revenue that will be lost in the short term from these tax cuts. But we don’t.
$1.5 Trillion In Debt Approved
Tax reform made some headway in mid-October when the Senate passed the budget. Within that budget was a provision that would allow the national debt to increase by approximately $1.5 trillion dollars to help offset the short-term revenue loss cause by tax reform. While $1.5 trillion sounds like a lot of money, and don’t get me wrong, it is, let’s put that number in context with some of the proposals that are baked into the proposed tax reform.
Pass-Through Entities
One of the provisions in the proposed tax reform is that income from “pass-through” businesses would be taxed at a flat rate of 25%.
A little background on pass-through business income: sole proprietorships, S corporations, limited liability companies (LLCs), and partnerships are known as pass-through businesses. These entities are called pass-throughs, because the profits of these firms are passed directly through the business to the owners and are taxed on the owners’ individual income tax returns.
How many businesses in the U.S. are pass-through entities? The Tax Foundation states on its website that pass-through entities “make up the vast majority of businesses and more than 60 percent of net business income in America. In addition, pass-through businesses account for more than half of the private sector workforce and 37 percent of total private sector payroll.”
At a conference in D.C., the American Society of Pension Professionals and Actuaries (ASPPA), estimated that the “pass through 25% flat tax rate” will cost the government $6 trillion - $7 trillion in tax revenue. That is a far cry from the $1.5 trillion that was approved in the budget and remember that is just one of the many proposed tax cuts in the tax reform package.
Are Democrats Needed To Pass Tax Reform?
Since $1.5 trillion was approved in the budget by the senate, if the proposed tax reform is able to prove that it will add $1.5 trillion or less to the national debt, the Republicans can get tax reform passed through a “reconciliation package” which does not require any Democrats to step across the aisle. If the tax reform forecasts exceed that $1.5 trillion threshold, then they would need support from a handful of Democrats to get the tax reformed passed which is unlikely.
Revenue Hunting
To stay below that $1.5 trillion threshold, the Republicans are “revenue hunting”. For example, if the proposed tax reform package is expected to cost $5 trillion, they would need to find $3.5 trillion in new sources of tax revenue to get the net cost below the $1.5 trillion debt limit.
State & Local Tax Deductions – Gone?
One for those new revenue sources that is included in the tax reform is taking away the ability to deduct state and local income taxes. This provision has created a divide among Republicans. Since many southern states do not have state income tax, many Republicans representing southern states support this provision. Visa versa, Republicans representing states from the northeast are generally opposed to this provision since many of their states have high state and local incomes taxes. There are other provisions within the proposed tax reform that create the same “it depends on where you live” battle ground within the Republican party.
Obamacare
One of the main reasons why the Trump administration pushed so hard for the Repeal and Replace of Obamacare was “revenue hunting”. They needed the tax savings from the repeal and replace of Obamacare to carrry over to fill the hole that will be created by the proposed tax reform. Since that did not happen, they are now looking high and low for other revenue sources.
Retirement Accounts At Risk?
If the Republicans fail to get tax reform through they run the risk of losing face with their supporters since they have yet to get any of the major reforms through that they campaigned on. Tax reform was supposed to be a layup, not a Hail Mary and this is where the hazard lies. Republicans, out of the desperation to get tax reform through, may start making cuts where they shouldn’t. There are rumors that the Republican Party may consider making cuts to the 401(k) contribution limits and employers sponsored retirement plan. Even though Trump tweeted on October 23, 2017 that he would not touch 401(k)’s as part of tax reform, they are running out of the options for other places that they can find new sources of tax revenue. If it comes down to the 1 yard line and they have the make the decision between making deep cuts to 401(k) plans or passing the tax reform, retirement plans may end up being the sacrificial lamb. There are other consequences that retirement plans may face if the proposed tax reform is passed but it’s too broad to get into in this article. We will write a separate article on that topic.
