How Does Deferred Compensation Work?

I first heard of a deferred compensation plan a few years ago when one of my old bosses left my company and within a few years, quickly became a high-flyer in the organization, overseeing operations in several countries and managing thousands of employees with a global biopharma.  Evidently, many things went right for him, and though he has constantly chided me over the years for not going with him, it was always tempting, but for me, money is only a part of the equation in my work-life balance and I’ve opted to stay put for now.  However, I was intrigued and admittedly, somewhat envious, when I learned of the deferred compensation plan he was offered as an executive officer of the company.

What is Deferred Compensation?

Deferred compensation is often referred to as non-qualified deferred comp or the proverbial “golden handcuffs”.  Essentially, a deferred compensation plan allows an employee to set aside a portion of their income over a prolonged period of time while it earns interest, while forgoing the tax implications of having such a high compensation structure at the present time.  For example, if you were making $500,000 per year with salary and bonus, but only really needed $200,000 to survive, you could probably sock aways $50,000 in the company 401K, set aside $100,000 in deferred compensation each year and with the remaining $350,000 in taxable compensation, tax laws being what they are now, you’d still have well over $200,000 in after-tax income each year, especially considering there’s probably a sizable mortgage interest deduction and other tax savings vehicles involved.  For those high compensated executives that don’t actually need to live up to their full income to enjoy a suitable standard of living, deferred compensation plans provide an extra means to stash away funds and earn interest on them without having to worry about the taxes until you’re in a lower tax bracket in retirement (if the administration doesn’t continue to make a push to have virtually all federal taxes shouldered by the top 10% of taxpayers in the country and redistributed to the remaining 90%, which is the direction things are headed now).

Deferred Compensation Tax Considerations

When considering the tax benefits, as mentioned, one also needs to consider what the tax brackets are going to look like in the future.  If, due to the significant income you will be taking in retirement, you’ll be in a high tax bracket anyway, the benefits of forgoing the taxes at today’s current rates for a rate that is even higher later may be muted substantially.  In effect, it would take several more years under proposed tax laws to realize the benefit of deferred compensation than under the current circumstances.

Risks of Using a Deferred Compensation Plan

There is some risk to leaving your money with your employer in a deferred compensation plan.  Because 401K assets are protected for the employees in the event of bankruptcy, employee participation in 401K plans is quite high.  The assets are invested in underlying assets in the employees name, and hence, they essentially own those assets and do not face risk of loss due to company solvency (unless of course, you’re holding too much company stock, which is evident from the data I highlighted in “401K Asset Allocation in the US“).  Now, with deferred compensation plans, the assets therein are actually treated as though they are an asset of the parent company.  Therefore, in a bankruptcy proceeding, it is entirely possible that deferred compensation assets would be treated as an asset subject to creditor purview and you may see your nest egg disappear in one fell swoop.  Obviously, a key reason companies draft these plans is to retain employees, so there is often not a lot of flexibility with respect to withdrawing funds on short notice or when departing for a competing firm (which my old boss just did again – so I presume he got a really…really sweet offer to make up for lost funds there).  For other circumstances such as death, the employee’s deferred holdings will vest immediately and the assets are available to the estate.

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Any Readers in a Deferred Comp Plan?  I’d be interested to hear your experience and additional tips/risks I didn’t touch on here.

Tagged as: deferred compensation, retirement plans, tax