How to Lower Your Tax Bill With Deferred Compensation
Non-qualified deferred compensation plans are an area of increased activity, with year-end planning and tax uncertainty. Executives and key employees can take advantage of managing today’s still-low tax brackets while staging a custom payout plan in retirement at potentially lower rates.
First, it’s important to understand how these plans work and what the pros and cons are.
What is Deferred Compensation?
These plans come in many forms, but a non-qualified deferred compensation plan (Section 409(a) plan which we’ll discuss here), is an unfunded, unsecured promise to pay compensation at a future date. Section 409(a) refers to income earned in one year that is paid out in a future year.
To attract and retain key talent, these plans allow high earners to defer income beyond the traditional 401(k) limits. The contributed funds grow tax-deferred like a 401(k) and can be withdrawn later at a hopefully lower tax rate (at retirement, for example, when your income stops).
Essentially the plan sets out the rules, and unlike a 401(k), it can favor highly compensated employees. The employee decides how much to defer, and the funds either get invested in a selection of investment options, or they mirror certain investments. This means the company promises to give you the return of say, the S&P 500 index, while not actually investing in it. You may be able to defer salary, bonuses, or other earned income.
What are the Pros and Cons?
- Tax deferral to a future date, when you may be in a lower tax bracket. You only pay Social Security and Medicare tax.
- Wealth building beyond what a 401(k) provides, due to the significantly higher contribution amounts.
- Potential for significant tax savings by pushing out income to years when you may be in a lower bracket. Plus, reducing your income below certain thresholds can mean lower taxes on other types of income, e.g. capital gains, avoiding surtax, future Medicare premium payments, etc.
- Fund Protection: It’s essentially a promise by the Company to pay you later. Plus, the funds are subject to creditors in the event of insolvency or bankruptcy. Employees are typically viewed as a lower priority than general creditors.
- Key Point: Understand your company’s ability to pay this when it comes due. If you are not sure and your company is a bond issuer, use your bond credit rating.
- Is there a Rabbi Trust? These are a source of funds set aside by the Company to provide security that the funds will be paid. Rabbi Trusts are still subject to creditors, however.
- Elections may be irrevocable. You must elect payout on a pre-determined date. If you need the funds sooner, tough luck, as loans are not allowed. You may be able to change the amount you defer year-to-year, however, if you find yourself socking away too much in any one year.
- Cannot be rolled to IRA. This is a big consideration if you leave your job before the scheduled payout. If you leave, all that money could be taxed at once while you’re still a high earner.
Here are a few key questions to ask yourself before making the leap:
- Do you already max out your 401k? It almost always makes sense to do this first, because of the protections in place.
- Can I afford to do this? Review your financial plan to make sure you can afford it and not crimp cash flow. Otherwise, you may find yourself in a pinch or selling something you shouldn’t to create liquidity.
- Is the company financially secure? The longer the deferral and payout periods are, the greater the risk because more things can go wrong with the company over longer timeframes. If you are close to retirement, however, you can potentially make a big dent in your tax bill by deferring income just a few years and stage payouts accordingly during retirement. With proper analysis, you can spread those out in a manner that balances cash needs with staying in lower tax brackets.
- What are the investment choices? If they aren’t good, it may not make sense at all to do this.
- What happens if I leave? Read your documents! If the company forces a payout if you leave or retire early, you may find yourself with an enormous tax bill, as you can’t roll these funds to an IRA and continue the tax deferral.
- Maybe it doesn’t make sense to do this year? If tax rates go up, then deferring income may be more valuable next year than now. Therefore, you should discuss your tax situation with your CPA and financial advisor now, considering what your projected tax rates and cash flow needs are today versus down the road.
Gary is a Wealth Manager at BDF and member of the Firm’s Investment Committee. He specializes in executive and stock-based compensation plans, including stock options, restricted stock and deferred compensation. He combines his tax knowledge, executive compensation experience and capital markets expertise to help clients reduce their tax burdens and achieve each of their unique goals.