Tax Reform May Be Delayed
Given all the variables in the mix, passing tax reform before December 31st is starting to look like a tall order to fill. If the Republicans are looking for new sources of revenue, they should probably look for sources that are uniform across state lines otherwise they risk splintering the Republican Party like we saw during the attempt to Repeal and Replace Obamacare. We are encouraging everyone to pay attention to the details buried in the tax reform. While I support tax reform to secure the country’s place in the world both now and in the future, if provisions that make up the tax reform are rushed just to get something done, we run the risk of repeating the short lived glory that tax reform saw during the Reagan Era. They passed sweeping tax cuts, the deficits spiked, and they were forced to raise tax rates a few years later.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
How Do Single(k) Plans Work?
A Single(k) plan is an employer sponsored retirement plan for owner only entities, meaning you have no full-time employees. These owner only entities get the benefits of having a full fledge 401(k) plan without the large administrative costs associated with traditional 401(k) plans.
What is a Single(k) Plan?
A Single(k) plan is an employer sponsored retirement plan for owner only entities, meaning you have no full-time employees. These owner only entities get the benefits of having a full fledge 401(k) plan without the large administrative costs associated with traditional 401(k) plans.
What is the definition of a “full-time” employee?
Often times a small company will have some part-time staff. It does not matter whether you consider them “part-time”, the definition of full-time employee is defined by the IRS as working 1000 hours in a 12 month period. If you have a “full-time” employee you would not be eligible to sponsor a Single(k) plan.
Types of Contributions
There are two types of contributions to these plans. Employee deferral contributions and employer profit sharing contributions. The employee deferral piece works like a 401(k) plan. If you are under the age of 50 you can contribute $19,500, in 2021, in employee deferrals. If you are 50 or older, you get the $6,500 catch up contribution so you can contribute $24,000 in employee deferrals.
The reason why these plans are a little different than other employer sponsored plans is the employee deferral piece allows you to put 100% of your compensation into these plans up to those dollar thresholds.
In addition to the employee deferrals, you can also contribute 20% of your net earned income in the form of a profit-sharing contribution. For example, if you make $100,000 in net earned income from self-employment and you are over 50, you could contribute $24,000 in employee deferrals and then you could contribute an additional $20,000 in form of a profit sharing contribution. Making your total pre-tax contribution $44,000.
Establishment Deadline
You have to establish these plans by December 31st. In most cases that plan does not have to be funded by 12/31 but you have to have the plan document signed by 12/31. You normally have until tax filing deadline plus extension to fund the plan.
Loans & Roth Deferrals
Single(k) plans provide all of the benefits to the owner of a full 401(k) plan at a fraction of the cost. You can set up the plan to allow 401(k) loan and Roth deferral contributions.
SEP IRA vs Single(k) Plans
A lot of small business owners find themselves in a position where they are trying to decide between setting up a SEP IRA or a Single(k) plan. One of the big factors, that is often times the deciding factor, is how much the owner intends to contribute to the plan. The SEP IRA limits the business owner to just the 20% of net earned income. Whereas the Single(k) plan allows the 20% of net earned income plus the employee deferral contribution amount. However, if 20% of your net earned income would satisfy your target amount then the SEP IRA may be the right choice.
Advanced Strategy Using A Single(k) Plan
Here is a great tax strategy if you have one spouse that is the primary breadwinner bringing in most of the income and the other has self-employment income for a side business. If the spouse with the self-employment income is over the age of 50 and makes $20,000 in net earned income, they could set up a Single(k) Plan and defer the full $20,000 into their Single(k) plan as employee deferrals. If they had a SEP IRA, the max contribution would have been $4,000.
A huge tax savings for a married couple that is looking to lower their tax liability.
About Rob……...
Hi, I’m Rob Mangold. I’m the Chief Operating Officer at Greenbush Financial Group and a contributor to the Money Smart Board blog. We created the blog to provide strategies that will help our readers personally , professionally, and financially. Our blog is meant to be a resource. If there are questions that you need answered, pleas feel free to join in on the discussion or contact me directly.
