How to Use Deferred Compensation Plans to Lower Your Tax Burden

High-income earners, particularly executives, often search for ways to strategically manage their taxable income while building long-term wealth. The progressive tax system can place significant burdens on those with substantial earnings. A powerful yet sometimes underutilized strategy to address this is the use of deferred compensation plans.

Deferred compensation plans are commonly offered to executives and high-ranking personnel in a company. These plans help align compensation with future financial needs, reduce current tax burdens, and acknowledge the pivotal roles these executives play. Let’s delve into how deferred compensation plans function, their key benefits, and strategic applications to potentially lower your tax burden.

What Are Deferred Compensation Plans?

A deferred compensation plan is a contractual agreement between an employer and an employee, allowing the employee to postpone receiving a portion of their income until a future date, typically after retirement or upon parting ways with the company. These plans often supplement qualified retirement plans like 401(k)’ s. 401(k)’s have annual contribution limits that can restrict high earners from fully deferring income.

While deferred compensation plans are non-qualified and don’t have the same ERISA protections as qualified plans like a 401(k), they also don’t face the same contribution caps. Because the income is deferred, it is not immediately taxed, allowing for tax payments to be postponed until the money is actually distributed—often when the recipient’s tax rate may be lower.

Key Features of Deferred Compensation Plans

These plans come in various forms. The most common is the non-qualified deferred compensation plan (NQDC). Here are a few defining features:

1. Elective Deferral: Executives typically choose the amount or percentage of their compensation to defer each year, per the employer’s plan rules.
2. Tax Deferral: The deferred amount is not included in taxable income until it’s distributed. Postponing the receipt contributes to tax deferral and potential tax rate management during high-income years.
3. Unsecured Promise: Deferred compensation is an unsecured promise from the employer. This means the funds are part of the company’s general assets and are subject to creditors if the company goes bankrupt.
4. Distribution Options: Executives choose the future distribution schedule of their deferred compensation, such as a lump sum or installment payments. The decision for how the compensation is distributed is typically required before the start of the plan.

How Deferred Compensation Plans Lower Your Tax Burden

The most appealing feature of deferred compensation plans is their ability to manage tax liabilities and minimize them. helping keep more money in your pocket. Here’s how:

1. Shifting Income to a Lower Tax Period. By deferring a portion of their income to retirement, executives may shift income to years when taxable income is lower, potentially moving them from a higher federal tax bracket to a lower one.
2. Reducing Current Taxable Income: Elective deferrals into these plans lower current taxable income, similar to pre-tax 401(k) contributions. By doing so, exposure to high marginal tax rates, phase-outs, and even certain surtaxes is reduced.
3. Investment Growth on a Tax-Deferred Basis: Deferred compensation plans often have investable options, allowing funds to grow tax-deferred. This means annual taxes on interest, dividends, or capital gains aren’t applied, fostering more efficient growth.

Strategic Considerations for Executives

While deferred compensation plans are a potent tool, there are necessary strategic considerations:

1. Company Stability. Since deferred compensation is unsecured, assessing your employer’s financial health is crucial to protect against loss in case of bankruptcy.
2. Distribution Planning. Carefully plan the distribution election and timing to avoid higher tax brackets and minimize the tax impact of the distributions.
3. Coordination with Other Retirement Assets: Consider aligning deferred compensation deferrals with other retirement savings avenues. Additionally, coordinate with other future retirement income sources like 401(k)’s, pensions, or social security to help ensure a holistic financial strategy.
4. State Tax Considerations: If relocating to a state with lower or no income tax post-retirement, deferring compensation until then can result in additional tax savings.

Final Thoughts

Deferred compensation plans provide high-income executives with a valuable opportunity to manage their current tax burdens, align income with future needs, and grow wealth on a tax-deferred basis. While these plans involve complexities and risks, their potential benefits can be substantial when integrated into a comprehensive financial plan.

Before making deferral elections, consider consulting a Certified Financial Planner like myself. I help navigate the nuances of your executives face with their compensation, taxes, and investments. Understanding your company’s plan and making it fit for you is critical to tailoring a strategy that fits your goals.

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