Many of us will never need to worry about deferring compensation. In fact, the idea of waiting to get paid for work we do now until a year or more in the future would seem ludicrous. But if you're in a position where you're being offered a Nonqualified Deferred Compensation Plan, first count yourself lucky because you're likely a high-paid executive, then take a close look at your options.
Simply put, deferred compensation is an agreement between an employer and an employee to hold back a portion of earnings for work performed today for payment in the future. Deferred compensation plans are a benefit most commonly offered in executive pay packages. Because the planning and tax implications associated with deferred comp are complex we recommend consulting with your financial advisor before making the decision to sign on. But the following points will help give you a basic understanding.
Key takeaways from a tax and financial planning perspective:
- Participation will reduce current taxable income
- Earnings grow tax deferred until distribution
- Consider maxing out 401k savings first; then NQDC, since this will provide the opportunity to save more, potentially filling the gap that can arise between income needed in retirement and income received from 401 (k) plans, pensions and Social Security
- Consider flexible distribution options - either during employment or in retirement. To qualify for a tax advantage, the IRS requires a written agreement stating the specified period of deferral of income. An election to defer income must be irrevocable and must be made prior to performing the service for which income deferral is sought (Ex: An election to participate for 2012 must be filed in December 2011).
A big challenge when it comes to saving for retirement is creating alignment between current income needs and saving for the future. If you are eligible to participate in a Nonqualified Deferred Compensation Plan then the next step is to see how this type of retirement savings fits into your overall plan for wealth accumulation and financial independence.
The good news is that the decision is up to you and there is a great deal of flexibility. Plus, the impact of working now and getting paid later can be invaluable. Talk with your financial advisor to see if it makes sense for you.
Note: Changes in tax laws may occur at any time and could have a substantial impact upon each person’s situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors with RJFS, we are not qualified to render advice on tax matters. You should discuss tax matters with the appropriate professional.