Deferred Compensation Plan - "Ideal" Strategy?

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nyseeker
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Deferred Compensation Plan - "Ideal" Strategy?

Post by nyseeker »

I have a question regarding an "optimal" strategy for NQDC plans. I work for a Fortune 500 company that is doing quite well and is a well-established player in the high-tech space. I am 56 with a net worth of around $6M and plan to work for around nine years before heading out into the retirement sunset. Since I am in the higher marginal tax bracket, I have tried to maximize my contribution to the non-qualified deferred compensation plan offered by the company. This is a "rabbi trust" scheme; I can direct my investments but it is not protected against risk in case the company gets into dire financial straits. My NQDC investments have grown to about 12% of my assets.

Even though the risk may be small in terms of my company's solvency and, hence, the NQDC plan, I have been planning on taking out the deferred income(s) after a rolling 5-year initial period (designated when putting money into it and cannot be changed) instead of staying in it until retirement. Basically, if I defer $x this year, $y next year, etc., I will withdraw $x_grown in +5 years, $y_grown in +6 years,... My logic is that this may be a reasonable way to allow for growth for about 5 years or so, which will "pay for the taxes" when I receive the income, and also insulate myself against a low-probability deleterious financial status of my company.

I know that there is no magic bullet since we don't have a crystal ball, but was wondering whether the strategy above is a reasonable one or too cautious or too aggressive? Is there a structured way of thinking in analyzing/hedging the risk and devising an optimal strategy for NQDC?
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FiveK
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Re: Deferred Compensation Plan - "Ideal" Strategy?

Post by FiveK »

One could possibly develop some analog "degree to which the company will be ability to pay back the deferred compensation" and go from there. A simpler alternative is to make a yes/no choice: don't participate at all if you doubt the company will remain solvent.

If you decide to participate, it usually isn't favorable to take distributions while you continue to work. That's because the selling point of deferring compensation now is the expected lower marginal tax rate when receiving that income later.
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nyseeker
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Re: Deferred Compensation Plan - "Ideal" Strategy?

Post by nyseeker »

FiveK wrote: Thu Sep 09, 2021 5:28 pm One could possibly develop some analog "degree to which the company will be ability to pay back the deferred compensation" and go from there. A simpler alternative is to make a yes/no choice: don't participate at all if you doubt the company will remain solvent.

If you decide to participate, it usually isn't favorable to take distributions while you continue to work. That's because the selling point of deferring compensation now is the expected lower marginal tax rate when receiving that income later.
Thanks for your response and insights.

Your point re: deferring until not working is well taken. I was taking a slightly differing view on this: setting a limited deferral horizon (I have set it to five years) allows for tax-free growth, which at least defrays the tax hit that is more elevated since it occurs when working. Of course, this is sub-optimal if the company risk is low/absent. However, it seemed like it is somewhat of a compromise position between these two options:
  • Not deferring at all. Zero risk of catastrophic loss. Zero deferral benefit.
  • Deferring until retirement. Potential (unquantifiable) risk of catastrophic loss. Maximum deferral benefit.
Given that the risk is not really quantifiable (at least to me), it seems like setting the dial somewhere between these two options is just a guess based on personal risk tolerance and other factors. I wasn't sure whether there was something better that could be done.

One possibility was hedging against the risk by taking counter positions. Our company policy prohibits (as is, I think, customary) trading in company stock options that could be used to hedge. There was also a deferred compensation "insurance" program I read about that worked in sort of a "cooperative" manner, i.e., people in somewhat similar risk tiers and in NQDC plans chip in some amount that would be used to pay off potential collapse of a participant's NQDC plan - not sure how well these worked.
milktoast
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Re: Deferred Compensation Plan - "Ideal" Strategy?

Post by milktoast »

I use a NQDC plan on >70% of my salary and bonus. Honestly, I think in-service withdrawal is a poor idea.

NQDC is a tax arbitrage play. Marginal rate now vs marginal rate in the future. If the future is while you are still working at same company, why has your pay gone down?

In my case, I'm opting for maximum duration after retirement. Because that more or less minimizes my marginal rate. Right now I haven't yet filled the 12% bracket from my plan of payments over 15 years from 56-70. And I'm deferring at 40% marginal. So my potential gain is ~25%.

To reduce risk, I'm putting all my bonds in NQDC. That reduces the expected value of the account (reducing my portfolio loss if company dies) and it will pay out prior to my 401k which is still mostly stocks. I'll pivot 401k to bonds to maintain balance as NQDC pays down.
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FiveK
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Re: Deferred Compensation Plan - "Ideal" Strategy?

Post by FiveK »

nyseeker wrote: Thu Sep 09, 2021 5:51 pm...setting a limited deferral horizon (I have set it to five years) allows for tax-free growth, which at least defrays the tax hit that is more elevated since it occurs when working.
Depending on how much higher the marginal rate on deferred withdrawals is, the after-tax result can be worse than simply making taxable investments instead of deferring in the first place.

The result can also be better, depending on specifics....
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nyseeker
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Re: Deferred Compensation Plan - "Ideal" Strategy?

Post by nyseeker »

milktoast wrote: Thu Sep 09, 2021 6:00 pm I use a NQDC plan on >70% of my salary and bonus. Honestly, I think in-service withdrawal is a poor idea.

NQDC is a tax arbitrage play. Marginal rate now vs marginal rate in the future. If the future is while you are still working at same company, why has your pay gone down?

