A Beginner's Guide to Deferred Compensation

You’ve climbed the corporate ladder, you’re making good money and suddenly someone from human resources presents you with a newfangled employee benefit — the opportunity to participate in a deferred compensation plan.

Deferred compensation plans can be a great savings vehicle, especially for employees who are maximizing their 401(k) contributions and have additional savings for investment, but they also come with lots of strings attached. In general, deferred compensation plans allow the participant to defer income today and withdraw it at some point in the future (usually upon retirement) when taxable income is likely to be lower. Like 401(k) plans, participants must elect how to invest their contributions. However, unlike with 401(k) distributions, which have a great deal of flexibility, deferred compensation participants must make distribution elections at the time of deferral, with very little flexibility to change the distribution method in the future.

Here’s a brief guide that may help you better understand deferred compensation and whether you should participate.

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Should you participate?

A few questions to consider are:

• What is the financial strength of your employer? Deferred compensation plans are essentially an IOU from your employer. If the company goes bankrupt, deferred compensation is considered an unsecured debt of the company and may mean a total loss of your contribution.
• How much of your wealth is tied to your employer? In addition to salary, you may have stock options, restricted stock units or stock purchase plans, all of which are tied to the future of one company. Adding deferred comp exposure on top of these may be assuming more risk than is appropriate.
• How long before you plan to retire or leave your current employer? If you are more than 15 years from retirement, there is more risk something could threaten your employer’s financial stability in the meantime. Who thought GE would be facing financial difficulties 10 years ago?
• Consider your tax bracket now and what it may be in the future. Can deferring now put you in a lower tax bracket? And considering all future sources of income, what is your tax bracket likely to be in retirement? This is especially hard since no one knows for sure what tax rates or brackets will be in five, 10 or 15 years. For example, last year we advised a client to defer approximately $30,000, and reduced his marginal tax bracket from 32% to 24% (saving roughly $2,400 in federal tax).

Two fundamental deferred compensation decisions

For employees who do elect to participate in a deferred compensation plan there are two important choices to make — when to take distributions and how to take them. These two decisions are intertwined and require careful thought and planning. In most cases, these elections are difficult to change and require a five-year waiting period if changes are allowed under IRS rules governing deferred compensation plans.

Answering the ‘when’ question

Deferred compensation doesn’t have to be taken in retirement, but ideally should be, since the primary motivation is income tax reduction. In some cases, the triggers for deferred comp distribution are beyond your control. For example, in most cases you (or your heirs) will be forced to take distributions upon a separation of service, death or disability. Ideally, you want to take your distributions during retirement, when other sources of income are likely to be less.

Answering the ‘how’ question

This works in concert with when you elect to take deferred compensation distributions. Most plans allow for either a lump sum payment or equal payments over a period of years. The strategies to consider are beyond the scope of this overview, but this is where missteps can be costly. Among the considerations are:

• At what age do anticipate retiring? Ideally, you don’t want to receive deferred compensation distributions until after you retire.
• When do you plan to take Social Security? We often advise clients to take deferred compensation distributions upon retirement and defer commencing Social Security. Each year of Social Security deferral equates to about an 8% annualized increase in benefits.
• Can you accumulate enough in deferred compensation and other accounts to cover your anticipated living expenses between retirement and age 70½ when you must commence distributions from 401(k) and IRA accounts?
• Should you ladder annual lump sum distributions or take equal distributions over a period of years?

Final thoughts for all participants

We recommend getting professional guidance from a financial planner or tax professional early, when you first start participation in a deferred compensation plan.

Finally, most deferred compensation plans allow the participant to choose investment options for their deferred compensation balances, much like a menu of investment options for a 401(k). In some cases, each year’s deferred compensation balance can be invested differently. If this option exists, one can coordinate the lump sum distribution election and the investments, ideally reducing the account volatility as one gets closer to each distribution.

If you participate in a deferred comp plan or are offered the opportunity, make sure to plan carefully and consider how this asset fits within the context of your total retirement plan.