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The Anatomy of a Great Deferred Compensation: A Beginner’s Guide


Consider the risks and rewards involved before taking advantage of this executive perk. After climbing the corporate ladder, you're earning good money, and then human resources offer you a new employee benefit - a deferred compensation plan.

For employees who are maximizing their 401(k) contributions and have additional savings for investment, deferred compensation plans can be an excellent savings option, but they come with many conditions.

Generally, deferred compensation plans permit participants to defer income today and withdraw it at retirement (when their taxable income will be lower). Participant contributions must be invested in the same way as those of 401(k) plans.

Deferred compensation participants, unlike 401(k) plan participants, must make distribution decisions at the time of deferral and have very little flexibility to change distribution methods later.


Here’s a brief guide that may help you better understand deferred compensation and whether you should participate.

Should you participate?

Here are a few things to think about:

1-     How financially stable is your employer?

In essence, deferred compensation plans are a promise from your company. Deferred compensation is regarded as an unsecured liability of the firm and might result in the complete loss of your contribution in the event of bankruptcy.


2-    How much of your wealth is dependent on your job?

You might also receive stock options, restricted stock units, or stock purchase plans in addition to your salary, all of which are dependent on the success of a single company. It might not be prudent to assume additional risk by including deferred comp exposure on top of this.


3-     How soon do you intend to retire or quit your job now?

There is a greater chance that anything might jeopardize the long-term financial security of your employer if you have more than 15 years till retirement. Ten years ago, who would have imagined that GE would be in financial trouble?


4-    Think about your current and potential future tax brackets.

Can you get into a lower tax bracket by delaying now? What is your likely tax bracket in retirement, taking into account all potential sources of income? This is especially tricky as no one knows for sure what tax rates or brackets will be in five, 10 or 15 years. For instance, we suggested to a customer last year to defer around $30,000 and lower his marginal tax rate from 32% to 24% (saving about $2,400 in federal tax).



Two fundamental deferred compensation decisions

When and how to accept distributions are two crucial decisions that employees who want to participate in a deferred compensation plan must make. 

These two choices are connected and need considerable consideration and preparation. If modifications are permitted under IRS regulations regulating deferred compensation programs, they often need a five-year waiting period and are challenging to amend.


How to answer the ‘when’ question

Although taking deferred pay in retirement is not required because the main incentive is income tax savings, it is recommended. The events that lead to postponed comp distribution might occasionally be beyond your control.

 For instance, you will often be required to accept distributions upon separation from service, death, or incapacity (or upon the death of you or your heirs). Your distributions should ideally be taken in retirement when other sources of income are probably going to be reduced.


How to answer the 'how' question

When you choose to draw distributions from your deferred compensation plan, this works together. The majority of programs permit either a lump sum payment or equal installments over several years. 

The strategies to consider are beyond the scope of this overview, but this is where missteps can be costly. Among the considerations are:

* When do you intend to retire? Deferred compensation payouts should ideally not be made until after retirement.

* When do you intend to start receiving Social Security? We frequently suggest to customers delaying the start of Social Security and taking delayed compensation benefits upon retirement. A Social Security income boost of around 8% annually results from each year of deferral.

* Are you able to save enough money in deferred compensation and other accounts to satisfy your projected living costs between retirement and the age of 7012, at which time you must start taking distributions from your 401(k) and IRA accounts?

* Should you distribute money in equal amounts over several years or in annual lump sums?


The final thoughts of all participants

When you initially begin participating in a deferred compensation plan, we advise that you get advice from a financial advisor or tax expert.

Last but not least, many deferred compensation plans offer participants the opportunity to invest their deferred compensation balances, similar to a 401(k). 

Deferred compensation accounts can be invested differently each year in some cases. If this option is available, one can synchronize the investments with the lump sum distribution choice, ideally lowering the account volatility as the distribution dates approach.

Plan carefully and consider how this asset fits within the context of your total retirement plan if you participate in a deferred compensation plan.



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