Understanding Executive Compensation: Deferred Compensation (Part 1)

by | Dec 26, 2022 | Wealth Management

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By:  Paul Horn, CFP®, CPWA®, Senior Financial Planner

You’ve likely daydreamed about the future. A future where you spend the weekend relaxing in front of the lake, and your grandkids run while you open a bottle of fine wine. Reducing preoccupations and enjoying the small details in life come from hard work and dedication. Undeniably, money buys necessities and luxuries in life. Though somewhat indirectly, one of the biggest things money can buy is financial peace of mind.

As an executive, you can maximize deferred compensation benefits to grow your success and get you closer to the life you envisioned. Here are some insights about the benefits brought by the big title jobs.

The Blueprints of Your Executive Compensation

You may have been offered executive compensation benefits as an integral part of your employment. These perks, benefits, or programs go beyond what average employees receive. Executive compensation is provided to an exclusive group of employees that the company has deemed vital to its ongoing success to help attract and retain its top talent.

You may be rewarded benefits like a company car or more significant benefits like additional insurance benefits. Most commonly, companies have plans to retain top talent using long-term incentives like deferred compensation.

Understanding what these benefits mean and how to maximize them is crucial. Not using these benefits properly will lead to a tax headache that can be avoided with proper planning. Let’s take a closer look at some of the more common benefits and how they transition from blueprints to materials that build the life you desire.

The Materials You Need – Deferred Compensation Plans

By definition, you are highly compensated if you have access to executive compensation benefits. Therefore, tax planning becomes vital to your success. At the end of the day, it’s about how much you keep and not how much you make.

Access to a deferred compensation plan can be the best way to save for the future and manage your taxes simultaneously. Through deferred compensation, you can choose to defer a portion of your salary and bonus into a plan where the taxes are deferred to a later date when you receive the payout.

Building Strong Foundations

Non-Qualified Deferred Compensation (NQDC)

A Non-Qualified Deferred Compensation (NQDC) plan allows individuals to defer a portion of their income now and then withdraw 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 that are non-qualified do not have to comply with Employee Retirement Income Security Act (ERISA), like a 401(k) or 403(b). Additionally, they 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, such as 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. There are two common choices, 1) a lump sum option, or 2) receiving payments over a set amount of time, like five or ten years. For example, if you defer $50,000 in 2022 you could choose to receive that $50,000 at retirement or as a $10,000 a year payment over five years.

Details You Can’t Miss

Non-Qualified 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 and is subject to creditor claims, 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’s important to have strong faith in the company’s long-term viability.

Buying the Best Furniture – Choose Your Distribution Option Wisely

Once your distribution elections are made, it can take time to make changes. Most plans limit the changes you can make and require you to work for 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 who is 59 and plans to retire at age 60 changes their elections for distribution. As a result, the new changes typically will be paid out at age 65 based on the five-year rule.

Let’s look at an example and why you typically want to spread the payments over time. Imagine 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% for 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.

Earthquake Proof – Tips for Deferred Compensation

  • Work with a tax professional or Certified Financial Planner™ professional to determine how much to save and the distribution’s timing.
  • Save to a deferred comp plan after you have maxed out your employer-sponsored plan like a 401(k).
  • Remember that changes can be made to your distribution election, but this may force you to further delay when you receive the money.
  • It is typically best to receive distributions years after you leave the employer.

Deferred Executive Compensation: Key to Financial Peace of Mind

Maximizing the benefits delivered to you through deferred compensation is a great way to protect your investments and grow your wealth. Understanding how to plan for taxes concerning your executive deferred compensation increases your chances of reducing your tax burden. By properly managing the benefits offered to you as an executive, your wealth can grow, and at the same time the external factors tied to your finances may be reduced.

Deferred compensation is one of many executive compensation plans you should keep an eye out for. Equity compensation, such as stock options, are incentives your employer provides that you can maximize to your advantage. Restricted Stock Units (RSUs), Non-Qualified Stock Options (NSOs), Incentive Stock Options (ISOs), and Employee Stock Purchase Plans (ESPP) are some of the stock options available to employees as compensation. We will discuss these further in an upcoming blog.

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 website 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 remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy (including those undertaken or recommended by Company), will be profitable or equal any historical performance level(s). Please see important disclosure information here.

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