If you have the option of getting deferred compensation (deferred comp), you might know that you can plan how you receive your payouts in a way that can reduce your multi-year tax liability.
While some people tend to make random elections for getting deferred comp, this can result in a payout that is not tax-efficient. The result is a tax liability that is higher than it needs to be. To make the most of the money you earn, you want to pay the lowest taxes you can.
It can pay to know a lot about non-qualified deferred comp plans (NQDCs), how they work, and how they can be optimized as a life-long retirement income plan, especially when you consider the tax benefits that one of these plans can give you.
How Your NQDC Plan Works
Each NQDC plan is unique. NQDCs must have an official written document that spells out the rules for that plan. If you have one, you should request a copy of your plan document to find out the specific terms of the plan you have through work. There are three main points you’ll want to think about for your deferred comp plan terms:
- How does money go into the plan?
- How are the funds taxed?
- How does money come out of the plan?
How Money Goes Into the Plan
Some plans allow employee and employer contributions. Others may allow only one type of contribution.
- Employee: When you elect to defer a portion of your salary or bonus, you will complete a form to have this done. 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: If there are to be contributions made by your employer, they will let you know how much and what rules must be met for the company to be able to make these contributions.
How the Funds Are Taxed
- Employee: 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. This can be used to reduce annual tax liabilities.
- Employer: With the funds your employer puts in, FICA taxes are usually owed at the time you vest in those contributions. They are often subject to a vesting schedule, which means you must stay at the job for a set length of time to be able to receive all of the funds they put into the account for you. Thus, if you leave early, you would not pay FICA tax on any amounts for which you do not meet the vesting rules.
With either type of contribution, per the IRS you will not pay FICA taxes on any earnings that accrue in an NQDC plan. Still, you will pay income tax on the payments when they come out of the plan and are paid to you. That is where your chances for tax planning come in. You can choose the way the money will come out of the plan.
How the Money Comes Out
At the time you put money into your NQDC, you must elect how and when it will be paid. Most of the time, you cannot change this. The earliest the first payout is allowed to occur is five years from the year you put the money into the plan.
- Lump sum: Some plans only offer a lump-sum payment option. For instance, you might elect a lump sum to be paid out five years, seven years, or 10 years from the year you defer the income.
- Installment payouts: Some plans offer the option for the funds to be paid out in installments. For instance, you could choose payments to be made over ten years to start, which could begin five years from the day of payment.
You make a payout election for each year of contributions to the plan. For instance, if you defer payment into a plan in 2027, you would select when and how to receive it at the time of deferment.
With some plans, you can elect payout options that differ according to the types of contributions (for instance, an installment payout out on your own deferred amounts, and a lump-sum payout on the funds your job puts in).
Changing Your Payout Election
Although payout elections may be considered irrevocable, which means you can't change them, in many cases you can change them. Your ability to make changes will come with restrictions. For instance, a deferred comp plan could describe a scenario to make a change, such as: “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.”
Certain events may trigger a payment that will occur differently from what you have elected. In your plan document, they may be referred to as triggering events or distributions.
Your plan document will explain how your funds will be paid out. This will depend on the type of triggering event, such as:
- Emergency or disability distributions
- Change of control
Examples of triggering events include:
If you are let go from your job, your plan may give you the vested balance within 60 days. If you had elected annual installment payouts upon retiring, they might start even though they hadn't been 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.
Map out a timeline of the future income you expect to have when you retire. Before you elect your NQDC payout dates, you may be able to choose the dates that are likely to occur in years when other sources of taxable income are lower. For instance, suppose you have a large 401(k) balance. When you reach age 72, you will have to take required minimum distributions, which will result in additional taxable income. If your plan allows it, you may want your payout in 10-year payments from age 60 to 70. When your NQDC payout ends, then your 401(k) payments 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 plan, 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 from your chosen payout option during each year.
Other Choices: 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."
Such plans are unfunded, meaning that if the company goes into debt, the funds could be claimed by the company’s creditors. If you're not sure about the future of the company, that could be a reason to elect to have all deferred comp amounts be paid to you in a lump sum as soon as possible.
Planning Is the Key
With NQDC payouts, planning to time payouts with your future can help you get the most after-tax income from the plan. That means you need to have a fairly clear plan for the future to be able to wisely choose your payout methods. Still, if you know you're getting an NQDC, you could be used to planning things for a few years, so this might not be an issue.