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The Great Executive MigrationWhat Happens When You Soak the Rich with Higher State TaxesWilliam L. MacDonald
On May 18, 2009, the Wall Street Journal (WSJ) printed a thought-provoking article entitled “Soak the Rich, Lose the Rich.”1 The authors, Stephen Moore, senior economics writer for the WSJ and Dr. Arthur B. Laffer, Vice Chairman and Lead Director of RCG, laid out some persuasive arguments against taxation, albeit contrarian in this populist economy. A worthwhile read, the arguments may affect you. The article entered in the trend toward state proposals to raise income taxes on the wealthy to make up for gaping budget deficits. As Dr. Laffer and Mr. Moore correctly state, “Here’s the problem for states that want to pry more money out of the wallets of rich people. They can leave tax-unfriendly states and move to tax-friendly states.”
If you have the ability to tax defer a portion of your income (with no limit) while working in a high income tax state, and then retire in one of the nine tax-haven states with no income tax, mentioned by Dr. Laffer, then you may have the best of both worlds. You can enjoy the surf of sunny California or the lifestyle of urban Manhattan during your working years and later retire to that pastoral farm in Tennessee, small ranch in Texas or on spacious boat moored off the coast of Florida. And with more money in your pocket. You can thank our friend Bill Clinton who, in 1996, signed legislation extending tax breaks to tens of thousands of business people who retire to states with no or lower income tax rates than paid in the state where they lived during their working lives. Chart I  *Equal-weighted averages
Source Tax Law The legislation enacted in 1996, which was sponsored by Senator Harry Reid, Democrat of Nevada, essentially provides that only the state in which an individual is a resident or domiciliary may tax the individual on his or her retirement income. Consider this example: If an employee participates in a tax-deferred retirement plan, covered by the source tax law while working in California or New York, then moves and becomes a resident of a state with no income tax before receiving plan distributions, those distributions will escape state income tax in New York, California or any other state. This amount could be significant. Chart II below outlines the difference a California resident would have in retirement income, if he or she retired to Nevada (one of the zero income tax states) instead of California. Chart II  Assumed Federal tax rate of 35% and CA tax rate of 10%
Understanding the Law Retirement income protected by the source tax law includes income from tax-qualified plans and some other types of tax-favored retirement plans and arrangements, including individual retirement accounts. The source tax law also applies to income from nonqualified deferred compensation plans (described in § 3121(v) (2) (C) of the Internal Revenue Code of 1986, as amended (the "Code")) that satisfies either of two conditions.
Distribution Management As discussed above (Chart I), currently there are nine states with no state income tax, and a number of attractive states to retire with low rates. Today the focus should not only include how to accumulate your retirement assets; it should also focus on distribution and where you will retire. The consultants of RCG believe that your accumulated wealth should not be dependent upon any single asset, asset class or tax assumption. An increase in the top Federal tax rate from 35 percent to 52 percent reduces the value of distribution by approximately 25 percent in any tax deferred investment strategy. As in chart II, adding the state’s rate compounds the problem. True diversification is not only asset diversity, but also varying distribution sources with varying tax treatment. A portion of the investments you make for your retirement are better served in non-taxable bucket designed to provide a hedge against higher tax rates in the future. Chart III  As illustrated in Chart III, a portion of your income will be taxable as regular income. For example, accounts such as savings bonds, 401(k) and nonqualified plans. You can plan this bucket by taking advantage of the source tax provisions and, perhaps, planning to retire in a state with no or lower income taxes than you currently incur. With your 401(k), you can roll those dollars over and postpone payment until 70 ½ years old. Your nonqualified plan could have the flexibility of re-deferring payments to later years. The second bucket is your assets taxed at capital gains. These assets include your real estate, long-term stock holdings and mutual funds. If capital gains rates stay low, you may want to draw down from this bucket earlier. The final bucket is your non-taxable income. For most of us this next bucket is tax-exempt bonds. The Roth 401(k) and Roth IRA have too many restrictions for highly compensated executives.
Re-deferral A basic industry standard “multi-bucket” model puts limitations on your retirement elections. Most retirement plan designs do not offer the flexibility that is allowed by IRC §409A. As an example, let’s say an executive decided to re-defer the retirement payment one year prior to receiving it. IRC §409A allows that payment to be re-deferred for a minimum of five years. However, most administration systems do not separate the payment years. In other words, all 15 payments are treated as one in the same bucket. This means that the executive must defer the entire 15-year retirement stream out five years. This outcome lacks the flexibility you need in retirement (Chart IV). Chart IV  This point of re-deferral is such an important area that we need to discuss how RCG has solved this problem. Chart V shows a simpler alternative that adds flexibility. It treats each of the 15 payments as separate buckets upon distribution, which gives the participant added flexibility. Each year’s payment could be eligible for re-deferral, so if the participant decides to wait one year, he or she could re-defer year one, and begin to draw down as planned in year two and so on. This opportunity was made possible by innovative technology developed by our partner Benefits Group WorldWide. Chart V  To build on this, there is a new trust arrangement that employers are using to produce a tax-advantaged distribution strategy. The concept uses RCG’s Management Security Plan (MSP). Under this arrangement, a portion of your accumulation is deposited into an after-tax strategy account, accumulates tax deferred and pays out without §409A restrictions in a non-taxable manor2. If tax rates increase before the participant moves to a no income tax state, this account can be used for income. What sets the MSP apart from traditional nonqualified plans is the way investment gains and distributions are taxed.
In Summary
Planning your retirement event with a diversification strategy could make a substantial difference in how you live out those golden years. With a smart distribution strategy in place, you also enjoy the flexibility to plan your distributions and control how your assets will be taxed. We may not be able to control state legislators’ appetite for taxation, but we do have control over our own thoughts and our actions. Yiihaa! Texas . . . here we come. 1 Laffer/Moore article. Click here: http://online.wsj.com/article/SB124260067214828295.html2 If properly structured, distributions are non-taxable.
Securities are offered by Retirement Capital Group Securities, Member FINRA / SiPC. Retirement Capital Group Securities, Inc. is a wholly owned subsidiary of Retirement Capital Group, Inc. Investors should consider the investment objectives, risks and charges and expenses of the contract and underlying investment options, risks carefully before investing, The prospectus contains this and other information about the investment company and must precede or accompany this material. Please be sure to read it carefully. The opinions, estimates, charts and/or projections contained hereafter are as of the date of this presentation/material(s) and may be 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. William L. MacDonald, Registered Representative - California Insurance License #0556980
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We are all concerned about the financial well being of the states in which we live. But closer to home, we ask how this trend could affect executives with nonqualified deferred compensation plans? Be not afraid. The news may be okay.
The source tax law will apply if distributions from the nonqualified deferred compensation plan are made in a series of substantially equal periodic payments (made not less frequently than annually) for (1) the life or life expectancy of the recipient (or the joint lives or joint life expectancy of the recipient and the recipient's designated beneficiary), or (2) a period of at least 10 years. Without regard to the form or time of distributions, the source tax law also applies to payments received after termination of employment under a nonqualified deferred compensation plan "maintained solely for the purpose of providing retirement benefits to employees in excess of the limitations imposed by one or more of sections 401(a)(17), 401(k), 401(m), 402(g), 403(b), 408(k) or 415 of [the] Code on plans to which any of such sections apply."
Retirement planning for highly compensated executives is becoming infinitely more complex; however, there are tools available to maximize your spendable income in retirement. After all, it’s not how much you have, but how much you keep that makes the difference.