In my case, I'm opting for maximum duration after retirement. Because that more or less minimizes my marginal rate. Right now I haven't yet filled the 12% bracket from my plan of payments over 15 years from 56-70. And I'm deferring at 40% marginal. So my potential gain is ~25%.

To reduce risk, I'm putting all my bonds in NQDC. That reduces the expected value of the account (reducing my portfolio loss if company dies) and it will pay out prior to my 401k which is still mostly stocks. I'll pivot 401k to bonds to maintain balance as NQDC pays down.
Thanks for your input.

I think your % deferral strategy is similar to mine - I try to defer to reduce my current paychecks to more or less zero. Note that, in my case, stock awards do constitute a substantial portion of my annual compensation and, of course, is not subject to deferral.

Agreed re: tax arbitrage. I wasn't expecting the tax rate to go down while I'm working. It does fluctuate depending on stock rewards, etc., but the marginal rate is probably steady. I was trying to balance between potential risk and not optimizing from a tax arbitrage perspective.

The focus on bonds in the NQDC is a great idea, I think. I hadn't thought of this - thanks. This, as you indicate, reduces the expected value of the account and concomitant risk. I will look into this option in a bit more detail.

You have given me some good insights to chew on - I appreciate it.
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nyseeker
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Re: Deferred Compensation Plan - "Ideal" Strategy?

Post by nyseeker »

FiveK wrote: Thu Sep 09, 2021 6:32 pm
nyseeker wrote: Thu Sep 09, 2021 5:51 pm...setting a limited deferral horizon (I have set it to five years) allows for tax-free growth, which at least defrays the tax hit that is more elevated since it occurs when working.
Depending on how much higher the marginal rate on deferred withdrawals is, the after-tax result can be worse than simply making taxable investments instead of deferring in the first place.

The result can also be better, depending on specifics....
Thank you. You are correct. In my case, the marginal tax rates tend to be stable Y-o-Y though some fluctuations do occur due to changes in stock compensation numbers for myriad reasons. So, the net is that I expect the five-year window to be a win even accounting for taxes.

The idea suggested by milktoast earlier in the thread re: using the NQDC for the bond portion of the portfolio does make a ton of sense. I may look into this.
DVMResident
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Re: Deferred Compensation Plan - "Ideal" Strategy?

Post by DVMResident »

milktoast wrote: Thu Sep 09, 2021 6:00 pm I use a NQDC plan on >70% of my salary and bonus. Honestly, I think in-service withdrawal is a poor idea.

NQDC is a tax arbitrage play. Marginal rate now vs marginal rate in the future. If the future is while you are still working at same company, why has your pay gone down?

In my case, I'm opting for maximum duration after retirement. Because that more or less minimizes my marginal rate. Right now I haven't yet filled the 12% bracket from my plan of payments over 15 years from 56-70. And I'm deferring at 40% marginal. So my potential gain is ~25%.

To reduce risk, I'm putting all my bonds in NQDC. That reduces the expected value of the account (reducing my portfolio loss if company dies) and it will pay out prior to my 401k which is still mostly stocks. I'll pivot 401k to bonds to maintain balance as NQDC pays down.
Adding another aspect to your point: some of that $6m net worth is tax deferred. That means the OP will have RMDs - potentially a lot.

The OP is currently 56 and planning to work until 65. RMDs start at 72. Stretching to the DCP distributions to the maximum (10 years?) may overlap with RMD distributions. If avoiding the DCP/RMD overlap, that's only a 6 year window between the first full retirement year and RMD. The DCP is currently valued at $720k and growing contributions by a six-figure amount per year (reduce paychecks to "zero") plus whatever the market does. Even with a bond-heavy allocation, the DCP might end up >$2.5m. A 6 year DCP distribution could be >$400k/yr.

I'm not convinced there is much tax arbitrage opportunity here.

OP, what's your current marginal rate and your projected retirement marginal rate?
Longdog
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Re: Deferred Compensation Plan - "Ideal" Strategy?

Post by Longdog »

Is there really tax free growth on the deferred amount? You won’t owe taxes at your marginal income tax rate on the full amount distributed each year in the future, including growth component?
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nyseeker
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Re: Deferred Compensation Plan - "Ideal" Strategy?

Post by nyseeker »

DVMResident wrote: Thu Sep 09, 2021 8:20 pm ...
Adding another aspect to your point: some of that $6m net worth is tax deferred. That means the OP will have RMDs - potentially a lot.

The OP is currently 56 and planning to work until 65. RMDs start at 72. Stretching to the DCP distributions to the maximum (10 years?) may overlap with RMD distributions. If avoiding the DCP/RMD overlap, that's only a 6 year window between the first full retirement year and RMD. The DCP is currently valued at $720k and growing contributions by a six-figure amount per year (reduce paychecks to "zero") plus whatever the market does. Even with a bond-heavy allocation, the DCP might end up >$2.5m. A 6 year DCP distribution could be >$400k/yr.

I'm not convinced there is much tax arbitrage opportunity here.

OP, what's your current marginal rate and your projected retirement marginal rate?
Thanks for your comments. Good points all!

Some details... Taxable investments are approximately 50% of retirement savings. Tax-deferred stuff is distributed mostly over 401-K's and IRA's (with less in Roth). As you point out, the limited window until RMD kicking in will definitely reduce the effectiveness of the arbitrage. You are also right in that the DCP portion does grow quite substantially due to heavier contributions to minimize current tax hit that is driven by non-deferred stock comp.

Re: current marginal tax rate. Currently at 37% (MFJ max) but fluctuates slightly, moving a tad lower depending on stock comp...
DVMResident
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Re: Deferred Compensation Plan - "Ideal" Strategy?

