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When it comes to compensation, the more you make, the more you pay — in taxes, that is.
So if your employer provides you with the option of deferred compensation, it can be an intriguing way to put off that tax burden. However, weighing all the benefits and drawbacks can help you determine if using deferred compensation fits in well with your overall financial plan.
What is deferred compensation?
Broadly speaking, deferred compensation refers to any and all compensation plans that allow you to postpone a portion of your income to the future, reducing your current taxable income. This includes both qualified and nonqualified deferred compensation plans.
Qualified deferred compensation plans — 401(k)s, profit-sharing plans, incentive stock options, pensions — are protected by the Employee Retirement Income Security Act of 1974, which sets strict fiduciary standards for employee benefit plans. For instance, all employees must have plan access, there are restrictions on plan contribution amounts, and plan assets must be held in a separate trust account out of reach of creditors.
» Saving for retirement? Read about other retirement plans
Here we focus solely on nonqualified deferred compensation plans, also called supplemental executive retirement plans or elective deferral plans, which are not required to follow ERISA guidelines. NQDC plans can offer further flexibility and options for the employee; however, this also means they carry additional risk.
These plans have been dubbed “golden handcuffs'' because they're often used as a retention tool for key talent or highly compensated employees. The significant reduction in taxable income is extremely attractive, or “golden.” Since plans may require that you stay with your employer to receive the deferred income, you’re “handcuffed” or heavily incentivized to remain with your company for the longer term.
One common type of deferred compensation is the 457 plan, which refers to employer-sponsored NQDC plans typically available to governmental employees (local and state) along with certain nongovernmental organizations, such as nonprofits.
How deferred compensation works
Those eligible to participate in a deferred compensation plan will generally need to adhere to certain procedures. To participate, there may be a defined enrollment period, and you’ll need to establish a written agreement with your employer designating details such as:
Amount of income deferred: Having a good forecast of your expected earnings is important, as you’ll need to decide how much income to withhold for the coming year. Usually, employees can elect to defer a portion of their salary, bonus or other eligible cash payments. Your plan may allow you to roll your elections over from year-to-year, or it may require that you make new elections each year.
Deferral period: You will also need to schedule when you’d like to receive your deferred income. You may be able to select a lump-sum distribution or installments spread across several years, starting in say five or 10 years’ time. You can weigh your options and strategically plan to have income distributed to meet expected financial goals, such as a child’s future tuition payments, or choose to wait until retirement.
» Other ways to save for college: Learn about 529 plans
Investments: Deferred compensation is an agreement that your employer will distribute your deferred income to you, at a later date, along with any investment growth you would have earned. Note: Your deferred compensation is not placed directly into an investment, but you designate investment choices for bookkeeping purposes. Your employer uses your choices as a benchmark to calculate the appropriate investment returns owed during the deferral period.
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Benefits of deferred compensation
There are compelling reasons to consider NQDC plans, especially for highly compensated employees.
When you defer receiving income, you also defer paying federal and state taxes on that income until it’s paid out to you. This can be especially appealing if you’re currently in a high tax bracket and expect to be in a lower tax bracket in the future. You can take advantage of reducing your present taxable income and scheduling your distributions to arrive in lower tax bracket years.
Not only do you benefit from deferring income taxes until later, but the money you’ve socked away in your deferred compensation plan grows tax-deferred as well. This means you’re not responsible for paying taxes on your investment growth until distribution.
» Other tax strategies: Learn how to reduce capital gains taxes
Since NQDC plans aren’t subject to ERISA standards, there’s no cap on your contribution amount. Traditional retirement plans and accounts can be insufficient for helping highly compensated employees adequately save for retirement. A supplemental NQDC plan can be an attractive way to generate additional retirement savings and income.
With deferred compensation plans, employees can choose when to receive distributions. Your plan may allow you to schedule “in-service” withdrawals or distributions so you can access your deferred income prior to retirement to meet other financial goals or obligations. For example, at different points over the years, you may want to buy a new home or pay your child’s college expenses. You can schedule income distribution to meet those needs.
Compared with other retirement accounts such as 401(k)s or traditional IRAs, NQDC plans can offer more flexibility; there are no age restrictions on withdrawals and no required minimum distributions.
There are significant reasons to be cautious when deciding whether to move forward with an NQDC plan.
Since assets are not held in a separate trust and are commingled with company funds, you could suffer a complete loss if your company encounters financial hardship. And leaving your employer could mean forfeiture of your deferred income. Making sure to read through the fine print of your company’s NQDC plan can help you understand the risks and stipulations related to your future payout.
Because receiving the income you deferred isn't guaranteed, it’s critical to consider the financial health of your employer when deciding whether to participate in your NQDC plan. Advisors often suggest maxing out all other qualified plans before contributing to the NQDC plan (since qualified plans have ERISA protections) and considering short-term deferral periods if you have concerns about your company’s future outlook.
After selecting your distribution date, it can be difficult to make any changes, so tread carefully when timing your deferral period. Many employees with access to NQDC plans may have additional forms of equity compensation with a timing element, such as restricted stock units or stock options. Taking a holistic approach can help you plan out your income stream and minimize your potential tax burden.
In addition, there are some limitations to NQDC plans compared with qualified retirement plans such as 401(k)s. Employees cannot take loans from their deferred compensation plan. And upon receiving plan distributions, funds cannot be rolled into an IRA or other tax-deferred retirement vehicle.
The range of investment options that you can designate for bookkeeping purposes varies from employer to employer. Some plans may offer as many investment choices as in your company’s 401(k) investment menu. Other plans may be more restrictive, offering only limited or expensive investment choices, or potentially only company shares. It could add risk to your overall investment portfolio if you’re overly exposed to your company’s stock or unable to sufficiently diversify your portfolio.
Some employees intend to change residency to a lower-tax state upon retirement and consider deferring compensation until they’ve done so. However, certain states base deferred compensation taxes on your elected payout period; for payout periods less than 10 years, you may be required to pay taxes to the state in which the compensation was earned.
And, the tax code changes all the time. When planning far ahead, it’s hard to know what to expect.
With deferred compensation plans, the devil is in the details. Though there are many benefits to participating, NQDC plans bear some important risks. Consulting with a trusted financial advisor to plan out your current and future financial situation can help you decide whether to take advantage of your deferred compensation plan.
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