Should I Use a Deferred Compensation Plan? [Video]

by Michelle Smalenberger, CFP® / February 27, 2023

A deferred compensation plan is a benefit that is available to most corporate executives. And today this is what we are talking about.

We’re going to cover a few key items about deferred compensation plans. From what it even is and when to use it, to key timing for tax decisions, and some pros and cons, you will learn how this impacts your financial plan.

Why Use a Deferred Compensation Plan?

Very simply, deferred compensation is income that you are earning today that you are choosing to put off until some point in the future. There are two big reasons why people want to use this benefit. First is tax savings. If today, I am in the 37% income tax bracket because of my high income, I may choose to defer some of this income into a time where I might be in a lower tax bracket, like the 24% bracket. You can see there are some meaningful dollars I can keep by paying taxes at a lower rate.

A second reason people might want to use this as a benefit is maybe you just need some additional savings for the goals and expenses you are going to have in retirement, or the future in general. Maybe your social security or 401(k) savings aren’t enough, and you just need more. To fill up that gap, you might decide to use deferred compensation to give you the additional money you need. 

How Can Timing Impact Taxes?

Now I mentioned there are some key moments you need to be aware of from a tax perspective. There are a few types of taxes we are talking about where you can save. 

First there are FICA taxes. This is the percentage for Medicare and social security withheld from all paychecks. If you choose to defer some of your income into a future year, you will still pay FICA taxes today. Even though it’s deferred, you earned the money today so you pay the taxes today.. 

However, federal and state taxes are going to be paid at the future date. This is because you aren’t yet receiving the money. You’ve earned it today, but you decided you will receive it in the future. That’s when you will pay the federal and state taxes. 

How Much Money Can I Defer?

One key thing to keep in mind, and one of the really big benefits of deferred compensation plans, is you don’t have a limit. This means you could really put aside a meaningful amount. 

Now, your company might have in their plan that you can defer only up to 70%, 80%, or 90%. But as far as the IRS is concerned, you can defer an unlimited amount. This is very different from things like IRA or 401(k). A tool like this could make your plan very flexible. 

Even though there is no limit for how much you can defer, one thing you have to remember is you can not undo this. Once you have elected to defer the income into the future it’s a irrevocable choice, meaning it cannot be changed. So this deferral can’t be undone. There is one factor we will talk about later that you can change, but it is not the undoing of the election to defer income. This makes deferred compensation plans something you want to be very careful with. 

What Do You Need to Decide?

Let’s talk through some key decisions you need ro make if this is something you decide is for you. First, should you even defer income? Is this something you should use? If it is, you need to decide when you want to receive the income on the date you defer it. If I am filling out my paperwork, I need to say exactly when I want to receive it. This is hard because no one knows the future. It’s really important to have you financial plan in place, so that you know how to make this choice. 

Another thing you should know is that  you can receive this deferred income before you are 59 ½ . That age might sound familiar to you because that’s the age when you can start taking money out of an IRA without a penalty. If you take out money before this age, you have a  10% penalty. 

This is something that makes your income flexible for you. Maybe you are someone who wants to retire in the years before 59 ½. With this tool, you will have some of the income you need before you can access your retirement accounts.  

Finally, the final question: when I start to receive that income in the future, how do I want to receive it? Do I want a lump sum in that future year, or do I want to receive it in installments? You could set the amount you’re deferring for the future, and say “give it to me at retirement, but over the span of 5 or 10 or 15 years.” So you can see there are lots of options here. You can choose how you want to receive it. But there are some key decisions you have to know well in advance before you start getting this money.

Do You Have What You Need to Make These Choices?

I just want to pause because you are starting to see that a financial plan is so important. That is what gives you clarity, so when you make these decisions you can. With a financial plan, you have the confidence you need to live out your plan.

As a resource for you, we have created a comprehensive blog that gives you more information about deferred compensation plans. It details everything you need to know and examples for what this might actually look like. If you are deferring income year after year, you are going to want to see how this adds up together to make sure this is actually beneficial to you.

Now let’s dig into this last point. There are a lot of advantages, but there are some serious disadvantages you will want to consider before you make an election. 

What Are the Pros? 

We already mentioned all the tax savings you can get by deferring income. Additionally, you might gain tax deferred growth! The income that you defer can actually be growing during the waiting period. This is because you can make wise investment choices with this money. Another pro we talked about was how this tool makes early retirement possible. With a deferred compensation plan, you aren’t bound to the 591/2 age limit IRAs are. 

Now one last thing that we didn’t touch on in detail, is the state tax savings. Let’s assume you are someone who lives in a high state income tax rate because of where you are working. But in the future, you could see yourself moving to a different state, with a lower or no state income tax. If you are someone who is considering that, this is something you will want to pay attention to. 

If you move, you can pay your deferred compensation at that new state’s tax rate. You would have to choose an installment plan over the course of 10 years or more, Then, your state tax rate can actually be the state you moved to, rather than the state that you earned the money in. This could mean even more tax savings for you! 

What Are the Cons to Deferred Compensation Plans?

Now, let’s switch to some of the negatives, or drawbacks of a deferred compensation plan. One of the main reasons corporate executives choose not to use this benefit is that this money deferred into the future is not guaranteed to be there for you. The IRS allows this option because there has to be substantial risk of forfeiture. 

What that means is that there is a real risk that you could lose this money. This is because the money you are deferring does not stay in an account specific to you. It stays a part of company money, which they have available to pay their creditors. If your company isn’t doing well, the money you are deferring could get used by the company to pay their bills or if they go bankrupt this is money they would use to pay creditors instead of paying you. 

That’s what it means to have a substantial risk of forfeiture. There is a real risk you could lose it all. It happened back in 2012 with Kodak and in 2008 with Chrysler. These companies went bankrupt and the deferred compensation was lost. While this doesn’t happen often, it is a serious risk that we thoroughly evaluate for our clients before choosing to use deferred compensation. The company you work for is very important. 

Remember how I said you can’t undo an election? It’s irrevocable. However, if you made the election and you said you want to receive the money at retirement, you can further the deferred date. You just have to add five years to the original deferral date. This creates more risk in addition to the risk we are already taking. If I’m going to defer my income until retirement, I could delay my election by 5 more years after that. This is more risky because we already don’t know the future and an additional five years might hinder you from doing so. 

Another con is that your employer investment options might not be what you need. Like 401(k) plans, we rarely have great investment options. Finally, unforeseen financial needs is always a possibility. I might elect to defer my income and find out I actually needed that money today. But you can’t undo that. So these cons are things to consider in addition to the pros. 

Next Steps for Your Deferred Compensation Plan 

You might decide for all these reasons, this is still the right strategy for you–and it might be! But there are a lot of factors involved, each that could mess up your financial plan. If you have questions about your deferred compensation plan, why wait to get answers. Reach out, and schedule a time to chat with our team! 

If you are looking to keep learning, don’t forget to take a look at our blog post. We actually have ten key questions you should to ask yourself when you evaluate this benefit and if it fits with your plan. 

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