Post by DVMResident »

nyseeker wrote: Thu Sep 09, 2021 8:45 pm
DVMResident wrote: Thu Sep 09, 2021 8:20 pm ...
Adding another aspect to your point: some of that $6m net worth is tax deferred. That means the OP will have RMDs - potentially a lot.

The OP is currently 56 and planning to work until 65. RMDs start at 72. Stretching to the DCP distributions to the maximum (10 years?) may overlap with RMD distributions. If avoiding the DCP/RMD overlap, that's only a 6 year window between the first full retirement year and RMD. The DCP is currently valued at $720k and growing contributions by a six-figure amount per year (reduce paychecks to "zero") plus whatever the market does. Even with a bond-heavy allocation, the DCP might end up >$2.5m. A 6 year DCP distribution could be >$400k/yr.

I'm not convinced there is much tax arbitrage opportunity here.

OP, what's your current marginal rate and your projected retirement marginal rate?
Thanks for your comments. Good points all!

Some details... Taxable investments are approximately 50% of retirement savings. Tax-deferred stuff is distributed mostly over 401-K's and IRA's (with less in Roth). As you point out, the limited window until RMD kicking in will definitely reduce the effectiveness of the arbitrage. You are also right in that the DCP portion does grow quite substantially due to heavier contributions to minimize current tax hit that is driven by non-deferred stock comp.

Re: current marginal tax rate. Currently at 37% (MFJ max) but fluctuates slightly, moving a tad lower depending on stock comp...
Congrats! These are big numbers.

I'd ballpark your tax arbitrage is notable up to ~$2m DCP. $2m distributed over 6 years will take to you the top of the 24% bracket. To get to $2m in 9 years, consider adding $100k/yr to the DCP (assume 4% real, $ in 2021 values). Adjust your targets market returns and tax brackets change.

>$2.5m DCP will push your marginal rate into the 35-37% bracket. High DCP balances have no-to-little tax savings. You will be savings at the marginal rate to pay the same marginal rate in retirement. You take on company risk for no-to-little upside.

However, there might be another play here...

Half-baked, crazy concept: for every dollar contributed DCP beyond $100k/yr, do an equal amount Roth conversions. This is in effect a "free" Roth conversion. Heavy Roth "free" conversion will reduce your RMDs - maybe even to the point where you can decompress your DCP distributions over more than 6 years with your DCP/RMD overlap staying within the 24% bracket.

Fellow forum members, please poke holes in that idea.
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nyseeker
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Re: Deferred Compensation Plan - "Ideal" Strategy?

Post by nyseeker »

DVMResident wrote: Thu Sep 09, 2021 9:55 pm Congrats! These are big numbers.
Thanks. After all the volatility and churn last year, numbers don't seem to provide the same level of confidence/comfort as they should (I know this is overstating it!)
I'd ballpark your tax arbitrage is notable up to ~$2m DCP. $2m distributed over 6 years will take to you the top of the 24% bracket. To get to $2m in 9 years, consider adding $100k/yr to the DCP (assume 4% real, $ in 2021 values). Adjust your targets market returns and tax brackets change.
That's been the ballpark (probably a bit north of it) contribution over the years, though I started out a bit more aggressive.
>$2.5m DCP will push your marginal rate into the 35-37% bracket. High DCP balances have no-to-little tax savings. You will be savings at the marginal rate to pay the same marginal rate in retirement. You take on company risk for no-to-little upside.
I had a slightly different take/question on this. Even if the tax bracket pushed up to 35-37%, it would still be beneficial to use the DCP since the gains are tax sheltered until the retirement distributions (this is similar to a 401-K being beneficial even if the tax rates remain the same even into retirement). Thoughts?
Half-baked, crazy concept: for every dollar contributed DCP beyond $100k/yr, do an equal amount Roth conversions. This is in effect a "free" Roth conversion. Heavy Roth "free" conversion will reduce your RMDs - maybe even to the point where you can decompress your DCP distributions over more than 6 years with your DCP/RMD overlap staying within the 24% bracket.
Interesting... I need to run the numbers on this. Taking the tax hit right now would seem to remove the tax deferred returns portion of the 401-K, which would be counterproductive (cf. last quoted section).

Thanks for your thoughts on this. Much appreciated.

I should have probably posted earlier in the thread. I am mostly a "DIY" investor who has been on the Vanguard Index Funds path since around 1992. I use Vanguard PAS for my taxable investments and manage the tax-deferred portions on my own. My current asset allocation target is 85% stocks/15% bonds (this falls into VG's "very aggressive" bracket) with PAS doing their thing across domestic/international stocks and bonds and me generally targeting 85%/15% US stocks and bonds on the tax-deferred side, which makes me a bit heavy on US equities. I haven't been able to get satisfactory answers from PAS re: deferred comp and a for-fee CPA/Financial Advisor acting as a consultant wasn't too helpful either - hence trying to tap into the collective wisdom of Bogleheads. I have already gotten great lines of thought in this thread, so it seems like a good move!
milktoast
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Re: Deferred Compensation Plan - "Ideal" Strategy?

Post by milktoast »

nyseeker wrote: Thu Sep 09, 2021 11:36 pm I haven't been able to get satisfactory answers from PAS re: deferred comp and a for-fee CPA/Financial Advisor acting as a consultant wasn't too helpful either - hence trying to tap into the collective wisdom of Bogleheads. I have already gotten great lines of thought in this thread, so it seems like a good move!
I left PAS for exactly this reason.

