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
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.
- 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.
- 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.