Time to Read: 8 Minutes
If you’re a highly compensated employee of a public or private company, you may be able to build up your retirement savings well beyond your 401(k) contributions. Participating in your employer’s deferred compensation (DC) plan can help build significant retirement savings, but if not carefully planned it can result in unintended tax consequences or unforeseen risks.
While we covered the basics in Deferred Compensation 101 this article dives into the key questions that BWM advisors help answer for high earners. We work with San Diego and national companies who offer these options, like Qualcomm, Thermo Fisher, Illumina, and Pfizer.
Should I save into my Deferred Compensation Plan?
Deferred compensation can be a nice upfront tax benefit. It can also be a detriment. It all comes down to how you’re doing it.
Depending on how much you make, how you’re paid (salary, bonuses, employer stock), and what it costs run your household, we’ll help you figure out how much to save and the best accounts to allocate your savings into.
Before contributing to deferred compensation, you may have some better savings opportunities to take advantage of:
- Employer Sponsored 401(k) – The money you contribute into your 401(k) is 100% yours, unlike contributions into your deferred compensation plan.
- Health Savings Account (HSA) – This is a way to get a tax deduction now and take tax-free distributions to pay for qualified medical expenses later.
- Backdoor Roth contribution – This provides tax free growth and eliminates unnecessary required minimum distributions later.
- Mega Backdoor Roth 401(k) – This is a way to contribute up to $58,000 per year into your 401(k), based on the 2021 limits.
Even without excess income to save, there are creative ways to use deferred compensation to your advantage. By contributing your salary to deferred compensation in years you have income from other sources, you can offset your taxable income and smoothout your tax bill. For example, you may want to recognize additional income from other sources without creating a large tax bill. This may be from non-qualified stock options (NQSOs) you exercised, restricted stock options that vested, or appreciated investments you sold.
Say you have $200k of non-qualified stock options that you want to exercise without creating a large tax bill. You can simply exercise your NQSOs, which creates $200k of taxable income, and then defer $200k of salary to your employer’s deferred compensation plan. By doing this, your tax rate will be the same as it would have been (give or take) had you not exercised options or contributed to your employer’s deferred compensation plan. But now you’ve eliminated your single stock risk and saved into a diversified mix of investments.
Since your deferred benefits won’t be protected from your employer’s creditors in the case of bankruptcy, it’s important to believe in the long-term success of the company you work for before choosing to participate in the deferred compensation plan.
How much should I save into my Deferred Compensation Plan?
Overfunding your DC plan may lead to unnecessary risks, possible cash flow issues, and a lack of flexibility or control over your taxes in retirement. Since you can only modify your contribution amount once a year, it’s a good idea to first consult with your BWM advisor about how to invest your excess savings. On a case-by-case basis, here are key factors we’d consider before telling you how much to save into your DC plan:
- Other income sources – Will your other sources of income (social security benefits, IRA distributions, other investments) cover your expected costs in retirement? Based on the amount of income received from these other sources, when it’s received, and how it’s taxed, we can recommend how much to save into your DC plan to meet your retirement goals.
- Your tax rate today vs. retirement – Deferring income today may lead to increased tax benefits over the long run if you expect to be in a lower tax bracket in retirement. But if not carefully planned, deferred compensation payments may cause higher, unintended tax bills.
- State of residency – Generally, deferred compensation is taxable in the state where you worked. However, if you elected to receive your deferred benefits over a period of ten years or more, then your state tax liability is based on the tax rate of the state you reside in when benefits are received. For this reason, if you’re working in a high-income tax state like California or New York, but plan to retire in a state with no income tax (like Florida, Texas, Washington, or Nevada), putting more of your excess savings into a deferred compensation plan may increase your overall tax benefits in the long run.
After carefully considering each of these factors, we’ll come up with a savings strategy that gives you the best chance to achieve your short and long-term financial goals.
How should I elect to receive my deferred compensation benefits?
Generally, you can elect to receive your deferred compensation payments over a period of one to ten years. But this decision must be made well in advance of receiving benefits. In the face of uncertainty, electing to take your deferred benefits over ten years is typically the best way to smooth out your taxes. But everyone’s situation is different, and there may be cases when electing to receive your payments over a shorter time horizon would be the most beneficial if you have a clear picture of when you want to retire and what your income will look like.
For example, imagine you plan on retiring at age 65 and delaying social security until age 70. Upon retiring, you may have a five-year window when you’re in a lower tax bracket than you were while working. In this case, taking your benefits over 5 years may keep your taxes lower than if you spread them over ten years. This is because taking over ten years would cause you to recognize deferred benefits in some of the years you’re also collecting social security and taking required minimum distributions from your IRA, which begin at age 72. Consequently, income from all these sources in the same tax years may bump you into a higher tax bracket.
Since you must elect your payout schedule years before retiring, you may end up facing higher taxes in the years your benefits are received than you originally anticipated. In this case, we’ll try to offset some of your tax bill by looking at certain tax deduction strategies, such as stacking charitable contributions or making a qualified charitable distribution (QCD) from your IRA.
How should I choose the investments in my Deferred Compensation plan?
It depends on a variety of factors that we’ll help you evaluate. As a part of our service, BWM advisors offer allocation guidance on accounts we cannot manage in-house, such as your 401(k) and deferred compensation plan. We’ll use your investment choices to build a portfolio that aligns with your risk tolerance, considers your payout schedule, and matches your cash needs in retirement.
For example, imagine you expect to have increased costs in early retirement to pay for things like your kids’ or grandkids education, a second home purchase, and more travel. These expenses could easily be covered with funds in your deferred compensation plan that need to be paid out. With this in mind, we may recommend more conservative investments for the assets in your deferred compensation plan earmarked for these early-retirement costs.
After covering your short-term cash needs, you may need less money from deferred compensation later in retirement because you’re spending less and receiving income from social security and required minimum distributions. In this case, it may make sense to invest the remaining funds in your deferred compensation plan in an allocation that complements your longer-term investments.
Overall, our goal is to help you select a payout schedule and investment allocation that matches your cash needs and accounts for your short-term and long-term goals in retirement.
Making decisions about deferred compensation can be a complex and challenging process to handle on your own. Deciding without the help of an experienced advisor may lead to higher taxes and unwanted risks in retirement.
At BWM, we’ll review your full financial picture to help you create a savings strategy that’s best for your specific needs. If this means participating in your employer’s deferred compensation plan, we’ll determine how much you need to save, and create a tax-efficient strategy for blending your deferred benefits with your other income sources in retirement.