With my NQDC being bond heavy it’s easy to figure out my marginal brackets. Just assume 0% real.

You are working longer, so it gets harder to tune. Since you have social security at 70 and then RMD. But you should be able to figure it out pretty close with various scenarios for drawdown timing.

The way I think about risk reward us as follows. The delta in marginal rate is the gain that I get from taking the risk. I would not contribute another dollar if that dollar would be taxed in the 32% bracket because 5% tax savings doesn’t justify the counter party risk.
DVMResident
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Re: Deferred Compensation Plan - "Ideal" Strategy?

Post by DVMResident »

nyseeker wrote: Thu Sep 09, 2021 11:36 pm
DVMResident wrote: Thu Sep 09, 2021 9:55 pm >$2.5m DCP will push your marginal rate into the 35-37% bracket. High DCP balances have no-to-little tax savings. You will be savings at the marginal rate to pay the same marginal rate in retirement. You take on company risk for no-to-little upside.
I had a slightly different take/question on this. Even if the tax bracket pushed up to 35-37%, it would still be beneficial to use the DCP since the gains are tax sheltered until the retirement distributions (this is similar to a 401-K being beneficial even if the tax rates remain the same even into retirement). Thoughts?
I agree with Milktoast's recommendation for heavier bond allocation in the DCP. I also keep a heavier bond allocation in my DCP.

If you do the same with your DCP, my assessment is you're trading conservative (2%?) tax-deferred gains for a taking on company risk and forced distribution schedule. In contrast, your taxable accounts have access to tax-managed growth (e.g. muni bonds), control on when to realize gains, and are taxed at the LTCG rate instead of the income rate. Up to 6 times the top of the 24% bracket, your plan has large tax savings and a 'no-brainer.' Beyond that, this plan should eek out a technical win by thin margins.

I would still max out the DCP but for different reasons: you may retire earlier than planned allowing a longer distribution period with lower account balances or your RSU may not stay high. So I still endorse the idea.

My Roth suggestion above is a "yes, and..." comment to further optimize your. I think you could be doing something better than trading high marginal for the same high marginal rate. Roth conversions and resetting taxable tax basis are two obvious ones to me.
NotWhoYouThink
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Re: Deferred Compensation Plan - "Ideal" Strategy?

Post by NotWhoYouThink »

You aren't saving anything on taxes with this plan, and are likely to pay more.

The TCJA expires at the end of 2025, and marginal rates will go up, so if you withdraw in 5 years while you are still working, you will be paying the higher marginal rate on all of the deferral amounts, plus all of the gain - no benefit of the (currently) lower capital gains rate on any of the gains.

We aren't allowed to discuss potential but currently unenacted future tax rates on this forum, but they are discussed everywhere else on the internets, and you might consider that when deciding whether you want to pay taxes now or later. But even with today's law your plan looks guaranteed to result in more money to the Treasury and less to you. So thanks from the rest of us.
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nyseeker
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Re: Deferred Compensation Plan - "Ideal" Strategy?

Post by nyseeker »

milktoast wrote: Fri Sep 10, 2021 12:08 am I left PAS for exactly this reason.

With my NQDC being bond heavy it’s easy to figure out my marginal brackets. Just assume 0% real.

You are working longer, so it gets harder to tune. Since you have social security at 70 and then RMD. But you should be able to figure it out pretty close with various scenarios for drawdown timing.

The way I think about risk reward us as follows. The delta in marginal rate is the gain that I get from taking the risk. I would not contribute another dollar if that dollar would be taxed in the 32% bracket because 5% tax savings doesn’t justify the counter party risk.
PAS has worked out pretty well otherwise, I think, since it is a reasonable autopilot for me. However, I don't know whether it is worth 0.3% or slightly lower - though it is still comparable to other providers.

I think your construct with DCP with bonds is a good one to simplify its mental model. It allows me to think only about the tax arbitrage and completely forget about the tax-deferred growth aspect of it. This leads to a starker quantification of risk that reduces the "shine" of the plan perhaps if the tax difference advantage is marginal.

Along this line of thinking, it seems like a "short term treatment", i.e., like a 5-year rolling window for deferral as I had described (and follow currently) doesn't seem too bad since the "minimal tax arbitrage" model would perhaps imply that DCP participation may not be worth it in the longer run since the upside is simply a small tax rate differential.

I need to run the numbers on different scenarios to get a better fix on this. I really appreciate your insights on this - thanks.
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nyseeker
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Re: Deferred Compensation Plan - "Ideal" Strategy?

Post by nyseeker »

NotWhoYouThink wrote: Fri Sep 10, 2021 7:57 am You aren't saving anything on taxes with this plan, and are likely to pay more.

The TCJA expires at the end of 2025, and marginal rates will go up, so if you withdraw in 5 years while you are still working, you will be paying the higher marginal rate on all of the deferral amounts, plus all of the gain - no benefit of the (currently) lower capital gains rate on any of the gains.

We aren't allowed to discuss potential but currently unenacted future tax rates on this forum, but they are discussed everywhere else on the internets, and you might consider that when deciding whether you want to pay taxes now or later. But even with today's law your plan looks guaranteed to result in more money to the Treasury and less to you. So thanks from the rest of us.
Very welcome :) Your point is well taken - thanks. The DCP started a few years back, so some of it will be available well before the TCJA expiration. On a, say, 15 year stretch (using my start date with the DCP as the beginning), I am expecting varying tax environments - some of the deferrals may encounter the same tax environment they went in and some may face a more beneficial/adverse treatment (who am I kidding - it will in all likelihood be adverse). I wasn't trying to account for it since it is somewhat unknowable other than general trends perhaps.

