Question

Tommy (age 47) and his wife, Michelle (age 49), live in Columbus, Ohio, where Tommy works for Callahan Auto Parts (CAP) as the vice president of the brakes division. Tommy’s 2018 salary is $360,000. CAP allows Tommy to participate in its nonqualified deferred compensation plan in which participants can defer 15 percent of their salary for five years. Tommy also participates in CAP’s qualified 401(k) plan. Tommy’s current marginal tax rate is 24 percent and CAP’s current marginal tax rate is 35 percent.Assuming Tommy earns a 6 percent after-tax rate of return and he expects his marginal tax rate to be 30 percent in five years, what before-tax deferred compensation payment in five years would make him indifferent between receiving the deferred compensation payment or 15 percent of his salary now (ignore payroll taxes)?

Answer 1

Indifferent point between making deferred compensation payment in 5 years or receiving 15% of his salary now where,

Future value of after tax benefit from receiving 15% of salary now=Before tax deferred compensation*(1-Tax rate)

Future value of after tax benefit from receiving 15% of salary now:

$

15% of salary

(360000*15%)

54000

Less: Tax at current marginal tax rate

(54000*24%)

12960

After tax benefit of receiving 15% of salary now

41040

Future value of after tax benefit from receiving 15% of salary now

41040*(1+after-tax rate of return)^years=41040*(1+0.06)^5

54920

54920=Before tax deferred compensation*(1-Expected marginal tax rate in 5 years)

54920=Before tax deferred compensation*(1-0.30)

Before tax deferred compensation=54920/0.70=$ 78457