Deferred Compensation Plan

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Gardener
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Deferred Compensation Plan

Post by Gardener »

My wife has recently been offered the option to participate and contribute to her employer's non qualified Deferred Compensation plan. Would this make sense to do even though it is very possible that my wife will not be working here at retirement age? Second, would we get hit with the 10% early withdrawal penalty if she were to terminate employment before retirement (and consequently receive her lump sum of deferrals)?

Quick Summary of Facts:
Wife is 29 years old
Classified as a Highly Compensated Employee, therefore is limited to only 4% contributions in regular 401k
Deferred Compensation Plan is nonqualified (risk of losing all deferrals if company becomes insolvent)
25% , 4.75% state income bracket
Good Fund options in this plan
At retirement age, can elect distributions in annual installments paid over 5, 10 yrs or a single lump sum
Company Match is 25% of spouse's contribution, to a max of 6%
Max deferment is 50%

Thank you in advance.
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TomatoTomahto
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Re: Deferred Compensation Plan

Post by TomatoTomahto »

Some other responder can probably give you the intricate pros and cons of such a plan. My wife, who has such a plan available to her, chose not to participate. Her employer is extremely unlikely to become insolvent, but she based her decision on the general principle that she's already very tied to the company's performance, and that diversification is good under almost any circumstances.
I get the FI part but not the RE part of FIRE.
dickenjb
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Re: Deferred Compensation Plan

Post by dickenjb »

I participated in one of these, but only when I was about 45 and 10 years from retirement and well into the top bracket and AMT zone.

Would not do it if in 25% bracket and 29 years old. Too much risk for too little gain.

I think if you read the plan document you will find the deferred money is paid out over a max 10 years after separation from employment (not retirement).
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JamesSFO
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Re: Deferred Compensation Plan

Post by JamesSFO »

The real catch is that when you leave the company (other than for retirement) you have to get paid out the money and so it doesn't defer so well.
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dmcmahon
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Re: Deferred Compensation Plan

Post by dmcmahon »

Check the details. If you opt for 10 years of quarterly payments there should be no lump sum distribution issue. The date when payments begin may also be flexible, e.g. payments start at age 59.5, or upon retirement if over 60, etc. So hopefully her plan offers very real deferral benefits. The most obvious risk is that the company offering the plan becomes insolvent, since her deferred comp is just another debt for the company and she has to get in line with all the other creditors. I've seen some people on this board suggest that the best way to mitigate this risk is to begin contributions in the last 5 years of employment prior to retirement. With tax rates significantly higher this year (in California) the deferral has considerable value if one anticipates being in a lower bracket after age 60. By selecting the series of payments she may also be able to avoid retroactive state income tax (Cali wants you to pay them when you withdraw the lump sum even if you retire to another state, but treats the series of payments as it would any other pension, meaning you'd only owe tax in the state you live in when receiving the payments). As an example, a high income Californian faces a 40% federal rate and a 12% state rate. What's more, the high AGI may expose her investment income to the 4% Medicare surtax. By deferring enough income until retirement, she may be able to pay just 28% + 9% and avoid the surtax, and moreover she'd get tax deferred compounding on the balance until retirement.

All that said, the main benefit is to someone in a high bracket today - in the 25% bracket, it seems questionable unless she badly needs the tax deferred space.
Willy
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Re: Deferred Compensation Plan

Post by Willy »

Don't disagree with most of the comments so far, but I would seriously consider participating, at least for 2% of pay. This will result in .5% of pay matching contribution from the employer. Your wife won't get that matching contribution otherwise. I realize that .5% of pay is not a huge amount. Still, why pass it up, unless your wife has serious concerns about the financial status of the company?
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siamond
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Re: Deferred Compensation Plan

Post by siamond »

My own deferred compensation plan allows me to say that the income deferred for year X can be either distributed when I quit (or retire) + 6 months, *OR* after a fixed period of time.

Given that the OP's wife is so young (and obviously very successful, by the way), and given the generous company match, it might make sense to use such a provision (e.g. distribute after 2 or 3 years?) if it is available.

Still, this all seems a rather slippery slope.
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TomatoTomahto
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Re: Deferred Compensation Plan

Post by TomatoTomahto »

I admit that I don't really know how these things work, but my impression is that they don't make sense unless you expect to be in a lower marginal tax bracket when the deferred comp is paid out. Is that true?
I get the FI part but not the RE part of FIRE.
Willy
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Re: Deferred Compensation Plan

Post by Willy »

That is generally correct, Tomato, but here, where there is an employer matching contribution involved, I would say it is worth participating unless you were pretty sure your tax rate at the time of distribution would definitely be less than at the time of contribution. We obviously don't know all of the facts, but I suspect that is quite unlikely.
HopeToGolf
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Re: Deferred Compensation Plan

Post by HopeToGolf »

I say defer enough to capture the match. However, there probably is a break even point where in the future the taxes deferred now could be higher due to being in a higher tax bracket at withdrawal (she leaves before retirement) and this amount exceeds the match.