Also, even with the tax increases, the tax-deferred growth (assuming non-bond allocation) would still offset them to redound in a net benefit in many scenarios, IMO.
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nyseeker
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Re: Deferred Compensation Plan - "Ideal" Strategy?

Post by nyseeker »

DVMResident wrote: Fri Sep 10, 2021 6:11 am I agree with Milktoast's recommendation for heavier bond allocation in the DCP. I also keep a heavier bond allocation in my DCP.

If you do the same with your DCP, my assessment is you're trading conservative (2%?) tax-deferred gains for a taking on company risk and forced distribution schedule. In contrast, your taxable accounts have access to tax-managed growth (e.g. muni bonds), control on when to realize gains, and are taxed at the LTCG rate instead of the income rate. Up to 6 times the top of the 24% bracket, your plan has large tax savings and a 'no-brainer.' Beyond that, this plan should eek out a technical win by thin margins.
Good point - food for thought, certainly. Treating the DCP as a "bond-only" vehicle does crystallize the "tax-benefit-only" view very clearly (this was not something I was doing before). Doing this also brings to fore the issues you raise above, e.g., incurring LTCG "now" may be better than treatment as income at a higher tax rate due to RMDs and the rest.
DVMResident wrote: Fri Sep 10, 2021 6:11 am I would still max out the DCP but for different reasons: you may retire earlier than planned allowing a longer distribution period with lower account balances or your RSU may not stay high. So I still endorse the idea.
This has been my thinking as well. However, after this discussion, I am not completely sure. I need to do some number crunching to see whether it makes sense.
DVMResident wrote: Fri Sep 10, 2021 6:11 am My Roth suggestion above is a "yes, and..." comment to further optimize your. I think you could be doing something better than trading high marginal for the same high marginal rate. Roth conversions and resetting taxable tax basis are two obvious ones to me.
I need to think about this a bit. Intuitively, doing a Roth conversion while in the highest(ish) bracket seems to be perhaps unrealistically pessimistic. Of course, as another commenter pointed out, TCJA expiry may change the landscape significantly.

I appreciate your thoughts and inputs on this - thank you!
Boston Girl
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Re: Deferred Compensation Plan - "Ideal" Strategy?

Post by Boston Girl »

Take a look at state taxation on any withdrawal strategy from non-qual rabbi trust plan. If you set up equal systematic withdrawals to occur over a minimum10 year period following retirement, your payments are exempt from state taxation.

FICA is usually withdrawn at point of deferral. You will receive a W-2 once withdrawals start but no withholding for social security.

Careful of contributions while residing in multiple states. Each state is likely to pursue taxes (source taxation), regardless of where you finally land.

I participated in such a plan. The plan's risk of default was minimal in my opinion. Deferring taxes at the highest tax rate, after reaching FICA limits, meant no social security withholdings at all. The money has helped the transition to retirement greatly.
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nyseeker
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Re: Deferred Compensation Plan - "Ideal" Strategy?

Post by nyseeker »

Boston Girl wrote: Sun Sep 12, 2021 7:49 am Take a look at state taxation on any withdrawal strategy from non-qual rabbi trust plan. If you set up equal systematic withdrawals to occur over a minimum10 year period following retirement, your payments are exempt from state taxation.

FICA is usually withdrawn at point of deferral. You will receive a W-2 once withdrawals start but no withholding for social security.

Careful of contributions while residing in multiple states. Each state is likely to pursue taxes (source taxation), regardless of where you finally land.

I participated in such a plan. The plan's risk of default was minimal in my opinion. Deferring taxes at the highest tax rate, after reaching FICA limits, meant no social security withholdings at all. The money has helped the transition to retirement greatly.
Thank you. Excellent points re: state taxation and FICA. I hadn't included state tax considerations explicitly in my planning since my primary residence has been NY and I am not sure whether this will change in retirement. I will take a look at the considerations you brought up.
MileKing
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Re: Deferred Compensation Plan - "Ideal" Strategy?

Post by MileKing »

Boston Girl wrote: Sun Sep 12, 2021 7:49 am Take a look at state taxation on any withdrawal strategy from non-qual rabbi trust plan. If you set up equal systematic withdrawals to occur over a minimum10 year period following retirement, your payments are exempt from state taxation.
Deferred comp distributions paid over a minimum 10 year period are not automatically exempt from state taxation. If you start taking distributions while a resident of the same state in which you earned the money, you will still pay that state's income tax on the distributions regardless of the length of the distribution period. I believe Boston Girl was referring to the federal source taxation rule which applies when deferred compensation is earned by an employee or former employee while a resident of a state, but paid when the individual is no longer a resident of that state. In that case the deferred comp distribution is not subject to the earning state's income taxes if the compensation is paid over the individual's life or life expectancy or is paid in installments scheduled over 10 years or more.

For the original poster, you may want to consider where you plan to retire and look at that state's income tax rates to identify if you will benefit by waiting to take distributions. In general, I agree with those who posted that in-service distributions are not the best approach. In your case, it sounds like your overall comp can vary greatly from year to year so starting distributions while still working would not seem to offer the tax benefits the deferred comp plan is designed to provide. Also, you state your net worth is around $6M with about 12% ($720k) in the deferred comp plan. What is your anticipated level of retirement spend? If your firm was to go bankrupt and you lost all of the deferred comp money, would that significantly change your retirement plans and level of spending? If not, why not keep deferring, push distributions out to start when you retire (and perhaps move to a tax friendly state if you are not already in one), and take distributions over the longest period of time you can?
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nyseeker
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Re: Deferred Compensation Plan - "Ideal" Strategy?

