To defer, or not to defer?
That is the question executives with access to deferred compensation plans at work must answer each year.
The plans, made available to company officers or other high earners, let employees set aside part of their annual salary or bonus, to be paid at some point in the future. Money set aside grows tax-deferred, until paid out to the employee.
Formally known as nonqualified deferred compensation plans, the plans are a way to let highly paid employees — typically, those making at least $115,000, but often much more — stash away more money than allowed under 401(k)s and similar retirement plans. Companies may pay interest on the deferred money or allow employees to choose from a menu of investments.
But the plans come with risks. By deferring money, employees are essentially accepting an IOU from their employer. While funds in a 401(k) are protected if the company runs into trouble, money deferred in a nonqualified plan is not. So in case of bankruptcy, employees with deferrals become unsecured creditors of the company and must line up behind secured creditors in the hopes of getting paid.
“There is a risk you may not see the money,” said Micky Reeves, a wealth adviser with Buckingham Strategic Wealth in Plano, Texas.
That may be one reason that over the past decade or so, just under half of employees eligible for the plans participate, on average, according to a report from the Newport Group, which devises and administers the plans.
Participation generally tracks economic sentiment, the report noted: Estimated participation dipped to as low as 40 percent of eligible employees in 2010, as the country was emerging from a downturn, before rebounding to more typical levels by 2013.
The Plan Sponsor Council of America, a nonprofit lobby group for employers that offer retirement plans, recently found similar levels of participation but noted that employers offering matching contributions on deferred money reported much higher participation (62 percent).
As the economy has recovered and competition for talented employees intensifies, more companies see such plans as important for recruiting and retaining executives, human resources consulting groups say. A recent Newport Group survey of more than 100 companies in the Fortune 1000 found that 92 percent offer nonqualified plans, up from 78 percent two years ago.
And, while the plans are more prevalent at larger corporations, consultants and financial advisers say they are seeing a trend toward more midsize companies offering them, as they compete with larger companies for top talent.
Since highly paid employees usually max out their 401(k) contributions quickly, deferral plans can be attractive. For 2017, the maximum employee contribution to a 401(k) is $18,000, plus an extra $6,000 for those over 50.
Employees consistently indicate that their top reason for participating in the plans is to save for retirement, and they turn to nonqualified plans in part because of their flexibility, said Gary Dorton, vice president for employer solutions and service with the Principal Financial Group, a provider of the plans. “You can really tailor it to your specific need,” he said.
Consider employees who want to retire at age 62. They are not required to start withdrawing money from their 401(k)s until they turn 70 1/2 and can maximize Social Security payouts by delaying receipt of benefits. So, they could time payouts from their deferred compensation to provide income in those early retirement years, letting their other savings and investments grow.
“They’ll say, ‘I’ll use my nonqualified plan to bridge that gap,’” Dorton said. Principal offers an online calculator that can help participants plan how to time deferrals.
Whether the plans work for a specific employee, however, depends on many variables.
Dr. Peter Steckl, 59, an emergency room physician in Atlanta, also does consulting work for a malpractice insurer that offers deferral of up to half of his pay. When the plan was first presented to him, he said, “It sounded attractive to me.”
But after conferring with his financial adviser, he decided not to participate. After reviewing his finances, his adviser forecast that based on current tax policy, Steckl was unlikely to fall into a lower tax bracket after retirement. The insurance company is financially sound, so the risk of losing his money is remote. “It’s nice to have the option,” he said. But with big tax benefits unlikely, he added, “Why take that chance?”
His adviser, Scott Beaudin, a financial planner and founder of Pathway Financial Advisors in Burlington, Vermont, said he generally recommends deferrals only if there is a compelling reason. Many people, he said, react viscerally to the idea of deferring income — it feels good to avoid the tax man, even if temporarily. But it does not always follow that clients will be better off waiting, he said, instead of taking the income when it is earned, paying taxes at current rates, and then investing the money.
In addition to potential tax savings, Beaudin said, other sound reasons to defer include having children who are applying to college, to increase the chances of a financial aid award; or, to push income into the future if the client is involved in litigation or a contentious divorce (opposing lawyers tend to focus on assets available now, he said, rather than on money that is off the table until well into the future).
Another potential deferral scenario is if an employee plans to relocate after retirement from a high-tax state to one with lower or no state income taxes, like Florida. Deferring the money and having it paid out later in the lower-tax state can provide a significant tax break.
Beaudin said he was seeing more smaller companies, particularly in the technology sector, offering deferred compensation plans, which makes him wary. Companies like to retain cash to fund research and development, he said, but the situation may be risky for employees, who may feel pressured to participate to show that they’re supporting the venture. “There may not be anything at the end of the rainbow,” Beaudin said.
Reeves, the wealth adviser, recalled a client who had been regularly deferring income. His company was acquired, and the buyer ended the deferred compensation plan, forcing a payout of more than $500,000 — all of which was taxed at the top 36.9 percent marginal tax bracket.
The lesson? “You want to tread carefully,” Reeves said.
To help manage the risk, Reeves suggested limiting deferred compensation to no more than 10 percent of overall assets, including other retirement accounts, taxable investments and even emergency cash funds.
Typically, employees must choose how much to defer and when they would like to receive the payout. Once they make a selection, there is usually little room to change the plan, under stricter payout rules adopted after the Enron debacle. (The company accelerated payouts of deferred money to protect some executives, just before it filed for bankruptcy protection.)
The financial benefits of deferral plans are generally most advantageous when money is deferred for longer periods, said Heidi O’Brien, a partner in Mercer’s executive benefits group — 15 years, rather than five. The trade-off, however, is that the funds are “at risk” for longer periods, should something happen to your employer.
Joel Isaacson, a wealth manager in New York City, recommends that installment payouts stretch no longer than five to 10 years. “It’s not money I’d want to put off for 20 years,” he said.
Employees need to consider that they not only get their salary from their employer, but may also have stock grants and other compensation, Isaacson noted. So deferring large amounts may make their finances overly dependent on one source. “People have to look at the total exposure they have to a company,” he said.