Deferred compensation is one of the most powerful tax minimization tools legally available. But because it’s uncommon—most companies limit access to top executives—it’s less frequently discussed. If you get an email from HR saying you’re eligible for a non-qualified deferred compensation plan, you may not realize what an amazing benefit just became available to you.
What is deferred compensation?
Deferred compensation (or deferred comp) is a two-party contract between you and your employer that essentially says, “Don’t pay me now; pay me later”. You get to define when later is. In the meantime, your employer directs your delayed payments into a deferred compensation plan.
By deferring your compensation, you lower your current taxable income. And with careful planning, you can schedule payment for when you are in a lower tax bracket (e.g., retirement).
Even if you are in the same bracket when your deferred comp is paid, you can still benefit from tax-deferred growth. Not only can you take any money you might save on taxes now and invest it, but the money within the deferred compensation plan has the potential to grow. The mathematics of tax-deferred growth are identical for a deferred compensation plan and a defined contribution plan, like a 401(k) or 403(b).
Benefits of deferred comp
Deferred comp offers two advantages (and one big disadvantage) compared to 401(k) plans.
The IRS limits how much you can contribute to a 401(k) plan each year. The limit is $20,500 for 2022 and $22,500 for 2023. (If you are 50 or older, you can contribute an additional $6,500 in 2022 and $7,500 in 2023.) In contrast, the IRS does not limit the amount of compensation you can defer. You could zero out your taxable income, in theory. Practically speaking, many companies limit deferral to between 50% and 90% of salary so you don’t disappear from payroll.
While 401(k) plans are designed to help you save for retirement, deferred comp can be used for anything. If your primary financial goal is retirement, a 401(k) is the first and best option: You might get a company match, and the funds are protected by ERISA laws against creditor claims (more on that below).
Of course, if you withdraw money from a 401(k) plan before age 59½, you typically face a 10% penalty. In contrast, a deferred comp plan can be used for any goal, and there are no withdrawal penalties. We have seen participants use deferred comp to save for college, buy a second home, fund a new business, and many other purposes.
The downside of deferred comp
If your company goes bankrupt, any money you have in a deferred comp plan could be at risk. While ERISA laws protect 401(k) plans, deferred comp plans are viewed like any other asset. To access your funds, you’ll stand in line with all the other creditors, and payment isn’t guaranteed.
That’s a very big caveat, so if you think your company might be financially unstable, DO NOT risk using a deferred comp plan.
That said, deferred comp plans tend to be limited to senior executives. Often these executives are in a position to spot any solvency concerns early and may be able to shut down the deferred comp plan and distribute plan assets. If these distributions are made at least six months prior to bankruptcy, they typically are not subject to creditor claims.
The Quorum approach to deferred comp
We tend to encourage any Quorum Private Wealth clients with access to deferred comp to use it. We work with these clients to determine how much to defer and the most advantageous time to receive deferred income. We look at deferred comp as one part of a holistic and detailed financial plan.
Quorum also provides education and communication for several deferred comp plans, meaning we are intimately familiar with both how they work and how employees can use them strategically. We offer detailed financial planning to each participant in the plans we work with.
If your deferred comp plan is administered by a large, hands-off company, consider working with an advisor to understand how the benefit fits in with the rest of your financial circumstances. Unlike 401(k)s, where you may be able to get away with spending 10 minutes enrolling, setting up contributions, naming beneficiaries, and selecting investments, deferred comp plans require more planning. A good advisor will ask you about equity-based compensation, outside assets, financial goals outside of retirement, and more.
While these plans can be incredibly powerful tax savings tools when used strategically, they can be “weapons of financial destruction” if they’re used carelessly.
Bottom line? If you are offered this amazing benefit, find a team that can help you take maximum advantage. If you have questions about how Quorum can help, reach out.
