It's no secret that many corporate executives make a ton of money. But how do they manage to keep so much of it away from the tax man?
Finding the answer involves digging into the arcana of retirement plan law. In simplest terms, however, the key to getting favorable tax treatment is to accept a substantial risk of loss -- something that executives who've gotten used to stock options and lucrative compensation packages aren't necessarily all that used to.
Pushing the limits
When it comes to making retirement contributions, most workers are used to much more pedestrian measures with far lower limits. IRAs let you set aside $5,000 per year, while 401(k) plans offer limits of $17,000 annually. If you're 50 or older, you can add $1,000 and $5,500 respectively to those figures.
Even if you're self-employed or fortunate enough to have an employer making a big contribution on your behalf, the statutory limit for companies to contribute to workers' defined-contribution plan accounts is $50,000 this year. And although defined benefit plans can allow you greater contributions, they also come with an annual limit on how much income they can generate in retirement -- currently $200,000.
What do you do if that's not enough? As a recent article in Barron's discussed in some detail, executives resort to what's known as nonqualified pension plans and deferred compensation.
What's waiting for these CEOs
Deferred compensation is a big deal for many executives. Wal-Mart (NYS: WMT) CEO Michael Duke has more than $85 million in deferred comp waiting for him when he retires. CVS Caremark (NYS: CVS) has a package worth almost $27 million.
Moreover, those who've already retired or are planning to retire shortly are among those with some of the top balances. Sam Palmisano, who recently vacated the CEO spot at IBM (NYS: IBM) , has deferred comp worth more than $68 million. James Mulva, who will shortly retire from ConocoPhillips (NYS: COP) now that its split-up is complete, has a balance of more than $44 million, while McDonald's (NYS: MCD) Jim Skinner will have $38 million in deferred comp when he retires this month.
The big decision
One major focus of the Barron's article was whether these CEOs would decide to take one-time lump sums or annuity payments for the rest of their lives. That's the same decision that millions of ordinary workers face in their own pension plans, although the dynamics are very different for each group.
Typical workers rely on their pensions as a big part of their retirement income. As a result, the decision to take a lump sum can have a huge impact on one's standard of living during retirement. Taking a lump sum gives you flexibility to time your spending whenever you want -- but at the cost of losing the guarantee of monthly payments that will last as long as you live. Choosing a lump sum can create a big money crunch further down the road, especially if you outlive your actuarial life expectancy.
For high-powered executives, the sheer amount of money involved raises different considerations. Regular pension payments can be enough to push retired executives into top tax brackets, which in turn forces executives to make predictions about where future tax-law changes will take top rates. In addition, the formulas that determine how much retirees get in lump-sum payments are producing higher payouts in the current low-interest-rate environment.
Take the money and run
Perhaps the most important element, though, is how deferred compensation doesn't give executives preferred status over ordinary corporate creditors. Employers have to keep 401(k) money in segregated accounts that are safe from creditors, but executives can lose a compensation package if their company goes bankrupt. That too argues on the side of taking the lump-sum money and running, although some executives choose to go with the annuity -- either as an affirmation of the company's business model or as a sign of general confidence.
CEOs and other corporate executives getting lucrative pay packages with valuable perks is nothing new. Although you probably don't have access to all the tricks that CEOs use to save millions, making the most of your retirement plans and making smart decisions about any pension you may have coming to you is just as important for your financial health.
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At the time thisarticle was published Fool contributor Dan Caplinger expects that he'll never be truly rich. He doesn't own shares of the companies mentioned. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of IBM. Motley Fool newsletter services have recommended buying shares of McDonald's, creating a diagonal call position in Wal-Mart, and creating a synthetic long position in IBM. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy won't retire on you.
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