Certain companies offer deferred compensation plans in which a portion of an employee’s income is set aside and paid later, typically during retirement. While these plans can provide significant tax advantages and additional savings opportunities beyond traditional retirement plans, they’re unsuitable for everyone. This guide will help you understand the benefits and risks of deferred compensation plans and determine if participating in one aligns with your financial goals.
1. Understanding Deferred Compensation Plans
Is it safe to participate in a deferred compensation plan?
Unlike a 401(k), your deferred compensation account is not legally yours; it belongs to your employer and could be at risk if the company faces financial difficulties. Consider your employer’s long-term financial stability before participating. If you have concerns about your employer’s ability to pay in the future, it may be wise to avoid the plan.
How does a deferred compensation plan differ from other retirement accounts?
Deferred compensation plans are generally less flexible than traditional retirement accounts. For example, 401(k) distributions in retirement can be adjusted based on your needs until age 73, when required minimum distributions begin. Additionally, these required distributions are the minimum amount, not the specific amount you must distribute. In contrast, deferred compensation plans often have more rigid payout structures, such as lump sums or fixed installment plans.
2. Assessing Your Financial Situation
Are you maximizing other tax-advantaged accounts first?
Before considering a deferred compensation plan, ensure you’re fully utilizing other tax-advantaged accounts:
a) Employer’s retirement plans: Max out your contributions to accounts like 401(k)s before considering deferred compensation. These accounts tend to offer more flexibility and security.
b) Health Savings Accounts (HSA): If you’re eligible, maximize contributions to your HSA. For 2024, the limits are $4,150 for single coverage and $8,300 for family coverage, with an additional $1,000 catch-up contribution for those 55 or older. HSAs offer triple tax advantages: tax-deductible contributions, tax-deferred growth, and tax-free withdrawals for qualified medical expenses. Although these are often considered medical savings accounts, they can be wisely utilized as retirement savings accounts.
How much income can you afford to defer?
Evaluate your current cash flow needs carefully. Once you elect to defer income during open enrollment, you typically can’t change the amount until the following year. Ensure you’re not deferring so much that you’ll struggle to meet your current financial needs.
3. Tax Considerations
How will deferring income affect your current and future taxes?
Deferring income can reduce your current tax burden, but it’s crucial to consider potential future tax implications. While you delay federal and state income taxes on deferred compensation, you still pay Social Security and Medicare taxes upfront.
The plan is most beneficial when it allows you to defer income from a higher-tax year to a lower-tax year. However, predicting future tax rates can be challenging, especially if your distributions are many years away.
Are there special tax considerations?
Some plans may offer advantages such as avoiding The 3.8% Net Investment Income Tax. Additionally, there may be state tax strategies to consider, such as the potential to avoid state income tax on distributions if they’re paid out over ten or more years and you move to a lower-tax state.
4. Investment Strategies
How should you invest in a deferred compensation plan?
Most deferred compensation plans offer investment options similar to 401(k) plans. Your investment strategy should align with your risk tolerance and the time horizon until you will receive the deferred compensation.
– Long-term approach: If you have decades until distribution, you might consider more aggressive investments to potentially increase returns.
– Near-term approach: If distributions will begin soon, you may want to choose less volatile investments to protect your savings.
Remember that there’s always a potential for loss when investing. Your overall financial situation, risk tolerance, and time horizon should guide your decisions.
5. Distribution Options
When should you receive the deferred income?
The timing of your distributions depends on your employer’s plan rules, your financial goals, and your tax situation. Common options include:
– Lump-sum distribution at retirement or termination of employment
– Distribution schedule over a specific number of years (often ranging from 3 to 20 years)
It’s important to note that once you set a distribution schedule, it’s usually difficult to change afterwards. You may need to decide years in advance, and the income will be taxed in the year you receive it. However, in most cases, you will need to affirm a deferment every year so you can change a distribution schedule for the next participation period.
Are in-service distributions an option?
Some plans allow for distributions before you leave your employer. While this can be useful for major expenses like college tuition or a second home, it may defeat the purpose of tax deferral. Taking distributions while still employed could push you into a higher tax bracket, potentially negating the tax benefits.
6. Annual Review and Flexibility
How often should you reassess your participation?
Participating in a deferred compensation plan isn’t a one-time decision. It’s crucial to review your participation annually, considering:
– Changes in your financial situation
– Updates to tax laws
– Your employer’s financial health
– Your career plans and potential job changes
During open enrollment periods, you may be able to adjust the amount you defer for the upcoming year. Use this time to reassess your strategy and make necessary changes.
7. Seeking Professional Advice
When should you consult a financial advisor?
Given the complexity of deferred compensation plans and their long-term impact on your finances, it’s often beneficial to seek professional advice. Consider consulting a financial advisor if:
– You’re unsure how a deferred compensation plan fits into your overall financial strategy
– You need help evaluating tax implications
– You want assistance in balancing current cash flow needs with long-term savings goals
– You’re nearing retirement and need to plan your distribution strategy
Deferred compensation plans can be a powerful tool for high-income earners to reduce current taxable income and save for the future. However, the plans come with unique risks and complexities that require careful consideration. By asking yourself these seven key points and regularly reassessing your participation, you can make informed decisions that align with your long-term financial goals.
Remember, while deferred compensation plans can offer significant benefits, they’re not suitable for everyone. Before deciding to participate, it’s essential to consider your entire financial picture, including other retirement savings, current cash flow needs, and long-term objectives.
