Take the Tax Sting out of Bonuses

HR Agenda: Compensation & Benefits

Consider these tax-advantaged ways to reward employees with incentive compensation.

​Everyone wants to save a buck. Whether it’s a multinational corporation looking to trim its tax bill or an employee watching a retirement account’s performance, the aim is to get the best tax advantage for every dollar. One way for companies to make that happen is to pay profit-sharing and similar bonuses into workers’ 401(k) plans and health savings accounts (HSAs).

In making contributions in those ways, employers get an immediate tax deduction, and employees get the benefit of receiving a tax-deferred or tax-free contribution—depending on the type of account. “It’s the best of both worlds when an employer gets a current deduction and an employee doesn’t pay income tax” either now or in the future, says Eddie Adkins, compensation and benefits tax practice leader in the Washington, D.C., office of Grant Thornton LLP, the Chicago-based accounting and consulting firm.

Generally, under the tax code, Adkins says, the “mirror image” concept applies: The deduction that the employer takes for compensating an employee must be reported by the employee as income. But an employer’s payment of bonus or profit-sharing money into an employee’s 401(k) “is a very nice benefit,” he continues, “because it’s one of the special situations where an employer can take a tax deduction before the employee reports the money as income.”

Tax advantages also come about when bonus or profit-sharing cash for employees is put into their HSAs, notes Jerry Ripperger, director of consumer health at the Principal Financial Group in Des Moines, Iowa. Under the rules for HSAs—which can be funded by employees, employers or anyone else and can be rolled over from year to year—employers’ contributions are not reported as income to the employee. (Contributions by the employee and by others are reported as adjustments to income.) Funds withdrawn are not taxed as long as they are used for qualified medical expenses.

If a company’s aim is to give a $1,000 cash bonus to each employee, Ripperger says, “it will spend about $1,100 to maybe put $600 in [an employee’s] pocket.” The reduced amount results from the employer’s paying taxes under the Federal Insurance Contributions Act (FICA) and under the Federal Unemployment Tax Act. The employee also must pay FICA and is taxed at the supplemental tax rate, he says. But if the bonus is paid in the form of a contribution to an HSA, he says, “$1,000 gets you $1,000.”

It’s also a way to enlarge employees’ health-cost nest eggs when the company is having a good year, Ripperger adds.

Similarly, putting employees’ bonus money directly into their 401(k) accounts is a way for a company to help fund their retirement, notes David Paik, a partner in the employee benefits and executive compensation group at the Los Angeles law firm Sheppard Mullin Richter & Hampton LLP.

Moreover, paying bonus money into 401(k)s and HSAs can be attractive to companies as they increasingly use incentive pay to reward performance while they hold the line on salaries, says Steve Levin, consulting director with RSM McGladrey Retirement Resources in Fort Lauderdale, Fla. “Once it gets built into base pay, it’s hard to ever go back,” he says. “A lot of employers try to cap increases in base pay and say, ‘We’ll pay you for performance.’ ”

Adkins, however, wonders whether some employees would be more motivated by cash in their pockets than a bigger balance in their 401(k) accounts. Some employees, he says, may think, “ ‘I work hard. I’ve got this incentive pay, and now it’s locked up in my 401(k) and I can’t get to it.’ Will it motivate employees as much as if they get paid currently?”

Adkins says companies might consider letting employees choose how they prefer to receive their profit-sharing payouts. “It’s more attractive any time you give employees a choice. If they like their incentive option better, they may work harder to fulfill their goals.”

A Few Resistance Factors

If a company wants to make across-the-board contributions to HSAs or 401(k) accounts rather than disburse incentive pay in cash, it might find that its biggest challenges lie in its own workforce demographics. Younger employees might prefer to have the cash to buy a car, save for a home or pay for a graduate degree. For those employees in particular, financial “education would be important in all of this,” Paik says, and companies would need to show employees “the magic of compounding.”

Marjorie Glover, chair of the executive compensation and employee benefits practice of the New York law firm Chadbourne & Parke LLP, also cites the need for education to counter resistance. It’s important for young people to understand that “if you can’t afford to save when you’re actively in the workforce and young and healthy, imagine what it would be like at 70 or 80,” she says.

In addition, Glover says, it may help to emphasize to employees that “a Social Security crisis is looming. Employees must be more self-reliant.” Adding bonus money to a 401(k) “can be a wonderful incentive and a good recruitment tool.”

Older employees, typically more concerned about health care and retirement, may be more receptive to receiving additional health and retirement account contributions.

