Deferred compensation is a form of compensation that allows high-income earners to delay the receipt of a portion of their income until a later date, typically after retirement. It is an arrangement that offers both advantages and disadvantages for both employers and employees.
On one hand, deferred compensation provides financial flexibility, tax advantages, and long-term savings opportunities. On the other hand, it comes with risks and limitations that individuals must carefully consider. In this article, we will explore the pros and cons of deferred compensation, shedding light on the key factors that should be weighed when deciding whether to participate in such programs.
The Benefits of Deferred Compensation Plans
For highly paid professionals, deferred compensation plans can be a good way to save for retirement after maxing out contributions elsewhere because deferred compensation plans have no contribution limits. Consider these additional benefits:
Tax Mitigation Strategies
Do you live in a state with high-income tax but are considering retiring to a state with no income tax, like Florida? Deferred compensation plans help you save on your tax bill by allowing you to put more money into your plan and lower your tax bracket while you are working. You will not owe federal income tax on the funds contributed until they are withdrawn in retirement, typically when you are in a lower tax bracket. Additionally, if you are planning on moving to another state without an income tax for retirement, this could also provide some tax savings.
Retirement Income Bridge
Deferred compensation plans can be used to generate income for a couple or individual as they begin retirement and want to maximize their Social Security income by delaying collecting it until age 70. It can also be used to supplement income in retirement if the market has taken a hit and your portfolio has suffered.
Deferred Compensation Plan Drawbacks
While the pros of deferred compensation plans seem like incredibly useful tools for your wealth management strategy, there are some points to consider when using a deferred compensation plan.
Company Solvency Risks
This may be the largest risk you can face when using a deferred compensation plan. If a company declares bankruptcy, your deferred compensation plan could be completely or partially dissolved in the bankruptcy. This is because when you participate in a deferred compensation plan, you are considered to be a creditor of the company. Also keep in mind that if you choose a longer-term payout option, this increases the risk that the company may go bankrupt during this time. You should closely examine your company’s plan and consult a trusted financial advisor before participating.
Lump Sums Could Affect Your Taxes
Most plans do not allow you to access the money earlier than your retirement, however, if you change jobs, you may have to collect the money in one lump sum. Collecting one large lump sum could wreak havoc on your tax mitigation strategy for that tax year.
Lack of Diversification
Deferred compensation should always be coupled with other retirement strategies that don’t involve your company. This is because as an executive, you may have an inordinate amount invested in your employer’s stock. If the company suffers an economic blow, your employer’s stock could lose value and your deferred compensation plan could also be in jeopardy. This could be devastating to your retirement plan.
We’re Here for You
Deferred compensation can be an appealing option for financial flexibility and long-term savings opportunities. It offers tax advantages, allows individuals to delay tax payments, and provides a means to save for retirement or other long-term goals. However, it's essential to consider the potential downsides as well.
Consulting with an experienced and knowledgeable financial advisor to evaluate the specific terms and conditions of the deferred compensation plan can help you make an informed decision. Our Favor Wealth team can help design a comprehensive and personalized plan tailored to your values and goals. Contact us at 626-529-0445 or email Ricky directly at info@favorwealth.com.
About Ricky
Ricky Biel is founder, wealth manager and Chartered Retirement Planning Counselor℠ professional at Favor Wealth, an independent financial advisory firm serving individuals and families near Pasadena, California. Ricky Biel founded Favor Wealth with a desire to provide unbiased, client-centered, community-based financial advice. Ricky and his team of caring, smart professionals want their clients to feel like they’ve done them a favor, making it easier than ever to accomplish their financial goals by blending proven investment methodologies with creative financial technologies. He is on a mission to help his family of clients feel both a sense of relief and excitement about their future. Favor Wealth takes care of their clients’ needs first and foremost and goes the extra mile to make their clients’ finances grow. To meet and see how the Favor Wealth team may be able to help, contact them today at 626-529-0445 or email Ricky directly at info@favorwealth.com.
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