Should I Defer Compensation? What to Know First

Deferred compensation represents a significant financial strategy, particularly for individuals in higher income brackets. It involves postponing a portion of current earnings until a future date. This approach can be a valuable tool for long-term financial planning, but it requires careful evaluation.

Understanding Deferred Compensation Arrangements

Deferred compensation is a contractual arrangement where an employee’s earned income is paid out at a later date. Unlike traditional retirement plans such as 401(k)s, these are non-qualified deferred compensation (NQDC) plans. This means they do not receive the same protections afforded by the Employee Retirement Income Security Act (ERISA). Funds within NQDC plans generally remain part of the employer’s general assets and are subject to the claims of the employer’s creditors.

Common forms of NQDC plans include Supplemental Executive Retirement Plans (SERPs), phantom stock arrangements, and elective deferral plans. Employees typically elect to defer a portion of their salary, bonuses, or restricted stock units (RSUs) before the compensation is earned. The agreement specifies the amount to be deferred and outlines the future payout schedule, which is established at the time of deferral and becomes irrevocable.

Employers often “informally fund” these plans by setting aside assets in a rabbi trust or through corporate-owned life insurance policies. While these mechanisms provide a means for the employer to set aside funds, these assets legally remain the employer’s property. This structure prevents immediate taxation for the employee, but it also means the funds are not shielded from the company’s general creditors if the company becomes insolvent.

Advantages of Deferring Compensation

A primary advantage of deferred compensation plans is the ability to postpone income tax obligations until the compensation is received. This delay allows the deferred amount, along with any earnings, to grow on a tax-deferred basis, potentially leading to greater accumulation. The income is taxed at ordinary income rates when distributed, creating an opportunity to manage tax liabilities effectively.

Another benefit involves the potential for future lower tax rates. By deferring income from a higher current tax bracket during peak earning years, individuals may receive the funds during retirement when they anticipate being in a lower tax bracket. This can result in a reduced tax burden on the deferred income. The growth within the plan can also compound more efficiently without annual tax erosion.

Deferred compensation provides an avenue for long-term wealth accumulation, especially for individuals who have already maximized contributions to qualified retirement plans like 401(k)s. Since NQDC plans do not have the same contribution limits as qualified plans, they allow high-income earners to save significantly larger sums for retirement. This supplemental savings capacity can enhance financial security.

These plans also serve as a tool for employers to attract, retain, and incentivize key talent. By offering a substantial future benefit, companies can encourage employee loyalty and align an executive’s financial interests with the long-term success of the organization. The deferred payout often comes with vesting schedules that encourage continued employment.

Factors to Consider Before Deferring

Assessing the financial stability of the employer is a consideration before committing to a deferred compensation arrangement. Since deferred compensation represents an unsecured promise from the company, the funds are at risk if the employer faces bankruptcy or severe financial distress. Deferred funds could be lost to the company’s general creditors, as they are not protected by ERISA like qualified plans. Reviewing the employer’s financial statements, credit ratings, and industry outlook is advisable to gauge this risk.

Evaluating one’s personal financial situation and liquidity needs is important. Deferring compensation reduces current take-home pay, directly impacting immediate cash flow. Individuals should ensure they have adequate emergency savings, typically three to six months of living expenses, and can comfortably meet all current financial obligations before opting for deferral. Deferred compensation funds generally offer limited access prior to predetermined distribution events, meaning they cannot be readily accessed for unforeseen expenses.

Projecting future tax rate expectations is another element of the decision-making process. The benefit of tax deferral hinges on the assumption that an individual will be in a lower tax bracket when the compensation is received. This assessment should consider both federal and state income tax implications, especially if there are plans to relocate to a state with different tax laws in retirement. An increase in future tax rates or a higher income level during distribution could diminish the intended tax advantages.

Understanding the specific distribution options and their triggers is essential, as these terms are generally irrevocable once established. Payouts can be structured as a lump sum or as installments over a specified period, typically triggered by events such as separation from service, a predetermined date, disability, or death. Some plans may allow for re-deferral, but strict rules apply, often requiring the request at least 12 months in advance and extending the deferral for a minimum of five additional years.

Many NQDC plans offer hypothetical investment options that mirror the performance of market indices or mutual funds. While these options allow the deferred amount to grow, participants should understand that they do not own actual investments; rather, the employer’s obligation to pay grows based on these hypothetical returns. Review any associated administrative fees or charges that may impact the net growth of the deferred funds.

The impact of deferred compensation on other financial benefits warrants careful consideration. While deferred compensation is typically subject to Social Security and Medicare (FICA) taxes when it becomes nonforfeitable (vested), receiving payments after retirement generally does not count as “earned income” for the Social Security earnings test. This means NQDC payments usually will not cause a reduction in Social Security retirement benefits for those under full retirement age. A reduction in current taxable income due to deferral could also affect eligibility for certain loans or other income-dependent benefits.

Making Your Deferral Decision

The decision to defer compensation is a personal one, shaped by individual financial goals, tolerance for risk, and career trajectory. It requires balancing the potential for significant tax advantages and long-term wealth accumulation against reduced current liquidity and the risk of forfeiture if the employer’s financial health deteriorates. Understanding these trade-offs is fundamental to an informed choice.

While the prospect of tax-deferred growth and supplemental retirement savings is appealing, the complexities and risks associated with NQDC plans necessitate expert guidance. Consulting with qualified financial advisors, tax professionals, and estate planners is recommended. These professionals can provide tailored advice, evaluate specific plan details, and assess the long-term implications of deferral in the context of an individual’s unique financial landscape. This counsel is important for navigating the rules of deferred compensation and making decisions that align with one’s broader financial strategy.