At my company, there is no match so the arguement to contribute is tough unless you can defer enough to lower your tax bracket (save rather than need the cash flow) or you are close to retirement (and expect to be in a lower bracket).
sambb
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Re: Deferred Compensation Plan

Post by sambb »

aren't the assets in deferred compensation protected from litigation or bankruptcy if you get sued? It adds safety if you get in trouble? I dont believe it can be touched since it is still with the employer? not sure.
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TomatoTomahto
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Re: Deferred Compensation Plan

Post by TomatoTomahto »

I can see that perhaps I should research this topic. Thinking a bit on it, it seems that one should also take into account whether one will be getting SS benefits at distribution time, and how this night reduce the SS benefit.
I get the FI part but not the RE part of FIRE.
l2ridehd
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Re: Deferred Compensation Plan

Post by l2ridehd »

There are lots of pro's and con's with these plans. Do some research on Rabbi Trusts. That is what they are usually based on. I had that option and I did participate. We could defer any compensation over I think 223K and any or all of our annual bonus. I did both the last 8 years before retirement. It earned a good return and I accumulated a high 6 figure amount. It gets paid out over 10 years after retirement. (my choice)

Here are some issues. It used to earn what ever the company was paying for there highest borrowing rate. Which was running 6 to 8% a year for the first 8 years. Dropped to around 5% the final year. When I retired they changed the plan to one where I had to chose how it was invested. Sounds like a good change, right? Not so as they only gave us 3 possible investment options. A money market fund, an S & P 500 fund and a core bond fund. All ishares. I have done OK this year as I just used my AA and selected the MM for the next payout amount with the rest in CB and S & P at my AA. I personally liked the almost guaranteed ROI of a high corporate bond rate. Also if the company has financial issues and become insolvent you will be standing in line with all other creditors. Probably a low risk, but never the less a risk.

This plan allowed me to hold off getting SS until 70 so the 8% SS growth. Overall it has so far worked out well. However the limited investment choices could be an issue going forward.
Bill M
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Re: Deferred Compensation Plan

Post by Bill M »

I participate in one of those with my employer. Its a great deal, but you need to be careful about the company rules. Some devilish details--- Can you keep the deferral pending after leaving the company? Can you change the payout dates after salary is deferred? Are payout dates frozen when you leave the company?

There are no IRS/tax penalties involved with pre-age-59 distributions, since it is a "non-qualified plan". You do pay income tax when the deferred amounts are paid out.

Beyond the company match, to make sense it does require a lower tax rate when funds are distributed than current. As a "highly compensated employee", that is likely to be true. If the plan provisions require a lump sum upon leaving the company, that is a huge tax impact, and a huge red flag.
Wagnerjb
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Re: Deferred Compensation Plan

Post by Wagnerjb »

dickenjb wrote:I participated in one of these, but only when I was about 45 and 10 years from retirement and well into the top bracket and AMT zone.

Would not do it if in 25% bracket and 29 years old. Too much risk for too little gain.

I think if you read the plan document you will find the deferred money is paid out over a max 10 years after separation from employment (not retirement).
I agree with Dickenjb. I also did not take part in our NQDC plan until I was around 45 years old, and I would not consider enrolling at age 29 unless the benefits were very substantial. In this case, they don't seem compelling to me.

Best wishes.
Andy
Imdeng
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Re: Deferred Compensation Plan

Post by Imdeng »

You, of course, have the option of rolling over your balance to your new 401K or to an IRA - so the balance continues to be tax-deferred. You can also leave the money in the account - you can defer any payout.
JamesSFO wrote:The real catch is that when you leave the company (other than for retirement) you have to get paid out the money and so it doesn't defer so well.
Imdeng
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Re: Deferred Compensation Plan

Post by Imdeng »

Hmm... it seems there are wide variations in plan rules. My employer allows the 457 plan balances to be rolled over to an IRA or 401K that accepts rollover. The plan itself is very well managed, provides access to very low cost index funds (Wellington at 0.19% ER, S&P 500 Index funds as 0.05% ER...) and has very low cost ($4 per quarter for balances below $100K). I have been making maximum contributions there and will continue to do so.
Wagnerjb
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Re: Deferred Compensation Plan

