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Do You Have a Pre-Tax Cash Management Account for Your Key Executives?David Stecher CPA, CFP, CLU, ChFC
First of all, what is a Pre-Tax Cash Management Account (PTCMA)? A PTCMA is simply an IRC § 409A-compliant deferred compensation plan that has the attractiveness of widely used after-tax cash management accounts (ATCMA). Every highly compensated executive who earns more than they spend utilizes some form of ATCMA. Whether it is through their bank, brokerage house, financial planner or investment advisor, executives must put their money somewhere and usually it’s in an ATCMA (hopefully not the mattress). So why would highly compensated employees be interested in pre-tax savings? The reason is they are essentially using the tax dollars that would have gone to Uncle Sam to enhance the amount of after-tax assets that will be used to address unfunded personal liabilities in the future. In addition, a PTCMA is not subject to income tax on current earnings. Therefore, all of the annual gains and/or interest earned in the account are available to continuously compound. Pre-tax savings coupled with tax-deferred growth provides for substantially more dollars available to address needs like children’s education, home purchases, childcare, and providing care to aging parents. Typically the question asked is, “What happens if tax rates go up?” Table 1 illustrates how many years it would take for the advantages of pre-tax deferrals to be realized in an increasing tax environment. Table 1:
Plan DesignIRC § 409A provides the roadmap to available plan design and parameters. A great degree of flexibility is provided to plan sponsors within § 409A. In the eyes of the highly compensated employee, the lack of flexibility equals increased risk; conversely, increased plan flexibility decreases risk. The initial provision to consider is: “How does an executive get money out of the PTCMA?” The more flexible the distribution options, the less risky the plan. The dates of distribution must be determined when an executive initially elects to defer or contribute salary and bonus to their account. The election to defer salary must be made prior to the year in which the salary is earned, usually in the months of November and December. Bonus deferral elections are treated separately and typically need to be made 6 months prior to the end of the bonus period; usually by June 30th. Once an executive determines how much to contribute, the next step is to determine when to access the funds – see Table 2 for a typical deferral election. Table 2:
Table 2 illustrates a typical PTCMA deferral and distribution strategy. It is helpful to look at the situation from the perspective of the executive. When he or she goes through a financial planning exercise, the financial planner will assess the following:
The difference between income and expenses dictates dollars available for savings (either pre-tax or after-tax). Quantifying the future unfunded liabilities determines when the employee will need to access the funds in the PTCMA. The assessment of investment risk will dictate the appropriate asset allocation for each sub-account, also commonly referred to as “buckets.” When designing a PTCMA, the risk of losing the account must be considered. The fact that these accounts are non-qualified deferred compensation plans, and as such, must be subject to the claims of corporate creditors in the event of corporate insolvency must be remembered. A Rabbi Trust is recommended to limit other risk issues such as:
A Rabbi Trust is practically worthless if it is not funded. Therefore, we recommend that the sponsoring company establish a corporate resolution to always maintain sufficient assets in the trust in order to pay all outstanding participant liabilities. Investment Strategy“What type of investments would attract your money?” When the highly compensated employee utilizes a financial planner, the planner initiates an investment strategy specifically for his or her client. We recommend a similar approach:
Corporate Funding of the Plan LiabilityOnce the PTCMAs have been established, the sponsoring company must determine how to hedge these liabilities. If the company is a current taxpayer, Corporate Owned Life Insurance (COLI) is usually the most economic hedge. If not, institutional mutual funds provide a good solution. The cost of the mutual fund alternative would be the income taxes due on the mutual fund gains in the current period. The costs of owning COLI are the insurance and administrative charges within the policy. A simple comparison of the related costs will highlight the preferred solution. Education and CommunicationAfter taking the time to design and implement a PTCMA, it is equally important to ensure that it is adequately communicated and understood. Designing and implementing a participant website is essential for proper communication and monitoring. The site should be available 24/7 and provide:
Ideally, participants should also have access to a call center for basic questions, as well as access to investment advisors for asset allocation advice. Education can be provided economically through a multi-media approach using web casts, video conferencing and conference calls. AdministrationSince the PTCMA is a § 409A compliant deferred plan, it is essential to provide integrated plan design, investment monitoring, asset liability hedging and participant communication and education. A variety of administration platforms are available, depending on the size and complexity of the plan. When considering an administrator, examine the following needs within your company:
All of this entails a great deal of effort, but with the proper administrative system the majority of the work is outsourced. ConclusionHighly compensated executives are contributing billions of dollars per year to after-tax cash management accounts. Employers now have the tools to provide a low-cost benefit to these executives by allowing them to contribute to pre-tax cash management accounts.
Investors should discuss their own unique situation with their tax and financial professionals. RCG does not give legal or tax advice and the opinions presented in these materials should not be construed as such. All examples are hypothetical and not intended to represent any specific investment. The opinions, estimates, charts and/or projections contained hereafter are as of the date of this presentation/material(s) and maybe subject to change without notice. RCG endeavors to ensure that the contents have been compiled or derived from sources RCG believes to be reliable and contain information and opinions that RCG believes to be accurate and complete. However, RCG makes no representation or warranty, expressed or implied, in respect thereof, takes no responsibility for any errors and omissions contained therein and accepts no liability whatsoever for any loss arising from any use of, or reliance on, this presentation/material(s) or it contents. Information may be available to RCG or its affiliates that are not reflected in its presentation/materials(s). Nothing contained in this presentation constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any investment product. Investing entails the risk of loss of principal and the investor alone assumes the sole responsibility of evaluating the merits and risks associated with investing or making any investment decisions. Securities Offered Through Retirement Capital Group Securities,
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