By Douglas P. Hepburn, CPA/PFS, CFP
When designing a financial plan for executives, one of the major risks to consider is job loss. During the 2001 recession, executives and people over 45 years old were more likely to experience long-term unemployment than ever before. This trend is expected to continue. The U.S. Department of Labor indicates that the average length of unemployment is 18 months, so planning for unforeseen transition cannot be overlooked, and must be addressed well in advance.
Know the Cash Flows
Clients who have a good handle on their monthly expenditures are more likely to know where they can economize to build reserves before an event happens. As a general recommendation, having at least six months of expenses in liquid, low-risk assets is a prudent choice. Of course, this needs to be coordinated with other expected resources.
Unemployment compensation is one source, but it won’t come close to matching an executive’s salary. Generally, the benefit is limited to 50 percent of quarterly income, but is usually capped at a maximum weekly amount. Higher-paid employees, therefore, will have less of their income replaced. The more clients make, the less they will receive as a percentage of pretermination income.
Some companies offer severance packages for termination without cause, so contracts and company policies need to be reviewed as part of the planning process. Unless the client has a contract or is being "packaged out," severance is generally determined by tenure.
If there is a change in control, however, severance payments in excess of three times the executive’s average compensation over the last five years are subject to the 20 percent excise tax on “golden parachute” payments. This is in addition to income tax owed on those payments.
If the former employer’s retirement plan allows for after-tax contributions, these will be distributed to the participant at the time a rollover is requested and could be a nice, tax-free resource at a difficult time.
Because of the contribution limitations on 401(k) plans, many companies offer excess deferral plans to executives. Review the summary plan description for these, as some companies force terminated employees to take their deferrals as soon as administratively practical. Other employers will distribute deferrals seven months after separation from service or after Dec. 31 of the year of separation, whichever is later, creating the opportunity to defer that income into the next tax year. Still others will allow deferrals to be taken out over a period of years. These distributions will be taxable as ordinary income, but there are no early withdrawal penalties like pretax qualified plan distributions.
Equity compensation, such as restricted stock and stock options, has its perks, but depending on the plan provisions, clients in transition may be subject to accelerated vesting or expiration dates. These accelerations are particularly important with incentive stock options, since qualifying dispositions are determined by the exercise and sale dates, and are taxed at capital gains rates, notwithstanding the affects of the alternative minimum tax.
Reaching the Other Side
Your client will ultimately land at a new position. When that happens, there are several issues to consider concerning his or her financial planning decisions.
The first thing that most people think of resolving is their 401(k) rollover. Some argue that moving the rollover into a new employer’s 401(k) plan as soon as possible is important because of the ERISA protections and the ability to borrow, but by keeping rollover money in an IRA, clients will have the option to invest in more and broader-based investment options than may be available in the new company’s retirement plan. This decision will have to be made after a thorough evaluation of the new 401(k) plan. Regardless of how the rollover is handled, clients still should enroll in the new employer’s retirement plan as soon as they become eligible.
Nonqualified salary deferral plans require an election to participate prior to the beginning of the tax year, but newly hired employees usually have a 30-day window to make their salary deferral election, beginning on their date of hire. If not done immediately, it could be 11 months before the next election opportunity.
Equity compensation granted at the time of hire requires serious consideration and analysis to determine whether a Section 83(b) election should be made. This enables the employee to have capital gains treatment on the sale of the grant in exchange for accelerating the income tax to the current year. The downside is that, if the client separates from service prior to the vesting date of the grant, the taxes paid are forfeited.
For corporate executives, the wide array of executive benefits combined with the risk of uncertain employment makes the role of CPA financial advisors critical to pursuing and preserving financial success.
Douglas P. Hepburn, CPA/PFS, CFP, is an advisor representative of Multi-Financial Securities Corporation, member FINRA/SIPC. He can be reached at dhepburn@hepburnadvisors.com.
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