A Beginner’s Guide to Deferred Compensation

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By:  Paul Horn, CFP®, CPWA®, Senior Financial Planner | Wealth Manager

Understanding the Basics

A Non-Qualified Deferred Compensation (NQDC) plan allows individuals to defer a portion of their income now and then withdrawal the money typically in retirement when their income is lower. Most of the time the amount of money deferred can be invested in stocks or bonds so the money can grow over time.

Deferred Compensation plans are called non-qualified because they do not have to comply with Employee Retirement Income Security Act (ERISA) like a 401(k) or 403(b) and can be offered to a certain group of employees like executives. These plans will have a written agreement between the employer and employee that outlines all the rules like how much can be deferred when the payout can occur and what investment options are available.

You will make annual elections on how much income you would like to defer and when you would like to receive that money back in the future. Most commonly you can choose a lump sum option or receive payments over a set amount of time like five or ten years. For example, if you defer $50,000 in 2021 you could choose to receive that $50,000 at retirement or as a $10,000 a year payment over five years.

Rules You Need To Know

Deferred Compensation plans do not follow ERISA guidelines, so it is very important to fully understand the rules for your plan.  For example, some plans will have many investment and distribution options while others may only offer limited (or no investment) options.

The deferred compensation stays on the company’s financial statements, so it is not fully protected if the company has financial issues down the road like filing for bankruptcy. When choosing to use a deferred compensation plan it is important to have strong faith in the company’s long-term viability.

Choose Your Distribution Option Wisely

Once your distribution elections are made it can be difficult to make changes. Most plans limit the number of changes you can make and require you to work at least another 12 months before you retire. Another common rule is that any changes made will delay the distribution by five years. For example, an individual that is 59 and plans to retire at age 60 makes some changes to her elections for the distribution. As a result, the new changes typically will be paid out at age 65 at the earliest based on the five-year rule.

Let’s take a look at an example and why you typically want to spread the payments out over time. An individual retires in 2022 with deferred compensation of $600,000 and chooses to receive everything as a lump sum. Assuming no other income sources the $600,000 would be taxed at a Federal income tax rate of 35% for a couple filing jointly (based on current Federal income tax rates and not factoring in deductions). However, if they choose to spread the payments over five years, they would receive $120,000 per year for five years. Assuming no other income sources they would be taxed at a Federal income tax rate of 22% each of those five years. By delaying the payments, the individual greatly reduces the tax burden and creates an income stream for the first five years of retirement. 

How We Can Help

We can look at your plan documents and provide guidance on how much you should save each year and provide recommendations on the best distribution options. If you have a plan in place already, we are happy to review it and see if any changes should be made to how you will receive distributions from the plan. These decisions vary for each individual based on their income needs and tax situation.

Summary

Deferred compensation plans offer a wonderful way for people to delay income which can potentially be taxed at a lower tax bracket in retirement and create a cash flow stream for a part of retirement. When these plans are structured effectively, they can allow you to retire early and have a stream of income in your early and middle years of retirement.

The challenge though lies in the options people choose for when to receive the money in the future. It is very important to work with your BFSG adviser so we can help you navigate how to receive the money in retirement. These plans can be complex, and it is important to understand how to most effectively use this great employer benefit!

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s web site or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please see important disclosure information here.

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