The Fiduciary Rule: Exposing Your 401(K) Advisor’s Secrets
It’s here. On June 9, 2017, the long awaited Fiduciary Rule for 401(k) plans will arrive. What secrets does your 401(k) advisor have?
It’s here. On June 9, 2017, the long awaited Fiduciary Rule for 401(k) plans will arrive. The wirehouse and broker-dealer community within the investment industry has fought this new rule every step of the way. Why? Because their secrets are about to be exposed. Fee gouging in these 401(k) plans has spiraled out of control and it has gone on for way too long. While the Fiduciary Rule was designed to better protect plan participants within these employer sponsored retirement plans, the response from the broker-dealer community, in an effort to protect themselves, may actually drive the fees in 401(k) plans higher than they are now.
If your company sponsors an employer sponsored retirement plan and your investment advisor is a broker with one of the main stream wirehouse or broker dealers then they may be approaching you within the next few months regarding a “platform change” for your 401(k) plan. Best advice, start asking questions before you sign anything!! The brokerage community is going to try to gift wrap this change and present this as a value added service to their current 401(k) clients when the reality is this change is being forced onto the brokerage community and they are at great risk at losing their 401(k) clients to independent registered investment advisory firms that have served as co-fiduciaries to their plans along.
The Fiduciary Rule requires all investment advisors that handle 401(k) plans to act in the best interest of their clients. Up until now may brokers were not held to this standard. As long as they delivered the appropriate disclosure documents to the client, the regulations did not require them to act in their client’s best interest. Crazy right? Well that’s all about to change and the response of the brokerage community will shock you.
I will preface this article by stating that there have been a variety of responses by the broker-dealer community to this new regulation. While we cannot reasonably gather information on every broker-dealers response to the Fiduciary Rule, this article will provide information on how many of the brokerage firms are responding to the new legislation given our independent research.
SECRET #1:
Many of the brokerage dealers are restricting what 401(k) platforms their brokers can use. If the broker currently has 401(k) clients that maintain a plan with a 401(k) platform outside of their new “approved list”, they are forcing them to move the plan to a pre-approved platform or the broker will be required to resign as the advisor to the plan. Even though your current 401(k) platform may be better than the new proposed platform, the broker may attempt to move your plan so they can keep the plan assets. How is this remotely in your employee’s best interest? But it’s happening. We have been told that some of these 401(k) providers end up on the “pre-approve list” because they are willing to share fees with the broker dealer. If you don’t share fees, you don’t make the list. Really ugly stuff!!
SECRET #2:
Because these wirehouses and broker-dealers know that their brokers are not “experts” in 401(k) plans, many of the brokerage firms are requiring their 401(k) plans to add a third-party fiduciary service which usually results in higher plan fees. The question to ask is “if you were so concerned about our fiduciary liability why did you wait until now to present this third party fiduciary service?” They are doing this to protect themselves, not the client. Also, many of these third party fiduciary services could standardize the investment menu and take the control of the investment menu away from the broker. Which begs the question, what are you paying the broker for?
SECRET #3:
Some broker-dealers are responding to the Fiduciary Rule by forcing their brokers to move all their 401(k) plans to a “fee based platform” versus a commission based platform. The plan participants may have paid commissions on investments when they were purchased within their 401(k) account and now could be forced out of those investments and locked into a fee based fee structure after they already paid a commission on their balance. This situation will be common for 401(k) plans that are comprised primarily of self-directed brokerage accounts. Make sure you ask the advisor about the impact of the fee structure change and any deferred sales charges that may be imposed due to the platform change.
SECRET #4:
The plan fees are often times buried. The 401(k) industry has gotten very good at hiding fees. They talk in percentages and basis points but rarely talk in hard dollars. One percent does not sound like a lot but if you have a $2 million dollar 401(k) plan that equals $20,000 in fees coming out of the plans assets every year. Most of the fees are buried in the mutual fund expense ratios and you basically have to be an investment expert to figure out how much you are paying. This has continued to go on because very rarely do companies write a check for their 401(k) fees. Most plans debit plan assets for their plan fees but the fees are real.
