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 is 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 taxes) until you’re in a lower tax bracket. 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.
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, the 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 have these distributions received in retirement when you’ll likely be in a lower ordinary income tax bracket compared to your marginal tax bracket 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, tax rates, 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 (i.e., in retirement) vs. paying now?
- 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, contributing the amount needed to receive the maximum employer match can be a benchmark to aim for when determining 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 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 out the distributions into the first few years of retirement to stay in lower tax brackets. Be aware of other income sources in retirement, such as required minimum distributions from retirement accounts, Social Security benefits, and strategies that involve realizing income, such as Roth conversions. A great way to offset these income sources can be coordinating with any charitable donations that are planned for retirement (such as donor-advised fund contributions).
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 their annual open enrollment period. Once you’re enrolled, you’ll be able to update your elections for that particular year. You can elect if you want 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 per IRS guidelines. However, these plans commonly allow participants to adjust the timing of when payments occur if they satisfy the requirements below.
- To further delay an income payment, it must be scheduled at least 12 months from the current date to be eligible for a change.
- Deferred income payments must be pushed out at least five years from the current planned payment date when changing elections.
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.
