Is a Deferred Compensation Plan Right for Your Retirement?
Many high-income earners are familiar with deferred compensation plans. A deferred compensation plan is an addition to an employee’s regular compensation that is set aside to be paid at a later date, such as in retirement. (1) Generally, taxes on this income are deferred until payout.
If you’re in the high-income earner category, this may sound like a great option. Any opportunity to avoid taxing your income is good, right? Well, there are more things to consider than just the tax implications.
While there are some great advantages of deferred compensation plans, there are also some drawbacks to consider. Let’s discuss the pros and cons of deferred compensation plans before deciding if this is the best option for you.
The Benefits of Deferred Compensation Plans
For high earners, deferred compensation plans can be a good way to save for retirement after maxing out contributions elsewhere because deferred compensation plans have no contribution limits. Consider these additional benefits:
Deferred compensation plans help you save on your tax bill by allowing you to put more money into your plan and lower your tax bracket while you are working. You will not owe federal income tax on the funds contributed until they are withdrawn in retirement, typically when you are in a lower tax bracket. Keep in mind that if you are planning to move to another state with high income tax, this could greatly hinder your tax savings.
Retirement Income Bridge
Deferred compensation plans can be used to generate income for a couple or individual as they begin retirement and want to maximize their Social Security income by delaying collecting it until age 70½. It can also be used to supplement income in retirement if the market has taken a hit and your portfolio has suffered.
Deferred Compensation Plan Drawbacks
While the pros of deferred compensation plans seem like incredibly useful tools for your wealth management strategy, there are some points to consider when using a deferred compensation plan.
Company Solvency Risks
This may be the largest risk you can face when using a deferred compensation plan. If a company declares bankruptcy, your deferred compensation plan could be completely or partially dissolved in the bankruptcy. This is because when you participate in a deferred compensation plan, you are considered to be a creditor of the company. Also keep in mind that if you choose a longer-term payout option, this increases the risk that the company may go bankrupt during this time. You should closely examine your company’s plan and consult a trusted financial advisor before participating.
Lump Sums Could Affect Your Taxes
Most plans do not allow you to access the money earlier than your retirement, however, if you change jobs, you may have to collect the money in one lump sum. Collecting one large lump sum could wreak havoc on your tax mitigation strategy for that tax year.
Lack of Diversification
Deferred compensation should always be coupled with other retirement strategies that don’t involve your company. This is because as an executive, you may have an inordinate amount invested in your employer’s stock. If the company suffers an economic blow, your employer’s stock could lose value and your deferred compensation plan could also be in jeopardy. This could be devastating to your retirement plan.
Is a Deferred Comp Plan Right for You?
Understanding the ins and outs of deferred compensation plans can be tricky, but you don’t have to navigate these financial decisions alone. At The Rosamond Financial Group, we specialize in working with successful business owners, executives, and affluent families to help them understand their unique financial needs. If you’d like us to look at your deferred comp plan or if you have other financial planning questions, book a free introductory meeting online! Plus, check out what clients are saying about working with us here.
Preston Rosamond is a financial advisor and the founder of The Rosamond Financial Group Wealth Management, LLC with over two decades of industry experience. He provides comprehensive wealth management and financial services to successful business owners, corporate executives, and affluent retirees who enjoy simplicity and seek a professional to help them pursue their goals. Preston personally serves his clients with an individual touch, a sincere heart, and his servant’s attitude is evident from the moment you meet him. Learn more about Preston or start the conversation about your finances with him by emailing email@example.com or schedule a call on his online calendar.