Fall's arrival means it's time for those with access to company-sponsored nonqualified deferred compensation to decide whether to participate.
Deferred compensation is an employer-sponsored plan in which the participant elects to forgo current wages or a bonus in exchange for a promise to be paid at a future date.
The advantage of deferred compensation is that the amount deferred is excluded from gross income in the year contributed, so there's no federal or state income tax owed. However, FICA taxes are still paid.
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The money inside the plan is invested in a select group of mutual funds. There are no taxes on the mutual fund earnings while the funds are inside the plan.
At the time of withdrawal, funds are taxed at ordinary federal and, if applicable, state income tax rates.
Nonqualified deferred compensation money is different from a 401(k) in a variety of ways, but it's not eligible for an IRA rollover.
The OBBB gives us two reasons to consider deferred compensation
The One Big Beautiful Bill (OBBB) ushered in a wave of important tax changes. The seven individual income tax rates set by the Tax Cuts and Jobs Act (TCJA) have been made permanent, and the top rate remains at 37%. ("Permanent" is a relative term, though, since tax rates could be changed by future laws.)
The standard deduction was increased and made permanent. The limit on state and local taxes (SALT) you can deduct on your federal tax return will be increased to $40,000 starting in tax year 2025. From 2026 to 2029, that limit will increase by a fixed 1% each year, with the cap reverting to $10,000 in 2030.
Reason No. 1 to consider deferred compensation: The SALT deduction
The SALT deduction limit is phased down to a minimum of $10,000 after modified adjusted gross income (MAGI) reaches the upper limit of the phaseout range ($600,000 in 2025). Two points to make clear:
- The increased SALT deduction is temporary
- The phaseout begins at $500,000 of MAGI
If your MAGI is within the deduction phaseout range or higher and you itemize state and local taxes, you might want to consider using deferred compensation to potentially lower your MAGI if you find you're being phased out of the SALT deduction.
Tax Year | SALT Deduction Limit | MAGI Range for Deduction Phaseout |
|---|---|---|
2025 | $40,000 | $500,000 to $600,000 |
2026 | $40,400 | $505,000 to $606,333 |
2027 | $40,804 | $510,050 to $612,730 |
2028 | $41,212 | $515,151 to $619,191 |
2029 | $41,624 | $520,302 to $625,716 |
2030 and later | $10,000 | — |
Reason No. 2 to consider deferred compensation: Prevent bracket creep
The OBBB only slightly changed the amounts in each bracket from the TCJA. However, investors still must contend with bracket creep. This is when your total income pushes you into a higher tax bracket.
If you can afford to defer a portion of your bonus, deferring will mean less taxable income in that year.
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Executives with other sums of money coming due — for example, stock vesting or options exercising — might be pushed into the next tax bracket. If bracket creep is a concern, using deferred compensation is worth reviewing.
Risks of using deferred compensation
You must be mindful of the risks of deferred compensation, namely the lack of liquidity. Money deferred might not be available for several years, or you could be deferring income to a higher tax bracket in the future.
There is also creditor risk: How is deferred compensation treated in the event the company goes bankrupt? Reviewing the company plan is important.
Final thoughts
The OBBB gives us reason to reconsider deferring income, namely, if an individual needs to maximize the SALT deduction.
Deferring income to help prevent bracket creep is also something to consider. However, consider the lack of liquidity and the risk of being an unsecured creditor.
Now is the time, given plan deadlines are coming up, to schedule a call with your financial adviser and review if participating in your company's deferred compensation makes sense.
Ideally, the decision as to whether to defer or not should be made in the context of a financial plan.
Michael Aloi, CFP, specializes in working with high-income professionals and executives. For more information, please email the author at maloi@sfr1.com or visit his website, www.michaelaloi.com.
Investment advisory and financial planning services are offered through Summit Financial LLC, a SEC Registered Investment Adviser, 4 Campus Drive, Parsippany, NJ 07054. Tel. 973-285-3600. This material is for your information and guidance and is not intended as legal or tax advice. Clients should make all decisions regarding the tax and legal implications of their investments and plans after consulting with their independent tax or legal advisers. Individual investor portfolios must be constructed based on the individual's financial resources, investment goals, risk tolerance, investment time horizon, tax situation and other relevant factors. Past performance is not a guarantee of future results. The views and opinions expressed in this article are solely those of the author and should not be attributed to Summit Financial LLC. Summit is not responsible for hyperlinks and any external referenced information found in this article.
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