The uncertainty over future State and Federal Tax Rates is creating more client questions regarding deferred compensation plans. Over the past month, a couple of high-earning, commission based insurance producers asked for guidance with the decision to participate in their company’s non-qualified deferred compensation plan. Unfortunately, the decision to participate is not as straight forward as we would like. One must weigh the timing of the payout with their current cash flow needs and how the decision could affect current and future taxes. A few points to consider:
Cash Flow Needs – Can you afford to defer income today? Many commission based earners struggle to manage the inconsistent cash flows to meet their lifestyle needs. If one needs liquidity in the short term, they should not defer income regardless of timing and taxes. This also serves as a good reminder of the importance of saving aggressively during the good times.
Timing – How long is the deferral period? Cash flow needs are directly related to the length of deferral. Each company’s deferred compensation plan has its own unique set of rules and once chosen they are very difficult to change without incurring a penalty. In general, the longer you defer the compensation the better, as you are postponing the tax liability while growing the assets.
Deferred compensation plans typically offer various payout options: lump sum or installments. It is critical to align the payouts with a solid financial plan in order to manage future cash flow needs and tax liabilities.
Taxes – Will you be in a lower tax bracket when payouts begin? Often this is the biggest factor when deciding to defer income. If you are in a higher bracket today then it is advantageous to defer your income. Determining future tax brackets is easier when you have a set retirement date in mind.
If you believe tax rates will be coming down in the future, the impact of deferral can be significant. Unfortunately, it is very hard to predict future tax policy.
Location – Do you plan to relocate in the near future? One of our insurance producer clients is looking to retire in two years and move from Illinois to Florida. Illinois just increased their individual income tax rate to 4.95%. Florida has no state income tax rate. By deferring income, he is locking into a 4.95% savings. Having an idea of where you will be living in the future can have an impact on your decision as state tax rates vary. Click to request a copy of The Best States to Retire in from a Tax Perspective.
Strength of Company – How financially stable is your company? Non-qualified deferred compensation plans do not offer the same level of asset protection as a 401k plan. Should the company go bankrupt, the forthcoming payments are not guaranteed and you are treated as an unsecured creditor. Do not participate in the plan if you are not confident in the company’s future.
Investments – What investment choices are available? Similar to a 401k plan, companies will select the investment choices for the plan. Often times the choices will include an attractive fixed rate choice, company stock, or a mutual fund lineup. Be sure to review the investment choices prior to making an election as a poor investment lineup could diminish any potential tax savings.
As evidenced above, there are many factors to consider when deciding whether to participate in a deferred compensation plan. The benefits of deferring taxes with compounding investment growth, makes for a compelling case. However, the decision is best answered when incorporating the factors into the context of an overall financial plan.