By: Colleen Weber
News and Updates
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By Colleen Weber, CFP®, CPA
If you’re a high-income-earner, you have some challenges when it comes to tax-advantaged investing strategies. But just because government restrictions make it harder to invest in traditional accounts, such as Roth IRAs with their income phaseout rules and 401(ks) with their contribution limits, that doesn’t mean you’re out of luck. Your company’s deferred compensation plan may be your ticket to minimizing your taxes. But before signing on the dotted line, you need to understand how these plans work and the pros and cons of participating in one.
What Is A Deferred Compensation Plan?
A nonqualified deferred compensation plan is a way for high-earning employees and executives to postpone receiving their income until a later date, which also means paying taxes on it later. If you expect to be in a lower tax bracket down the road, deferred compensation can be especially appealing.
And since I know your next question will be about interest, here’s the answer. The money you defer can be invested for growth during its deferral. This works much the same way as a pre-tax 401(k) where your money can grow tax-deferred. However, it is not a 401(k) and does not have all the same benefits and protections.
Why Should I Consider Deferred Compensation?
Unlike 401(k) plans, there is no annual contribution limit to a deferred compensation plan. So, for high earners who max out their 401(k) each year, it offers another tax-deferred way to save for the future. Because it is tax-deferred, you have more money to put to work earning interest which compounds over time.
Another benefit of a deferred compensation plan is that you can use it to reduce your taxable income in the current year. This helps you manage which tax bracket you fall into and also affects eligibility for different programs and benefits. Being able to control your taxable income is a very powerful tax-planning tool.
Finally, with deferred compensation, you may be able to bypass the required minimum distributions that everyone else is subject to at age 70½. You can do this by agreeing to the distribution schedule outlined in the plan description if your specific plan allows for it.
Why Should I Say No To Deferred Compensation?
While you can see that there are a lot of benefits to deferred compensation, there are also drawbacks. One of the major ones is that the money you defer in one of these plans is not protected in the same way as it would be in a 401(k) or another qualified retirement plan. That means that if your company is facing bankruptcy, your deferred compensation is not protected from creditors. It is still technically the company’s money, since they haven’t paid it out yet, and they could be forced to give it to their creditors, leaving you with nothing.
Also, the money in a deferred compensation plan is not protected from your personal creditors if you face bankruptcy. While you can go through bankruptcy and come out the other side with your 401(k) still intact, that’s not the case with deferred compensation. Your deferred compensation will be used to pay back the debts that you owe.
In addition to a lack of protection, there are rules dictating when and how you can take your deferred compensation. These are plan-specific. Some plans allow you to defer compensation for a few short years while others require you to defer it until retirement. You also can’t take the money early or take a loan against it. Even when you are eligible for withdrawals, there are often specific rules regarding when and how you can take them.
Some plans will allow you to roll the money into another tax-deferred account, while others won’t. Some allow you to take the money with you when you change jobs and others do not. Some will force you out of the plan if you terminate employment, which could have a big impact on your tax bill.
What Should I Do?
Because there are so many plan-specific stipulations, it’s important to review your company’s plan thoroughly with a financial professional before signing up. A deferred compensation plan can be a great blessing, but it can also become a terrible nightmare.
If you’re considering participating in your employer’s deferred compensation plan, let me help you review the plan documents first and see how participation may fit into your overall financial plan. Book a free introductory meeting online to get started!
Colleen Weber is a fee-only financial advisor, CERTIFIED FINANCIAL PLANNER™ professional, and CPA with more than 15 years of financial planning experience. Providing comprehensive financial planning and wealth management, she specializes in serving clients nearing retirement, retirees, busy professionals, and women. She is passionate about developing financial plans that save clients on taxes, and investment strategies that help them pursue their goals. Learn more about Colleen by connecting with her on LinkedIn or booking a complimentary phone call meeting.