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For those eligible, a deferred compensation plan is a powerful employee benefit to accelerate savings and reduce taxes. But they aren’t without tradeoffs.
Every year we hear from people who want to evaluate participating in the program — they strive to make a prepared, confident election, only to spend way too much time analyzing a hundred different variables and ultimately rush the decision each year.
And with the majority of Fortune 1000 companies offering these plans to key employees, this might be your year to understand how they work and contribute for the first time or increase your contributions.
There are a few key factors to consider before participating in your employer’s DCP.
First, understand the risks. As a non-qualified deferred compensation plan, your DCP account is, by rule, an unsecured liability of your employer. Meaning if your employer goes bankrupt, you could lose part, a majority, or all, of your balance in this account.
So, before contributing a dime to your DCP account, you’ll want to evaluate the financial health of your employer. While only around 2% of publicly traded companies file for bankruptcy protection each year — and, in many cases, DCP participants recover a sizable part of their money even in the case of bankruptcy — you’ll still want to frame your contribution as a liability of your employer.
Next, you want to assess how much personal exposure you have to your company’s plan.
- Calculate your distribution timeline for prior and future deferrals. The longer the deferral, the more significant the potential tax benefit, but the more risk you take.
- Calculate your total exposure to your employer. This includes your DCP balance, the market value of any company stock and options, and any company-sponsored pension.
- Lastly, calculate the percentage of your total net worth in your company’s deferred compensation plan. The lower the ratio, the more comfortable you should be in making additional contributions.
The next key factor in evaluating your decision is the tax benefit. With top marginal tax rates as high as 90% in the 1960s and 70% in the 1970s, the primary use of these plans was to shift income into lower-tax retirement years.
Now, with lower tax rates, tax brackets fairly compressed and higher executive compensation (meaning potentially large payouts from deferred compensation and other assets in retirement), most tax analysis is done at the top marginal tax bracket, both pre- and post-retirement.
Today, the main benefit of the plan is the tax deferral feature — the ability to invest your money pre-tax and have it grow untaxed until the money is paid out.
For example, deferring income for 15 years at the top marginal tax bracket and earning a pre-tax return versus an after-tax return results in 36% more wealth even after paying income taxes on a lump-sum distribution from the deferred compensation plan at the end of the period.
Behold the power of compounded tax-free gains.
The third question you’ll need to answer is how much to contribute. Before contributing to a deferred compensation account, you want to make sure you are allocating funds to other tax-advantaged and safer accounts.
That means you first need to fully fund your 401(k) plan, health savings account or individual retirement account.
After that, consider how much additional savings you can afford from a cash flow perspective.
Then, if cash flow is an issue to deferring additional income, consider using cash from selling any stock-based compensation you receive, like restricted stock units or stock options, as they vest to fund deferred compensation. RSUs will be taxed as income as they vest, increasing your tax bill today. Deferring income can be a way to offset that additional income and invest those proceeds tax-deferred.
Lastly, you must select when the money ultimately gets paid.
Again, this decision comes down to the tradeoff between deferring taxes for as long as possible and the account being an unfunded liability of your employer.
With most plans, you can elect to distribute the money while still employed or at termination/retirement. From there, you will need to decide if you want the funds allocated to you as a “lump sum” or spread over several years. We’ve seen the options range here from as few as three years to as many as 15 years.
Typically, we suggest deferring for as long as possible for those comfortable with the risk to get the maximum tax benefit.
Obviously, there is a lot to whether to defer money into a DCP and balance the risk and rewards of the plans. But, hopefully, answering these four questions will help you make a confident decision.
— By Isaac Presley, CEO of Cordant Wealth Partners