Skip to content
Deferring Income Saves the Best for Last for High Earners By David Stubblefield, CFP® CDFA®
June 28, 2017

Background

Business meeting
Many workers have access to deferred compensation programs for their retirement through the familiar workhorse 401(k) plan, which allows participants to set aside pretax money that will eventually benefit them when they separate from employment into a presumably lower tax bracket.

For certain highly compensated employees there are non-qualified deferred compensation programs that can continue these pretax savings for their compensation that goes beyond the amount considered by law ($270,000 in 2017) for qualified plans. While similar to qualified plans in the ability to save money on a pretax basis, there are significant differences to consider.

If you are fortunate enough to work for an organization that offers these types of plans, and you are eligible to participate, you should revisit the potential benefits offered by these plans. This commentary will explain the primary benefits and concerns with using a nonqualified deferred compensation plan.

The primary benefit of deferred compensation programs is the ability to continue employee and employer contributions of your qualified plans (such as your 401(k) or company pension) on your compensation above the amount considered for qualified plans. This allows for increased current tax deferral and tax-deferred growth on greater amounts of money.

For example, an executive who consistently earns more than $270,000 and has the ability to save additional money may want to consider deferring some of the income until the money can be distributed and taxed in a more favorable tax environment (usually in retirement).

If you are a participant in one of these plans, make sure you revisit your options when your enrollment period comes around. The election to defer compensation for a particular year is typically irrevocable. This is one reason why it is very important to review your cash flow needs before making a decision.

With that in mind, here are the three critical components of your plan you must understand:

1. RISK OF FORFEITURE

In the 401(k) plan, your funds are protected by law. Deferred compensation plans allow tax deferral due to the risk of forfeiture. Risk of forfeiture means the income you earned but previously deferred into a deferred comp plan is “Non-Qualified” and considered a promise to pay by your company - not a protected account like your 401(k). If a company goes bankrupt, you simply become just another unsecured creditor in line with your hand out hoping to get paid what is owed you.

2. THE RULES OF YOUR PARTICULAR PLAN

Understand what your plan allows you to do. The variance in plan rules from employer to employer can be incredibly diverse. What kind of compensation can you actually defer (i.e., salary, cash bonus, or stock option proceeds)? What kinds of rules govern the plan if your firm is not financially healthy when you need the funds? How long do you anticipate remaining with your employer? Will you be moving to another state with a lower tax rate for your retirement? Consult with your financial advisor as you sort through the options.

3. DISTRIBUTION OPTIONS

Your organization’s deferred comp plan will have its own set of distribution options, the most common ones being a lump sum distribution or multiple installments over time. Most deferred comp plan distributions start the year after you separate from service. Your plan may allow for distributions before you retire or allow for a one-time extension of at least five years before you begin distributions. Your plan may require you to make a distribution election for each year you participate. You will need to pinpoint your future financial needs, often well in advance. It is very difficult to change the distribution schedule once you’ve created it.
You need a clear idea of the role deferred compensation will play in achieving your retirement or other financial goals. Setting aside a portion of your annual income in a deferred compensation vehicle efficiently takes advance planning to reap the tax advantages and properly time the receipt of funds.

TAKEAWAYS:
  • When the election is made to a deferred compensation plan for a particular year, the election is typically irrevocable.
  • Know the rules of your plan; unless you feel comfortable analyzing all the possible outcomes in your deferred compensation plan, it is best to have a financial advisor who is familiar with your financial circumstances.
  • Keep an eye on the financial health of your company to make sure it can honor financial obligations down the road.
  • A deferred compensation plan can be a great tool to save money for the future on a tax-advantaged basis.

Disclosures:

Past performance is no guarantee of future results, and the opinions and other information in the commentary are as of June 28, 2017. This summary is intended to provide general information only and is reflective of the opinions of Commerce Trust Company.

This material is not a recommendation of any particular security, is not based on any particular financial situation or need, and is not intended to replace the advice of a qualified attorney, tax advisor or investment professional. Diversification does not guarantee a profit or protect against all risk.

Commerce does not provide tax advice or legal advice to customers. Consult a tax specialist regarding tax implications related to any product and specific financial situation.

Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

RELATED ARTICLES

ABOUT THE AUTHOR

David Stubblefield
David Stubblefield Senior Financial Planner Commerce Trust Company
David is a financial planner with Commerce Trust Company. He is a member of the financial advisory services team, a dedicated financial planning practice within Commerce Trust that provides objective financial advice to clients. Following a thorough assessment of a client’s unique situation and thoughts regarding wealth, David develops holistic and coordinated plans to help clients meet their short-term and long-term goals as well as take full advantage of various planning, tax, and investment strategies along the way. His areas of focus include planning for financial independence, retirement, divorce, executive compensation, estate preservation, and business succession. David joined Commerce in 1995 and has held positions in private banking, credit analysis, commercial business development, and retail sales. David received his bachelor of science degree in business administration from Southeast Missouri State University. He holds both the CERTIFIED FINANCIAL PLANNER™ and Certified Divorce Financial Analyst™ designations. Additionally, David is a member of the Financial Planning Association and the Institute for Divorce Financial Analysts.
Skip to Navigation Back to top