The Truth about Deferred Compensation – Smart Tax Move or Mistake?

Deferred compensation is often explained as a smart tax strategy, but the reality is more complicated than most people realize. In this video, we'll talk about how deferred compensation plans actually work, when they can reduce taxes, and when they might increase risk.

Resources:

- Alliance of Comprehensive Planners: https://www.acplanners.org

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TRANSCRIPT:

Bridget: Hey, John. Today we're talking about deferred comp. I have two tales of good deferred comp and bad deferred comp, and I want to just talk through those and the concepts of deferred comp. And if your company offers that, I want to help you try to navigate the decision. First of all, what is deferred comp? It’s like a 401(k) in a lot of ways, but there's going to be one key difference that I talk about later. So you put money into your deferred comp and then you don't have to pay tax on it now.

And then when you leave the company, you get the money at times that you determine. And sometimes you don’t even have to leave the company, and you can say, “I want it in 10 years.” So you might say, “Okay, my kids are going to college that year; I'm going to want the money then.” And then you can kick the can down the road again, generally once. So then your kid is going to college, you're still at the company, you don't need the money, so you kick the can again. Does that make sense?

John: Yeah. So maybe it'd be worth just talking about why a company would have a deferred comp plan. Why is this case? I had a friend of mine who said, “Hey, suddenly I've got this deferred comp thing. What's going on with this? Why not just 401(k)?” Go ahead.

Bridget: It gives people a way to save more. What else do you think?

John: Well, one of the things that we see is there are certain rules around how much people can contribute to a 401(k) if they're highly compensated in technical language, so basically the leadership of the company, in many cases founders and the executive level folks. There are some rules around how much they can save in a 401(k) and in some cases, they might not be able to. We've had folks that are in as clients that can’t save as much as they would like. The maximum limit is like $20,000 or $25,000 from the IRS rules.

Well, because they fit in this kind of subcategory, they can only put away $5,000 a year for retirement into their 401(k) plan, or $10,000. They can't do more because of some of these rules. So then sometimes they'll have a non-qualified deferred compensation plan, which as you said is like 401(k), but it doesn't have some of those other rules to it. So that's one place that we'll see that. And then there have been some other places where everybody's making a lot of money, but they're limited to what they can put in the 401(k).

If I'm making $50,000 or $75,000, putting away $25,000 is going to replace a lot of my income. If I'm making half a million dollars, putting away $25,000 bucks a year is not going to replace that much income. So that non-qualified plan can let me do more saving for retirement that's closer to my salary. A lot of people say, “Why do we even have this thing?” These are two places where you might say, “Hey, I want to save more,” and you’re going to have that non-qualified deferred compensation plan.

Bridget: Yeah. So I want to talk about another similarity to 401(k)s, and then I'll talk about why I almost never recommend deferred comp programs.

John: Yeah.

Bridget: So the other similarity that makes it seem very much like a 401(k) is that you get an account and you can pick investments from this account. And so, your money gets invested in whatever funds you pick. And so, then you can see it grow. And you don't pay tax on it until you get the income. So that means it grows deferred. This is similar to 401(k) and is good.

John: Right.

Bridget: Okay. So here's why I don't like these. Unlike the 401(k) where the money has to be actually set aside with a custodian in a separate account, this is different; I call it a hypothetical account. It doesn't have to actually be funded. So one reason the companies like it is because they can pretend like they're paying people, but then if they go bankrupt, there might be nothing there for the people. And people might think, “My company's solid. It's never going bankrupt.”

But history's littered with people who thought that and then worked at a company that went bankrupt. So if the company goes bankrupt, you are not on top of the list. Employees are on the top of the list for getting paid back. After the employees are paid back, then we can hope for deferred comp people. It just depends on how the company is and how the bankruptcy court works. And these highly paid executives that deferred a lot of compensation and then had it supercharged in stock funds that are hypothetical, that are not really accounted for anywhere, won’t get paid. That’s why I call them hypothetical accounts.

You can lose all your money and that is a risk. Say you're investing your money in a S&P 500 or something. An S&P 500 has plenty of risk, but people don't think it's going to go to zero. Companies go bankrupt all the time, but the S&P 500 is always chugging along, even if it goes down. The risk in an individual company is just so much higher. So all you're getting is market returns, but you're taking on a lot of risk and you're not getting paid for that. There’re some complaints. What are your thoughts?

John: That’s exactly how we explain it. You become a creditor of the company. You get a statement that says what the balance is, but that’s their promise to pay you in the future.

Bridget: Right.

John: It’s kind of like when you go to work for them, their promise is that they're going to pay you for the work that you do. And so, there's no cash account set aside for those things. Of course, the difference is I work for two weeks or a month and they pay me. There's a really short time frame for them to pay me as opposed to 10 years down the road. I think that's exactly right. You're taking on some additional risk. And some folks are comfortable with that. Like you said, I think people tend to think, “Geez, my company is really solid.” And as you said, history is littered with companies that were solid until they weren't.

