Is Deferred Compensation A Good Idea?
June 18, 2009 – 6:45 am
Larger corporations sometimes offer their executives the choice of “deferred compensation.” Although I won’t personally be eligible for this until I’m a director or VP, when I heard HR mention this during my job orientation I became intrigued.
What is “deferred compensation?”
Deferred compensation (DC, which is my acronym, not an industry standard) is an arrangement where and employee (or business owner) defers some of their income until a specified date. According to some definitions retirement accounts, pensions, and some life insurance policies would be considered deferred compensation. What I’m most interested in discussing today, however, is the choice of deferring some of your regular income through a deferred compensation (DC) program.
“Qualified” versus “Non-Qualified” Deferred Compensation Plans
“Qualified” plans meet IRS guidelines that can be rather strict, including non-discrimination requirements, limited employer contributions, and additional reporting requirements. “Non-qualified” DC plans also exist, and they are considered “non-qualified” because the don’t meet the IRS guidelines to be “qualified”. Employers miss out on tax deductions in non-qualified plans until the employees’ funds are actually paid out, and the benefits to the employee could potentially be taxable even if the employee doesn’t take possession of the funds. It appears that non-qualified plans primarily benefit business owners who want to set some business earnings aside.
I’m assuming my plan at work is a qualified plan, and if so such a plan may provide the following benefits:
- tax advantages. Like regular 401k’s, “qualified” DC plans provide a way to defer taxes on income. Taxes would not be due until the money is paid out to you.
- DC can be rolled over into an IRA
- benefits grow tax free
- you can contribute more total dollars to a DC plan than a 401k. By the time I am eligible for this program in my company I’d likely be a “highly compensated employee”, which means I may not be allowed to contribute up to the maximum federal 401k limit (15,500 this year).
What are the downsides? Here are a few I can think of:
- withdrawals are taxed at the ordinary income tax rate, so there are no tax advantages for long term capital gains. Similar to IRA’s and (regular) 401k’s clearly some tax planning would be important when choosing to participate in a DC plan.
- I’m not clear on what kind of investment options are available. If it’s all over-priced (expensed) mutual funds I’m more likely to pass.
- From what I’ve read I believe the deferred compensation is at risk should the company get sued or go out of business. Unlike 401k funds that are yours, deferred compensation is a liability from the company to you and to my knowledge is not safe from lawsuits or business financial troubles.
- It’s unclear to me how withdrawals are made. Do you have to agree to a fixed schedule, or can you decide how much to be “paid” separately each year?
In summary, deferred compensation plans may be a valuable tool should this choice be available to you at some point in your career. Careful planning however is a must, and deciding to participate and how much to contribute will require some work and several assumptions. If you spend less than you earn, then clearly you don’t need all of you income immediately. Therefore in the future it is reasonable to assume that if you life a frugal lifestyle or try to save your raises that you may have quite a bit of additional income to defer. I personally wouldn’t use such a program as the primary component of my savings plan, but it might be worth including it based on your own situation.
Below are a few other ideas I think might be worth investigating if you can use a DC plan. All of these ideas, however, would need to be individualized to your own situation and may require DC plan flexibility that might not be available:
- You could potentially adjust the combination of your deferred compensation and 401k contributions to maximize the company match. I don’t know if there is a match on DC at my firm, and I don’t know if it would be in addition to the (small) 401k match we have or if it would be a swap. My guess is that the match would have to be in addition to the 401k match or that there is no match.
- You could potentially use DC to drop your family income level down low enough so that you could contribute to a Roth IRA. I think the married filing jointly limit is somewhere around $150,000/yr (wouldn’t it be nice if I had that problem!). You may not have an issue with that income limit now, but as your investments grow it’s important to think through decisions now that could give you flexibility if you ever get to that point. I also recognize that in 2010 you’ll be able to convert regular IRA’s to Roth’s regardless of income limitations, but it’s unclear if that capability will remain available forever.
- If you live frugally AND think you’ll be able to control your retirement income then a DC program might be able to save you some on taxes. Similar to withdrawals from an IRA or 401k, if you don’t receive much earned income or interest from your investments during your retirement then any withdrawals would be at a low tax bracket. This would require your retirement income to be flexible though. If your retirement is funded through a monthly pension for example you won’t be able to control your payments from one year to the next. If you sell tax-efficient securities that have appreciated to provide your retirement income, however, you might choose to skip withdrawals for a few years and take DC payments (or regular IRA distributions) as a way to pull money out at a low tax rate.
Image Credit: Stevie-B
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