Post by Wagnerjb »

Imdeng wrote:You, of course, have the option of rolling over your balance to your new 401K or to an IRA - so the balance continues to be tax-deferred. You can also leave the money in the account - you can defer any payout.
JamesSFO wrote:The real catch is that when you leave the company (other than for retirement) you have to get paid out the money and so it doesn't defer so well.
My understanding is that one cannot roll over Deferred Comp withdrawals to an IRA or 401K. I suppose you can take the withdrawal and pay tax on it, then separately you can contribute to an IRA. But your contribution to an IRA is governed by the normal restrictions and has nothing to do with the NQDC plan.

Best wishes.
Andy
freebeer
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Re: Deferred Compensation Plan

Post by freebeer »

Imdeng wrote:You, of course, have the option of rolling over your balance to your new 401K or to an IRA - so the balance continues to be tax-deferred. You can also leave the money in the account - you can defer any payout.
JamesSFO wrote:The real catch is that when you leave the company (other than for retirement) you have to get paid out the money and so it doesn't defer so well.
lmdeng, that was absolutely not true in my case. The DCP I participated in, as part of senior management team of a Fortune 1000 corporation, had the feature that if you left the company before retirement age was reached you just got it all paid out as ordinary income. It meant very ugly taxes in 2010. But this provision makes sense since the whole point of this type of "top hat" plan is to defer income over and above the limits in 401K or IRA - so if you could roll it over to 401K or IRA that would be a loophole.
Topic Author
Gardener
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Re: Deferred Compensation Plan

Post by Gardener »

Op here. Thank you everyone for helping to break this down for me.

Couple of quick clarifications:

Reading through the Summary of Plan Provisions, I see that if employment is terminated before normal retirement age, account is paid in a single lump sum, regardless of our payment elections.

Regarding distributions...Payments are not eligible for rollover in an IRA or any other retirement plan.

It probably doesn't change any advice given, but we are actually in the 28% bracket, not the 25% as I initially posted.

And one more question-

From my wife's Deferred Compensation Plan material: The company match is 25% of your contribution, to a maximum of 6%. In order to take advantage of the full company match, you must contribute at least 6% total between the 401k and the Deferred Compensation Plan...

So, to take full advantage of the match, we would need to contribute 4% (max allowed for HCE) in the regular 401k and the other 2% in the Deferred Compensation Plan?
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JamesSFO
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Re: Deferred Compensation Plan

Post by JamesSFO »

Gardener wrote:...
Reading through the Summary of Plan Provisions, I see that if employment is terminated before normal retirement age, account is paid in a single lump sum, regardless of our payment elections.

...
To me this is what makes it somewhat unattractive, also many times the investments are wrapped in annuities with fees over 1%.
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dmcmahon
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Re: Deferred Compensation Plan

Post by dmcmahon »

Gardener wrote: Reading through the Summary of Plan Provisions, I see that if employment is terminated before normal retirement age, account is paid in a single lump sum, regardless of our payment elections.
Seems like a deal-breaker IMO. What are the odds that your relatively young wife will leave them before the normal retirement age, triggering a big tax bill?
Gardener wrote: Regarding distributions...Payments are not eligible for rollover in an IRA or any other retirement plan.
As expected IMO. The whole point is to get around limits in regular IRA/401k savings vehicles - the IRS isn't going to leave some giant back door open!
Gardener wrote: It probably doesn't change any advice given, but we are actually in the 28% bracket, not the 25% as I initially posted.
Makes getting a lump-sum distribution an even worse proposition then, since years of savings taken in a single year could put her in the 33% bracket or higher.
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TomatoTomahto
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Re: Deferred Compensation Plan

Post by TomatoTomahto »

Gardener wrote:Reading through the Summary of Plan Provisions, I see that if employment is terminated before normal retirement age, account is paid in a single lump sum, regardless of our payment elections.
Losing control of tax timing in an effort to gain a bit of control over tax timing isn't a great idea. For a young worker, it seems like putting the cart before the horse to try to get a smallish employer match at risk of a big taxable event when you don't want it.
I get the FI part but not the RE part of FIRE.
freebeer
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Re: Deferred Compensation Plan

Post by freebeer »

