Should you consider deferring compensation as part of your financial plan?

Suppose you are a high-earning executive who regularly maxes out your 401(k) and IRA, and you are looking for additional tax-efficient ways to save for the future. If your company offers a deferred compensation plan for top executives and you haven’t already enrolled, now may be the time for a closer look. You could defer a portion of your salary or bonus, let it grow within the plan and pay taxes only when you receive the income years later.

“These plans can be a powerful complement to your savings strategy for retirement or other goals,” says Amy Permenter, Head of Corporate Executive Planning, Planning Center of Excellence, Bank of America Private Bank. “But there are a lot of variables, so it’s important to consider the benefits and risks before deciding.” Here, Permenter addresses some plan basics.

How do executive deferred compensation plans work?

Unlike 401(k)s and other qualified plans that are typically open to any employee and are subject to the rules and protections of the Employee Retirement Income Security Act (ERISA), nonqualified deferred compensation plans, or NQDC, are generally exempt from ERISA requirements. NQDC plans are typically offered as an additional income deferral or savings vehicle to employees above a certain income threshold.

Plans vary from company to company. Essentially, they enable you to defer a portion of your income or bonus, often up to a cap set by the company, and to select when you would like to receive the money—say, upon retirement, or at a time when you know you’ll face a major expense. Inside the plan, the money can grow with federal and state income taxes deferred until you receive it. (In general, you'll owe taxes for Social Security, Medicare and unemployment insurance in the year the compensation is deferred.) Each year, you can determine whether to participate and how much of your income to defer. But your decision must be made before the start of the year when you will earn the money.

Why should I consider participating?

As you rise in management and your wealth increases, deferring a percentage of your income can make a significant difference in your current tax obligation. The higher your current tax rate, the greater the potential advantage. When you receive the money later, you could be in a lower tax bracket, or your situation may have changed in other ways that could affect your taxes. For example, some states have no state income tax, and under certain circumstances, moving to such a state and receiving NQDC plan distributions in 10 or more annual payments could mean a reduction in your state taxes. Unlike with 401(k)s and IRAs, the IRS does not limit NQDC plan contributions, and there are no required minimum distributions (though your plan may have its own rules and limits).  

Another advantage: While money in a bank account has a way of getting spent, these plans offer a systematic, disciplined approach to saving. Contributing, say, $20,000 to $50,000 a year over 15 or 20 years can be very meaningful. For participants who plan to retire early, NQDC plan distributions could provide cash flow and enable you to avoid taking premature withdrawals from your other retirement funds or filing for Social Security benefits.

If I move forward, what decisions will I have to make?

There’s flexibility in how much you contribute, how the money will be invested and when you’ll receive it. Each decision matters. Once you’ve chosen to defer the income, your deferral decision is irrevocable. Unlike with a 401(k), even if your income picture suddenly changes, it’s nearly impossible to access the money in an NQDC plan early. Be sure to understand your cash flow and ensure that your remaining income will cover your expenses and other needs.

Depending on the terms of your company's plan, you also get to decide when to begin withdrawing the money from an NQDC plan. You may choose to receive a lump payment, which could help you meet a major expense, or you could stretch the payments over several years to spread out your taxable income. While you can’t withdraw the money earlier than planned, you may have the option of pushing out the time when you’ll receive it. This can be a good option if you have plenty of liquidity and don’t need the income. Just keep in mind that if you change the distribution election, you must delay receipt of the funds for at least five years beyond when you would otherwise have taken the payment.

You’ll also likely have a range of investment choices to consider—often, a variety of funds such as those in your company’s 401(k). Depending on how soon you’ll need the money, you could choose to invest conservatively or aggressively, and you may need to adjust your asset allocation and investment choices to reflect changes in your circumstances or in investment markets during the years between income deferral and distribution. Your private wealth advisor can help you align the asset allocation in your NQDC plan with your overall portfolio.

What other risks should I consider?

Future tax rates are impossible to predict. If rates are substantially higher when you begin taking withdrawals, that could reduce or eliminate the benefit of lowering your taxable income in the year of deferral. If you plan to retire to a state that has a lower tax rate, selecting a different form of distribution may produce a more favorable tax outcome. Moreover, these plans are generally exempt from ERISA protections and are generally unfunded. If your company fails, you’ll go to the back of the line as a general creditor and might receive only a portion of the money you’re due. It’s best practice to max out your 401(k) or other qualified plans, and only contribute money to an NQDC plan that, if the worst happens, you can afford to lose.

How can Merrill help?

Busy executives may be tempted to scan their company’s plan and make quick decisions based on conventional wisdom or something they’ve heard from a colleague or friend. But the details matter. Your Merrill team can help you understand the specifics of your company’s plan and help you develop a strategy that fits with your long-term financial objectives.