You've heard the adage, "It takes money to make money." That is very often true. Similarly, it takes income to pay income taxes. If you are in a position where you are offered deferred compensation, you may have the opportunity to pay less in income taxes and have more money when you need it the most.

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What Is Deferred Compensation & What Are Deferred Compensation Plans?

Deferred compensation is what it sounds like. An employer will offer you the opportunity to defer a portion of your compensation for several years. Doing so defers taxes on any earnings until you withdraw. Examples include pensions, retirement plans, and stock options.

There are two types of deferred compensation plans:

• Qualified deferred compensation
• Non-qualified deferred compensation (NQDC)

The most common type we will discuss here is the NQDC plan. Unlike 401(k) plans, NQDCs have no limit to how much income you can defer each year. In fact, if you're in the top tax bracket, these plans can have significant tax benefits. That means you can defer a large enough portion of your income to drop down into a lower tax bracket, thus reducing the amount you must pay in income taxes.

Often referred to as "golden handcuffs," NQDC plans are used to attract and retain top employees. The "golden" part refers to the potential tax benefit for the employee. The handcuff refers to a penalty attached to any employer contributions to deferred compensation that kicks in if the employee leaves (especially for a competitor), retires early, or is terminated. That means the employee must stay with their company, or the deferred compensation is penalized, so the employer gets some extra assurance they will get to keep their valued employee for the long haul.

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How Does Deferred Compensation Work?

Your company will designate an amount you may defer and how long you may defer that amount–usually five years, ten years, or until you retire.

After determining how long you will defer your income, you will also need to decide if you want to receive your deferred compensation in one lump sum or across multiple years. Standard options are a five-year or 10-year payout period, which has tax benefits we will articulate below.

The next choice you need to make with your NQDC is which investment option you want your returns indexed. This is just a bookkeeping mechanism, as your money isn't actually invested. Some companies offer options like what’s available in your 401(k) or may have options tethered to an actual asset (company stock) or a national index like the S&P 500. Occasionally, the company may choose for you by offering a guaranteed "rate of return" on the compensation, but this is rare.

Is Deferred Compensation Considered Earned Income?

Deferred compensation is not considered earned, taxable income until you receive the deferred payment in a future tax year. For example, the use of Roth 401(k)s as deferred compensation is an exception, requiring you to pay taxes on income when it is earned.

Is Deferred Compensation Taxable?

In the case of many highly compensated employees, their expected income is much higher in their last few years of service than it will be in the first few years of retirement. You can expect a lower tax bracket when the compensation is finally paid out in retirement.

Say you are 60, plan to retire at 65, make $500,000 per year, and you’re a single tax filer. Your company allows you to defer up to 20% of your compensation over ten years. If you take the income now, with 2023 tax rates, you will pay 35% in taxes on $500,000, for a total tax bill of $175,000. But if you defer until retirement, you could be looking at a 24% tax rate, for a tax bill of $120,000.

Here’s the best part.

If you decide to defer and not send that $175,000 to the government this year, you get to earn interest on that money for the next 5 years. So, if you’re earning 5% interest, at age 65, that’s almost $50,000 more than you would have had originally.

As you can see, the compounding effect of earning interest on money you normally would have sent to the government is significant.

Schedule a free, no-obligation meeting today to learn more about deferred compensation.

Contrary to popular belief, expenses tend to increase in the first few years of retirement. You may need some of that money to travel, move, or pay for education for children or grandchildren. Deferring compensation can allow you to keep more money overall, so you have it when you need it.

Additionally, it's important to know that states treat deferred compensation differently depending on the payout period. If you plan to move to a different state in retirement and your NQDC payout period is less than ten years, you will have to pay taxes on the payout in the state where you earned it. Conversely, if the payout period is ten years or more, you will pay taxes in the state where you move.

Let's say you live in Minnesota, where there is a state income tax, but you plan to move to Texas, where there is no state income tax, two years into retirement. If you elect a five-year payout for your $500,000 salary, you will pay Minnesota state taxes (around 7%) on your deferred income. So, over those five years, you will receive $100,000 per year and have to pay 7% in income taxes on all of it–resulting in a tax bill of $35,000. On the other hand, if you elect a 10-year payout, you'll receive $50,000 per year, and you will only pay that 7% in taxes on the two years you live in Minnesota–resulting in a tax bill of just $7,000.

What Are Some Risks Associated With Taking NQDCs?

NQDCs do have their drawbacks. For example, even if you don't leave the company, they come with fewer protections than are available with 401(k)s. Additionally, they're not protected from creditors in bankruptcy. So, if your company goes under, you might lose your compensation.

NQDCs are also less flexible than other types of retirement accounts. You can’t take them as loans or roll them into an IRA. Further, once you make your distribution election, you can’t change it.

What Happens To Deferred Compensation if I Quit?

Most of us don't stay in one job forever. Depending on the terms of your NQDC 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 known as "golden handcuffs," because they keep essential employees at the company.

However, you have options for what to do with your 401(k) or another qualified deferred compensation plan when you quit or are let go from a job. You should check your specific schedule for details.

What Happens To Deferred Compensation if I Am Laid Off?

In challenging times, it's common to see companies conduct large-scale layoffs. If you're laid off and have an NQDC plan, it's essential first to check the terms of your plan, as it should have specific provisions for such instances.

However, you should rest easy knowing that the account will remain active/invested if you are laid off. But as is always the case with NQDC plans, your deferrals are not protected from the company's creditors. As layoffs could be an early indicator of financial trouble at the company, it may be an excellent time to evaluate or reevaluate your distribution election, if your employer permits.

Is a Deferred Compensation Plan Right for Me?

It makes sense to consider the long game when electing to take deferred compensation. Here are a few questions to consider:

• Are you maximizing your traditional retirement plan contributions?
• Do you plan to be with your company until retirement?
• When the deferred compensation payments start, will you be in a lower tax bracket?
• Are you comfortable with the distribution options?
• What are investment options available in the plan?
• Is your company financially secure?
• Do you plan to move once you retire?
• Do you anticipate expenses (e.g., medical bills) that will require funds in the short term?
• Does your employer offer company stock purchases in the deferred compensation plan and the company 401(k)?

The question of whether to defer compensation is driven by your financial goals. If you work with a seasoned advisor, they can help you work through key questions and potential scenarios as you make your NQDC plan decisions.

If you want to learn more about deferred compensation and other non-cash compensation strategies, download our complimentary eBook, Including Non-Cash Compensation in Your Financial Plan: A Case Study.

This information is not intended to be a substitute for individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.

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