FAQs to Help You Navigate Your Deferred Compensation Options
As a corporate executive or other high-income earner, you likely have a wide range of benefit options to consider. A deferred compensation plan is one of those benefits that, while valuable, can also be challenging to navigate. Here we provide answers to commonly asked questions regarding deferred compensation plans.
What is a deferred compensation plan?
As the name suggests, a deferred compensation plan is a retirement benefit that allows an employer to defer a portion of an employees’ compensation until a later date. Typically, these assets are distributed at retirement. The deferred compensation can then be paid out all at once or as installments across a number of years. A deferred compensation plan may consist of a pension, a retirement plan or employee stock options. These plans are typically only available to high-income earners, such as corporate executives.
How does a deferred compensation plan work?
Basically, you enter into an agreement with your employer on how much of your salary you would like to defer. These deferrals are made prior to paying federal income taxes, which are due when the funds are withdrawn. State income taxes are also deferred until you make a withdrawal, at which point you pay taxes to the state in which the income was earned, not the state in which you live when the income is distributed. Deferrals are typically subject to Social Security and Medicare taxes at the time they’re made.
One main benefit of deferring assets is that your current salary is reduced by the amount of your deferral, which has the potential to reduce your tax bill in the current year. Assuming you’re in a lower tax bracket when you retire, the tax savings can be significant.
How does a deferred compensation plan differ from other types of retirement accounts?
Similar to other retirement accounts, the assets contributed to a deferred compensation plan are excluded from your taxable income in the current year and allowed to grow tax-deferred for retirement.
In contrast to a 401(k) plan or traditional IRA, there are no limits on how much you can contribute to a deferred compensation plan. This means you have an opportunity to save significantly more in your deferred compensation plan than in other retirement accounts. Many employees choose to defer all (or a significant portion) of their annual bonus in order to beef up their retirement savings and take advantage of the tax benefits provided by these accounts.
Another difference between deferred compensation plans and other types of retirement accounts is that deferred compensation plans typically require you to make an upfront election on how and when you’ll receive the funds. You may choose to distribute the assets as a lump sum or take payments over a certain number of years, but you must make your intentions clear when you begin participating.
What are the pros and cons of participating?
Pros include:
- No contribution limits
- An opportunity to defer taxes during prime earning years
- Flexible payout options
- An opportunity to maximize Social Security by delaying your benefit start date
- A boost to your retirement savings, which may allow you to retire earlier
Cons include:
- Upfront distribution elections mean you’re not able to access money early
- If you change jobs, you may lose the account or be forced to distribute in a lump sum, which could mean a big tax bill
- If not held in a separate trust, assets could disappear altogether if the company declares bankruptcy
- Limited investment diversification, especially if you’re already heavily weighted in company stock
What should I consider before signing up?
The most important consideration is risk. If your employer fails, you have the potential to lose any assets you’ve invested. You should also consider your overall investment allocation. Is a significant portion of your portfolio tied up in company stock? If so, it may be unwise to put even more eggs (i.e., assets) in the company basket. Also, can you be 100% sure how you’ll want those assets to be distributed years down the road? If not, you may want to wait a bit before participating.
Could you use some help navigating the ins and outs of your deferred compensation plan? Creative Planning is here for you. We understand the unique challenges faced by corporate executives and other high-income earners. We take a holistic approach to helping you plan for the future by integrating all aspects of your personal financial life and workplace benefits into a single, comprehensive plan. Put simply, we’re here to help you achieve your goals.
If you’d like help navigating your retirement benefits, or with any other financial matter, schedule a call with a member of our team.
