You’ve heard the adage “it takes money to make money.” That is very often true. Similarly, it 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 in income taxes 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 a portion of your compensation for a number of years, and doing so defers taxes on any earnings until you take a withdrawal. Examples include pensions, retirement plans, and stock options.
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). Unlike 401(k) plans, NQDCs have no limit to how much income you can defer each year, and if you’re in the top tax bracket, these plans can have big tax benefits. That means you can defer a large enough portion of your income to drop down into a lower tax bracket, thus reducing the amount you have to pay in income taxes.
Often referred to as “golden handcuffs,” NQDC plans are used to attract and retain top employees. The “golden” part is the potential tax benefit for the employee. 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. That means the employee has to stay with his/her company or the deferred compensation is penalized, so the employer gets some extra assurance they will get to keep their valued 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 that amount—usually five years, 10 years or until you retire.
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 five-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 is which investment option you want your returns indexed to. This is really just a bookkeeping mechanism, as your money isn’t actually invested. Some companies offer options similar to what is available in your 401(k) 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.
How is deferred compensation taxed?
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 in retirement.
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 10-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.
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 for children or grandchildren. Deferring compensation has the potential to allow you to keep more of your money in the long run so you have it when you need it the most.
Additionally, it’s important to know that states treat deferred compensation differently depending on the payout period. If you plan to move to a different state in retirement and your NQDC payout period is less than 10 years, you will have to pay taxes on the payout in the state in which it was earned. Conversely, if the payout period is 10 years 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, where there is no state income tax, two years into retirement. If you elect a five-year payout for your $500,000 salary, you will pay Minnesota state taxes, likely around 7%, on the entirety of your deferred income. So, over that five-year period, you will receive $100,000 per year, and you will have to pay 7% in income taxes on all of it—resulting in a tax bill of $35,000. On the other hand, if you elect a 10-year payout, you’ll receive $50,000 per year, and you will only pay that 7% in taxes on the two years you live in Minnesota—resulting in a tax bill of just $7,000.
What are some risks associated with taking NQDCs?
NQDCs do have some drawbacks. For example, even if you don’t leave the company, they come with fewer protections than are available with 401(k)s. Additionally, they’re not protected from creditors in bankruptcy. So, if your company goes under, you might lose your compensation.
NQDCs 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.
Is a deferred compensation plan right for me?
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 (e.g. 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.
CSA®, AIF®, Series 65 Advisory Registration Jim has more than 35 years of experience in the financial services industry, including years spent with Morgan Stanley. Throughout his career Jim has helped clients with life planning, coaching them on how to help achieve their vision by leveraging their financial resources and focusing on work-life balance. This led him to form Live Your Vision, LLC in 2009 and enter into a partnership with Wealth Enhancement Group in 2019. Jim is...Read More