Nonqualified deferred compensation plans can be a valuable tool for retirement planning, especially for high-income earners who want to defer more income than qualified plans, such as 401(k) plans, allow. However, these plans also involve significant risks and demand a sound strategy to reap the most advantageous benefits. If you’ve been invited to participate in your company’s deferred compensation plan, here’s what you should know before you enroll.
What’s a deferred compensation plan?
When looking at nonqualified plans — also referred to a 409A plans or supplemental executive retirement plans (SERPs) — there’s a lot of fine print involved. But put simply, an employee participating in a deferred compensation plan agrees to defer payment of compensation, up to a certain amount per year, to a date in the future.
A deferred compensation plan could make sense if you’ve maxed out your 401(k) plan contribution, and you’re looking for ways to defer more income (and possibly taxes) until retirement or another future year. Most participants choose to defer compensation until after retirement, assuming they’ll be in a lower tax bracket once they’re no longer earning wages. That assumption should be modeled carefully, especially with today’s tax rates now extended beyond 2025 and future income sources still uncertain.
What are the risks of an unfunded deferred compensation plan?
While these plans can serve as a valuable tax-planning tool, they also come with significant risk. Unfunded deferred compensation plans are essentially an unsecured “promise to pay.” Payment is subject to the continued existence and the financial health of the company.
What’s more, bankruptcy offers no protection. If the company were to declare bankruptcy, your contributions could be used to pay off the company’s debts, leaving you and the other participants with nothing.
Why participate in a deferred compensation plan?
With these potential pitfalls, why would anyone want to participate? First, deferred compensation contributions are excluded from your current income, potentially lowering your income tax burden. Secondly, funds within the plan are invested and grow tax-deferred. Your specific investment options will vary with your company’s plan. Third, you can plan to receive distributions in retirement or another lower-income year, when your marginal tax rate may be lower than while you’re still working.
Before you enroll
Should you participate in an unfunded deferred compensation plan? There’s a lot to consider, including cash flow, company risk, current and future tax rates, the timing of future income, and the investment options that are available. Here are several questions to ask.
- Do I have the cash flow/liquidity that allows me to defer more income?
- Have I diversified my personal balance sheet enough to account for the business risk?
- Will the business sustain success?
- Will I receive a material benefit by pushing my tax bill into a future year versus paying now, given current tax rates and my projected retirement income?
- Are the investment options within the plan the best for me and my investment portfolio?
Election considerations
Once you’ve decided to participate in the plan, you should consider three main questions.
1. How much should you contribute to your deferred compensation plan?
To determine the contribution that makes sense for you, first decide how much exposure you’re comfortable with. If the company were to declare bankruptcy or go out of business, can you still maintain financial stability without any of the compensation you’ve deferred?
Beyond that, creating a savings plan coordinated with your retirement projection and factoring in employer contributions will help you determine your level of contribution. If there’s an employer match to the plan, the maximum match can be a great starting place when considering how much to contribute. The employee contributions to the plan may not be capped, but the contributions eligible for an employer match often are.
Lastly, plan for large upcoming expenses and tax bills to confirm that you’ll have access to cash when needed. Strategies to assist with liquidity hurdles often include deferring your bonus (if allowed), or selling company stock held in other areas of the balance sheet (i.e., options, common stock, etc.) The former can sometimes alleviate illiquidity issues caused by reducing your recurring salary payments, while the latter does the same while lowering exposure to a single company on your balance sheet.
2. How should the funds be invested?
Generally, your investment options will depend on the plan your company offers. To decide which option is best for your situation, ask yourself, “When will I need the money? How much risk can I tolerate? What rate of return do I need to achieve my goals?”
It’s also important to ensure that the investment allocation within the plan (i.e., the mix of stocks, bonds, real estate, etc.), keeps you in line with your overall portfolio targets when viewing this account together with 401(k)s, IRAs, and other brokerage/investment accounts.
One additional benefit of a deferred compensation plan is that dividends and interest payments received aren’t currently taxable. This makes your deferred compensation plan a great home for income-producing investments.
3. When should distributions start and at what pace?
To avoid adverse income tax situations, consider spreading distributions over the first several years of retirement or another planned lower-income period, rather than defaulting to a lump sum. The right pace depends on your broader tax picture, including wages, equity compensation, Social Security, charitable giving, Roth conversions, capital gains, and required minimum distributions (RMDs). Under current rules, many retirees generally begin RMDs at age 73, with age 75 applying to later birth cohorts; designated Roth accounts in 401(k) and 403(b) plans are not subject to lifetime RMDs. Modeling these items together can help avoid “stacking” deferred compensation on top of other income in the same year.
How to get started with a deferred compensation plan
Typically, if you’re eligible to apply, your company will notify and invite you to sign up during its annual open enrollment period. Once you’re enrolled, you’ll be able to update elections for that particular year. You can elect whether to participate, how much to defer that year, and when you’d like that year’s contribution to be paid out.
Once elections are made, it’s difficult to change elections from prior years under IRS guidelines. These plans commonly allow participants to further delay payments only if the change satisfies the requirements below.
- A subsequent deferral election generally must be made at least 12 months before the scheduled payment date and cannot take effect for at least 12 months.
- The payment must generally be deferred at least five years beyond the date it otherwise would have been paid.
The bottom line
Despite the risks, deferred compensation retirement plans offer participants several benefits, including structured savings, tax deferral, and investment growth prospects — but the complexities require careful consideration. Consulting with a qualified professional is a key first step toward determining what options are right for you.
Key takeaways
- Nonqualified deferred compensation plans, including 409A plans and SERPs, allow eligible employees to defer compensation to a future date.
- When thoughtfully incorporated into a financial plan, deferred compensation plans can serve as a valuable planning tool for individuals seeking additional tax-deferral and investment growth opportunities beyond traditional retirement plans.
- Before enrolling in a deferred compensation plan, it’s important to access factors such as cash flow needs, company risk, future tax considerations, and available investment options.
