Question

XYZ Corporation has a deferred compensation plan under which it allows certain employees to defer up to 25 percent of their salary for five years. (For purposes of this problem, ignore payroll taxes in your computations.)

a. Assume Julie, an XYZ employee, has the option of participating in XYZ’s deferred compensation plan. Julie’s marginal tax rate is 40 percent and she expects the rate to remain constant over the next five years. Julie is trying to decide how much deferred compensation she will need to receive from XYZ in five years to make her indifferent between receiving the current salary of $16,300 and receiving the deferred compensation payment. If Julie takes the salary, she will invest it in a taxable corporate bond paying interest at 8 percent annually (after taxes). What amount of deferred compensation would accomplish this objective?

Answer 1

If Julie were to take the salary now she would receive $9,780 after tax (16,300 x (1 -­ 0.40)). She would then invest this amount in taxable corporate bonds. After five years Julie would have accumulated $14,370 after taxes by taking the salary and investing it herself [(9,780 ×1.08⁵]. Thus, in order to be indifferent after five years between the salary and deferred compensation, she must receive enough deferred compensation that provides her with $14,370 after she pays tax at her 40% marginal tax rate. If she receives $23,950, she will have $14,370 after taxes [$23,950 × (1 -0­.40)].