With all of these changes taking place, now is the perfect time to take a good hard look at your company’s employer sponsored retirement plan. If your current investment advisor approaches you with a recommended “platform change” that is a red flag. Start asking a lot of questions and it may be a good time to put your plan out to bid to see if you can negotiate a better overall solution for you and your employees.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
Who Pays The Tax On A Cash Gift?
This question comes up a lot when a parent makes a cash gift to a child or when a grandparent gifts to a grandchild. When you make a cash gift to someone else, who pays the tax on that gift? The short answer is “typically no one does”. Each individual has a federal “lifetime gift tax exclusion” of $5,400,000 which means that I would have to give
This question comes up a lot when a parent makes a cash gift to a child or when a grandparent gifts to a grandchild. When you make a cash gift to someone else, who pays the tax on that gift? The short answer is “typically no one does”. Each individual has a federal “lifetime gift tax exclusion” of $5,400,000 which means that I would have to give away $5.4 million dollars before I would owe “gift tax” on a gift. For married couples, they each have a $5.4 million dollar exclusion so they would have to gift away $10.8M before they would owe any gift tax. When a gift is made, the person making the gift does not pay tax and the person receiving the gift does not pay tax below those lifetime thresholds.
“But I thought you could only gift $15,000 per year per person?” The $15,000 per year amount is the IRS “gift exclusion amount” not the “limit”. You can gift $15,000 per year to any number of people and it will not count toward your $5.4M lifetime exclusion amount. A married couple can gift $30,000 per year to any one person and it will not count toward their $10.8M lifetime exclusion. If you do not plan on making gifts above your lifetime threshold amount you do not have to worry about anyone paying taxes on your cash gifts.
Let’s look at an example. I’m married and I decide to gift $20,000 to each of my three children. When I make that gift of $60,000 ($20K x 3) I do not owe tax on that gift and my kids do not owe tax on the gift. Also, that $60,000 does not count toward my lifetime exclusion amount because it’s under the $28K annual exclusion for a married couple to each child.
In the next example, I’m single and I gift $1,000,000 my neighbor. I do not owe tax on that gift and my neighbor does not owe any tax on the gift because it is below my $5.4M threshold. However, since I made a gift to one person in excess of my $15,000 annual exclusion, I do have to file a gift tax return when I file my taxes that year acknowledging that I made a gift $985,000 in excess of my annual exclusion. This is how the IRS tracks the gift amounts that count against my $5.4M lifetime exclusion.
Important note: This article speaks to the federal tax liability on gifts. If you live in a state that has state income tax, your state’s gift tax exclusion limits may vary from the federal limits.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
Should I Gift A Stock To My Kids Or Just Let Them Inherit It?
Many of our clients own individual stocks that they either bought a long time ago or inherited from a family member. If they do not need to liquidate the stock in retirement to supplement their income, the question comes up “should I just gift the stock to my kids while I’m still alive or should I just let them inherit it after I pass away?” The right answer is
Many of our clients own individual stocks that they either bought a long time ago or inherited from a family member. If they do not need to liquidate the stock in retirement to supplement their income, the question comes up “should I just gift the stock to my kids while I’m still alive or should I just let them inherit it after I pass away?” The right answer is largely influenced by the amount of appreciation or depreciation in the stock.
Gifting Stock
When you make a non-cash gift such as a stock, house, or even a business, the person receiving the gift assumes your cost basis in the assets. They do not receive a “step-up” in basis at the time the gift is made. Example, I buy XYZ Corp stock in 1995 for $10,000. In 2017, those shares of XYZ are now worth $100,000. If I gift them to my kids, no one owes tax on the gift at the time that the gift is made but my kids carry over my cost basis in the stock. If my kids hold the stock for 10 more years and sell it for $150,000, their basis in the stock is $10,000, and they owe capital gains tax on the $140,000 gain. Thus, creating an adverse tax consequence for my kids.
