The Ins and Outs of Deferred Compensation Plans

The Ins and Outs of Deferred Compensation Plans

by | Jul 30, 2019 | Geoff Curran, Jeff Barnett, Retirement Savings, Tech Focus, Wealth Enhancement

Executives and other highly compensated employees might notice a different option in their benefits plan, beyond the usual 401(k). Some employers also offer Section 409A nonqualified deferred compensation plans to high earners, which have their own mix of rules, regulations and potential drawbacks to navigate. However, when you’re earning income in the hundreds of thousands, it’s important to consider every option for saving on taxes and setting aside a larger nest egg for retirement. Contributing to the usual bevy of IRAs and 401(k) might not be enough to see you through your golden years, and tools like deferred compensation plans could also help you bridge the gap of early retirement.

Deferred compensation plans look a bit different than the 401(k) you already know. Like a 401(k), you can defer compensation into the plan and defer taxes on any earnings until you make withdrawals in the future. You can also establish beneficiaries for your deferred compensation. However, unlike 401(k) plans, the IRS doesn’t limit how much income you can defer each year, so you’ll have to check if your employer limits contributions to start building your deferred compensation strategy. Elections to defer compensation into your nonqualified plan are irrevocable until you update your choices the following year, and you have to make your deferral election before you earn the income. If you’re in the top tax bracket (37.0% in 2019), 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.

Unlimited contribution amounts and optional payout structures may sound too good to be true, but nonqualified deferred compensation plans also have significant caveats to consider. The big risk is that 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 lacks those protections. 409A deferred compensation plans are nonqualified, and your assets are tied to the company’s general assets. If the company fails, your assets could be subject to forfeiture since other creditors may have priority. The IRS permits unlimited contributions to the plan in exchange for this risk, and the potential loss of deferred compensation can motivate company officers to maintain the health of the company.

Let’s review potential distribution options from nonqualified deferred compensation plans. 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 to 10 years later, or in retirement)
  • A change of company 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 or keep track of the compensation in a bookkeeping account. Investment options often include securities, insurance arrangements or annuities, so it’s important to evaluate the potential returns and tax benefits of your deferred compensation plan versus other savings options. Plan funds can also be set aside in a Rabbi Trust; however, those funds still remain part of the employer’s general assets.

Nonqualified deferred compensation plans have a variety of structures, rules and withdrawal options depending on how your employer builds the plan. Consider the following pros and cons of deferred compensation plans when reviewing your employer’s options.

Pros

  • You can defer a significant amount of income to better help you replace your income in retirement. The IRS does not limit contributions.
  • You have the ability to postpone income in years when you’re in high tax brackets until later when you expect to be in a lower tax bracket.
  • If your employer offers investment options, you may be able to invest the money for greater earnings.
  • There are no nondiscrimination rules for participants, so the plan can benefit owners, executives and highly compensated employees specifically. 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 prior to the year compensation is earned.
  • Depending on the terms of your plan, you may end up forfeiting all or part of your deferred compensation if you leave 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).
  • If you leave your company or retire early, funds in a Section 409A deferred compensation plan aren’t portable. They can’t be transferred or rolled over into an IRA or new employer plan.
  • Unlike many other employer retirement plans, you can’t take a loan against a Section 409A deferred compensation plan.

The questions below are helpful for assessing whether a deferred compensation plan makes sense for you.

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

Section 409A deferred compensation plans have inherent drawbacks and prominent risks, but they could help you save toward your retirement planning goals. We recommend working with a Merriman advisor to review your specific plan terms and financial situation when preparing for the future. We can help you decide whether a nonqualified deferred compensation plan makes sense for your situation, weigh issues like future taxes and create a long-term plan. We want you to feel ready for everything life has to offer.

 

Mega Backdoor Roth Explained!

Mega Backdoor Roth Explained!

by | Jul 23, 2019 | Geoff Curran, Jeff Barnett, Retirement Savings, Tech Focus

By: Geoff Curran & Jeff Barnett

Everyone thinks about saving for retirement, and not many people want to work forever. However, have you thought about the best way to save for the future? If you are setting aside the yearly max in your 401(k) and channeling extra savings to your brokerage, you might be missing out on powerful tax-advantaged saving opportunities. In this article, we will show you how we help clients maximize savings, minimize taxes and secure their future using the Mega Backdoor Roth IRA.

