Electing to delay part of your earnings until retirement can have benefits as well as potential drawbacks. Here's what you need to know before you act.
Delaying when you receive part of your earnings, possibly until you retire, can sound appealing from a savings and tax-efficiency standpoint. This type of payment is known as deferred compensation, and it can be especially attractive for those who have maxed out other tax-deferred savings vehicles such as 401(k)s and IRAs.
Lisa Kelley Leavy, family dynamics consultant, Wells Fargo Wealth Investment Management, says the coronavirus pandemic may not greatly impact the benefits of deferred compensation plans. But the pandemic experience could be a reason to consider how unexpected events might affect your savings, which might impact your decision to choose a deferred compensation plan.
Whether or not you updated your deferral elections at the end of 2020, Leavy says you also may want to consider working with your wealth planner to help identify future deferral-planning opportunities, particularly if your financial situation is complex.
Here, Leavy outlines potential benefits and drawbacks regarding deferred compensation plans.
1. Lower tax exposure
“For most high-earning employees, the biggest advantage of deferred compensation is the tax benefit,” Leavy says. For instance, someone who pays taxes at the highest tax bracket (currently 37%) may want to delay some of their income until retirement. This could potentially put them in a lower tax bracket now while working and/or later in retirement.
According to Leavy, many of her clients have asked about potential increases to income tax rates in the coming months. “If income tax rates increase for higher income individuals, this could make deferral planning more attractive for some people. Deferring income in a higher rate environment and receiving the income in retirement when you are potentially in a lower tax bracket can be effective tax planning. However, this approach involves long-range planning where you should carefully consider all of your potential sources of income and what your tax situation is likely to look like now and in retirement.”
2. Preservation of retirement funds
Deferred compensation can help provide income after you retire but before you’re required to take (or want to take) distributions from certain retirement accounts. For example, someone who puts $2 million into a deferred compensation plan with a 10-year payout would receive about $200,000 a year for 10 years. “Deferred compensation can still help with preservation of retirement funds,” Leavy says. “That allows retirees to maximize the tax deferral period on their IRAs and 401(k)s.” It’s also important to note that the Setting Every Community Up for Retirement Enhancement (SECURE) Act increased the beginning age for required minimum distributions to 72 years old. (Note: This does not affect individuals who turned age 70½ on or before December 31, 2019.)
3. Creation of a savings mindset
When weighing the pros and cons, Leavy notes one possible big advantage of deferred compensation: It helps reinforce a healthy savings mindset. “For some people, deferred compensation is an automatic investment,” she says. “It takes away the temptation to spend.”
1. Being a nonsecured creditor
Because deferred compensation plans are not covered by the Employee Retirement Income Security Act of 1974 (ERISA), participants have fewer protections than 401(k) contributors if the company providing the funds runs into financial trouble. “The economic impact of the pandemic will likely make some people examine this issue more closely,” Leavy says. “Because the company is holding the account, you are essentially a creditor of the company. It is them promising to pay you at a future date, so if the company goes through a bankruptcy, you could potentially lose that investment.”
2. Overestimating how much you save on taxes
Deferred compensation plans can increase your list of income streams, making it potentially easier to underestimate your income, even in retirement, Leavy says. People earning millions while working may have stock options, pension plans, IRAs, 401(k) accounts, rental property, and other accumulated assets that continue to generate income in retirement.
“If you have those other income sources as well as your deferred compensation, you can hit the highest tax bracket pretty quickly,” Leavy says.
3. An unexpected payout
Depending on the details of your plan, an employment change could turn your deferred compensation into a sudden payout, which can present tax implications. Leavy says anyone contemplating deferred compensation should keep that possibility in mind when reviewing the terms of the plan, especially if they frequently change jobs. “Be sure to weigh potential risks with potential rewards,” Leavy says.
She advises reviewing your long-term goals and opportunities with your wealth planner and tax advisor to make informed decisions as you establish your retirement plan.