Post by nyseeker »

Thanks for your detailed response and information.
MileKing wrote: Sun Sep 12, 2021 10:18 am Deferred comp distributions paid over a minimum 10 year period are not automatically exempt from state taxation. If you start taking distributions while a resident of the same state in which you earned the money, you will still pay that state's income tax on the distributions regardless of the length of the distribution period. I believe Boston Girl was referring to the federal source taxation rule which applies when deferred compensation is earned by an employee or former employee while a resident of a state, but paid when the individual is no longer a resident of that state. In that case the deferred comp distribution is not subject to the earning state's income taxes if the compensation is paid over the individual's life or life expectancy or is paid in installments scheduled over 10 years or more.
You are correct and aligns with my understanding as well. Something that may be relevant in my case was there was some confusion whether NY state could tax distributions that occur from NQDC plans that happen after someone leaves the state when the income was deferred when one was a NY state resident (notwithstanding the federal rule) . Looks like NY state clarified that they are not going to be able to do this; however, I need to read this more carefully to confirm.
MileKing wrote: Sun Sep 12, 2021 10:18 am For the original poster, you may want to consider where you plan to retire and look at that state's income tax rates to identify if you will benefit by waiting to take distributions. In general, I agree with those who posted that in-service distributions are not the best approach. In your case, it sounds like your overall comp can vary greatly from year to year so starting distributions while still working would not seem to offer the tax benefits the deferred comp plan is designed to provide. Also, you state your net worth is around $6M with about 12% ($720k) in the deferred comp plan. What is your anticipated level of retirement spend? If your firm was to go bankrupt and you lost all of the deferred comp money, would that significantly change your retirement plans and level of spending? If not, why not keep deferring, push distributions out to start when you retire (and perhaps move to a tax friendly state if you are not already in one), and take distributions over the longest period of time you can?
Many good points above.
Re: moving to a state that is more friendly to retirement withdrawals. This is definitely a possibility but there may be factors other than financial that drive this ultimately. However, this would definitely be a consideration.
Re: why not keep deferring. This is a valid perspective and something that I have been considering, i.e., let it ride if the risk is not calamitous. My annual expenses in retirement may range in the $75-100K range annually (in today's dollars), which should be adequately met by a smaller nest egg. Having said that, when the deferred amount was less than 10% or so, there was a sense that the risk of capital loss (not retirement) was not a serious perceived concern, but as the amount creeps up to, say, 20% or so, it may become somewhat of a concern - obviously, this is essentially a subjective assessment that is dependent on personal risk tolerance, etc.
diy60
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Re: Deferred Compensation Plan - "Ideal" Strategy?

Post by diy60 »

Be aware of any triggering events in your DCP. A co-worker was laid off, and offered another position in the same company several weeks later. The involuntary separation triggered the DCP payment plan (5 Years in his case) and was irreversible.
PowderDay9
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Re: Deferred Compensation Plan - "Ideal" Strategy?

Post by PowderDay9 »

What are your options for distributions? Do you get to choose each year?

We have a NQDC plan in a rabbi trust. We're targeting no more than 15% of net worth in it. We have the same AA in NQDC as our overall AA. We would not want to put all bonds in NQDC because bonds are used for safety and if the large company is going bankrupt, I imagine there's a good chance we'd be in a major recession too. I wouldn't want our equities to be low all while possibly losing bonds in NQDC.

We ran some models and NCDC makes a lot of sense at high marginal tax rates (as long as you believe your company is solvent long-term). Run some examples of $100k in NQDC vs whatever you'd have in taxable after paying taxes on the $100k. Then assume the money doubles for simplicity. You lose big on the taxable account because you have to pay LTCG on the annual distributions AND the final gain when you sell. Once you run some examples you'll see NQDC easily wins in your high retirement tax brackets.

I'd recommend deferring until retirement if you can (unless you're worried about the solvency of your company). Also think about the tax rate changes set for 2026.
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nyseeker
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Re: Deferred Compensation Plan - "Ideal" Strategy?

Post by nyseeker »

diy60 wrote: Sun Sep 12, 2021 5:04 pm Be aware of any triggering events in your DCP. A co-worker was laid off, and offered another position in the same company several weeks later. The involuntary separation triggered the DCP payment plan (5 Years in his case) and was irreversible.
Thank you. I explicitly opted out of this (separation event) since the timeline would be completely out of my control.
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nyseeker
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Re: Deferred Compensation Plan - "Ideal" Strategy?

Post by nyseeker »

PowderDay9 wrote: Sun Sep 12, 2021 9:53 pm What are your options for distributions? Do you get to choose each year?

