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.
We know your
time is valuable. Our specialists are ready with advice and guidance to help
when you're ready.
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