If you have the option of receiving deferred compensation, you might know of the possibility to plan how you receive your deferred compensation (deferred comp) payouts in a way that can reduce your multi-year tax liability.
Sadly enough, it is rarely the case that people know this. Instead, the tendency is to make random elections for receiving deferred compensation. This can result in a payout that is not tax-efficient, resulting in a tax liability that is higher than it needs to be.
It can pay to be knowledgeable of non-qualified deferred compensation plans (NQDCs), how they work, and how they can be more efficiently utilized when viewed in the context of a life-long retirement income plan. This is especially true when considering the tax benefits one of these plans can give you.
How Your NQDC Plan Works
Each NQDC plan is different. Each plan is required to have an official written document that spells out the rules for that plan. If you have an NQDC plan, you should request a copy of your plan document to find out the specific terms of your employer plan. There are three main points you’ll want to consider for 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 (usually regarding your contributions in increasing company performance or similar conditions) in order for the company to be able to make these contributions.
How the Funds Are Taxed
- Employee contributions—You pay FICA (payroll taxes) on the amount that you put into the plan when that amount is paid to you. Payroll taxes will come out of the portion of your paycheck that is not deferred into the plan. Sometimes this is used to reduce annual tax liabilities.
- 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 the tax planning opportunities present themselves—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. 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 the day of payment.
You make a payout election for each year of contributions to the plan. For example, if you defer payment into a plan in 2019, you would select when and how to receive it at the time of deferment.
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 change them. Your ability to make changes will come with restrictions, however.
For example, a deferred comp plan could describe a scenario to make a change: “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
A few examples of triggering events: if you are terminated your plan may distribute the vested balance within 60 days. Or, if you had elected annual installment payouts upon retiring they might 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, you may be able to choose the 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.
Many people end up choosing their payouts as a lump sum. The extra income bumps them into a higher tax bracket in that calendar year, causing more tax on their income. If they had chosen an installment payout they may have been able to reduce their tax liability on the payouts by between 10% and 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 during 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, SERPS (supplemental executive retirement plans), 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 be claimed by 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.
Planning is the Key
With deferred comp payouts, planning to time payouts with your future can help you get the most after-tax income from the plan. This does mean that you have to have a fairly accurate plan for the future to be able to wisely choose your payout methods. However, if you are in a position to be receiving an NQDC, you are probably used to planning things for a few years, so this might not be an issue.