Inheriting Stock
Instead, let’s say I continue to hold XYZ stock and when I pass away my kids inherited the stock. If I pass away in 10 years and the stock is worth $150,000 then my kids receive a “step-up” in basis which means that their cost basis in the stock is the value of the stock as of the date of my death. They inherit the stock at $150,000 value, sell it the next day, and they owe $0 in taxes due to the step-up in basis upon my death.
In general, if you have assets that have low cost basis it is usually better for your heirs to inherit the assets as opposed to gifting it to them.
The concept is often times reversed for assets that have depreciated in value…..with an important twist. If I purchase XYZ Corp stock in 1995 for $10,000 but in 2017 it’s only worth $5,000, if I sold the stock myself I would capture the realized investment loss and could use it to offset investment gains or reduce my income by $3,000 for the IRS realized loss allowance.
Here is a very important rule......
In most cases, do not gift a depreciated asset to someone else. Why? When you gift an asset that has depreciated in value the carry over basis rules change. For an asset that has depreciated in value, the carry over basis for the person receiving the gift is the higher of the fair market value of the asset or the cost basis of the person making the gift. In other words, the loss evaporates when I gift the asset to someone else and no one gets the tax advantage of using the realized loss for tax purposes. It would be better if I sold the stock, captured the investment loss, and then gifted the cash.
If they inherit the stock that has lost value there is no value to the step-up in basis because the stock has not appreciated in value.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
How Do Phantom Stock Plans Work?
In the world of executive compensation, there are a number of ways that a company can reward key employees. Although most companies are familiar with traditional deferred compensation plans, one of the lesser known options which is growing in popularity is called a “phantom stock plan”. Especially in small to mid-size companies.
In the world of executive compensation, there are a number of ways that a company can reward key employees. Although most companies are familiar with traditional deferred compensation plans, one of the lesser known options which is growing in popularity is called a “phantom stock plan”. Especially in small to mid-size companies.
Here is the most common situation, a closely held business or family business has a key employee that they would like to reward but also further tie that employee to the company. The current owners of the company do not want to give up equity but they want to tie this reward system to the actual performance of the company as if that key employee was an owner or shareholder. This can be accomplished via a phantom stock plan.
These plans provide select employees with additional compensation equal to the appreciation of a percent of the company for a partnership, LLC, or PLLC, or in the case of an S-corp or C-corp a given number of shares in the company even though the ownership only exists in theory. For example, I own a company that is incorporated as a partnership and I would like to reward a key employee by providing them with an annual cash reward equal to a 5% ownership stake in the company without formally making them a partner. Once the books are closed at the end of year I will issue a cash bonus to that employee equal to 5% of the net profits for the year. From the employee’s standpoint, they are receiving the monetary reward mimicking a 5% ownership share of the company so they have an incentive to continue to grow the company. From the employer’s standpoint, they have taken further steps to retain a key employee, they can deduct the additional comp pay to the employee, and the current owners have retained full control of the company.
The features of these plans and how they are design are limitless because they are just another flavor of nonqualified executive compensation plan. A few plan design features are listed below:
Companies have full discretion as to who is covered and not covered by the plan
Instead of paying out the benefit each year as compensation, the company can attach a vesting schedule to essentially put “golden handcuffs” on the key employee. If they leave the company prior to a stated date they lose the benefit.
When awarding the shares or ownership the company can limit the award to just the appreciation of their shares or ownership percentage and not award the full current value of the ownership percentage. These are called “appreciation only” plans. Appreciation only phantom stock plans can be viewed as a favorable option to key employees because it does not require them to make a cash outlay to purchase their ownership interest as would normally be required by an actual equity or share purchase.
How do these plans work from an operation standpoint? The ownership percentage or shares are issued to the employee as hypothetical units or “phantom units” that are just tracked internally by the company. The employee is taxed on the benefit and the company can take the deduction for the compensation paid when there is no longer a “risk of forfeiture”. In other words, when the employee vests in the benefit whether they decide to “sell their phantom shares” or not. As soon as the employee has the ability to “sell” their phantom interest in exchange for compensation that triggers the taxable event.
