‍Waiting to collect can create tax savings and compound growth

Many companies offer deferred compensation plans to their high-ranking corporate executives, allowing them to set aside a portion of their current earnings for future payout—often at retirement. If you’re new to this concept, it may seem counterintuitive at first. After all, why would anyone voluntarily choose to get paid years from now versus as soon those funds become available? The more you learn about deferred compensation, however, the more it may sense as an effective strategy for you—particularly if you’re a high-income-earner—to optimize tax-savings and build long-term wealth.

As you explore your options, here are some answers to common questions about deferred compensation.

1. Is deferred compensation related to a tax-deferred retirement plan?‍

Chances are you’re already familiar with your company’s 401(k) plan and may also have a traditional IRA, which stands for Individual Retirement Arrangement by the IRS, but are commonly known as Individual Retirement Accounts.  These widely available accounts are called “tax-deferred” because you don’t pay taxes on the investment earnings until you make withdrawals in retirement, at which time the money is taxed as ordinary income. Additionally, a 401(k) is known as a “qualified account,” which means it must be structured to meet specific IRS requirements.‍

A deferred compensation plan is different. First off, these plans are usually only offered to a company’s senior executives. Secondly, they are typically not subject to the same strict IRS rules, which means the terms, such as contribution limits and payout timelines, are defined by the company. For this reason, you may see the plan referred to as a non-qualified deferred compensation (NQDC) plan.

2. How do deferred compensation plans work?

The first thing to know is that deferred compensation plans are optional. You’re not required to participate and could elect to receive all of your compensation in the year you earned it. If you do choose to participate in the NQDC, you must make that decision before the start of the year in which you’ll earn the money.  Opting in allows you to put a portion of your compensation (salary or bonus money) into a separate account held by the plan. The plan may have a cap for how much you can contribute, and you’ll need to select a distribution schedule—that is, when you’ll receive the money—in advance. You won’t be able to access the funds until your chosen date arrives. Once you contribute to the plan, you’ll have input as to how that money is invested, and the funds will grow tax-deferred until the distribution date. When you receive a distribution from the plan, the money is taxed as ordinary income.

3. What’s the benefit of participating in an NQDC plan?

There are several reasons why deferring compensation can be beneficial. One of the most important reasons is tax deferral. Your years as a top executive will likely be the highest-earning period of your life, potentially placing you in the high income tax bracket. Deferring some of your compensation will lower your taxable income for the current year (potentially dropping you into a lower tax bracket). Also, you may be in a lower tax bracket after you retire, which means the money you withdraw from the plan would be taxed at that lower rate. In summary, deferring income strategically could ultimately save you a significant amount of money in taxes.

Beyond the tax advantages, the more flexible rules and customizable payout schedule of an NQDC plan may help you manage your needs for retirement savings and cash flow. For example, the NQDC plan enables you to put away more tax-deferred savings than the federal 401(k) limits allow, supercharging your wealth-building power. And, if you plan to retire at a relatively early age, you can schedule NQDC payouts to occur before age 59 and a half (the age at which you’re able to access your 401(k) or IRA funds without penalty).

4. Are there risks involved?

There are some potential downsides to consider. First is the binding nature of the NQDC. Once you agree to the terms of the plan, you can’t later change your mind about how much income you defer or when it can be withdrawn. This creates illiquidity risk, as you will not be able to access those funds until the preset distribution date, which might be many years in the future. Also, failing to time your distributions strategically could negate the tax deferral benefits if your income in the future is higher than anticipated and keeps you in a high tax bracket. Lastly, if your company happens to fail and/or go bankrupt, you could lose some or all of the money they were holding for you. For that reason, it’s advisable to only accept an NQDC plan from a well-established, financially secure organization.

5. How can I tell if deferred compensation is right for me?

Generally speaking, a NQDC could make sense for you if you’re currently in a high tax bracket, you’re already maxing out your 401(k), and you’re sure you can live without a certain portion of next year’s income. But don’t make the mistake of rushing to judgement. Your specific financial circumstances should weigh heavily in the decision. That’s why it’s best to consult an experienced financial advisor who can help you fully understand the terms of the plan, anticipate your total compensation and tax obligations, and develop a strategic plan to best meet your goals for retirement.

Reach out to Quotient Wealth Partners for further information and guidance. If you’re looking for navigating your retirement benefit options, schedule a complimentary, no-obligation meeting with an experienced financial advisor today.