Deferred compensation plan is a contractual agreement between employees and employers that allows employees to postpone receiving a portion of their current wages or bonuses to a future date, such as retirement. The tax on these income can be deferred, reducing taxable income for the current year when the income is deferred. However, taxes will still need to be paid when the money is distributed to you in the future.
If you anticipate being in a lower tax bracket when you receive this money in the future, this arrangement could provide tax advantages. That’s why many plans arrange for you to receive this money upon retirement when your tax bracket may be lower.
You have the option to receive the entire amount at once or spread the payments over several years to spread out taxable income. Each year, you have the choice of whether to participate in this plan and how much income to defer.
However, these plans can be quite complex, and if not handled carefully, they might result in unfavorable consequences. Let’s delve further into this.
Deferred compensation plans mainly come in two types. One is the qualified deferred compensation plan, including traditional 401(k) plans and Individual Retirement Accounts (IRAs). You can contribute to these plans with pre-tax income, and the earnings generated can be taxed at a later date.
However, when most people talk about deferred compensation plans, they are often referring to nonqualified deferred compensation (NQDC) plans. Unlike traditional 401(k) and IRAs, NQDC plans do not have annual contribution limits. However, your employer may dictate how much income you can defer annually.
Some NQDC plans allow you to invest the deferred compensation in various investment options just like choosing 401(k) investment items. However, some companies have stricter rules and only allow you to invest in company stocks.
Unlike 401(k) plans that are typically available to a broad range of employees, NQDC plans are usually reserved for high-income employees such as senior management personnel.
Therefore, when used correctly, NQDC plans can assist high-ranking corporate executives in taking advantage of lower future tax rates, boosting retirement savings, or preparing funds for significant future expenditures.
Nevertheless, there are significant risks associated with such plans that you need to understand. Unlike 401(k) and 403(b) plans, NQDC plans are not protected by the Employee Retirement Income Security Act (ERISA). This means that if the company goes bankrupt, you could potentially lose the entire balance in your account.
Some financial advisors recommend maximizing contributions to other retirement plans like 401(k) and IRAs before allocating funds to NQDC plans so that only the money you can afford to lose is invested in the NQDC plan.
While NQDC plans have basic rules, the specifics of each company’s plan vary. Some plans may have stringent restrictions, such as losing the deferred compensation if you leave the company and work for a competitor.
Therefore, these plans may be more suited for those intending to stay with the company long-term and who aim for gradual advancement within the company.
Though many companies may allow you to select a date to receive the deferred compensation, once the decision is made, it is usually final with minimal opportunity for changing the distribution schedule. Additionally, it’s important to note that while deferring income, you still need to pay Social Security and Medicare taxes on that portion.
Furthermore, no one can accurately predict future tax rates. Hence, if tax rates significantly increase when you receive the money, it could diminish or even negate the tax advantages of the plan. Therefore, careful consideration of your expected tax bracket when receiving the money is crucial. In some cases, using post-tax income contribution options like Roth 401(k) or backdoor Roth IRAs might be a better choice for high-income company executives. These accounts allow tax-free withdrawals under specific conditions post-retirement.
Deferred compensation plans, especially NQDC plans, can offer significant tax advantages for high-income corporate executives. However, it is essential to weigh the pros and cons of these complex plans. Due to the lack of protection under ERISA, there’s a risk of losing all deferred compensation if the company faces bankruptcy. Moreover, some plans have limited investment choices, and certain companies impose strict restrictions on these plans.
Since NQDC plans are ultimately investment tools, you may need to adjust asset allocations over time to align with your financial situation, investment goals, and market conditions. Thus, it’s advisable to carefully evaluate and consider the use of NQDC plans with the assistance of professional financial and tax advisors.
Remember, the future is uncertain, and tax rates can fluctuate. Therefore, thorough planning and evaluation are necessary before committing to a deferred compensation plan to ensure it aligns with your financial objectives.