We have a NQDC plan in a rabbi trust. We're targeting no more than 15% of net worth in it. We have the same AA in NQDC as our overall AA. We would not want to put all bonds in NQDC because bonds are used for safety and if the large company is going bankrupt, I imagine there's a good chance we'd be in a major recession too. I wouldn't want our equities to be low all while possibly losing bonds in NQDC.
Thank you for your insights. Much appreciated.
The 15% net worth target makes sense. I may end up with something like that. Currently, my AA in NQDC is the similar to my broader portfolio. I like the "bond only" suggestion, at least in a way to think about it purely as a "tax arbitrage" conceptually since it snips off the deferred growth aspect of it (more or less).
PowderDay9 wrote: Sun Sep 12, 2021 9:53 pm We ran some models and NCDC makes a lot of sense at high marginal tax rates (as long as you believe your company is solvent long-term). Run some examples of $100k in NQDC vs whatever you'd have in taxable after paying taxes on the $100k. Then assume the money doubles for simplicity. You lose big on the taxable account because you have to pay LTCG on the annual distributions AND the final gain when you sell. Once you run some examples you'll see NQDC easily wins in your high retirement tax brackets.
Good suggestion - I need to do this with a bit more granular detail to confirm the intuitive take that the NQDC is a substantial win. One minor comment: my taxable accounts don't tend to generate income annually via dividends/CG since they are all held in low-churn index funds; recently, VG turned on tax-loss harvesting on my account on a pilot basis and this may actually help further in terms of taxes on the taxable side.
PowderDay9 wrote: Sun Sep 12, 2021 9:53 pm I'd recommend deferring until retirement if you can (unless you're worried about the solvency of your company). Also think about the tax rate changes set for 2026.
Thanks. I have been vacillating between taking the rolling 5-year payouts and pushing it off further (and this thought process actually prompted me to post this topic). I may end up pushing the payoffs by 5 years if I feel fairly comfortable with the risk associated with my company's solvency. While this seems sensible, I am reminded of cases like Kodak where a seemingly solid company went off the rails and the EDCP participants were paid back pennies to the dollar. In this case, there were warning signs, though perhaps in retrospect -of course, I won't make the same mistake :wink:!
PowderDay9
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Re: Deferred Compensation Plan - "Ideal" Strategy?

Post by PowderDay9 »

nyseeker wrote: Mon Sep 13, 2021 9:20 am I like the "bond only" suggestion, at least in a way to think about it purely as a "tax arbitrage" conceptually since it snips off the deferred growth aspect of it (more or less).
I'm curious to know more about this. How does bond only create a tax arbitrage over something else like portfolio AA or equities only?
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nyseeker
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Re: Deferred Compensation Plan - "Ideal" Strategy?

Post by nyseeker »

PowderDay9 wrote: Mon Sep 13, 2021 12:13 pm
nyseeker wrote: Mon Sep 13, 2021 9:20 am I like the "bond only" suggestion, at least in a way to think about it purely as a "tax arbitrage" conceptually since it snips off the deferred growth aspect of it (more or less).
I'm curious to know more about this. How does bond only create a tax arbitrage over something else like portfolio AA or equities only?
What I meant by this was: if I rearrange my tax-deferred portfolio asset allocation so that I confine the NQDC assets to bonds only, it does a couple of things: firstly, it reduces the size of NQDC and associated risk in case adverse events occur; secondly, which was the point I was getting to: since it is confined to a bond focus, it does not, in the main, include the growth portion of the tax-deferred portfolio. If this is the case, I can view the NQDC purely in terms of the tax arbitrage it offers (i.e., trading current high tax rates for potentially lower ones in retirement) and not include the tax-deferred component in the analysis since it is not included in the bond-only concentration.

Even if I actually don't change my AA, viewing it this way allows me to consider NQDC only on the basis of its tax advantage rather than bringing in its tax-deferred growth aspect.
PowderDay9
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Re: Deferred Compensation Plan - "Ideal" Strategy?

Post by PowderDay9 »

nyseeker wrote: Mon Sep 13, 2021 12:32 pm
PowderDay9 wrote: Mon Sep 13, 2021 12:13 pm
nyseeker wrote: Mon Sep 13, 2021 9:20 am I like the "bond only" suggestion, at least in a way to think about it purely as a "tax arbitrage" conceptually since it snips off the deferred growth aspect of it (more or less).
I'm curious to know more about this. How does bond only create a tax arbitrage over something else like portfolio AA or equities only?
What I meant by this was: if I rearrange my tax-deferred portfolio asset allocation so that I confine the NQDC assets to bonds only, it does a couple of things: firstly, it reduces the size of NQDC and associated risk in case adverse events occur; secondly, which was the point I was getting to: since it is confined to a bond focus, it does not, in the main, include the growth portion of the tax-deferred portfolio. If this is the case, I can view the NQDC purely in terms of the tax arbitrage it offers (i.e., trading current high tax rates for potentially lower ones in retirement) and not include the tax-deferred component in the analysis since it is not included in the bond-only concentration.

Even if I actually don't change my AA, viewing it this way allows me to consider NQDC only on the basis of its tax advantage rather than bringing in its tax-deferred growth aspect.
Wouldn't you want to get the benefit of the tax-deferred growth aspect? If you are worried about having too much money in NQDC, you can reduce the contributions.

Here's an example but let me know if I'm not thinking about this correctly.

Take $100k of income (after Medicare taxes paid).
Assume current marginal tax rate of 35%.

In taxable this is $65k after income taxes are paid. Put it all in equities and assume it doubles in 10 years. At the end of 10 years you have $130k. Then you sell. Assume capital gains tax of 18.8% on the $65k LTCG. You'll pay $12.2k in taxes which leaves you with $117.8k

In NQDC you have $100k to start. Put it all in equities and assume it doubles in 10 years. At the end of 10 years you have $200k. Then you withdraw the funds. Hopefully you're in a lower marginal tax bracket but let's just assume 35%. You'll pay $70k in taxes which leaves you with $130k.

Assuming the company stays in business and you're not in the 0% capital gains bracket in retirement, then NQDC wins and it wins by more if you put equities into it because you save on the capital gains taxes in your taxable account.

