Pros and Cons of Deferred Compensation Plans

You may be able to reduce your current tax exposure, but it's important to know the risks.

Illustration of money trickling down in an hourglass

Savvy investors know the potential value of maximizing your tax-deferred 401(k) contributions. But there's a limit: For 2016, most employees can't contribute more than $18,000 to their plan. But for high-earning executives and employees looking for other ways to potentially lower their annual taxable income, a company-sponsored deferred compensation plan may offer additional benefits.

At the same time, though, these plans may expose you to risks not associated with a conventional 401(k). Employees considering participating in a deferred compensation plan, or companies thinking of establishing one, should weigh potential risks with potential rewards, says Lisa Kelley, CFP®, a Senior Wealth Planner at Wells Fargo Private Bank in Charlotte, North Carolina. 

"A deferred compensation plan gives you the potential to benefit from the compounding of long-term tax deferral and to save in a disciplined manner," she says. "Some people will say, 'Well, when I get my bonus, I'll put half of it away,' but then they get it and find other things to do with it. If you elect in advance that you're going to defer it, it gives you that discipline of savings. I've seen many of my clients accumulate significant retirement income by using that discipline."

Comparing deferred compensation and 401(k) plans
Deferred compensation plans are similar to 401(k)s in that they allow participants to defer a portion of their pretax income and place it in the plan. The contributions are deducted automatically from a regular paycheck or any bonus. Generally, the investment choices are the same as in the company 401(k). The payouts begin when the participant retires or reaches a specific age he or she agreed to when joining the plan. Because high earners may find that they are in a lower tax bracket in retirement, shifting income to the post-work years may provide some tax efficiencies.

"A deferred compensation plan gives you the potential to benefit from the compounding of long-term tax deferral and to save in a disciplined manner." — Lisa Kelley, CFP®, Senior Wealth Planner, Wells Fargo Private Bank

There are four big differences to consider when deciding between 401(k)s and deferred compensation plans, or both. 

1) Contribution limits 
The amount you are allowed to set aside in deferred compensation plans is set by the company and not by federal law. "With a deferred compensation plan, in theory, you could put almost all of your money in there," Kelley says. "And that's really the draw for most people: If you earn a substantial income and you want to be able to save more than that 401(k) limit, this gives you the opportunity to do that. If you wanted to defer half your annual bonus, you could do that in a deferred compensation plan, where you may not be able to do that in a 401(k) plan."

2) Protection levels 
Because deferred compensation plans are not covered by the Employee Retirement Income Security Act of 1974 (ERISA), participants have fewer protections than 401(k) contributors if the company were to run into financial trouble. And because the company is holding the account, "you are essentially a creditor of the company," Kelley says. "It is them promising to pay you at a future date, so if the company goes through a bankruptcy, you could potentially lose that investment."

3) Payout options
When participants put money into a deferred compensation plan, they have to set a payout date, which can be either at retirement or a specific year. The payout can come as a lump sum or withdrawals over a five- or 10-year period, depending on the plan design. By contrast, Kelley notes, 401(k) plans require investors to begin taking withdrawals at age 70 1/2, and there may be penalties for withdrawing funds prior to age 59 1/2. 

"If you take your payment from a deferred compensation plan over a 10-year period, you maximize the tax deferral, but you have that creditor risk for another 10 years," Kelley notes. "In talking to clients who are executives, sometimes the reaction I've gotten is 'I'm OK in making the decision to defer income now and put it in this plan because I understand what's going on with the company. But if I'm retired and I have that exposure for another 10-year period, I'm not as comfortable with that.' That's the decision you're weighing."

4) Rollover options
If you leave your employer, it's easy to roll over a 401(k). But if you have a deferred compensation plan, the payout must begin at termination. "That's one key risk: If you say 'I'm going to defer a large sum of money because I want to defer the taxation on this until I retire,' and something happens, such as losing your job or getting a new job, you could have a large payout you weren't expecting. You don't have the option to roll it over to an IRA or leave it in the account. If you leave, it starts paying out, and that could create unexpected tax issues."

Be sure to consult with your wealth and tax advisors so you can make informed decisions as you establish your retirement accounts. 

David Milstead has written for The Globe and Mail of Canada and The Wall Street Journal.

Image created from iStock

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Wells Fargo Wealth Planning Center, part of Wells Fargo Private Bank, provides wealth and financial planning services through Wells Fargo Bank, N.A. and its various affiliates and subsidiaries.

Wells Fargo & Company and its affiliates do not provide legal advice. Wells Fargo Advisors is not a legal or tax advisor. Please consult your tax or legal advisors to determine how this information may apply to your own situation. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are prepared.

This information is provided for educational and illustrative purposes only.

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