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Deferred Comp: A Plan for Unlimited Retirement Savings

Maxing out a 401(k) plan is the foundation of a retirement savings plan. But some highly compensated executives may have the option to participate in an additional deferred compensation plan that can offer the opportunity to save well above the limits on a 401(k) plan. The benefits include tax deductions in contribution years and tax-deferred growth like a 401(k) – but there’s no maximum for contributions.

In most instances, the taxes on the deferred compensation are not due until the funds are received well into the future. Of course, there are some tradeoffs and risks to be aware of, whether you are just thinking about participating or are approaching retirement and will soon begin receiving payouts from an existing plan. We dive into the details to help you understand these so-called “golden handcuff” arrangements.

Deciding to Participate in a Non-Qualified Deferred Compensation Plan (NQDC)

Because these plans do not have to comply with ERISA regulations, like a traditional 401(k), they are called “non-qualified.” This creates more flexibility but also comes with certain risks. There is no maximum contribution amount, so that they can allow for tax-deferred savings of bonuses, a percentage of salary, or other incentive compensation. Like a traditional 401(k), these plans are especially beneficial if taxes in retirement will likely be lower than taxes while working.

There is one big difference. These plans aren’t like a 401(k) where the money resides in your investment account — they’re a contract in which the firm agrees to pay you the amount in the future. One way to think of a deferred compensation plan is as an unsecured loan between you and your employer – and you are the lender. If the company goes bankrupt, your compensation may go with it.

The Nuts and Bolts of the NQDC

The election to defer compensation must be done in the year before it is earned, and it’s irrevocable. You also must specify the payment schedule and the triggering event at the time of deferral. The company’s plan may let the employee choose a lump sum withdrawal or installment payments over a certain number of years.

The lump sum will give you immediate control of your money but could result in a potentially higher tax bill unless you plan carefully to smooth your income stream. For example, the payment could be reinvested and used to fund an early retirement before claiming social security benefits. Laddering your payments over a series of years can provide more flexibility to match payments to expense needs and potential tax obligations.

The decision on how to structure your plan so to provide the right balance between control of the funds and tax-efficiency requires a careful look at your retirement plan, your expenses in retirement, and your other sources for funding your retirement so that you make the right decision.

Making the Right Moves as you get Close to Retirement

If you have a NQDC plan and you are getting close to your triggering event – usually retirement – it’s a good idea to review your financial plan. While you can’t usually change the terms of the NQDC, there may be other moves you can make to help you keep your income at the level you need and create tax efficiency.

Delaying Social Security is one common strategy. It may also be a good idea to look at your portfolio holdings for potential tax-loss harvesting. If charitable giving is in your plan, you could also choose to offset the additional income by making these gifts in the year(s) that the payments will increase your income. Since the benefit of a NQDC plan is the tax savings, it makes sense to ensure you have a plan before payments begin.

Bottom Line

If you’ve maxed out your 401(k) plan, an NQDC may provide the opportunity for additional retirement savings and tax benefits. However, it’s essential to carefully analyze the terms of the plan and understand your own income needs, expenses, and how your sources of retirement income will work together so that you can create an income plan that preserves the tax advantages.

John M. Piershale, CFP®, AEP®


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