When designed correctly, these plans can be a valuable tool for small to mid-size companies in their efforts to retain key employees.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
Small Business Owners: How To Lower The Cost of Health Insurance
As an owner of a small business myself, I’ve had a front row seat to the painful rise of health insurance premiums for our employees over the past decade. Like most of our clients, we evaluate our plan once a year and determine whether or not we should make a change. Everyone knows the game. After running on this hamster wheel for the
As an owner of a small business myself, I’ve had a front row seat to the painful rise of health insurance premiums for our employees over the past decade. Like most of our clients, we evaluate our plan once a year and determine whether or not we should make a change. Everyone knows the game. After running on this hamster wheel for the past decade it led me on a campaign to consult with experts in the health insurance industry to find a better solution for both our firm and for our clients.
The Goal: Find a way to keep the employee health benefits at their current level while at the same time cutting the overall cost to the company. For small business owners reducing the company’s outlay for health insurance costs is a challenge. In many situations, small businesses are the typical small fish in a big pond. As a small fish, they frequently receive less attention from the brokerage community which is more focused on obtaining and maintaining larger plans.
Through our research, we found that there are two key items that can lead to significant cost savings for small businesses. First, understanding how the insurance market operates. Second, understanding the plan design options that exist when restructuring the health insurance benefits for your employees.
Small Fish In A Big Pond
I guess it came as no surprise that there was a positive correlation between the size of the insurance brokerage firm and their focus on the large plan market. Large plans are generally defined as 100+ employees. Smaller employers we found were more likely to obtain insurance through their local chambers of commerce, via a “small business solution teams” within a larger insurance brokerage firm, or they sent their employees directly to the state insurance exchange.
Myth #1: Since I’m a small business, if I get my health insurance plan through the Chamber of Commerce it will be cheaper. I unfortunately discovered that this was not the case in most scenarios. If you are an employer with between 1 – 100 employees you are a “community rated plan”. This means that the premium amount that you pay for a specific plan with a specific provider is the same regardless of whether you have 2 employees or 99 employee because they do not look at your “experience rating” (claims activity) to determine your premium. This also means that it’s the same premium regardless of whether it’s through the Chamber, XYZ Health Insurance Brokers, or John Smith Broker. Most of the brokers have access to the same plans sponsored by the same larger providers in a given geographic region. This was not always the case but the Affordable Care Act really standardized the underwriting process.
The role of your insurance broker is to help you to not only shop the plan once a year but to evaluate the design of your overall health insurance solution. Since small companies usually equal smaller premium dollars for brokers it was not uncommon for us to find that many small business owners just received an email each year from their broker with the new rates, a form to sign to renew, and a “call me with any questions”. Small business owners are usually extremely busy and often times lack the HR staff to really look under the hood of their plan and drive the changes needed to improve the plan from a cost standpoint. The way the insurance brokerage community gets paid is they typically receive a percentage of the annual premiums paid by your company. From talking with individuals in the industry, it’s around 4%. So if a company pays $100,000 per year in premiums for all of their employees, the insurance broker is getting paid $4,000 per year. In return for this compensation the broker is supposed to be advocating for your company. One would hope that for $4,000 per year the broker is at least scheduling a physical meeting with the owner or HR staff to review the plan each year and evaluate the plan design options.
Remember, you are paying your insurance broker to advocate for you and the company. If you do not feel like they are meeting your needs, establishing a new relationship may be the start of your cost savings. There also seemed to be a general theme that bigger is not always better in the insurance brokerage community. If you are a smaller company with under 50 employees, working with smaller brokerage firms may deliver a better overall result.
