The Ins and Outs of Deferred Comp Planning

For many executives and highly compensated employees, deferred compensation can be a great addition to the overall savings and retirement plan. Unfortunately, for many who use it, it’s often misunderstood and misused. Although it shares some similar characteristics to a 401k plan, there are a number of differences that require a bit more planning to be properly utilized. Understanding what it is and how it works in concert with your other retirement assets will allow you to properly leverage this tool to its fullest extent.

What is it?

Similar to a pre-tax 401k, deferred compensation allows you to defer income from today into a later date in the future. The idea behind it is to shift income from today (Where you’re likely in a high tax bracket) out into retirement (When you expect to be in a lower tax bracket). For executives with high amounts of base salary, bonuses, and stock compensation, this can be incredibly valuable.

Despite the tax similarities to a 401k, there are other factors that you need to consider as well. For starters, deferred comp plans are non-qualified plans. This simply means that it isn’t ERISA protected and would be subject to a company’s creditors if they file for bankruptcy. In addition, deferred compensation plans often require you to choose a payout election. Instead of choosing when you take a distribution like you would with a 401k, you’re required to choose a payout election at the time you elect a deferral. This payout election could span over several years or be paid out in a lump sum. Lastly, your deferral elections can typically only be made once per year. It isn’t nearly as flexible with adjustments like a 401k could be.

Given the lack of flexibility and the requirement to make decisions today that could impact you 5, 10, or 20 years down the road, it’s important to analyze these contributions carefully by asking yourself a number of questions.

Questions to Ask

• Do I expect to be in a lower tax bracket in retirement?
  Most highly compensated employees would answer this question with a “yes”, however I would recommend taking a deeper dive to confirm. Any of the items below could result in equal or higher tax rates in retirement, which would negate the benefits of the deferred comp in the first place.
  • High Pension Income
  • High RMDs
  • Net Unrealized Appreciation of company stock
  • Stock Grant or Stock Option vesting in retirement
  • Change in US tax code
• Does my income and cash flow support these deferrals next year?
  For executives, total taxable income can vary greatly depending on bonus targets and stock compensation. Deferrals should likely adjust upwards and downwards based on this income fluctuation.
• How strongly to I feel about the company strength over my timeline?
  For executives 1-2 years out from retirement, the risk of bankruptcy of the company might seem small. For an executive 25 years out from retirement, this might be a greater factor
• What are the other likely income streams I have in retirement?
  The payout election you choose should complement the other sources of income you have. For example, you don’t want a lump sum payout in year 1 of retirement if you also expect several years of stock compensation to hit your tax return that year too.
• Am I leveraging every other tax tool available to me?
  Deferred comp is a great tax tool, but tools like 401ks, Back Door Roth IRAs, Mega Roth, Donor Advised Funds, and Health Savings Accounts are great as well. Don’t just choose deferred comp because you think it’s the only place left to save.

Cleveland Wealth, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.