The Pros and Cons of Deferred Compensation

financial advisor

By Joe Globensky, RFC®

Deferred Compensation

At some point in your career, you may be offered participation in a nonqualified deferred compensation (NQDC) plan. Currently more than 90% of public companies offer some sort of NQDC plan and nearly half (44%) of eligible employees participate.¹ But, how do you know if you should participate if you are given the opportunity? Let’s discuss the pros and cons of deferred compensation.

Pros of Deferred Compensation

For most highly compensated executives, the primary value of a NQDC plan is its ability to offer a much-needed additional opportunity to save for retirement. In addition, there are other benefits to consider, including:

No contribution limits

Retirement plans like a 401(k) have contribution limits ($19,500 for 2021; $26,000 for those age 50 and older). However, NQDC plan participants potentially can defer up to 100% of their compensation on a pre-tax basis.

Current, and potentially future, income tax mitigation

Deferrals into a NQDC plan will reduce participants’ taxable income, which can help avoid top tax rates on ordinary income, capital gains and dividends, and the Medicare surcharge. Another benefit comes to those who currently work in a high tax state, but plan on retiring in a low to zero tax state. When you withdraw money from the NQDC plan, you will reduce or eliminate state taxes on the deferred compensation contributions and growth.

Flexible payout options

Depending on the plan design, you can typically choose either a lump-sum distribution or opt to take withdrawals over a 5- to 10-year period. This offers greater flexibility than 401(k) or IRA accounts, which require withdrawals to begin at age 72 and impose penalties on most withdrawals prior to age 59 ½.

Retirement income bridge opportunity

A NQDC plan can be used to generate income during the early years of your retirement, allowing you to delay Social Security benefits and enabling tax-deferred 401(k) assets to continue growing until age 72, when mandatory required minimum distributions must be taken.

Help Close the Retirement Savings Gap

At higher income levels, qualified tax-advantaged deferral opportunities and Social Security benefits are limited. A NQDC plan can help participants plan for specific financial goals by serving as an additional income source in retirement.

Cons of Deferred Compensation

The rules governing when and how you may access the compensation you have deferred are unique to each specific NQDC plan. Some plans may permit short-term deferrals while others mandate those funds can’t be accessed until retirement. A plan may not allow assets to be rolled over or distributed if you change employers or impose other “golden handcuffs.”

Other potential participation concerns include:

Reduced protection/greater risk

As a participant in a NQDC plan, you become a creditor of the company. If the firm should ever become insolvent or declare bankruptcy, you could potentially lose all or part of your investment. If you choose a long-term payout option, such as 10 years, that means you will be taking on an additional 10 years of credit risk. While you may be comfortable with your employer’s outlook now while you are working there, what happens when you retire and have a decade of exposure with little to no knowledge of how the company is being run?

Lack of rollover options

If you leave your company or retire early, funds in a NQDC plan aren’t portable. They can’t be transferred or rolled over into an IRA or new employer plan.

An unexpected payout

Depending on the details of your NQDC plan, an employment change could turn your deferred compensation into a sudden payout, which can present tax implications and additional retirement income planning complications.

Final Thoughts

A nonqualified deferred compensation plan can have inherent drawbacks and prominent risks, but it could help you save toward your retirement planning goals. We recommend working with a financial advisor to review your specific plan terms and financial situation when preparing for the future.

At Connections Financial Advisors, we can help you decide whether a NQDC plan makes sense for your situation, weigh issues like future taxes, and create a long-term plan. Call us today at (217) 605-8130 or e-mail us here.

¹ Prudential/Plan Sponsor, 2018 Executive Benefit Survey

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