Plan Design Options
Since the legislation that governs the health insurance industry is in a constant state of flux we found through our research that it is very important to revisit the actual structure of the plan each year. Too many companies have had the same type of plan for 5 years, they have made some small tweaks here and there, but have never taken the time to really evaluate different design options. In other words, you may need to demo the house and start from scratch to uncover true cost savings because the problem may be the actual foundation of the house.
High quality insurance brokers will consult with companies on the actual design of the plan to answer the key question like “what could the company be doing differently other than just comparing the current plan to a similar plan with other insurance providers?” This is a key question that should be asked each year as part of the annual evaluation process.
HRA Accounts
The reason why plan design is so important is that health insurance is not a one size fits all. As the owner of a small business you probably have a general idea as to how frequently and to what extent your employees are accessing their health insurance benefits.
For example, you may have a large concentration of younger employees that rarely utilize their health insurance benefits. In cases like this, a company may choose to change the plan to a high deductible, fund a HRA account for each of the employees, and lower the annual premiums.
HRA stands for “Health Reimbursement Arrangement”. These are IRS approved, 100% employer funded, tax advantage, accounts that reimburses employees for out of pocket medical expenses. For example, let’s say I own a company that has a health insurance plan with no deductible and the company pays $1,000 per month toward the family premium ($12,000 per year). I now replace the plan with a new plan that keeps the coverage the same for the employee, has a $3,000 deductible, and lowers the monthly premium that now only cost the company $800 per month ($9,600 per year). As the employer, I can fund a HRA account for that employee with $3,000 at the beginning of the year which covers the full deductible. If that employee only visits the doctors twice that year and incurs $500 in claims, at the end of the year there will be $2,500 in that HRA account for that employee that the employer can then take back and use for other purposes. The flip side to this example is the employee has a medical event that uses the full $3,000 deductible and the company is now out of pocket $12,600 ($9,600 premiums + $3,000 HRA) instead of $12,000 under the old plan. Think of it as a strategy to “self-insure” up to a given threshold with a stop loss that is covered by the insurance itself. The cost savings with this “semi self-insured” approach could be significant but the company has to conduct a risk / return analysis based on their estimated employee claim rate to determine whether or not it’s a viable option.
This is just one example of the plan design options that are available to companies in an attempt to lower the overall cost of maintaining the plan.
Making The Switch
You are allowed to switch your health insurance provider prior to the plan’s renewal date. However, note that if your current plan has a deductible and your replacement plan also carries a deductible, the employees will not get credit for the deductibles paid under the old plan and will start the new plan at zero. Based on the number of months left in the year and the premium savings it may warrant a “band-aide solution” using HRA, HSA, or Flex Spending Accounts to execute the change prior to the renewal date.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
Tax Secret: R&D Tax Credits…You May Qualify
When you think of Research and Development (R&D) many people envision a chemistry lab or a high tech robotics company. It’s because of this thinking that millions of dollars of available tax credits for R&D go unused every year. R&D exists in virtually every industry and business owners need to start thinking about R&D in a different light because
When you think of Research and Development (R&D) many people envision a chemistry lab or a high tech robotics company. It’s because of this thinking that millions of dollars of available tax credits for R&D go unused every year. R&D exists in virtually every industry and business owners need to start thinking about R&D in a different light because there could be huge tax savings waiting for them.
Most companies don't realize that they qualify
Road paving companies, manufactures, a meatball company, software firms, and architecture firms are just a few examples of companies that have met the criteria to qualify for these lucrative tax credits.
Think of R&D as a unique process within your company that you may be using throughout the course of your everyday business that is specific to your competitive advantage. The purpose of these credits is to encourage companies to be innovative with the end goal of keeping more jobs here in the U.S. If you have an engineers on your staff, whether software engineers, design engineers, mechanical engineers there is a very good chance that these tax credits may be available to you. The R&D tax credits also allow you to look back to all open tax years so for companies that discover this for the first time, the upside can be huge. Tax years typically stay open for three years.