TomatoTomahto wrote:
Gardener wrote:Reading through the Summary of Plan Provisions, I see that if employment is terminated before normal retirement age, account is paid in a single lump sum, regardless of our payment elections.
Losing control of tax timing in an effort to gain a bit of control over tax timing isn't a great idea. For a young worker, it seems like putting the cart before the horse to try to get a smallish employer match at risk of a big taxable event when you don't want it.
this isn't just about tax *timing* though, it's also about compounding of pre-tax contributions and potentially allowing for lower tax bracket en route. I only had like 4 years of a DCP before I left MegaCorp, so I didn't get much compounding effect. But I was already in highest bracket in that final year due to stock option exercises so the lump-sum payout didn't necessarily hurt either and I had a lower marginal tax rate in a couple of those earlier year. and it was also a significant bit of enforced savings / live-below-your-means encouragement. All in all I'm glad I participated (and I got no employer match).
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TomatoTomahto
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Re: Deferred Compensation Plan

Post by TomatoTomahto »

freebeer wrote:
TomatoTomahto wrote:
Gardener wrote:Reading through the Summary of Plan Provisions, I see that if employment is terminated before normal retirement age, account is paid in a single lump sum, regardless of our payment elections.
Losing control of tax timing in an effort to gain a bit of control over tax timing isn't a great idea. For a young worker, it seems like putting the cart before the horse to try to get a smallish employer match at risk of a big taxable event when you don't want it.
this isn't just about tax *timing* though, it's also about compounding of pre-tax contributions and potentially allowing for lower tax bracket en route. I only had like 4 years of a DCP before I left MegaCorp, so I didn't get much compounding effect. But I was already in highest bracket in that final year due to stock option exercises so the lump-sum payout didn't necessarily hurt either and I had a lower marginal tax rate in a couple of those earlier year. and it was also a significant bit of enforced savings / live-below-your-means encouragement. All in all I'm glad I participated (and I got no employer match).
I'm glad that it worked for you and it might work for OP; my point is just that the benefit is not huge and might not be worth the lack of control. OP's wife is 29. What odds do you put on her staying at her current job long enough for tax-free compounding being a benefit relative to the lump sum she will get at a probably higher tax bracket? What's the average job duration at one employer? She sounds like someone who won't have a lower tax bracket for another 30 years, if then.

As regards enforced savings; I believe that most people on BH.org don't need encouragement or enforcement of savings -- most of them could use some enforced spending :D
I get the FI part but not the RE part of FIRE.
natureexplorer
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Re: Deferred Compensation Plan

Post by natureexplorer »

Gardener wrote:risk of losing all deferrals if company becomes insolvent
How will the company compensate her for taking this risk? It seems like the only compensation is in the form of providing you with additional tax-advantaged space.

Are you already maxing out all your other tax-advantaged space? For example, does the company allow non-deductible after-tax 401k contributions?
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Steelersfan
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Re: Deferred Compensation Plan

Post by Steelersfan »

Gardener wrote:Op here. Thank you everyone for helping to break this down for me.

Couple of quick clarifications:

Reading through the Summary of Plan Provisions, I see that if employment is terminated before normal retirement age, account is paid in a single lump sum, regardless of our payment elections.

Regarding distributions...Payments are not eligible for rollover in an IRA or any other retirement plan.
That's how my deferred comp plan worked as well.

Plus once we had set the distribution schedule we couldn't change it, except to make it extend over a longer period of time.

At age 29, the chances she'll still be with the same employer when she retires is very small. so odds are great that she'll get whatever she puts in (plus the match) as a one time distribution. The tax hit will be significant if she's in the plan for long.


I'd pass if I were her.
Bfwolf
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Re: Deferred Compensation Plan

Post by Bfwolf »

Quick thought experiment assuming your wife makes $100K.

If she doesn't do the deferred comp, she'll contribute $4,000 to her 401K and get a $1,000 match. Gross take home pay would be $96,000.

If she defers $2,000 in order to max her match, she'll contribute $3,920 to her 401K (she can only contribute 4% of her compensation which is now $98K instead of $100K) and get a $980 match. She'll also get $2,000 in the deferred compensation account and a $500 match there. Gross take home pay would be $94,080.

So net net, deferring $2,000 in the DCP would result in:

401K: -$100
Deferred Compensation: +$2,500
Gross take home pay: -$1,920.

In total, you're +$480 which is pretty nice and seems like a good reward for the DCP risk if you think the company is likely to remain in good financial standing. With such small sums, it would take quite a few years before a separation of service payout is likely to have some horrible impact on your tax bracket. Even if she's making $200K instead of $100K, putting in 2% a year is not going to be a ton of money unless she does it 10 years in a row. On the other hand, $480 per year may not seem worth it to you in the interest of simplicity.
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