Should You Participate in Your Company's Deferred Compensation Plan?
The quick answer
A deferred compensation plan lets you put off receiving part of your salary or bonus, and the income tax on it, until a later date, often retirement. It can make sense if you're in a high tax bracket now, expect a lower one later, have already maxed out your 401(k), and trust your company's long-term financial health. The biggest risk is that the money isn't protected: if your company goes bankrupt, you could lose it.
How does a deferred compensation plan work?
Many companies offer these plans to senior employees and executives. Here's the basic idea:
You choose how much to defer: Usually a percentage of your salary, bonus, or both. You typically have to decide before the year the money is earned.
You pick when you'll get paid: Often at retirement, after leaving the company, or on a set date, either in a lump sum or in yearly payments.
The money grows until then: Your account tracks investment options you choose, similar to a 401(k).
You pay income tax when you receive it: Not when you earn it. Social Security and Medicare taxes are generally still due when the money is earned.
Unlike a 401(k), there's no IRS limit on how much you can defer, but you also can't roll the money into an IRA or take a loan from it.
What are the benefits and risks?
The benefits
Lower taxes now: Deferring income in your peak earning years can move it out of the top tax brackets.
Possibly lower taxes later: If your income is lower when you receive the money, you may pay a lower rate.
More room to save: Once your 401(k) is maxed out, a deferred compensation plan lets you keep saving pre-tax.
A potential state tax break: If you receive the money as payments over at least 10 years, a federal law generally prevents your former state from taxing it after you move. That can matter if you plan to leave New York or New Jersey for a state with no income tax.
The risks
Your money isn't protected: The account is a promise from your employer, not a separate trust. If the company goes bankrupt, you're treated like any other creditor and could lose some or all of it.
Your choices are locked in: Payment timing is set up front and very hard to change later.
Less flexibility: You generally can't access the money early, even in an emergency.
More company exposure: If you already own a lot of company stock, a deferred compensation balance adds to your dependence on one employer.
When does it make sense to participate?
It's often a good fit if you:
Are in a high tax bracket now and expect a lower one later
Have already maxed out your 401(k) and other tax-advantaged accounts
Work for a financially strong, stable company
Won't need the money before your chosen payout date
Plan to retire to a lower-tax state
It may not be a good fit if you:
Have doubts about your company's financial health
Might need the money for a home, tuition, or other goals before retirement
Expect to be in the same or higher tax bracket later
Already have a large share of your wealth tied to your employer
How much should you defer, and when should you get paid?
How much: Only defer money you're confident you won't need before the payout date. Many executives limit deferrals to an amount they'd be comfortable losing if the company ran into trouble, and avoid deferring so much that it creates a large tax bill when it's all paid out.
When to get paid: This is the decision that matters most, because it's hard to change later. Plan payouts for years when your income will be lower, such as early retirement before Social Security and required minimum distributions begin. Spreading payments over several years, rather than taking a lump sum, can keep more of the money in lower tax brackets, and paying over 10 or more years may protect you from your current state's income tax if you move.
Frequently asked questions (FAQs)
Can I change when I get paid later? Usually only with strict limits. Changes generally must be made at least 12 months in advance and push the payment back by at least five years.
What happens to my deferred compensation if I leave the company? It depends on your plan and your elections. Many plans begin paying out after you leave, sometimes as a lump sum, which can create a large tax bill in one year.
Is a deferred compensation plan better than a 401(k)? No. Max out your 401(k) first. It has more protections and flexibility. A deferred compensation plan is an extra option on top of it.
Get help with your deferred compensation
Not sure whether to participate, how much to defer, or when to take your payouts? Reliant Wealth Advisory helps executives build a plan for their compensation, taxes, and retirement.
Click here or book a time below:
About the author
Michael Walstedt, CFA, CFP®, is the founder of Reliant Wealth Advisory, a fee-only fiduciary firm in Hoboken, New Jersey. He helps business owners, executives, and tech professionals in the New York/New Jersey area, as well as nationwide, with financial planning and investment management.
This article is for educational purposes only and is not tax, legal, or investment advice. Tax rules change, and your situation may differ. Consult a qualified tax professional before acting.
