Deferred Compensation Four-Part Series – Part One: Deferred Compensation Plans 101

Introduction:

Deferred compensation plans are complicated, overlooked, underused. Yet, these plans are one of the best opportunities to save A LOT on taxes. Like a nuclear power plant, they’re old, misunderstood, and some only remember the few events when they’ve melted down, but they have amazing tax saving power!

Because there’s little formal industry education, there’s a lot of client confusion. Also, many peers keep asking what the heck is “x” within this deferred compensation plan?

I love these plans but hate seeing disastrous client financial results without starting with eyes wide open.

Welcome to our series all about deferred compensation.

****PLEASE NOTE, this is an employer provided plan, this is not a plan an individual can open.

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Four-Part Series:

Part One: Deferred Compensation Plans 101 – Cliff Notes

Part Two: Should I Defer My Compensation? How Do I Invest It?

Part Three: Deferred Compensation Risks: Change of Control in Acquisition, Bankruptcy, and Irrevocability of Distributions and Investment Options

Part Four: Deferred Compensation: Financial Planning Opportunities and Tradeoffs

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Part One: Deferred Compensation Plans 101 – (Kind of) The Cliff Notes Guide

 What are the key benefits of a deferred compensation plan?

1. Primary: A W-2 high income earner’s last refuge to save on taxes with no IRS contribution limits. Total deferral limits and the type of compensation are dictated by the plan. After all eligible accounts like HSAs, 401(k)s, IRAs, or other qualified retirement savings options, are maxed out to reduce taxes. These babies might be the last defense in giving up even more to Uncle Sam.

Example, A W-2 healthcare sales professional earns a $175k base salary per year, but lands a huge commission check of $250k this year. Between her and her partner, after this commission check they will have $500k in income. As a Colorado resident, ~40% of that bonus will go to taxes: ~$100k.

1. 1. Desperate to pay less, she contributes to the following in 2022
      1. Health Savings Account (“HSA”) – $7,300 maximum amount
      2. Pre-Tax 401(k) Employee Maximum contribution – $20,500
      3. After-Tax “Mega” 401(k) contribution – $15,000
      4. Colorado College Invest 529 contribution – $10,000
      5. Back Door Roth IRA contribution (spouse and herself) – $12,000

$64,800 gets deferred and invested from a cashflow standpoint, but only three items reduce taxes: (1) the HSA, (2) the 401(k)-employee contribution, and (3) the 529 contribution = total of $27,800 tax deductions for federal, and $455 in state taxes. 

Piddly savings, compared to the extra $250,000 in income she received, and not much in tax relief. Then…She defers some comp…

She elects for $150,000 to be deferred this year; paid for five years starting at age 65. In her marginal tax bracket, she just saved another $60,000 in taxes this year deferring that income into the future—Now we’re talking.

2. More Tax Benefits: deferred growth on income AND GAINs (we hope)

1. 1. No earned income taxes, salary, or bonus where you would have paid ordinary income taxes on deferred compensation. See #1 above. (*You still owe Social Security and Medicare taxes in the year the income is deferred).
   2. Short-term or long-term capital gains from the investment growth compound tax-free. The second benefit.
      1. Example, Remember, in the above example, we deferred $150,000 and avoided $60,000 in income taxes. Don’t forget, that $150,000 grows without being impacted by taxes. Because, if that was invested in a taxable account, every short-term capital gain, income, or dividend reinvested, would be taxed 40%. It’s not, so the investment compounding is uninterrupted.

3. Less risk on employer stock and taxes when Restricted Stock Units (“RSU”) vest,  deferrals can offer a double benefit they reduce taxes and employer stock concentration risk. Something to watch out for, RSU vesting can bump investors into a greater marginal income bracket. Plus, when RSUs vest, many investors don’t want even more of their net worth tied to their employer. They want to sell!

