If you’re a successful professional, you may have been notified by your human resources department that you are eligible to participate in your company’s deferred compensation plan. Before signing on the dotted line, it is important for you to understand how these plans work and the pros and cons of participating in one.
What Is A Deferred Compensation Plan?.
A nonqualified deferred compensation plan is a way for high-earning employees and executives to put off receiving their income until a later date. In addition to putting off receiving the money, deferring compensation also puts off paying taxes on it. Because of this, they are especially appealing if you expect to be in a lower tax bracket at a later date.
Also, the money can be invested for growth during its deferral. This works much the same way as a pre-tax 401(k) where your money can grow tax-deferred. However, it is not a 401(k) and does not have all of the same benefits and protections.
What Are The Advantages Of Deferred Compensation?
Unlike 401(k) plans, there is no annual contribution limit to a deferred compensation plan. So, for high earners who max out their 401(k) each year, it offers another tax-deferred way to save for the future. Because it is tax-deferred, you have more money to put to work earning interest which compounds over time.
Another benefit of a deferred compensation plan is that you can use it to reduce your taxable income in the current year. This helps you manage which tax bracket you fall into and also affects eligibility for different programs and benefits. Being able to control your taxable income is a very powerful tax-planning tool.
Finally, with deferred compensation, you may be able to bypass the required minimum distributions that everyone else is subject to at age 70½. You can do this by agreeing to the distribution schedule set forth in the plan description if your specific plan allows for it.
What Are The Disadvantages Of Deferred Compensation?
While you can see that there are a lot of benefits to deferred compensation, there are also drawbacks. One of the major ones is that the money you defer in one of these plans is not protected in the same way as it would be in a 401(k) or other qualified retirement plan. That means that if your company is facing bankruptcy, your deferred compensation is not protected from creditors. It is still technically the company’s money, since they haven’t paid it out yet, and they could be forced to give it to their creditors, leaving you with nothing.
Also, the money in a deferred compensation plan is not protected from your own personal creditors if you face bankruptcy. While you can go through bankruptcy and come out the other side with your 401(k) still intact, that’s not the case with deferred compensation. Your deferred compensation will be used to pay back the debts that you owe.
In addition to a lack of protection, there are rules dictating when and how you can take your deferred compensation. These are plan-specific. Some plans allow you to defer compensation for a few short years while others require you to defer it until retirement. You also can’t take the money early or take a loan against it. Even when you are eligible for withdrawals, there are often specific rules regarding when and how you can take them.
Some plans will allow you to roll the money into another tax-deferred account, while others won’t. Some allow you to take the money with you when you change jobs and others do not. Some will force you out of the plan if you terminate employment, which could have a big impact on your tax bill.
How I Can Help
Because there are so many plan-specific stipulations, it is important to review your company’s plan thoroughly with a financial professional before signing up. A deferred compensation plan can be a great blessing, but it can also become a terrible nightmare.
If you’re considering participating in your employer’s deferred compensation plan, let me help you review the plan documents first and see how participation may fit into your overall financial plan. Call my office at (949) 221-8105 x 2128 or email me at michael.loo@lpl.com for help.
About Mike Loo
Mike Loo is an independent financial advisor with more than 20 years of experience in the financial services industry. His mission is to make a meaningful impact on the lives of clients and the people they care most about, help them make educated decisions with their money, and build a strong financial foundation for both themselves and their next generation. Mike is committed to meeting a high standard of excellence, taking the time to listen to clients’ needs, and designing strategies that aim to help clients save money and reduce debt. He seeks to fit a client’s investments into their life and educate them so they’ll understand their investments. To learn more about how Mike may be able to help, connect with him on LinkedIn, call his office at (949) 221-8105 x 2128, or email him at michael.loo@lpl.com.
Mike Loo is a registered representative for LPL Financial (LPL) and an Investment Advisor Representative (IAR) for Trilogy Capital (TC). Securities offered through LPL, Member FINRA/SIPC. Investment advisory services offered through TC, a Registered Investment Advisor. TC markets advisory services under the name of Trilogy Financial (TF), an affiliated but separate legal entity. TC and TF are separate entities from LPL.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.