If your income is greater than $400,000 a year, does making a $18,000 deferral to your company’s 401(k) retirement plan do much toward replacing your income in retirement? This less than 5% of income deferral to your retirement plan would leave you significantly underfunded to maintain your lifestyle in retirement. While you can save elsewhere through non-retirement accounts, your company may permit you to postpone receiving income through a Section 409A deferred compensation plan.

There are no IRS limits on how much compensation can be deferred; however, your company’s plan may have a limit. You could defer a bonus, incentive, or part of your salary in the present year and receive that, plus the potential for earnings on its investments, in future stated years. To do this, you must make an irrevocable election to defer compensation prior to the year in which you expect the compensation to be earned. If you’re in the top tax bracket (39.6% in 2017), this can allow you to defer income now and receive it at a later date (such as when you retire) in a lump sum or a series of payments when you expect to be in a lower tax bracket.

The major requirement to receive this deferral status is that your funds are subject to substantial risk of forfeiture. Unlike 401(k), 403(b), and 457(b) accounts where your plan’s assets are qualified, segregated from company assets, and all employee contributions are 100% yours, a Section 409A deferred compensation plan is nonqualified, and your assets are tied to the company’s general assets. If the company fails, your assets are subject to forfeiture, as creditors would have priority. Only through accepting this risk does the IRS permit unlimited contributions to this plan. If your employer doesn’t include this deferred compensation as part of the company’s general assets, making them subject to forfeiture, the deferred compensation becomes taxable immediately, plus a 20% penalty and interest. A potential reason for this requirement of substantial risk of forfeiture is to incentivize executives and business owners to maintain the health of the company, and to ensure they don’t inappropriately withdraw too much of its resources, and then try to leave.

A Section 409A deferred compensation plan can provide payment no earlier than the following events:

  • A fixed date or schedule specified by the company’s plan or the employee’s irrevocable election (usually 5 or 10 years later, or in retirement)
  • A change of control, such as a buyout or merger
  • An unforeseen emergency, such as severe financial hardship or illness
  • Disability
  • Death

Once your income is deferred, your employer can either invest the funds in securities, insurance arrangements or annuities, or keep track of the benefit in a bookkeeping account. The funds can be set aside, often called a Rabbi Trust; however, those funds remain a part of the employer’s general assets. Beneficiaries must be designated at the time of the income deferral election, but they can be changed as long as it doesn’t affect the time or form of benefits payments.

Consider the following pros and cons of deferred compensation plans.

Pros

  • They allow you to defer a significant amount of income to better help you replace your income in retirement. No IRS limits on contributions.
  • They give you the ability to postpone income in years where you’re in the top tax bracket for consumption in future years when you expect to be in a lower tax bracket.
  • If investment options are available, they provide the ability to select investments to increase earnings like other employer retirement plans such as a 401(k).
  • There are no nondiscrimination rules on who can participate, so the plan can be used to benefit only owners, executives and highly compensated employees. Other retirement plans may limit contributions or participation due to discrimination rules.

Cons

  • Your deferred compensation plus any investment earnings are subject to forfeiture based upon the general financial health of the company.
  • The election to defer compensation and how/when it will be paid out is irrevocable and must be made the prior to the year the compensation would be earned.
  • Depending on the terms of your deferred compensation, you may end up forfeiting all or part of your deferred compensation by leaving the company early. That’s why these plans are also used as “golden handcuffs” to keep important employees at the company.
  • The plan may or may not have investment options available. If investment options are available, they may not be very good (limited options and/or high expenses).
  • You have a lack of control of the assets.
  • If you leave your company or retire early, funds in a Section 409A deferred compensation plan aren’t portable, meaning they can’t be transferred/rolled over into an IRA or new employer plan.
  • You can’t take a loan against a Section 409A deferred compensation plan, while you can take a loan against many other types of employer retirement plans.

Ask your employer benefits department and peers the following questions when deciding whether to defer compensation.

  • Is the company financially secure? Will it remain financially secure?
  • Will my tax rate be lower when this deferred compensation is paid in the future?
  • Can I afford to defer the income this year?
  • Will my tax rate be lower when the payments are made?
  • Does the plan have investment options? Are the fees and selection of funds reasonable?
  • Does the plan allow a flexible distribution schedule?

We recommend that you speak with your advisor to determine whether it makes sense in your financial plan to participate in your employer’s Section 409A deferred compensation plan.