The one place where we do see it makes some sense or where I will recommend it—and it kind of it depends on the person—is doing some tax bracket management. Listen, if I'm in the top tax bracket now, and I'm pretty reliably sure I'm not going to be in the top tax bracket in five years when I retire, do I want to do non-qualified deferred comp for the next 35 years? Probably not. Listen, if it's five years, are there any guarantees? Nope. Is it a little more solid that, hey, in five years it's probably not going to go to hell in a handbasket immediately.

Hey, maybe I've got a better feel for that. I know I'm retiring because I'm going to be 60 or 70 or whatever years old, and I know that my taxes are going to go down, so I want to take some of that money out down the road. That could be a place where it makes some sense to do for sure. But as mentioned this, but I think people forget some of the factors. So the great thing is if I defer $100,000 into my deferred comp plan, I don't pay tax on that today. That's the selling point.

Great, my taxes are lower today. At some point all that money comes out and it's fully taxable. And if you're not thoughtful about it, you can miss the benefits. There’re different ways you can choose to do this. You mentioned folks who say, “Hey, I'm going to line it up, so it pays for college.” Well, that increases my taxable income in those years. And maybe I don't necessarily want that in those years. Or it can be a lump sum. Hey, in five or seven years, I’ll get a lump sum.

And we've had people go, “Oh, wait a minute, now I've got just as much income 10 years down the road or 8 years down the road as I would have had if I just paid it today.” So in some cases, it can be a little bit like robbing Peter to pay Paul. Not that it's wrong, necessarily, but wait a minute, let's be thoughtful about that. And for me, the shorter the time horizon, the more that tax arbitrage or tax planning is more likely to be beneficial. But like I said, it's not a panacea, and it's not just free money. There’re downsides to it for sure.

Bridget: Correct. So if you work at a place and you know you're retiring in the next five years, that's a time when I'm a lot more open to the idea of deferred comp, especially if you're at a high income in those last years. That's a place where I'm a lot more open to it than I am when you're working there for a long time, because again you can manage some things. Another time when it might be a good idea is if you're an executive and you're exercising a lot of options. And so, you know that your income's going to be really high. And again, if you got a five-year time horizon, I'm a lot more interested in this than if you have a 15-year time horizon. Go ahead.

John: The other thing that I come across all the time is people saying, “I need to put money into my retirement plan.” No, you need to have money for retirement. In some cases, that means taking advantage of retirement plans. I'm not saying it doesn't make sense. But also having money just stuck in a brokerage account that you can take and sell at capital gains tax rates down the road is not losing the game.

Bridget: The old-fashioned way.

John: Yeah. So that's the other thing. We get kind of brainwashed. When it comes to planning for college, we'll have people say, “I gotta use a college savings plan, I gotta use a 401(k).” Yeah, it makes sense. But man, if you just got a bunch of money sitting in your brokerage account, you're gonna be pretty happy with that too.

Bridget: The other thing is that you can end up having to take it at inopportune times. So sometimes people get laid off or fired and then it gets paid immediately. Unless the company goes bankrupt, it shouldn't evaporate. The whole point of this was to defer your compensation. But you might get fired on November 1st after a whole year of high income. You get it all at once in one lump sum on that day.

John: Yeah.

Bridget: You were just trying to defer all this income, assume all this risk, and then you get it all that day and you’re in the highest bracket anyway. But I gotta say, I have a success story in this regard. A client was not interested in my advice on this. They felt like their company was secure because of the way that the company was structured with a whole bunch of different infrastructure. Companies ran this thing, so it was like a cooperative company.

And so, they thought, “If this company goes down, these other places will come in and fix it. So the risk of bankruptcy is a lot lower. I'm just not worried about it.” And so yeah, they invested in their deferred comp. And then in these last several years right before retirement, they really invested and now they've got the first five years of retirement. They're retiring early and I've got the first five retirement years of cash flow planned out. So it was good. I guess I do mind being wrong, but sometimes I don't. It was a great move.

John: It's not that it doesn't work. It's just that there's a lot of other risks, a lot of other factors. It's not the one solution. But with a 401(k) plan, 99.9% of the time, putting money in your 401(k) plan is a generally good plan.

Bridget: Right.

John: I can say that almost unequivocally.

Bridget: If 401(k)s evaporate, that has to be fraud. It doesn't have to be fraud for you not to get your deferred comp money. It just has to be that the company can't pay for it.

John: Yeah. It's not wrong, but there’re more risks and you have to account for that. It's not a slam dunk.

Bridget: Exactly. So it’s a great time to wrap up. That’s a topic I like talking about. I'm Bridget Sullivan Mermel, and I've got a fee-only financial planning practice, Chicago, Illinois.

John: And I'm John Scherer. I've got a fee-only financial planning practice in Middleton, Wisconsin. Both Bridget and I are taking on new clients. We'd love to hear from you if you have a non-qualified deferred compensation question. But we're also both members of the Alliance of Comprehensive Planners. If you like what you hear on our show and you'd like to find an advisor in your area that thinks like us, you can check out acplanners.org.

Bridget: And don't forget to subscribe.

At Sullivan Mermel, Inc., we are fee-only financial planners located in Chicago, Illinois serving clients in Chicago and throughout the nation.  We meet both in-person in our Chicago office and virtually through video conferencing and secure file transfer.