Deferred Compensation

How deferred compensation plans work and why you might want to use one

What is Deferred Compensation and how does it work?

Deferred Compensation is a strategy where a portion of an employee’s income is set aside, or “deferred”, to a later date. This strategy allows employees to avoid recognizing income in the current year, and instead defer that income to a future year. In many cases, the taxes due on the income are also deferred to the future period in which the income is received. There are several different types of deferred compensation including retirement plans, pension plans, deferred savings, and stock-option plans. These plans are offered by employers as an incentive to attract and retain key employees. Many of these plans can be particularly effective at retaining talented employees due to certain elements of plans which reduce the amount of deferred compensation individuals receive if they leave their current companies.

One of the most common reasons an individual would utilize deferred compensation is to minimize their overall, long-term tax liability. The tax savings of utilizing these plans can be substantial, as oftentimes individuals have higher earnings along with a higher tax rate in their working years and can defer part of their income to retirement where their associated earnings and tax rate would typically be lower.

Many deferred compensation plans are structured so that amounts may be deferred over a period of 5 years, 10 years, or until the employee retires. A number of plans allow the individual to schedule distributions throughout the course of his or her career, as opposed to only during retirement, which provides the enrollee the ability to utilize these plans for short-term purchases.

Qualified versus Non-Qualified

Deferred Compensation plans are classified as either Qualified or Non-Qualified. While the term ‘Deferred Compensation’ is typically used to refer to Non-Qualified plans, the term actually covers both Qualified, like 401(k)s and 403(b)s and Non-Qualified. A company with a  Qualified plan in place ,ust offer it to all employees of the organization, contributions to these plans are capped, funds are provided for the sole benefit of recipients, and it’s protected from the employers creditors.

A Non-Qualified plan, or NQDC, is different from a qualified plan and is structured as an agreement between an employee and employer to defer a portion of the employee’s annual income to a later date. NQDC includes supplemental executive retirement plans, voluntary deferral plans, wraparound 401(k) plans, excess benefit plans, equity arrangements, bonus plans, and severance pay plans. With a NQDC, the employee can decide how much to defer each year which can result in tax advantages. These plans are particularly attractive to high income earners who are in high tax brackets and can save beyond the maximum allowable contributions for standard pre-tax retirement vehicles such as a 401(k). With these plans, employers have the ability to offer the plans only to select individuals within the company.

The funds within an NQDC are not invested the way they would be in a Qualified plan such as a 401(k). Instead, many companies index the balance of NQDC against the return of a specified investment. Some plans allow employees to select major stock or bond indexes for which the returns of the NQDC will be aligned to, and other companies may offer the same investment choices which are available within the employer’s 401(k) plan. Certain NQDC plans may also have specific conditions included, such as restrictions against working for a competitor.

There are some downsides to NQDC plans, such as the fact that loans cannot be taken from NQDC plans. Rollovers into IRA’s are also not permitted when the funds are paid out. Under a qualified plan, the benefits provided to employees are separated from the employer’s other assets and are not subjected to a potential loss under bankruptcy or other circumstances. With a NQDC, the plan represents a commitment from an employer to pay the employee back at a later date however these funds could be provided to creditors during liquidation.

How do the taxes work?

One of the primary advantages of a Deferred Compensation plan are the tax benefits. When an employee defers compensation to a future date, they also defer the tax liability to a future date. If the employee’s total income is less in the future when the funds are received and/or overall tax rates are less, then the individual can realize tax savings as a result of the deferral. Let’s illustrate the potential tax benefits with an example.

Greg is a 55 year old business executive who currently earns $750,000 per year, and his employer offers a NQDC plan. Greg decides he would like to defer $100,000 of his compensation out of the current year, and withdraw it over the first 5 years of his retirement in $20,000 annual increments beginning at age 60. As a single filer, the federal income tax Greg would have paid on the $100k amount in the current year was $37,000 based on the existing federal income tax rate of 37% for this income level.

In retirement, Greg’s income will be substantially less because of no longer working and having living expenses which are far below his current income level. With the $20,000 of deferred income included, Greg’s total retirement income will be $100,000 per year during the first 5 years of his retirement. Greg’s total income tax liability on the deferred compensation income of $100,000 during retirement is $24,000 due to the 24% tax rate at this income level, as opposed to the $37,000 he would have paid if the funds were received during his working years. Greg has saved $13,000 in taxes, or a reduction of 35% as a result of utilizing his employer’s deferred compensation plan.

Wrapping it up

There are several key considerations when determining if a NQDC is the optimal plan for an individual. Whether the employee is maximizing available traditional retirement plans, anticipated tax rates in the present and future, ability to afford the compensation deferral, financial security of the employer, flexibility of the plan’s distribution schedule, and available investment choices within the plan are all key factors to take into consideration.

For individuals who work for a financially secure organization, are already maximizing traditional retirement plans, expect to be in a lower tax bracket in the future, are comfortable with the investment options and distribution schedule of their available plan, and understand the risks involved, deferred compensation plans can be an excellent option to consider.

Word of Warning

One of the biggest risks of NGDC plans is the lack of control. Unlike a 401(k) which you have full control over the distributions (until RMDs come into play), with a NQDC plan, the distributions are set when you enter the plan, and can be accelerated if you quit for another job, are laid off/fired, or otherwise leave your employer early. This could lead to the payouts being accelerated and much of the income being taxed in one or two years. This could eliminate all the tax benefits accrued up to that time, and you may even end up worse off then if you never participated in the plan in the first place. Usually, these plans are only a good option if you have used all the other tax qualified plans you have available to you and even then, you should not have a majority of your wealth tied into these plans. It’s a useful tool, but not always the best tool for tax planning and retirement planning.

If you have questions on your Deferred Compensation plan don’t hesitate to reach out and contact us for a free consultation.