But those employees also may be more at risk of bumping up against limits on contributions to their 401(k) accounts. For 2005, the maximum an individual can contribute to a 401(k) is $14,000. Those who are 50 or older can make an additional $4,000 “catch-up” contribution. Thus, employees who are at their contribution limit may find little appeal in having their incentive compensation go into their 401(k)s.

However, if the employee has no choice as to whether profit-sharing money is put directly into his or her 401(k), the ceiling could be higher. The maximum contribution to a 401(k) this year when both employer and employee contribute is the lesser of 25 percent of compensation or $42,000.

Bear in mind, of course, that contribution limits may be affected also by the participation rates of employees, Levin says. For example, if employees who are categorized as not highly compensated put an average of 3 percent of their pay into their 401(k)s, those who are highly compensated may put in only 5 percent (2 percentage points above the contribution level for rank-and-file employees). A higher participation rate among regular employees, Levin notes, “boosts the ability of highly compensated employees to participate in the 401(k).”

A Less-Familiar Option

While the mechanisms of 401(k) accounts are well known to employers, the workings of HSAs may be less familiar. › These accounts have to be linked to high-deductible health coverage plans, which are designed to shift more health costs to employees and help employers apply the reins to their fast-rising health expenses.

The features of HSAs that enable them to be used in paying incentive compensation include their contribution rules and their carryover provisions. Anyone—the employee, the employer, a third party—can put money into an employee’s HSA within certain limits. In addition, unused amounts in HSAs can be carried forward year after year, and, in some instances, they can be transferred to other medical savings accounts.

The dollar maximums and minimums for high-deductible plans and their accompanying HSAs may seem complex at first, particularly since the arrangements are only in their second year. Under the rules for coverage of an individual in a high-deductible health plan, the deductible has to be at least $1,000, and the ceiling on out-of-pocket expenditures is $5,100. The maximum contribution to an HSA for that employee would be the deductible or $2,650, whichever is lower, Ripperger says. Employees who are 55 to 65 can contribute an extra $600 to the HSA in 2005 as a “catch-up” amount.

When an employee has family coverage under a high-deductible plan, the minimum deductible is $2,000, and the ceiling on out-of-pocket expenses is $10,200. The maximum contribution to the employee’s HSA is the deductible or $5,250, whichever is lower.

For HSAs to work best, everyone in a company needs to be enrolled, Ripperger says. “It’s more problematic in a dual-choice environment where someone has options.”

Although Ripperger has not yet dealt with any companies that have gone this route, he has fielded many phone calls from interested employers. He believes that the plan is best for companies with no more than 300 employees. “All are struggling with rising health care costs. All view this as an option to deal with those rising costs,” he said.

With HSAs, the employer gets a tax deduction for making a contribution, and the employee would not be taxed on the money if it is used solely for medical expenses, Adkins says. (HSA funds that are used for purposes other than qualified medical expenses are subject to income taxes and a 10 percent penalty.) Employees also are in “total control of the account,” he adds. Thus, employers’ contributions are accessible immediately.

Because HSAs were authorized only as of Jan. 1, 2004, and the Internal Revenue Service’s guidance for establishing them came later in the year, “they haven’t really taken off yet,” Adkins says. But that could soon change, he continues. “Complex systems need a lot of lead time to get ready for something,” he says, and large companies were not able to introduce them this year. “But I have to believe that given all the press and hype about health savings accounts, they’re going to get utilized” beginning next year.

The Communication Factor

Whether the message is about the introduction of HSAs or the use of 401(k) accounts for paying incentive compensation, experts say, clear communication is essential. Ripperger says that in a shift from cash payouts to HSA contributions, it’s incumbent upon HR managers to educate employees on why the change is being made and how employees will benefit.

Similarly, communication is key if a company plans to switch from paying out cash bonuses to making contributions to employees’ 401(k)s, says Adkins. He suggests HR managers conduct focus groups or conduct surveys to gauge employees’ reactions to the changes.

And if changes are made in the payout system, it’s important to notify employees well in advance, he says. Otherwise, you run the risk of workforce morale problems if employees were expecting cash and had plans for spending it.

Susan Ladika has been a journalist for more than 20 years in the United States and Europe. Now based in Tampa, Fla., her freelance work has appeared in publications such as The Wall Street Journal-Europe and The Economist.

Web Extras

• Health Savings Accounts: A Profit-Sharing Model for Employer Contributions (SHRM Compensation & Benefits Forum)
• Tax-Advantaged Health Accounts (Source: IRS)