Example, a California Google executive normally makes $250,000 annually. But this year, RSUs vest adding $95,000 in income. In the 45% combined marginal tax rate, another $45,000 goes to taxes. But! she decides to defer $100,000 into a deferred compensation plan. This move reduces $45,000 in taxes this year.

4. More money for college: Tax Credits and College Aid, In 2022, deferring income can increase your students’ eligibility for need-based financial aid and stay below the range to receive the American Opportunity Tax Credit, worth up to $2,500 per child in 2022. More money for Jimmy! College is not cheap.

Example: Your combined adjusted gross income(“AGI”) with your spouse is $160,000. Right at the income threshold to receive the American Opportunity Credit. Then, this year your wife receives a bonus of $50,000. Instead, of missing out on the credit, you defer the $50,000 into her deferred compensation plan.

Three benefits from this deferral: this saves you income taxes, you get the tax credit, and you get more eligibility for need-based financial aid.

5. Avoid state tax on the distribution (in specific distribution strategies) – Deferred compensation is taxed as earned income in the distribution year within the state it is received. While federal tax is due regardless, state tax is dependent on where the participant lives. This can be significant if a participant moves from a high-income tax state to a no state income tax state. So, if you move from a state where you are paying 10% to one where you pay 0%, that could be UUUggee. Elections must be annual distributions of at least 10-years.

Example, a California educational executive elects to have all distributions pay out over streams of 10 years or greater. They are in the 10.3% income state tax bracket, and defer $50,000 annually for 5 years, or $250,000.

Even though they will be in a lower tax bracket in retirement, they start a plan to move to either Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, or Wyoming to avoid state income tax. Moving pays!

 

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What are the challenges and downsides with deferred compensation? (Detailed examples in Part Three: Deferred Compensation Risks: Change of Control in Acquisition, Bankruptcy, and Irrevocability of Distributions and Investment Options)

1. Possible higher future tax rates = more taxes!, the exact opposite of our goal…You end up in a higher tax bracket and pay a lot more in taxes. How?
   1. Accelerated payments: Due to either a company change of control, or termination, accelerated payments can happen. ALL the money floods in at once.
      1. Lump sum benefits, instead of a stream of disbursements can push a client in a higher tax bracket then they were prior to receiving the deferred compensation.
   2. Life happens + bad planning: The most common and easily missed planning mistake is clients electing lump sum distributions versus a stream of payments. Most fail to consider all other sources of taxable income. Just deferring to defer without planning what other income will come in happens frequently. Participants can also start Social Security while receiving deferred compensation making more of this income taxable. More income in critical planning years can also remove a Roth conversion opportunity for more wealth in the future. Assets are owned by the company
      1. Bankruptcy – participants do not own the assets, they are general creditors, and will be paid based on their priority in bankruptcy.
         1. Yes, ALL your deferred income can be completely lost in bankruptcy.
      2. No transferability or borrowing, you can’t borrow from your accounts, like a 401(k), or transfer from one plan to another; that means you also can’t roll this over like a 401(k) either.
      3. Non-revocability of deferred options
         1. In most plans, distributions default a lump sum payout immediately at termination, or specific dates. Payments can also be elected over 5, 10, 15, or 20 years out. The payments can come monthly, quarterly, or annually, depending on the plan.
            1. While you have the calendar year to make changes, lump sums can’t be changed. And, if you want to re-defer your compensation with a stream of payments you must delay it out another 5-years.

2. Who is eligible and what are important dates?

1. 1. 1. Eligibility can vary based on compensation, position level, or at the discretion or invitation of management.
         1. It’s all over the board on what can be deferred: exclusively annual bonuses, salary + bonus, bonus and long-term incentive, and salary + bonus + long-term incentive.
      2. Enrollment periods are usually in November and December, and most participants can change the plan up till the end of the calendar year.

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That’s a quick cliff notes guide, stick around for Part Two: Should I Defer My Compensation? How Do I Invest It? 

*All tax amounts are rough estimates to illustrate potential savings, but that actual savings depends on taking all facts and circumstances into consideration.