As an executive or high earner, you may have the option to participate in a deferred compensation plan through your employer. Many large organizations—approximately 92% of Fortune 1000 companies—offer the benefit.
Does this mean deferred compensation is for you? Not necessarily. Here are a few pros and cons:
- Deferring may reduce the amount of income subject to high tax rates today, giving you greater after-tax compensation tomorrow.
- Future tax rates, however, are unknown. Deferring could shift the recognition of your income from a year in which applicable rates are relatively low to a year in which applicable rates are higher.
- In addition, as an unfunded company liability, deferred compensation can be risky. If your company files for bankruptcy before your deferred comp is paid out, you may never see that money. The bankruptcy of Enron and Chrysler wiped out employee deferred compensation, as did the failure of several seemingly safe banks and credit unions during the most recent financial crisis.
Five Critical Questions
Given these pros and cons, how do you determine whether participating in a deferred compensation plan is for you? To help you decide, we’ve put together a list of five critical questions to consider.
Q: What is my total exposure to my employer?
Most likely, you already have a significant concentration to your employer via human capital, company stock and stock options. Even the value of your personal residence, if it’s located near a large employer, could be at risk since a company’s demise can negatively impact local real estate prices. While there is no magic number for everyone, consider limiting the total exposure to your employer (stock, options, and deferred compensation) to no more than 25% of net worth.
Q: What is the value of my non-retirement account assets?
Assets held outside of an IRA or 401(k) are more accessible, should you need money, before you reach age 59 1/2. Having the bulk of your investment assets tied up in IRAs, 401(k)s and a deferred compensation plan may actually result in higher taxes if you need cash before you’re able to tap retirement accounts without penalty. Building up your non-retirement account portion of your nest egg could make more sense.
Q: What are the plan’s distribution elections?
Plans generally offer two types of distribution options: lump-sum or installment. A lump-sum distribution provides immediate access to all deferred compensation upon a distributable event (e.g., retirement), but income tax will be owed on the entire amount in that year, potentially causing your tax bracket to increase. Stretching payouts over 5, 10 or 15 years is often preferable from a tax perspective, although that also lengthens your exposure to the company’s financial stability.
Q: What’s my expected career path?
What is the likelihood you might lose your job or move to another company? Deferred compensation cannot be rolled over from one company to another. An unanticipated career change could cause the income you expected to receive in retirement to be paid out much earlier. The risk of deferred compensation distributions being triggered sooner than expected is also greater if your company is an acquisition target.
Q: What are the plan’s investment options?
Are your plan’s investment options well-diversified, low-cost index funds? High-cost or otherwise poor investment choices may offset much, if not all, of your tax-deferral benefit. It may make more sense to receive compensation in the current year and invest those dollars in a tax-friendly, low-cost portfolio of index funds.
How Vista Can Help
Tax-deferred growth and delayed income recognition (into years with lower taxes) are compelling reasons to participate in your employer’s deferred compensation plan. But the unpredictability of future tax rates and the risk of an unfunded company liability might outweigh these benefits.
Taking your answers to these five key questions into account, we can help explore the right approach for you. We’ll evaluate the perceived stability of your employer and plan’s options, while also considering your income and lifestyle needs, risk tolerance, timeframe, expected career path and other assets. In doing so, we aim to put you on the path to a happy, healthy retirement.