You’ve heard the adage “it takes money to make money”. That is very often true. However, it also takes income to pay income taxes. If you are in a position where you are offered deferred compensation, you may have the opportunity to pay less of them, and have more money when you need it the most.
What is deferred compensation?
Deferred compensation is more or less what it sounds like. An employer will offer the opportunity for you to defer, for a number of years, receiving a portion of your compensation.
There are two types of deferred compensation plans, qualified and non-qualified. The most common type, which we will discuss here, is non-qualified deferred compensation (NQDC). Often referred to as “golden handcuffs,” NQDC plans are used to attract and retain top employees.
That’s the golden part. The handcuff refers to a penalty attached to any employer contributions to deferred compensation that kicks in if the employee leaves (especially for a competitor), retires early, or is terminated. The employee gets a potential tax benefit, while the employer gets some extra assurance they will get to keep their employee for the long haul.
How does deferred compensation work?
Your company will designate an amount you may defer, and for how long you may defer—5 years, 10 years or until retirement are pretty typical.
After you determine how long you will defer your income, you will also need to decide if you want to receive your deferred compensation in one lump sum, or across multiple years. Common options are a 5-year or 10-year payout period, the latter of which has tax benefits we will articulate below.
The next choice you need to make with your NQDC wish which investment option do you want your returns indexed to. This is really just a bookkeeping mechanism, as your money isn’t actually invested. Some NQDCs offer options similar to what is available in their 401k or may have options tethered to an actual asset (company stock) or a national index like the S&P 500. In some cases—the company may make the choice for you by offering a guaranteed “rate of return” on the compensation but this is rare.
Say you are 60, plan to retire at 65, and make $500,000 per year. Your company gives you the opportunity to defer up to 20% of your compensation over a ten-year period. If you take the income now, you will pay a 37% tax rate on $100,000 of income, for a total tax bill of $185,000. But if you defer until retirement, you could be looking at a 24% tax rate, for a tax bill of $120,000.
Why utilize deferred compensation?
In the case of many highly compensated employees, their expected income is much higher in their last few years of service than it will be in the first few years of retirement. As such, you can expect to be in a lower tax bracket when the compensation is finally paid out.
Further, contrary to popular belief, expenses tend to actually increase in the first few years of retirement. You may find yourself needing some of that money to travel, move or pay for education. Deferring compensation has the potential to allow you to keep more of your money and have it when you need it the most.
If you plan to move, know that states treat deferred compensation differently, depending on the payout period. If your payout period is less than 10 years, you will have to pay taxes on it in the state in which it was earned. Conversely, if the payout period is 10 year or more, you will pay taxes in the state to which you move.
Let’s say you live in Minnesota, where there is a state income tax, but you plan to move to Texas in retirement two years in. If you elect a five-year payout for your $500,000 you will pay Minnesota state taxes, likely around 7%, on the entirety of your deferred income, for a tax bill of $35,000. On the other hand, if you elect a 10-year payout, you will only pay that 7% on two years ($100,000) of your income, for a tax bill of $7,000.
What are some considerations for taking NQDCs?
NQDCs do have some drawbacks. Even if you don’t leave the company, they come with fewer protections than are available with, for example, 401ks. They are not protected from creditors in bankruptcy. If your company goes under, you might lose your compensation.
NQCDs are also less flexible than other types of retirement accounts. You can’t take them as loans or roll them into an IRA. Further, once you make your distribution election you generally can’t change it.
Therefore, it makes sense to have the long game in mind when electing to take deferred compensation. Here are some questions to consider:
- Are you maximizing your traditional retirement plan contributions?
- Do you plan to be with your company until retirement?
- Will you be in a lower tax bracket when the deferred compensation payments start?
- Are you comfortable with the distribution options?
- What investment options are available in the plan?
- Is your company financially secure?
- Do you plan to move once you retire?
- Do you anticipate expenses (for example medical bills) that will require funds in the short term?
The question of whether to defer compensation is driven by your financial goals. A seasoned advisor can help you work through key questions and potential scenarios as you make your NQDC plan decisions.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.