When you participate in a deferred compensation plan, you can defer part of your salary and income taxes until sometime in the future. Although it sounds simple, there are assumptions and potential risks that must be addressed before opting in. Long-term planning is essential to determine if a deferred compensation plan is right for you.
Deferred compensation plan – who benefits?
The vast majority of deferred compensation plans are used as an additional executive retirement benefit. Higher earners can save more obviously, and this perk allows them to do just that.
For example, an executive age 52 earning $350,000 can contribute $25,500 into their 401(k), which includes the $19,500 annual limit + $6,000 catch up for being 50+ (2020). That’s 7.3% of their income. If the executive is eligible for a deferred comp plan, they would have the ability to maximize their savings and defer taxes, and unlike a 401(k) which has contribution limitations, deferred comp plans have no limits, though employers may specify limits.
The retirement lifesaver
If you’re designated a highly compensated employee (HCE), a deferred compensation plan can be a retirement savings lifesaver. When you’re an HCE, there are limitations to what you can contribute to a 401(k). However, a deferred compensation plan can help lessen the retirement savings difficulty brought on by the HCE designation. Learn more about HCE’s in our post How to overcome being designated a highly compensated employee.
7 deferred compensation questions to ask yourself
Just because you’re eligible for a deferred compensation plan doesn’t automatically mean you should participate. Here are the 7 questions to determine the benefits and risks to see if the deferred compensation plan is right for you.
1. Is it safe to participate in the deferred comp plan?
Are you sure your employer will be able to pay your deferred compensation in the future? Unlike a 401(k), your deferred compensation account is not yours; it is the property of your employer and is subject to potential loss. If the company goes bankrupt or is unable to pay its bills, you may lose the compensation you deferred.
My recommendation – stay away from the deferred comp plan if you have even a hint of concern about the financial future of your employer.
2. Do you max out your contributions to your employer’s retirement plan?
There are two reasons why you shouldn’t think of participating in a deferred comp plan unless you’re maxing out your retirement plan contributions.
First of all, retirement account distributions are more flexible. In retirement, you can take out as much or as little as you need until age 72 when required minimum distributions kick in, but even then that’s just a minimum. A deferred compensation plan, on the other hand, is much more restrictive regarding when that deferred income is paid out.
Secondly, those retirement plan contributions are your property. Deferred compensation is not yours. It’s your employer’s until it is paid out to you, which may not be for many years.
3. Are you maxing out an HSA?
A health savings account (HSA) is tax-deductible, tax-deferred, and tax-free when used for health care expenses. If you’re eligible for an HSA, meaning you have a high-deductible healthcare plan (HDHP), then you need to max this out. For 2020, it’s $3,550 for single coverage, $7,100 for a family, and a catch-up contribution of $1,000 if you’re 55 or older.
An HSA is the best retirement vehicle ever invented. Yep, I said that. Learn why I love an HSA in 7 Ways an HSA Can Help You Now and In Retirement
4. How will deferring income affect your taxes presently and in the future?
When you defer income, federal income tax is also delayed, but you do pay Social Security and Medicare taxes. A deferred comp plan is most beneficial when you’re able to reduce both your present and future tax rates by deferring your income. Unfortunately, it’s challenging to project future tax rates.
This takes analysis, projections, and assumptions. Luckily, each year during open enrollment, you can adjust the amount of income you defer, but that doesn’t change what you’ve already deferred. This is the dilemma of a deferred compensation plan.
Tax laws change every 4 to 8 years, rates rise, rates decrease, or deductions and credits change. The further in the future you’re trying to estimate, the harder it is. The key is, the longer you have until receiving the deferred income, the smaller amount you should defer unless it’s apparent there is a tax benefit to deferring more significant amounts.
Special state tax move
Distributions from a deferred comp plan are subject to state income tax in the state in which the income was earned, even if you reside in a different state when receiving the distribution. There is a way to avoid this if the distributions are paid out over at least 10 or more years. That could come in handy if you move to a state with a lower income tax rate.
5. How much income should you defer?
The first part of this equation is figuring the tax ramifications. The second is determining your cash flow needs over the coming year. Can you afford to forgo income over the next year? It’s important to note that once open enrollment closes, you cannot change the amount until the following year (most times).
You need to get the amount right the first time. Deferring income, but then not having enough to live on, and using credits cards defeats the purpose.
6. When should you receive the deferred income?
The answer to this question is based on your employer’s deferred comp plan rules, your goals, and the results of your tax assumptions and current year cash flow needs. Generally speaking, your employer will provide some flexibility in distributions options.
The options could range from a lump-sum distribution at retirement, or the time you’re no longer employed, to a distribution schedule over a range of a specific number of years ranging from 3 to 20 years — the more flexibility in selecting your distributions, the better for you.
However, this is a strict distribution schedule. You need to sometimes select many years in advance, and once decided, you are required to take distributions on the dates chosen. This means that income will be taxed in the future year you receive it.
Please note that some deferred comp plans will allow for a change in your deferred comp elections only under certain conditions. Please always read the deferred compensation plan documentation provided to you by your employer.
Some deferred comp plans do allow distributions before you separate from your employer. It can come in handy, especially if you need to meet goals such as college tuition or a second home. Nevertheless, taking in-service distributions may somewhat defeat the purpose. Remember, when received, deferred compensation is taxable as income. If you’re still employed, it’s added to your income, which could increase your tax rate. My advice is to use a deferred comp plan on a limited basis, if at all, for shorter-term goals.
Typical deferred compensation distribution
Typically a deferred compensation plan begins payouts when you are no longer employed with the employer, whether that be through retirement or a job change. Understanding the distribution possibilities and tax implications is more difficult the further you are away from retirement.
7. How should you invest the deferred compensation?
Most deferred comp plans offer investment options similar to 401(k) plans, but you need to determine your risk tolerance and when you will be receiving the deferred compensation. If you have decades until you’ll take distributions, you may opt for more risk to increase your potential returns. If distributions begin relatively soon, you might select less volatile investments.
Keep in mind there is a potential for loss when your deferred compensation is invested. Your risk tolerance and time horizon should dictate the best course of action regarding investments.
Whether or not to participate in a deferred compensation plan is one of the more difficult decisions to make. You’re making assumptions of several unknowns. Often you think this is a no-brainer, but when you actually analyze the possibilities, that isn’t always the case.
There are many benefits to a deferred compensation plan, but it’s not a once-and-done decision. It’s essential to annually review the role deferred compensation will play in your savings and future cash flow, taking into consideration your situation and the current and future tax laws.
Are you wondering whether you should participate in your employer’s deferred compensation plan? Don’t make a guess, schedule an appointment with us to analyze your situation.