Deferred compensation, or delaying receiving part of your before-tax earnings until a later date (such as when you retire), can sound appealing from a savings and tax-efficiency standpoint—especially for those who have maxed out other tax-deferred savings vehicles such as 401(k)s and IRAs. Not all employers offer such plans, but employees of companies that do may find themselves wondering if using the strategy is right for them.
Here, Lisa Kelley, Senior Wealth Planner at Wells Fargo Private Bank, outlines the potential benefits and drawbacks of these nonqualified deferred compensation plans. Be sure to consider these pros and cons before locking away a portion of your annual income until a future date.
Potential benefits
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1. Lower tax exposure
“For most high-earning employees, the biggest advantage of deferred compensation is the tax benefit,” Kelley says.
For example, someone who pays taxes at the highest tax bracket (currently 37%) may want to delay some of their income until retirement. This could potentially put them in a lower tax bracket now while working and later in retirement.
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2. Preservation of retirement funds
Kelley says deferred compensation can help fill the time after your retirement date and before you’re required to take distributions from your retirement accounts. For example, someone who puts $2 million into a deferred compensation plan with a 10-year payout would receive about $200,000 a year for 10 years. If timed correctly, those payments would cease at roughly the same time the individual would begin drawing required minimum distributions from 401(k) and IRA accounts (age 70 ½).
“For high-earning individuals, deferred compensation can provide a path to preserve tax-deferred compounding,” Kelley says.
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3. Creation of a savings mindset
When weighing the pros and cons, Kelley notes one big advantage deferred compensation may have: It helps reinforce a healthy savings mindset.
“For some people, deferred compensation is an automatic investment,” she says. “It takes away the temptation to spend.”
Potential drawbacks
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1. Being a nonsecured creditor
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.”
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2. Overestimating how much you save on taxes
Kelley says that deferred compensation plans can add to the list of income streams that make it too easy to underestimate your income, even during retirement. “People who earn millions while working frequently have stock options, pension plans, IRAs, 401(k) accounts, rental property, and other accumulated assets that continue to generate income,” Kelley says. “If you have those other income sources as well as your deferred compensation, you can hit the highest tax bracket pretty quickly.”
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3. An unexpected payout
If you change jobs, your deferred compensation could become a sudden payout, which can present tax implications. “Anyone contemplating deferred compensation will want to keep that possibility in mind,” she says. “Especially those who change jobs frequently.”If you are considering participating in a deferred compensation plan, be sure to weigh potential risks with potential rewards, says Kelley. She recommends reviewing your long-term goals and opportunities with your wealth and tax advisors so you can make informed decisions as you establish your retirement plan.
