The Pros and Cons of Deferred Compensation Plans
By Jake Withnell, CFP®
When you’re a high-income earner, you are well aware of the challenges when it comes to tax-advantaged investing strategies. Although government restrictions make it harder to invest in traditional accounts, such as Roth IRAs with their income phaseout rules and 401(k)s with their contribution limits, you’re not necessarily out of luck. Your company’s deferred compensation plan may be your ticket to minimizing your taxes. But before you sign on the dotted line, it’s important that you understand how these plans work—and the pros and cons of participating in one.
The Benefits of Deferred Compensation Plans
For highly paid professionals, deferred compensation plans can be a good way to save for retirement after maxing out contributions elsewhere because deferred compensation plans have no contribution limits. Consider these additional benefits:
Tax Mitigation Strategies
When planned correctly, deferred compensation plans help you save on your current tax bill by allowing you to contribute more money into your deferred compensation plan and lower your tax bracket while you’re working. Once you enter retirement years and your income from your employer goes away, the deferred compensation distributions are taxed at a lower rate compared to when you were employed. Additionally, if you are planning on moving to another state with lower income taxes during retirement, this could also provide some tax savings. Please, consult your tax advisor to fully understand these benefits and map out the best strategy for your current circumstance.
Retirement Income Bridge
Deferred compensation plans can be used to generate income for a couple or individual as they begin retirement and want to maximize their Social Security income by delaying collecting it until age 70½. It can also be used to supplement income in retirement if the market has taken a hit and your portfolio has suffered.
Deferred Compensation Plan Drawbacks
While the pros of deferred compensation plans seem like incredibly useful tools for your wealth management strategy, there are some points to consider when using a deferred compensation plan.
Company Solvency Risks
This may be the largest risk you could face when using a deferred compensation plan. If a company declares bankruptcy, your deferred compensation plan could be completely or partially dissolved in the bankruptcy. This is because when you participate in a deferred compensation plan, you are considered to be a creditor of the company. Also keep in mind that if you choose a longer-term payout option, this increases the risk that the company may go bankrupt during this time. You should closely examine your company’s plan and consult a trusted financial advisor before participating.
Lack of Current Liquidity
Another thing to keep in mind is that deferred compensation plans can dry up your short-term liquidity. So, while they may provide benefits long term, they cannot be used to supplement your current cash needs. Once you’ve selected the amount of compensation you would like to defer during the current plan year, you cannot adjust or eliminate your deferrals throughout the year. Before you make a decision, take a hard look at your cash needs so you don’t find yourself in a bind.
Lump Sums Could Affect Your Taxes
Most plans don’t allow you to access the money earlier than your retirement; however, if you change jobs, you may have to collect the money in one lump sum. Collecting one large lump sum could wreak havoc on your tax mitigation strategy for that tax year.
Lack of Diversification and Investment Options
Deferred compensation should always be coupled with other retirement strategies that don’t involve your company. This is because as an executive, you may have an inordinate amount invested in your employer’s stock. If the company suffers an economic blow, your employer’s stock could lose value and your deferred compensation plan could also be in jeopardy. This could be devastating to your retirement plan. Deferred compensation plans may also have a limited amount of investment options. The lack of diversification within the plan could be detrimental to the investment performance over the long term.
We’re Here for You
Do you still have questions? Remember that you don’t have to navigate financial decisions alone. In fact, it’s best to get the expertise of a seasoned and trusted professional. We at JGP Wealth Management enjoy working with our clients to solve their retirement planning challenges, and we offer a comprehensive range of financial services. We can walk you through the ins and outs of your company’s plan; we know what to look for and what types of strategies you should use to protect your wealth management plan from any risks associated with a deferred compensation plan.
Get started by reaching out to me at 503-446-6450, emailing firstname.lastname@example.org, or scheduling an introductory phone call online. And see what other clients have to say about working with me here.
Jake Withnell is a financial advisor at JGP Wealth Management, an independent, fee-based financial advisory firm in Portland, Oregon. Jake is known for going the extra mile for his clients and for his passion for working tirelessly to help his clients find solutions to their financial concerns so they can confidently live out the life they want. He prioritizes listening and understanding as the foundation of his relationships with his clients, and his highest hope is that they can spend more of their time and energy on their passions knowing he is watching over their financial future. Jake specializes in serving business owners, Nike executives, and retirees, and plays a key role in JGP’s portfolio management process, building and analyzing financial models, and conducting client cash flow analyses.Jake graduated from Eastern Washington University with a bachelor’s degree in professional accounting and finance. He is a Certified Public Accountant (CPA) and a CERTIFIED FINANCIAL PLANNER™ professional. Jake’s claim to fame is his time playing tight end for the Eastern Washington University Eagles, all while earning four-time Big Sky Conference First Team All-Academic honors! Jake values giving back to his community and does this by volunteering with the Children’s Cancer Association, Family Building Blocks, and New Avenues for Youth. In his free time, Jake takes advantage of the many outdoor activities the Northwest has to offer, such as trail running, mountain biking, and hiking. He loves traveling and spending long weekends at his family beach house in Seaside, OR. To learn more about Jake, connect with him on LinkedIn. You can also watch his latest webinar on 6 Ways to Maximize Your Nike Employee Benefits.