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Clearing Your Horizon

Deferred Compensation

Deferred compensation plans can be an important component of one’s executive compensation package, but it is critical to understand the complexities associated with deferred comp.

Here are several key considerations to keep in mind as you make deferred comp decisions:

Understanding Plan Terms: It's essential to thoroughly understand the terms and conditions of the deferred compensation plan, including eligibility requirements, distribution options (and changes thereto), vesting schedules, and investment options within the plan.

Tax Implications: Deferred compensation plans can offer tax advantages, but it's crucial to understand how contributions, investment earnings, and distributions are taxed (see our FAQ below).

Investment Options: Most deferred compensation plans allow participants to choose how to invest their contributions, offering a range of investment options very similar to one’s that you might see in a 401-k plan. Participants should assess these options carefully, considering factors such as risk tolerance, investment objectives, and time horizon. A mistake we often see is overlooking how investment allocations should change over time.

Distribution Strategies: Participants need to decide when and how they will receive distributions from the plan. Factors to consider include when you expect to retire, what you anticipate your income needs to be in retirement, at what age you intend to claim Social Security, and other assets available to fund your goals, just to name a few.

Employer Solvency: Since deferred compensation plans are sponsored by employers and are subject to creditors of the company, participants should assess their employer's financial stability and ability to fulfill future obligations under the plan.

Beneficiary Designations: Participants should review and update beneficiary designations regularly to ensure assets are distributed according to their wishes in the event of death.

A thorough understanding of these key factors is critical for participants to effectively manage their deferred compensation benefit and maximize their wealth over the long term. We believe most participants can benefit from the guidance of an advisor experienced in deferred comp complexities.

Frequently Asked Questions

Can you save too much in deferred compensation?

Yes, it is possible to save too much in deferred compensation. We’ve seen cases where deferred comp distributions and IRA RMDs caused individuals to pay a higher marginal tax rate than they would have during their work years. Coordination between 401k plans, Social Security and deferred comp plans is critical to minimizing your tax bite.

What are the tax considerations related to deferred compensation?

There are a variety of tax considerations related to deferred comp. Here are just a few:

What is your current income tax bracket and what will your tax bracket likely be when taking distributions?

Deferred compensation is considered “earnings” and subject to FICA (Social Security & Medicare). At current rates this is an additional ~8% tax on your distributions. Have you factored this into future cash flows?

What state income taxes will be incurred? Some states tax deferred compensation distributions even if you no longer reside in that state.

Should I elect a lump sum distribution or installments? If installments, over how many years?   

Your distribution elections should be carefully made at the time of deferral because changing it usually isn’t easy if it is permitted at all. Thoughtful planning and tax projections can help make the right decision.

How often should I review my investment allocation and when should I change it?

Managing the asset allocation of your deferred comp accounts requires understanding one’s total financial picture. Deferred comp plans are unusual in that they have an “expiration date” – a date which distributions commence and when they will end. These dates impact how the asset allocation of the accounts should change over time. 

Read our article on deferred compensation in Kiplingers