Deferred Compensation: What It Is and When It’s Beneficial
Deferred Compensation: What It Is and When It’s Beneficial
Deferred compensation plans are a valuable tool for high earners to manage their income, reduce taxes, and save for the future. Yet, many professionals overlook the nuances of these plans or underestimate their potential impact on long-term wealth. If you’re considering whether deferred compensation fits into your financial strategy, this guide will help you make an informed decision.
In my experience, deferred compensation plans can be game-changers for executives and high earners who want to maximize their income while minimizing tax burdens. With careful planning, they can provide financial flexibility and security for years to come.
Why Listen to Me?
As a CERTIFIED FINANCIAL PLANNER™ professional, I’ve helped numerous clients evaluate and optimize deferred compensation plans as part of their overall financial strategies. In my experience, understanding the details of these plans is critical to making the most of them while avoiding potential pitfalls.
• Deferred compensation allows you to postpone receiving income until a later date, often in retirement.
• It can reduce your taxable income now and provide tax-deferred growth.
• Understanding the risks, benefits, and flexibility of your plan is essential.
What Is Deferred Compensation?
Deferred compensation is an arrangement between an employee and an employer where a portion of the employee’s income is set aside to be paid out at a future date. This income is typically distributed during retirement or other specified events, such as job termination.
Types of Deferred Compensation Plans
1. Qualified Plans
Examples: 401(k)s, 403(b)s.
• Regulated under ERISA.
• Contribution limits apply (e.g., $22,500 for 2025, with a $7,500 catch-up for those 50+).
In my experience, deferred compensation can help fill income gaps in early retirement before Social Security or pension benefits begin.
Risks and Considerations
1. Employer Solvency
Non-qualified plans are tied to the employer’s finances. If the company goes bankrupt, your deferred compensation could be at risk.
2. Lack of Liquidity
Deferred income isn’t accessible until the agreed-upon distribution date, so it’s essential to have other liquid assets available.
3. Tax Law Changes
Future changes to tax rates or regulations could impact the benefits of deferred compensation.
Strategies for Making the Most of Deferred Compensation
1. Align with Financial Goals
In my experience, integrating deferred compensation into a broader financial strategy ensures it complements your savings, retirement, and tax goals.
2. Diversify Investment Options
If your plan allows investments, diversify across asset classes to mitigate risk.
3. Plan for Distribution
Consider the tax implications of lump-sum payouts versus periodic distributions. Spreading distributions over several years can help avoid pushing you into a higher tax bracket.
FAQs About Deferred Compensation
1. Can I Access Deferred Compensation Early?
Generally, no. Deferred funds are only accessible at the agreed-upon distribution date or during qualifying events, such as retirement or separation from the company.
2. What Happens If I Leave My Job?
In most cases, distributions begin upon termination, but plan details vary. In my experience, understanding your plan’s specific rules is critical before leaving your employer.
3. How Do I Reduce Taxes on Distributions?
Strategies include spreading distributions over multiple years, coordinating with other income sources, and leveraging charitable contributions for tax deductions.
Case Study: Maximizing Deferred Compensation
Scenario: Lisa, a 45-year-old executive, defers $50,000 annually through her employer’s non-qualified deferred compensation plan.
• Challenge: Lisa wants to minimize taxes and ensure she has enough liquidity for unexpected expenses.
• Solution:
• Lisa sets up a 10-year payout schedule beginning at age 60 to avoid large tax hits.
• She diversifies her plan’s investment options, ensuring growth potential without excessive risk.
• Lisa maintains an emergency fund and maxes out her 401(k) contributions for additional tax advantages.
Outcome: By aligning her deferred compensation strategy with her broader financial goals, Lisa reduces her tax liability and secures a comfortable retirement income.
Conclusion
Deferred compensation is a powerful tool for managing income, reducing taxes, and building wealth. By understanding how these plans work and incorporating them into your financial strategy, you can take full advantage of their benefits while mitigating potential risks.
If you’re considering a deferred compensation plan, I recommend working with a financial planner who can help tailor a strategy to your unique needs.
Disclaimer: Case studies are hypothetical and do not relate to an actual client of Lock Wealth Management. Clients or potential clients should not interpret any part of the content as a guarantee of achieving similar results or satisfaction if they engage Lock Wealth Management for investment advisory services.
