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—give employees the option to set aside part of their annual salary or bonus, to be paid at some point in the future. Employees can postpone today’s tax liability and potentially benefit from tax-deferred growth.
If you’ve been offered access to a deferred compensation plan, here’s what to consider:
Q: Do you have excess savings?
A: If you’re already maximizing contributions to your 401(k) and have excess savings you won’t rely on in the foreseeable future, a deferred compensation plan could be worth considering.
If, however, you anticipate needing funds before leaving your employer—maybe for a kitchen remodel next month or the purchase of a vacation home next summer—deferring might not be for you.
Q: Should I defer my base salary, bonus, or both?
A: The amount of compensation eligible for deferral and distribution of funds vary by employer. Your cash flow needs and tax situation will help determine what and when to defer.
At Nike, for example, eligible employees can defer up to 100% of three different sources of compensation: next-year’s base salary, performance sharing bonus, and long-term incentive plan compensation.
Because these three sources of compensation are paid out in different years, an election to defer them will impact future years’ taxes differently. A broader understanding of your earnings and taxes over multiple calendar years is needed to best determine the source—and amount—of compensation to defer.
Q: What are my plan’s distribution elections?
A: Deferred compensation plans offer a variety of distribution options, including lump-sum and installment payments. Many plans offer both “in-service” accounts—to access funds while still employed—and “retirement” accounts that distribute funds upon separation from service.
To maximize the benefits of a deferred tax liability, employees should consider electing a “retirement” account with the longest distribution period from separation of service. Nike, for example, allows 60 quarterly installments over 15 years.
Q: What are the tax implications?
A: Electing to participate in a deferred compensation plan may reduce the amount of income subject to tax rates today. 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 rates are higher—or vice versa.
Q: What are my plan’s investment options?
A: Employees can often select from a menu of investments, but high-cost or otherwise poor fund choices may offset much, if not all, of your tax-deferral benefit. If your plan’s investment options don’t include well-diversified, low-cost index funds, it may make sense to receive compensation in the current year and invest those dollars in a portfolio of index funds instead.
Q: Are there other risks to consider?
Certainly. By participating in a deferred compensation plan, employees are essentially accepting an IOU from their employer. While funds in a 401(k) are protected if the company runs into trouble, money deferred in a nonqualified plan is not. If your company files for bankruptcy before your deferred compensation is paid out, you may never see that money.
You may already have a significant concentration to your employer via human capital, company stock, and stock options. 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.
How Vista Can Help
Tax-deferred growth and delayed income recognition (potentially 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 the specifics of your situation 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, time frame, expected career path, and other assets. In doing so, we aim to put you on a happy and prosperous retirement path.