There's 2 big tax advantages of NQDC:
1. Your marginal rate is often lower in retirement than during your peak earning years.
2. You don't have to pay taxes twice in NQDC since you never have to pay capital gains taxes.

I think bonds should go into traditional 401k/IRA. If you run out of room then put municipal bonds in taxable. For NQDC, either use your portfolio AA or go 100% equities.
DVMResident
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Re: Deferred Compensation Plan - "Ideal" Strategy?

Post by DVMResident »

PowderDay9 wrote: Mon Sep 13, 2021 12:13 pm
nyseeker wrote: Mon Sep 13, 2021 9:20 am I like the "bond only" suggestion, at least in a way to think about it purely as a "tax arbitrage" conceptually since it snips off the deferred growth aspect of it (more or less).
I'm curious to know more about this. How does bond only create a tax arbitrage over something else like portfolio AA or equities only?
You keep your overall AA balanced across multiple accounts. Rebalancing occurs does not have to happen within every account; rather a total portfolio AA is maintained.

My rationale on holding more bonds in the DCP is the forced distributions occur over a shorter time horizon than other retirement accounts. Lower volatility gives me better control of the distributions. A secondary benefits is, while bond yields are low, it will generate less taxes liabilities (at income rates) and allows my higher growth assets to be located in Roth with longer time horizons with no additional market risk.
PowderDay9
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Re: Deferred Compensation Plan - "Ideal" Strategy?

Post by PowderDay9 »

DVMResident wrote: Mon Sep 13, 2021 8:59 pm Lower volatility gives me better control of the distributions.
That's a good point. Controlling volatility makes sense once you get to distributions and especially if you're trying to target an income for things like ACA subsidies. Once you get to higher retirement incomes (OP's situation), volatility might become less important.
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nyseeker
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Re: Deferred Compensation Plan - "Ideal" Strategy?

Post by nyseeker »

PowderDay9 wrote: Mon Sep 13, 2021 8:29 pm Wouldn't you want to get the benefit of the tax-deferred growth aspect? If you are worried about having too much money in NQDC, you can reduce the contributions.

Here's an example but let me know if I'm not thinking about this correctly.

Take $100k of income (after Medicare taxes paid).
Assume current marginal tax rate of 35%.

In taxable this is $65k after income taxes are paid. Put it all in equities and assume it doubles in 10 years. At the end of 10 years you have $130k. Then you sell. Assume capital gains tax of 18.8% on the $65k LTCG. You'll pay $12.2k in taxes which leaves you with $117.8k

In NQDC you have $100k to start. Put it all in equities and assume it doubles in 10 years. At the end of 10 years you have $200k. Then you withdraw the funds. Hopefully you're in a lower marginal tax bracket but let's just assume 35%. You'll pay $70k in taxes which leaves you with $130k.

Assuming the company stays in business and you're not in the 0% capital gains bracket in retirement, then NQDC wins and it wins by more if you put equities into it because you save on the capital gains taxes in your taxable account.

There's 2 big tax advantages of NQDC:
1. Your marginal rate is often lower in retirement than during your peak earning years.
2. You don't have to pay taxes twice in NQDC since you never have to pay capital gains taxes.

I think bonds should go into traditional 401k/IRA. If you run out of room then put municipal bonds in taxable. For NQDC, either use your portfolio AA or go 100% equities.
Your analysis is certainly correct if we focus only on the NQDC. Instead, if you think about the "total pool" of tax-deferred vehicles available to you including 401-K, IRAs, HSAs and NQDC, what I was trying to get to may become clearer.

Let's say I have a total pool of available tax-deferred vehicles, say 401-K, HSA and NQDC of $40,000 to invest in 2021, about $34K in 401-K+HSA and $6K in NQDC. Assuming I want to invest about 15% ($6000) in bonds, I can choose to distribute the stock portion ($34000) and bond portion ($6000) any way I want across these tax-deferred vehicles - I will ignore differences between these plans, e.g., tax-free medical usage for HSAs and instead focus on only the tax-deferral aspect. The net growth of this 85-15 portfolio and final disbursements will be, to the leading order, the same regardless of how I distribute it across the retirement vehicles - e.g., it doesn't matter whether I keep the bond portion in the 401-K or in the NQDC (again, ignoring differences outside of the deferral aspect).

Now, let's look at the NQDC and what we want to invest in it. To minimize the risk, I can choose to invest the bond portion of $6000 completely in it. This will keep the growth within the NQDC portion smaller and reduce the blast radius of a company bankruptcy. If I assume that the growth in the $6000 bond investment is negligible, the only advantage of using the NQDC would be to take advantage of the "tax arbitrage". This is true, regardless of whether I actually do the AA so that $6000 lands in the NQDC. If I have $40K to invest with a 85/15 AA and a $6K NQDC, the only benefit NQDC provides is the tax arbitrage, when I look at the whole tax-deferred landscape, regardless of whether I actually allocate $6K of bonds to it. This means that I may actually be better off in investing the $34K stocks in 401-K/HSA and simply use a taxable retirement account for the $6K in bonds if I don't think the tax arbitrage is worth the default risk in the NQDC. NB. I am assuming near zero or minimal growth rate in my bond investments.

Of course, if my potential available investment in NQDC is much larger than the bond investment I want to make in a given year, it may make sense to invest in the NQDC since it will allow me to take advantage of the tax-deferred gains in addition to potential tax arbitrage (the example you gave above).

Hope that clarifies things...
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