It’s that Time of Year Again for Executives – How much should you defer into your deferred compensation plan?

By Kelly Metzler, CFP®

A nonqualified deferred compensation plan offers executives and key employees another way to save for retirement on a tax-deferred basis.

If offered by your company, you’ll need to decide whether to participate, and if you do, you’ll have a designated enrollment period to make your deferral elections. Elections must be made before the start of the year in which you earn the income, so many companies have enrollment periods in November and December.

In the article, we talk about some of the key decisions you’ll need to make during enrollment, and what factors you should consider.

Should You Participate in Your Company’s Deferred Comp?

Deferred compensation plans can be a useful tool to boost your retirement savings. They allow you to defer additional income on top of your 401(k) contribution. This can be helpful for high-earning executives since 401(k) contributions are limited: just $22,500 in 2023, or $30,000 if you’re 50 and older.

There is no IRS limit on how much can be contributed to a nonqualified deferred comp plan, though some companies may establish their own deferral limits.

The key advantage of a deferred comp plan is the deferral of income taxes. Income that you defer into the plan is not taxed until it is distributed. The longer the period of tax deferral, the more advantageous. The benefit becomes even greater if you can defer income out of a high tax bracket, and receive the income when you are in a lower tax bracket, such as in retirement.

The advantages of these plans come with some strings attached though. There are restrictions and risk with nonqualified deferred comp plans. It’s important that you understand these before you decide to participate, as well as your plan’s specifics.

Risk & Restrictions

Unlike with your 401(k), income you defer into a deferred compensation plan is still considered an asset of the company. This means that in the event of a company’s bankruptcy or insolvency, assets in the deferred comp plan are subject to claims by creditors.

Deferred compensation plans don’t have age requirements for distributions like other retirement accounts. They can also be distributed while you’re still working. However, there are other limitations.

Once you make your deferral election, the deferral amount is irrevocable. You can’t change it mid-year, and instead you’ll have to wait until next year’s plan enrollment.

It can also be challenging, or even impossible depending on your company’s specific plan, to change the timing or form of payment you’ve elected. Even if a plan allows you to modify the payment date and/or form of payment, you must do so at least 12 months prior to the scheduled payment date. Also, any changes will delay the payment date by at least 5 years from the originally scheduled distribution. So, making a careful and strategic decision during your enrollment period is critical.

Decisions to Make During Plan Enrollment

You’ll have a few decisions to make during plan enrollment.

First, you’ll decide how much to defer. This is usually a percentage of your salary and/or bonus.

Then you’ll need to elect when you would like your deferrals distributed – either in a specific year or tied to an event like retirement or separation from service – and the form of payment (lump sum or installments).

You may also need to choose an investment allocation for the deferral. Note that investment changes are generally allowed throughout the year.

Some plans may allow for separate distribution accounts. This means that you could have multiple buckets of money, each with a different distribution date and form of payment.

How Much Should You Contribute to Your Deferred Compensation Plan?

How much to defer will depend on your cash flow and how much of today’s income you’re willing and able to set aside for future goals.

Also, what are your retirement and other financial goals, and how much do you need to be saving on an annual basis to reach them? You should make sure you’re maxing out your 401(k) before you start deferring into a deferred comp plan. But saving into a 401(k) alone isn't likely to enable you to achieve the same comfortable lifestyle as in your high-earning years.

You should also consider what other financial assets you have. If you don’t have non-retirement account assets, you may want to think about first building up a taxable brokerage account that can be used for unplanned expenses or expenses prior to age 59 ½. You can’t have unscheduled withdrawals (unless for hardship) from a deferred compensation plan. So it may be important to have other assets that you can tap into if needed.

Given the insolvency risk with deferred compensation plans, you should also think about the financial health of your company. How much of your retirement nest egg are you willing to concentrate in the plan?

Some companies may offer matching contributions on your deferrals. Perhaps, you can defer enough to receive your company’s full match.

When and How to Take Distributions

Some deferred compensation plans might allow you to choose a distribution date while you’re still working. While this defers income, and therefore taxes, out of the current year, you could end up with a higher tax liability. If the deferred income pays out while you’re still employed, you’ll have additional income on top of your normal compensation for that year, possibly bumping you into a higher tax bracket.

Timing distributions with your expected retirement is a good approach from a tax standpoint: you would be deferring income out of a high tax bracket and receiving the income when your marginal tax rate is potentially lower.

You may also have a choice of form of payment: lump sum or installment, and even a choice of how many years to take installments over.

Choosing a long distribution period may seem appealing to try and spread out taxable income as much as possible; also, the longer the payout period, the greater the benefit of tax-deferral. But that also means the longer the funds are subject to bankruptcy risk. You’ll need to weigh the trade-off of this risk against the benefit of tax-deferral.

You should also be aware if your company’s deferred compensation plan has other triggering events for distributions. Some plans may have different payment provisions for certain events like termination, change of control, or death, for example.

Revisit Your Participation & Election Each Year

Some plans may carry over your deferral elections from year to year unless you actively change them during enrollment. For other plans, you may need to make a deferral election during the enrollment period each year you want to defer.

Regardless, you should review your participation and elections every year. Have your financial circumstances or goals changed, or has your view of the company changed?

Conclusion

During your deferred comp enrollment, you’re making a distribution decision potentially a decade, or even more, in advance. A deferred compensation plan is just one of the many financial pieces you may have for your retirement. It’s important to have a thoughtful strategy that incorporates all of your financial resources when you make your deferral elections this year. If you’re wondering whether to participate in your company’s deferred compensation plan or how much to contribute, schedule a call.

As a financial advisor, I can analyze how a deferred compensation plan fits within your overall retirement plan and help you weigh the tax benefit versus risks of this type of plan.