 

Most people know they can contribute to their employer’s retirement plan from their paychecks through pre-tax and Roth contributions up to $19,000 a year ($25,000 if age 50 or older; IRS, 2018). What people miss is whether their retirement plan allows for additional after-tax contributions beyond this limit. Enter the supercharged savings!

It turns out that some company plans permit you to contribute up to the IRS maximum for total contributions to a retirement plan, which is $56,000 in 2019 ($62,000 with catch-up contributions; IRS, 2018). The IRS maximum counts contributions from all sources, including pre-tax employee deferrals, employer matching contributions, and even after-tax contributions for the Mega Backdoor Roth. That means you might be able to contribute an additional $20,000 or more after-tax each year after maxing your elective deferral and receiving your match. You can then convert the extra after-tax savings to Roth dollars tax-free. This more than doubles what most individuals can contribute to their retirement plan, and you won’t have to pay taxes on your Roth account distributions in retirement. This benefit is even greater when both spouses have this option available through their employers, so be sure to check both plans.

Retirement plans like those at Boeing, Facebook, and Microsoft permit easy conversions of after-tax to Roth dollars within the retirement plan. Other companies offer a variation where you can make in-service distributions and move after-tax dollars into a Roth IRA. Make sure to check with your benefits team to find out if your company’s retirement plan supports after-tax contributions and Roth conversions, the steps involved and the maximum amount you can contribute to the after-tax portion of your retirement plan. It’s important not to run afoul of plan rules or IRS requirements, so also be sure to consult experts like your accountant or financial advisor if you have any questions.  

Why contribute extra after-tax?
Now that we have covered the high-level view, let’s hammer down the why. The benefit of contributing to your employer’s after-tax retirement plan is that those contributions can subsequently be converted to Roth tax-free. This is sometimes called a ‘Mega Backdoor Roth,’ whereby you can contribute and convert thousands of dollars per year depending on your retirement plan. Once converted, these Roth assets can grow tax-free and be distributed in retirement tax-free. After several years of Mega Backdoor Roth contributions, you can amass a meaningful amount of wealth in a tax-free retirement account

How do I contribute?
1. Log in to your employer’s retirement plan through their provider website, such as Fidelity.

2. Find the area where you change your paycheck and bonus contributions (i.e., deferrals).

3. Find “after-tax” on the list showing how much you elected to contribute pre-tax, Roth, or after-tax to your 401(k).

4. Enter a percentage to have withheld after-tax from your upcoming paychecks and bonuses that works for your budget.

5. Select an automated conversion schedule, such as quarterly (Microsoft’s retirement plan even offers daily conversions!). If your plan doesn’t offer automated periodic conversions, contact your retirement plan provider regularly throughout the year to convert the assets.

6. Remember to select an appropriate investment allocation for your retirement account that aligns with your overall investment plan.

Is any part of the conversion taxed?
For retirement plans that don’t convert after-tax contributions to Roth daily, there may be growth in the account prior to conversion. This growth is subject to taxation at ordinary income tax rates. For example, if you converted $22,000 ($20,000 contributions + $2,000 investment growth over the period), you’ll owe income tax on the $2,000.

We suggest speaking with a Merriman advisor to determine if your retirement plan allows additional after-tax contributions, how to fit it within your budget and its impact on your retirement savings goals.

References: Internal Revenue Service. (2018, November 2). Retirement Topics – 401(k) and Profit-Sharing Plan Contribution Limits. Retrieved from https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-401k-and-profit-sharing-plan-contribution-limits

Traditional or Roth 401(k)?

Traditional or Roth 401(k)?

by | Jun 15, 2018 | Investing 101, Retirement Savings, Tech Focus

Often employers offer the option of contributing to a traditional 401(k) or a Roth 401(k). Do you know which one is right for you?

The primary difference is in the tax treatment. The traditional 401(k) gets a tax benefit at the time of contribution, because money contributed to such an account is not taxed. Moving forward, the earnings in your traditional 401(k) are not taxed as long as the funds remain in the account. When you begin to make withdrawals in retirement, the funds withdrawn are taxed as ordinary income.

Roth 401(k)s are taxed the reverse way. In these accounts, money is taxed when the contribution is made. Earnings on investments in your Roth 401(k) account are not subject to tax, and the money is not taxed when it’s withdrawn.

