Contributed by: Robert Ingram, CFP®
Many executive compensation packages offer types of deferred compensation plans. If you have one available, it can be a powerful tool to accumulate additional retirement savings. But is it right for you?
While this can be an effective way to reduce current income and build another savings asset, there are many factors to consider before participating. Plans can be complex, often less flexible than other savings vehicles, and dependent on the financial strength and commitment of the employer.
How Do Non-Qualified Deferred Compensation Plans Work?
By participating, you generally defer a portion of your income into a plan with the promise that the employer will pay the balance to you in the future, plus any growth and earnings on those assets. The amount you defer each year does not count towards your income in that year, thereby reducing your taxable income (at least for now). When the deferred income pays out to you in the future, it counts toward your taxable income at that time. These accumulated funds within the plan can also grow tax-deferred through different investment options, depending on how the plan is set up. This sounds a lot like contributions to a 401(k) plan in that contributions are not taxed in the year contributed, and earnings can grow tax-deferred.
However, unlike a qualified plan such as a 401(k) or pension plan, a non-qualified deferred compensation plan is not covered under ERISA, and there are no mandated income caps and annual contribution limits, like the annual maximum on a 401(k) (in 2024 $23,000 plus an additional $7,500 “catch up” for those age 50 and above). For high-income employees, having this ability to defer an even larger portion of income in addition to qualified plan contributions (and subsequently the taxes on that income) can be a significant advantage.
Because the plan is not under ERISA, it is also not a protected asset from creditors. The plan’s security depends on the financial strength of the employer and whether the employer has established certain funding arrangements.
The deferred compensation agreement also establishes when and how you can withdraw funds. Typically, the plan defines certain triggers for it to pay out, such as at a retirement date/age or at separation from service, for example. The plan can also have several different ways to allow for withdrawing (paying out) funds. Different options can include a lump sum distribution or set withdrawals spread out over a number of years (e.g., a schedule over three years, five years, or even as many as 15 years). Some plans may allow payouts to begin during your working years, while others may not. You may not have any other early withdrawal choices for hardships, plan loans, etc. There are no IRS-imposed required minimum distributions for qualified retirement plans (beginning at age 73 in 2023). However, you may also have less control over your withdrawals from a deferred compensation plan.
Advantages of a Deferred Compensation Plan
The plan allows you to defer current income or additional compensation today and claim it in the future. Doing this can lower your income, which is subject to income taxes in the current year, and help keep you in a lower tax bracket.
It can allow you to build tax-deferred additional assets for future needs (typically an additional retirement savings vehicle).
The plan is not subject to the ERISA requirements and the annual contribution limits of qualified retirement plans such as a 401(k) (unless otherwise set by the employer plan).
It can be customized for an employee or groups of employees.
Disadvantages of a Deferred Compensation Plan
These plans are not protected under ERISA, so you may risk losing your promised income and potential earnings if the employer company goes bankrupt or does not properly fund the plan.
The plan language may impose rules where you lose the money if you leave the employer.
The ability to withdraw funds is typically set on a predetermined schedule in the plan, such as at retirement, at termination, and either as a lump sum or spread over several years. This can limit some control and flexibility over when you have access to the money and how much income you will claim from the plan in a given year.
Deferring income today means having to claim that income in the future. If your income is higher in the future or if tax rates increase, deferring more income today could be less attractive.
Planning Considerations for Using Your Deferred Compensation Arrangement
Financial strength of the employer.
Since the dollars in the deferred compensation plan are not yours until they are paid out to you, the employer must be in a strong enough financial position to make good on its promise to pay.
Are you maximizing your contributions to your employer retirement plan?
If you’re not contributing up to the annual maximum to your 401(k), for example, doing that first makes more sense. The dollars you contribute are your own, not the employers’ and generally are more flexible for when and how you can take distributions.
What is your timeframe for needing the funds?
Ideally, the funds in your deferred compensation should be used in retirement. That is a benefit of deferring taxable income during your working years.
What is the right payout schedule?
There may be options for a single lump sum or a series of installment payments, such as an equal amount distributed over five or seven years, for example. Spreading out your payment may help limit the taxable income in a given year. However, when taking installment payments, you need to be comfortable remaining tied to the plan until the full balance is distributed.
These are some examples of the considerations for contributing to this deferred compensation plan. As with other types of employer compensation and retirement plans, deferred compensation plans can impact your financial situation in different ways, both in the current year and in future years. That’s why it’s critical that you work with your financial and tax advisors when making these kinds of planning decisions. So please don’t hesitate to reach out if we can be a resource.
Robert Ingram, CFP®, is a CERTIFIED FINANCIAL PLANNER™ professional at Center for Financial Planning, Inc.® With more than 15 years of industry experience, he is a trusted source for local media outlets and frequent contributor to The Center’s “Money Centered” blog.
Securities offered through Raymond James Financial Services, Inc., member FINRA/SIPC. Investment advisory services are offered through Center for Financial Planning, Inc. Center for Financial Planning, Inc. is not a registered broker/dealer and is independent of Raymond James Financial Services.
The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete. Any opinions are those of Bob Ingram, CFP® and are not necessarily those of RJFS or Raymond James. Raymond James Financial Services, Inc. and its advisors do not provide advice on tax issues, these matters should be discussed with the appropriate professional.