Plus, get a quick intro on this unique way to save for the future.

If your company offers a deferred compensation plan as a way to save for retirement, it’s important to understand the pros and cons of this type of agreement. After all, it may look attractive at first, but the reality is, it’s not for everyone.

What Is Deferred Compensation? 

First, let’s explain deferred compensation. It’s a type of agreement that allows you to hold part of your compensation and income taxes to be paid out at a later date, commonly when you’re ready to retire. Often, companies offer this retirement savings strategy to executives in an effort to retain them long-term. You may have even referred to it as “the golden handcuffs.”

The potential payout is quite alluring. But is deferred compensation worth it, all things considered? As someone with sought-after skills and experience, you’re a valuable asset to your employer. Are they offering you a valuable benefit in return? 

Advantages and Disadvantages of Deferred Compensation

Deferred compensation offers many benefits to employees, including:

• Reduces taxable income today. When you defer part of your pay for some time in the future, you lower the total amount of income taxes you pay today. For example, let’s say you are married and have a salary of $320,000 a year with a 20% bonus, but you decide to defer your bonus compensation each year. Instead of being taxed on a $384,000 annual income, you only have to pay taxes on your $320,000 income. This can save quite a bit for a couple in a high tax bracket.
• Possible lower future tax rate. Deferring your income for later can also mean you pay a lower rate on that income in the future. Deferring that bonus income until retirement, you will most likely be in lower tax bracket because you won’t have your normal income. For example, if you owed taxes on $320,000 of income, you were most likely in the 24% federal tax bracket. Retiring the following year, theoretically, the only income you would have would be $64,000, which would be taxed at a lower marginal tax bracket of 12%.
• An opportunity for the funds to grow and for you to save much more. This deferred comp can often be invested in the market while you wait to realize it. In addition, there aren’t limits to the amount you can contribute each year, unlike your 401(k) plan. So, you may be able to save your whole annual bonus or a large percentage of your salary, for example.

But remember that deferred compensation has its share of risks, too. 

• • Investment risk. While your company will allow you to invest in a menu of funds, these plans aren’t like a 401(k). They don’t have the same ERISA protections as your 401k. This is a contract in which the firm agrees to pay you the amount in the future. The structure of the plan might also restrict your investment choices, possibly confining you to only the company’s stock as an option.
  • Lack of portability. Unlike a 401(k), funds in a deferred compensation plan cannot be transferred or rolled over into an IRA account.
  • You’re essentially your employer’s creditor. 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. For many people, that can be a huge potential risk and enough to avoid a deferred compensation plan altogether, depending on the health and predicted future of the company.
  • Lack of liquidity. The money in a deferred compensation plan is generally not available until the triggering event (usually retirement) happens. And you can’t borrow against the balance. This can be a problem if you need access to cash for unexpected expenses or opportunities.

How a Non-Qualified Deferred Compensation Plan Works

There are a few rules to follow when enrolling in a non-qualified deferred compensation (NQDC) plan. Here’s what you can expect:

• You must elect to participate in the year before you earn the payout.
• Your election is usually irrevocable.
• You must decide on the payment schedule and the triggering event at the time of deferral (for example, when you retire).

Before enrolling with your employer, read the small print. It’s critical to make sure you truly understand your side of the agreement.

Later, when it’s time to retire and receive your payout, usually you can choose to receive either a lump sum withdrawal or installment payments over a certain number of years. Here are the pros and cons of each approach.

• Lump sum withdrawal: This option gives you immediate control of your money, but you may have to pay more in taxes unless you carefully smooth your income stream. For example, one idea is to reinvest your payment to fund an early retirement before you claim social security benefits.
• Installment payments: Alternatively, if you space out your withdrawals over a series of years, you may reduce your tax payments—and get more flexibility out of your money too.

It always helps to talk to a financial advisor to figure out the best approach for you and your family.

What to Do If You’re Offered a Deferred Compensation Plan

Your employer’s deferred compensation plan can offer you more income in retirement, especially if you’ve already maxed out your 401(k) contributions. Just make sure you’re evaluating the health of the company long-term, and analyzing your own income needs, expenses, and current investments.

If your company offers a NQCD and you’re getting close to retirement, talk to an advisor who can help you analyze the pros and cons in light of your own personal financial situation and goals. Remember, there are options. Take the time to sit with someone you trust who can help you decide the right path forward.

Lake Road Advisors, a Fee-Only, independent financial planning firm with offices in Corning, NY, Ithaca, NY and Portland, OR works with clients virtually all across the country. Paul Sydlansky, the founder of Lake Road Advisors LLC, has worked in the financial services industry for 20+ years. Prior to founding Lake Road Advisors, Paul worked at Morgan Stanley in Manhattan for 13 years. While at Morgan Stanley, Paul was a senior-level manager within the Institutional Equities Department. In 2018 he was named to Investopedia’s Top 100 Financial Advisors list. Paul received a Bachelor’s degree in Economics from Marist College and holds an MBA from New York University Leonard N. Stern School of Business. Paul is a CERTIFIED FINANCIAL PLANNER™ and a member of the National Association of Personal Financial Advisors (NAPFA) and the XY Planning Network.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.