If the investor’s marginal tax rate is the same at the time of contributions and withdrawals, the traditional and Roth accounts would produce the same results.

Because of these differences in tax treatment, taxpayers in the lowest tax brackets should contribute to Roth accounts, while taxpayers in higher tax brackets will want to use traditional retirement accounts. As a general strategy:

When you’re in the 12% tax rate or lower: Contributions should be made to a Roth 401(k).

When you start moving into the 22% tax bracket: 50% of contributions be made to a traditional 401(k), and 50% to a Roth 401(k).

In your peak earning years: As you move into years with marginal tax rates above 22%, most or all retirement contributions should be made into a traditional 401(k) instead of the Roth.

If you’re still not sure which option is right for you, we’re happy to help.

How the TAP Annuity Works for Washington State Employees

How the TAP Annuity Works for Washington State Employees

by | Sep 12, 2017 | Geoff Curran, Wealth Enhancement

When planning for retirement, Washington State employees have lots of options. The employer-based retirement for the Washington Public Employees Retirement System (PERS 3) is one part defined benefit (pension) and one part defined contribution. The state’s contribution and obligation is on the pension side and is based on a formula that creates a guaranteed lifelong income stream for the participant. The employee’s contributions are put into an investment account (the defined contribution portion of the plan) like a 401(k) where you can choose between a few investment options. Returns and payments from investments in the defined contribution plan aren’t guaranteed and are subject to risk; however, they have the potential to grow at a faster rate than your pension benefit.

Once retired, you can either withdraw from the defined contribution portion like a regular retirement account or turn part or all of this account into a guaranteed income stream through the plan’s Total Allocation Portfolio (TAP) annuity.

What is the TAP annuity?

The TAP annuity provides a guaranteed income stream with a 3% automatic inflation increase each year. Furthermore, your beneficiaries receive a refund of any undistributed portion of your investment in the TAP annuity upon your death. For example, if a retiree contributes $200,000 into the TAP Annuity and passes away five years after retirement, having only received $60,000 in monthly income, their heirs would be entitled to a refund of $140,000. (more…)

The insidious effects of inflation

by | Apr 9, 2013 | Lowell Parker, Preparing for Retirement

We have all heard the expression, “back in my day…” followed by the amount a particular item used to cost. While it’s somewhat of a cliché, it does carry a lot of weight. The impact of inflation on your cost of living has real consequences, and factoring it into your retirement plan is of paramount importance.

Consider someone who is planning to retire at 66 years old. Current actuarial figures give them a retirement window of about 25 years. Using 3% for average annual inflation, the future value of a dollar 25 years out is $.48. Put another way, you can afford to buy less than half as many goods 25 years into retirement as you could when you started. Fortunately, that is not the end of the story.

There are several ways to insulate your retirement income from the effects of inflation.

One solution has to do with retirement pensions. Once the pension spigot is turned on, one thing that can increase the flow is a Cost of Living Adjustment, or COLA. A COLA increases annual pension amounts based upon the previous year’s rate of inflation. The important thing to know is whether your pension has a COLA. Without one, you will become increasingly dependent upon other assets as time goes on. Remember, 25 years from now a dollar will be worth less than half of what it is worth today. With a COLA, you will still need to understand how your increasing income stream fits in with your other assets and your specific retirement plan.

Another pension source most people have in retirement is Social Security Income, or SSI. The COLA for SSI is tied to the Consumer Price Index. As such, it varies from year to year.

The final piece to consider is your retirement accounts, such as IRAs, Roth IRAs and taxable brokerage accounts. These accounts do not provide a fixed income stream in the sense that a pension does. Typically, they are invested in an allocation of stocks and bonds controlled by you or your investment advisor. Distributions are on an as-needed basis.

Stocks have historically been the best long-term hedge against inflation. In a sense, they act as a super charged COLA for your retirement accounts. How much stock you allocate to these accounts and how the accounts will supplement your pensions requires careful consideration.

No two retirement plans are alike. Understanding how the unique pieces of your retirement puzzle fit together to meet your retirement goals is what’s important. If you have not already done so, take the time to sit down with a professional who can help you figure out where you are, where you want to go and most importantly, how to get there.