How to Make Your Deferred Comp Plan Elections
Many folks have the possibility of planning how they receive their deferred comp payouts in a way that can reduce their multi-year tax liability. Sadly enough, this rarely happens. Instead, people make random elections as to when they will receive their deferred compensation and this can result in a payout that is not tax efficient and results in a tax liability that is higher than it needs to be.
Let’s take a look at deferred compensation plans (referred to as NQDC or non-qualified deferred compensation), how they work, and how they can be more efficiently utilized when viewed in the context of a life-long retirement income plan.
How Your Deferred Comp Plan Works
Each deferred comp plan is different. Each plan has an official plan document that spells out the rules for that plan. You’ll need to request a copy of your plan document to find out the specific terms of your employer plan. There are three main things you’ll want to know about your deferred comp plan terms.
- How Money Goes Into the Plan
- How the Funds are Taxed
- How Money Comes out of the Plan
How Money Goes Into the Plan
Some plans allow employee and employer contributions; others allow only one type of contribution.
- Employee contributions - When you elect to defer a portion of your salary or bonus, you will complete an enrollment form or benefit election form. You’ll specify the amount you want to defer into the plan, and you must also pick a future payout date. With proper planning, you can choose a payout date that will be coordinated with a life-long retirement income plan.
- Employer contributions — if there are to be employer contributions your employer will let you know how much and what conditions must be met (such as profitability metrics) in order for the company to be able to make these contributions.
How the Funds Are Taxed
- Employee contributions - You will pay FICA (payroll taxes) on the amount that you put into the plan. The payroll taxes will come out of the portion of your paycheck that is not deferred into the plan.
- Employer contributions - With employer contributions, FICA taxes are usually owed at the time you vest in those contributions. Employer contributions are usually subject to a vesting schedule — meaning you must stay with the employer for a specific length of time to be eligible to receive all the funds they contributed for you. Thus if you left early you would not pay FICA tax on any amounts for which you had not met the vesting requirements.
With either type of contribution, per the IRS you will not pay FICA taxes on any investment earnings that accrue in an NQDC plan, but you will pay income tax on the distributions when they come out of the plan and are paid to you. This is where tax planning opportunities present themselves — in the way you choose how the money will come out of the plan.
How the Money Comes Out
At the time you put money into your deferred comp plan you must elect how and when it will be paid back out. Most of the time this is an irrevocable election (meaning you cannot change it later) and the earliest the first payout is typically allowed to occur is three years from the year you put the money into the plan.
- Lump sum - Some plans only offer a lump sum distribution option. For example, you might elect a lump sum to be paid out five years, seven years, or ten years from the year you defer the income.
- Installment payouts - Some plans offer the option for the funds to be paid out in an installment — for example over a ten year period of time which will begin five years from today.
You make a payout election for each year of contributions to the plan.
With some plans you can elect different payout options for different types of contributions; for example, an installment payout out on your own deferred amounts and a lump sum payout on employer contributed amounts.
Changing Your Payout Election
Although payout elections may be considered irrevocable — in many cases, you can, in fact, change them — but your ability to make changes will come with restrictions.
For example here is how one major deferred comp plan describes it, “You can postpone your payout date but must give notice 12 months prior to the previously scheduled distribution date. And the new date must be at least 5 years after the first scheduled date.”
In addition, certain events may trigger a distribution that will occur differently than what you have elected. In your plan document, this may be referred to as a triggering event or triggering distribution.
Your plan document will explain how your funds will be paid out depending on the type of triggering event. Things that may trigger distributions are:
- Emergency or disability distributions
- Change of control
As an example, if you are terminated your plan may distribute the vested balance within 60 days. Or upon retirement, your elected annual installment payouts may automatically start even though they weren’t scheduled to start for another five years.
Each plan sets its own terms so you must refer to your document to see how your plan works.
If you map out a timeline of your future projected retirement income BEFORE you elect your deferred comp payout dates then you may be able to choose payout dates that are likely to occur in years where other sources of taxable income are lower.
For example, suppose you have a large 401(k) balance. When you reach age 70 ½ you will have to take required minimum distributions and this will result in extra taxable income. If your plan allows it you may want your deferred comp to payout in ten-year installment payments from age 60 to 70. When your deferred comp payout ends then your required distributions would begin.
Too many people end up having their payouts occur as a lump sum and that extra income bumps them into a higher tax bracket in that calendar year. If they had chosen an installment payout they may have been able to reduce their tax liability on the payouts by 10 or 15%.
Even if there aren’t tax savings opportunities, a retirement income plan can show you the amount of after-tax income that will result in each year from your chosen payout option.
Other Considerations — Funded or Unfunded
Deferred comp plans come in many forms; one type of plan is designed to benefit top executives. These types of plans may be called top hat plans or SERPS (supplemental executive retirement plans) or, excess benefit or benefit equalization plans.
Per the IRS such deferred comp plans are unfunded — meaning if something bad happens to the company the funds could become subject to the company’s creditors. If you are uncertain about the future of the company this could be a reason to elect to have all deferred comp amounts be paid to you in a lump sum at the earliest possible date.
Bottom line: with deferred comp payouts, planning can help you get the most after-tax income from the plan.