How does deferred compensation plan work

After all, paying more tax on income you earn and receive is better than paying no tax on income earned but never received.

Saving can be a challenge at any income. For highly paid workers who frequently engage in lifestyle inflation as their income increases, deferring compensation can help keep spending under control. Disciplined investors can achieve forced savings without a SERP, though. Consider setting up regular monthly contributions to a brokerage account. This will give you the flexibility to invest the money and use it when you need it. By paying taxes on your income today, and investing the rest in a brokerage account , you can benefit from exposure to the market as well as flexibility in case you have unexpected cash needs.

Are you working in a high-tax state but plan to retire in a state with low or no income tax? If so, a nonqualified deferred compensation plan could give you a greater tax benefit, as you avoid tax now at higher rates.

Always focus on what you can control. Tax laws can change at any time, especially these days. Tax savings should be a component of the decision to participate, but not the main driver.

Investors with money in tax-deferred accounts like a k or a traditional IRA must begin required minimum distributions RMDs at age Since withdrawals are taxed as ordinary income, RMDs can push people into higher tax brackets. Treat the cause not the symptom. Keep in mind that funds from a nonqualified deferred compensation plan will also be taxed as ordinary income when withdrawn.

Instead, consider using different types of accounts to add tax diversification. A brokerage account has no RMD requirement. Also, by drawing from both tax-deferred and taxable assets in retirement, it can help provide flexibility to manage your tax situation in retirement and even harvest losses to offset gains. Whether or not a nonqualified deferred compensation plan makes sense for your individual situation will depend on many factors.

One of those key determinants is how diversified your assets are in general, and how much financial exposure you have to your employer. Executives may unknowingly have a great deal of financial risk through their employer.

Aside from the salary, benefits, and other perks provided by the company, employees are also exposed through stock options and equity compensation , having company stock in their k , and participating in an employee stock purchase plan.

Rather than prioritize tax savings, consider the opportunity to diversify in a low-cost tax-efficient investment strategy. After all, achieving your personal goals should be the central priority. Darrow Wealth Management is an independent registered investment advisor and fiduciary money manager.

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If the company goes bankrupt, a NQDC plan is considered an unsecured debt of the company, which may mean a total loss of your contribution. This question begs you to consider your income and wealth concentration risk.

In addition to salary, you may have stock options, restricted stock units or stock purchase plans, all of which are tied into the future of one company. Adding NQDC further increases your exposure and risk here. The longer you have until a triggering event like retirement, the greater the risk of financial instability for your employer. During times of economic crisis that are very difficult to predict i. Remember Chrysler in and Hertz in ? Consider what your tax bracket is now versus what it might be in the future.

This is particularly hard since no one knows for sure what tax rates or brackets will be in 5, 10 or 15 plus years.

Speaking to a qualified tax professional can be a critical part in guiding you on this type of planning. NQDC plans sometimes known as deferred compensation programs, or DCPs, or elective deferral programs, or EDPs allow executives to defer a much larger portion of their compensation and to defer taxes on the money until the deferral is paid.

Explore our 3-part series on making the most of nonqualified deferred compensation plans. That said, NQDC plans aren't for everyone. Before you enroll, it's important to understand exactly how such plans work and how one might fit into your overall financial plan. NQDC plans have the potential for tax-deferred growth, but they also come with substantial risks, including the risk of complete loss of the assets in your NQDC plan.

We strongly recommend that executives review their NQDC opportunity with their tax and financial advisors. The Tax Cut and Job Act of December the Act established new income tax rates, corporate tax rates, and modifications to many deductions. It also impacted nonqualified plans in several ways. The Act included a new deferral provision for certain types of broad-based employee equity, which may apply to certain private companies. Lastly, the Act grandfathered compensation vested prior to under existing contracts.

NQDC plans aren't like other workplace savings vehicles, which typically let employees defer a portion of their salary into a segregated account held in trust, and then invest these funds in a selection of investment options. Often used by employers as an attraction and retention vehicle, an NQDC plan is more like an agreement between you and your employer to defer a portion of your annual income until a specific date in the future.

Depending on the plan, that date could be in 5 years, 10 years, or in retirement. Most companies provide NQDC plans as an executive retirement benefit, because k plans often are inadequate for high earners. For example, consider Susan.

By contrast, Susan could choose to set aside a much larger percentage of her salary into an NQDC plan each year, creating an appropriate retirement cushion. But there are downsides to NQDC plans. For example, unlike k plans, you can't take loans from NQDC plans, and you can't roll the money over into an IRA or other retirement account when the compensation is paid to you see the graphic below.

Unlike a qualified plan, where benefits are segregated from the employer's general assets, your deferred compensation deferred into the NQDC remains in the employer's general assets and is subject to potential loss.

The plan essentially represents a promise by the company to pay you back.