considering should i defer my compensation

As a corporate executive, you may be offered the opportunity to participate in your firm’s deferred compensation plan. To understand whether it makes sense for you to defer your compensation, let’s discuss non-qualified deferred compensation plans and the potential benefits and drawbacks of participating in these types of plans.

What is a deferred compensation plan?

A deferred compensation plan is any plan where an employee can postpone or defer receipt of a portion of their earned income until some time in the future. The intention is to reduce your currently taxable income and delay taxation until you receive the income in the future.

Non-qualified vs qualified plans

You are probably already familiar with qualified deferred compensation plans. Common retirement plans such as pensions, 401k, and 403b plans are qualified deferred compensation plans. ERISA covers each of these plans and offers greater tax advantages over non-qualified plans in exchange for more stringent requirements such as universal access to the plan and limitations on plan contribution amounts.

Non-qualified deferred compensation (NQDC) plans still have rules, but the employer and employee have more flexibility within those rules. These plans are often offered to executives and may be called 409a plans or Supplemental Executive Retirement Plans (SERPs). They are often put in place to allow executives to defer more income than they can with the company’s 401k plan.

Rules for Non-qualified deferred compensation (NQDC) plans

In order to receive tax advantages, non-qualified deferred compensation plans must adhere to certain rules. There must be a written plan describing the specifics of the arrangement. The plan must include the compensation amount to be deferred, the schedule on which the deferred amounts will be paid in the future, and the triggering event. In addition, the employee must make an irrevocable election to defer compensation and specify the compensation amount before the year in which the compensation is earned.

The Amount

When determining the amount to be deferred, you will need a reasonable estimate of your income for the following year. Also, consider not only your tax burden for the next year but also the potential tax burden in the future when you will be receiving the deferred compensation. And remember, these funds will be out of your reach until the triggering event. More on that later.

timing and trigger events in non-qualified deferred compensation plansThe Schedule

The plan must specify the schedule on which the deferred amount will be paid in the future. This could be a lump sum, or the payouts could be spread out over a period of years. Remember that receiving the total amount deferred and any investment earnings on that amount in one lump sum could leave you in a less desirable tax situation than had you not elected to defer any of the income. When deciding on a payout schedule, remember to consider any pension income, social security, or other income you will be receiving at the same time. And, of course, you must consider your financial goals and the tax implications.

Triggering Event

The plan must specify a triggering event or events. Retirement is the event that most participants have in mind when electing to defer income. However, many plans also include options for a fixed future date, death, or disability. In addition, many plans include a change in ownership or control of the company as a triggering event. For a select few plans, certain emergencies will also act as a triggering event. The benefit of NQDC plans, compared to qualified plans, is that there is no penalty for distributions before age 59 ½. Therefore, if the triggering event occurs before the employee reaches age 59 ½, while the income will be subject to income tax, it will not be subject to the 10% penalty. In addition, there are no Required Minimum Distributions (RMDs) on NQDC plans.

Another requirement is that the agreement must be in place prior to the year in which the compensation is earned. As a participant in an NQDC plan, you may be asked to enroll during the summer for the next calendar year. Not only is this requirement stipulated by the IRS, but knowing how much income is being deferred by participant employees allows the employer to plan for the amount of compensation expected to be paid out for the coming year.

Trade-offs

As usual, there are trade-offs associated with the tax advantages of an NQDC plan. For the employer, unlike with qualified plans, with a non-qualified deferred compensation plan, the business cannot take a deduction for the amounts deferred until they are actually paid out to the employee. As the employee deferring income, you have the opportunity to reduce your tax bill currently, and with a non-qualified plan, there are no limits imposed by the IRS on the amount you can defer. However, your employer may impose limits.

The trade-offs for reducing your current tax bill include loss of control over investing, loss of control over the timing of the income, and even potential partial or total loss of the deferred income. When you enter into the arrangement with your employer to defer, you agree to the future payout schedule. You do not have the option to accelerate that schedule or further defer that schedule. For instance, if you have an unexpected expense or even an unusually large tax bill, you cannot access the deferred funds until a triggering event. On the flip side, you may lose control over a large payout. In many deferred compensation plans, a change of ownership or control is included as a triggering event. If your company is purchased or your division is spun off, it may be considered a triggering event. 

In addition, the method of payment may be different for certain types of triggering events. For instance, in the case of a change in ownership, the deferred compensation may be paid out in a lump sum. In practical terms, accelerating all of the deferred compensation into a single year may be painful in tax terms. The effect of the lump sum payout may be compounded by a retention bonus offered by the new employer to entice executives to stay on through a transition period. That large increase in income in a single year can actually leave you in a worse situation than if you had not deferred the income in the first place.

Another factor to consider is that most of these plans are unsecured. In other words, the funds to pay you in the future are not set aside in an account with your name on it. In order to take advantage of the preferred tax treatment, the funds must remain among the company’s general assets and are subject to the claims of creditors. So, if the company experiences hard times or even bankruptcy, it may not have the funds to pay you in the future. In that case, you would lose the income you earned and deferred. 

When participating in an NQDC plan, you are receiving a promise to pay in the future in exchange for reduced taxes currently. You have to evaluate whether you believe that the company will be able to honor that promise.

Other considerations

As mentioned above, the payout schedule for the future is set prior to deferring your income. You do not have the option to draw income as you wish or further defer the income. Regardless of your income situation from other sources, you must take the deferred income on schedule. In some cases, this can bring about a significant tax burden, especially if the payout was triggered by separation from employment and you have moved on to another executive position.

In conjunction with an NQDC plan, you may be offered investment options for the deferred amounts. Since the deferred income isn’t actually held in an account for you, it cannot be directly invested. Instead, the investment that you select is intended to determine the rate of return at which your deferred compensation should be credited. Among the factors to consider and compare is the rate of return that you could earn on the after-tax funds if you did not defer the compensation. Keep in mind that all deferred compensation and investment returns attributed to that compensation will be taxed at ordinary income tax rates when paid out. Long-term capital gains on any after-tax amounts invested would be taxed at lower long-term capital gains rates.

Should you defer income?

Having the option to defer income can be a really useful tool in income and tax planning. If you are close to retirement and are comfortable that the company will be able to honor its promise to pay, the deferral of compensation and taxes can reduce your overall tax burden. One key factor to consider is the difference between your current marginal tax bracket and your anticipated tax bracket when the income will be paid out. In some cases, the payout will be during retirement. But, in other cases, depending on the payout schedule you selected, it could be at a fixed date – perhaps when you anticipated an expense like tuition.

When choosing a payout schedule, be sure to understand the implications of your triggering event. Separation from your employer could be your retirement, but it could also result from an involuntary separation such as a layoff. Or it could result from accepting a position elsewhere.

What happens if the deferred income begins to be paid out on schedule in each of those situations? In some cases, the deferred compensation can allow you to retire early and help bridge the gap until you are eligible for Medicare. Certainly, there are scenarios in which a Non-qualified Deferred Compensation plan is an excellent option. However, it is critical to be sure that you understand all provisions of the plan and have excellent tax and income planning in place to ensure that you reap all of the benefits available to you.

This article is intended to be educational and thought-provoking rather than financial advice. hen we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals. We examine these factors and many others during our financial planning process to determine appropriate financial strategies for YOU.

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