How Do Deferred Compensation Plans Work?

A Deferred Compensation Plan (DCP) is an exclusive benefit that certain employers provide for their highly compensated employees.

The plan is similar to your 401(k) as it allows you to contribute and invest dollars on a pre-tax basis, reducing taxable income in the year you contribute.

You elect how much of your compensation you want to defer now and decide when you want to receive your income in the future. The amount you can defer and the payout structure is specific to your employer’s deferred compensation plan (DCP).

When used correctly, a deferred compensation plan can potentially reduce your tax bill by thousands. The decision on how much to defer and when to receive your distributions takes a considerable amount of planning.

Deferred Compensation and Your 401(k)

First, it’s important to understand the differences between your 401(k) and a deferred compensation plan. Your 401(k) is considered a qualified profit-sharing plan. It complies with the Employee Retirement Income Security Act (ERISA), which requires regular testing to ensure all participants receive a respectively equal benefit.

All qualified employees can enroll in an employer sponsored 401(k) plan.

A non-qualified deferred compensation plan is an agreement between an employer and employee. It enables the company to withhold a portion of your compensation, invest it, and distribute it later.

Unlike your 401(k), a non-qualified deferred compensation plan is not available to everyone at the organization. Typically, this type of plan is made available to high-earning executives.

There is some risk associated with a deferred compensation plan: the income you defer becomes an unsecured liability of the company putting your money at risk if the company goes bankrupt.

Employees at Microsoft who are level 67 or higher have access to DCP.  At Intel, employees who are grade level 10 or higher have access to SERPLUS (Intel’s deferred compensation plan), and highly compensated executives at NIKE also have access to the company’s deferred compensation plan.

Key differences between a Deferred Compensation Plan and a 401(k)

Like your 401(k), deferred compensation is a vehicle to help defer taxable income and reduce current tax liabilities.

The income you defer is invested over time and disbursed in retirement when you likely are in a lower tax bracket.

Deferred Compensation Can Help Reduce Your Tax Bill

The most efficient way to reduce the amount of income tax you pay is to control the amount of income you earn/recognize annually.

For many people, compensation comes from three diverse sources: your salary, cash bonuses, and stock awards. You can control how much income you receive from your salary and bonus using a deferred compensation plan and significantly reduce your total taxable income.

Your other source of income may come in the form of stock awards (RSUs). You do not have control over when your shares vest, and when that occurs, the market value at vest is recognized as ordinary income.

With proper planning you can use the proceeds from RSUs to supplement your cash-flow, allowing you to significantly increase your DCP deferrals.

Use RSUs to Fund Your Lifestyle Expenses

Purely from a tax treatment perspective, as your stock grants vest, it’s as if you were given cash and decided to use every dollar to purchase your company’s stock. Most often, employees hold on to their vested shares and allow them to accumulate over time in their investment account. Although this may lead to building significant wealth over time, there is considerable risk in having a sizable proportion of your investment assets tied to your company stock.

We recommend you sell these shares immediately after you receive them and use the proceeds to help fund cash-flow needs. This strategy not only helps you maintain a more diversified portfolio, but it also allows you to increase the amount of income you can comfortably defer. The result is a lower tax bill.

Selling your RSUs when they vest means you’ll have several large “pay days” throughout the year and you will need to plan accordingly.

Creating an annual cash-flow projection that accounts for your salary, estimated bonus, and RSU vesting schedule will help you determine how much you can defer and ensures you have enough income to cover living expenses. Be sure to use a conservative estimate for the stock price upon vesting, as this portion of your income will fluctuate.

Determine the Amount of Income to Defer

You will want to make sure you are fully funding all your other pre-tax accounts, such as your 401(k) and HSA before deferring any of your income within a deferred compensation plan.

If your company offers the Mega Backdoor Roth provision within your 401(k), you’ll want to consider that benefit as well. Once your tax-advantaged accounts are fully funded, your decision on how much to defer into DCP will become clearer.

Before enrolling and contributing to a deferred compensation plan you should think about how long you plan to stay with the company.

It may not make a lot of sense to defer sizable portions of your income if you don’t plan to stay with the company long term.

Each plan will have a set of rules around what happens to the money in your account should you leave before retirement.

You may receive your deferred income in a lump sum, which could have an adverse effect on your tax bill, or you may even forfeit some of your income. Understanding the distribution rules in the event of death is also an important aspect to understand and will vary based on the company’s plan. You will want to talk through these decisions with your advisor to ensure you plan properly.

Establishing Your Deferred Comp Distributions

A deferred compensation plan is different than a 401(k), where you’re able to withdraw money early (with penalty) or wait until retirement to withdraw funds until they are depleted.

You need a plan to help ensure your money comes out on time, at the right time, and in amounts that make sense for you.

For each deferral (each year that you defer salary/bonus), you must decide when you want to start receiving your money and over what time frame.

As money is distributed, you are taxed, so it’s important that you consider how much tax you’re willing to pay each year after your withdrawal begins. You will need to factor in future sources of income, such as Social Security and required minimum distributions (RMDs) and the potential for continued vesting of RSUs upon separation of service.

Should You Enroll in a Deferred Compensation Plan?

You will want to make sure you are fully leveraging all your other tax-advantaged employee benefits before enrolling in a deferred compensation plan.

It is a great benefit to help you reduce your tax bill by thousands; however, it is also one of the most complicated to implement and manage. We work with many employees at Microsoft, Intel, and Nike to help them understand how deferred compensation works and how it should be leveraged with their other employee benefits.

If you have questions about what is best for you and your long-term goals, we encourage you to schedule time with one of our advisors.