Accountants may not be aware of these credits
One of the main questions we get from business owners is “Shouldn’t my accountant have told me about this?” Many accounting firms are unaware of these tax credits and the process for qualifying which is why there are specialty consulting firms that work with companies to determine whether or not they are eligible for the credit. Some of our clients have worked with these firms and the company only pays the consulting firm if you qualify for the tax credits. Kind of a win-win situation.
We recently attended a seminar that was sponsored by Alliantgroup out of New York City and on their website it listed the following description of companies that qualify for these credits:“
Any company that designs, develops, or improves products, processes, techniques, formulas, inventions, or software may be eligible. In fact, if a company has simply invested time, money, and resources toward the advancement and improvement of its products and processes, it may qualify”.
We love helping our clients save taxes and in this case, like many others, we were looking at R&D in a different light.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
Avoid These 1099 “Employee” Pitfalls
As financial planners we are seeing more and more individuals, especially in the software development and technology space, hired by companies as “1099 employees”. “1099 employees” is an ironic statement because if a company is paying you via a 1099 technically you are not an “employee” you are a self-employed sub-contractor. It’s like having
As financial planners we are seeing more and more individuals, especially in the software development and technology space, hired by companies as “1099 employees”. “1099 employees” is an ironic statement because if a company is paying you via a 1099 technically you are not an “employee” you are a self-employed sub-contractor. It’s like having your own separate company and the company that you work for is your “client”.
There are advantages to the employer to pay you as a 1099 sub-contractor as opposed to a W2 employee. When you are a W2 employee they may have to provide you with health benefits, the company has to pay payroll taxes on your wages, there may be paid time off, you may qualify for unemployment benefits if you are fired, eligibility for retirement plans, they have to put you on payroll, pay works compensation insurance, and more. Basically companies have a lot of expenses associated with you being a W2 employee that does not show up in your paycheck.
To avoid all of these added expenses the employer may decide to pay you as a 1099 “employee”. Remember, if you are a 1099 employee you are “self-employed”. Here are the most common mistakes that we see new 1099 employees make:
Making estimated tax payments throughout the year
This is the most common error. When you are a W2 employee, it’s the responsibility of the employer to withhold federal and state income tax from your paycheck. When you are a 1099 sub-contractor, you are not an employee, so they do not withhold taxes from your compensation…………that is now YOUR RESPONSIBILITY. Most 1099 individuals have to make what is called “estimated tax payments” four times a year which are based on either your estimated income for the year or 110% of the previous year’s income. Best advice……..if 1099 income is new for you, setup a consultation with an accountant. They will walk you through tax withholding requirements, tax deductions, tax filing forms, etc. It’s very difficult to get everything right using Turbo Tax when you are a self-employed individual.
Tracking mileage and expenses throughout the year
Since you are self-employed you need to keep track of your expenses including mileage which can be used as deductions against your income when you file your tax return. Again, we recommend that you meet with a tax professional to determine what you do and do not need to track throughout the year.
The tax return is prepared incorrectly
No one wants a love letter from the IRS. Those letters usually come with taxes due, penalties, and a “guilty until proven innocent” approach. There may be additional “schedules” that you need to file with your tax return now that you are self-employed. The tax schedules detail your self-employment income, deductions, estimated tax payments, and other material items.
Important rule, do not cut corners by reducing the gross amount of your 1099 income. This is a big red flag that is easy for the IRS to catch. The company that issued the 1099 to you usually reports that 1099 payment to the IRS with your social security number or the Tax ID number of your self-employment entity. The IRS through an automated system can run your social security number or tax ID to cross check the 1099 payment and 1099 income to make sure it was reported.
Legal protection
As a 1099 sub-contractor, you have to consider the liability that could arise from the services that you are providing to your “client” (your employer). As a self-employed individual, the company that you “work for” could sue you for any number of reasons and if you are operating the business under your social security number (which most are) your personal assets could be at risk if a lawsuit arises. Advice, talk to an attorney that is knowledgeable in business law to discuss whether or not setting up a corporate entity makes sense for your self-employment income to better protect yourself.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
