Since Republic Act (RA) 7641, also known as the Retirement Pay Law, does not require companies to set up formal retirement plans, why, then, should the consider doing so? The answer is very practical in nature: to enable both the company and the employee to avail of the tax advantages that exist only in conjunction with a retirement plan formally filed with the Bureau of Internal Revenue (BIR). An important point to note here is that the applicability of tax benefits is the fundamental difference between a plan filed with the BIR and one that is not.
Some distinct tax advantages of a tax-qualified plan as prescribed by RA 4917 are as follows:
- Retirement benefits paid to qualified employees are tax-exempt, subject to certain conditions;
- Contributions to the retirement fund are a tax-deductible expense for the company;
- The earnings of the retirement trust fund are tax-free; and
- Systematic build-up of future obligations under RA 7641.
The tax advantage gained by an employee, assuming the necessary conditions are satisfied, is clear in the following example: Given a benefit based on 20 years of service, the income tax payable on the corresponding earnings would correspond to nearly 7 years of service. The difference between tax-exempt and taxable benefits is thus undeniably significant to the employee. Note that the benefit of an employee who voluntarily resigns from the company will always be taxable, regardless of his age and years of service upon voluntary separation.
In the same light, the tax advantage a company gains by registering a retirement plan with the BIR is obvious: contributions to the plan are a tax-deductible expense, which means the taxable income of the company may be significantly reduced.
Finally, retirement trust funds are not subject to the usual 20% withholding tax, which means the fund grows faster and reduces, to some extent, the contributions required from the company to build up the fund.
Note that a key requirement of the BIR for a retirement plan to be tax-qualified is that the retirement fund must be held in trust – with the direct result of the retirement trust fund becoming a legally separate entity from the Company.