Why Would I Want to Defer Compensation?

An old proverb states “A bird in the hand is worth two in the bush” suggesting one should be content with what they have (or will have shortly) rather than roll the dice on the unknown.  One who wholeheartedly believes in this proverb may react swiftly and decline to enroll in their employer-offered deferred compensation plan.  This could be perceived as a rational decision; why would you want to receive a portion of your salary or bonus in 5+ years when you can receive it now?   What benefits could there be to electing to give up your bird, or compensation, and “roll the dice” on the unknown?

Currently regulated by Section 409(A) of the Internal Revenue Code (IRC), nonqualified deferred compensation (NQDC) plans allow employees to move earned income from one year to future years, thus allowing for income tax and cash flow planning opportunities.  This is different from deferred compensation in the form of elective deferrals to qualified plans (such as a 401(k) plan) or to a 403(b) or 457(b) plan.  By moving earned income to future years, you can reduce the current year’s taxable earnings which can be extremely beneficial during high earning years.  In the example below, assume a single person expects to earn a salary of $200,000 and receive a bonus of $100,000 in 2017 and then retire in 2018.  Let’s assume he has expected portfolio interest income of $50,000 (starting in 2017 and continuing) and will receive $20,000 per year from social security during retirement.  Lastly, to make the comparison simple, assume all figures below are in “taxable income” before applying the tax rates by ignoring the deductions and personal exemptions. In Figure 1 you will find this individual’s total income, total taxes due, effective tax rate, and then the amount of money taxed at their marginal tax bracket for 2017. Column 2 displays the outputs assuming he did not elect to defer any compensation.  Note that his effective tax rate is over 28% and that $158,349 (which is mainly comprised of his bonus) is taxed at 33%.  Now suppose he defers his bonus to 2022; he elects not to receive the funds in 2017 but rather receive the payment in 2022.  Notice the significant drops in both the individual’s effective tax rate and the portion of income taxed at his highest bracket, the 33%.

Figure 1

Effective Tax Rate = taxes due divided by total taxable earnings

Marginal Tax Rate = the highest tax rate they pay, or the tax rate paid on the last dollar earned

Deferring income does not allow you to avoid taxes, it simply defers the taxes due to the point in time that you receive the income.  Continuing with the above example, let’s assume it is now 2022 and no changes have been made to tax rates.  The individual is now receiving social security but let’s assume he earns $60,000 on interest income as his portfolio may have grown over the past 5 years.  Refer to Figure 2.  In the No Deferral column, you will see the effective tax rate is 19.67%, which is significantly lower than 2017 and also lower than the 24.10% effective tax rate for the Defer Bonus scenario.  If a 10-year installment instead of a lump sum is selected for distribution, the effective tax rate for year 2022 would be even lower. Intuitively this makes perfect sense – taxes would be lower during retirement as income has dropped significantly.  The true conclusion of deciding if deferring is worth it under our set of assumptions would be based on total taxes paid.  In the no deferral situation the individual paid $114,638 in taxes in 2017 and 2022 combined and in the deferring scenario they paid $109,281 for a difference of $5,357.

Figure 2

Based on this scenario, is deferring compensation a good idea?  Sure, the individual would pay about $5,357 less in taxes assuming nothing changes.  However, revisit the original proverb, “A bird in the hand is worth two in the bush”.  Deferring compensation is not just a certain, or known, event as there are numerous assumptions and changes that can positively or negatively impact a decision to or not to defer compensation.  Here are six important questions to ask yourself when deciding whether an NQDC plan is right for you:

1. Do I annually maximize my contributions to traditional retirement plans? You should make the maximum contributions allowed by IRS ($18,000 and $24,000 for people at age 50 or over in 2016) to a qualified plan such as 401(k) or 403(b) plan each year before enrolling in a NQDC plan. The 401(k) and 403(b) plans are protected under the Employee Retirement Income Security Act, while an NQDC plan is not.  In addition, the money inside a qualified plan has more choices of distributions when you retire including rolling over to an IRA and stretching the payments over many years.
2. Is my company financially secure?  You must feel confident that your company will be able to honor this commitment down the road.
3. Is my future income tax rate likely to be lower?  Future tax rates are unknown and are out of your control.  If tax rates increase (decrease), the benefit to deferring compensation could be reduced (increased substantially).  Review your projected income during retirement years (or whenever you plan to receive a distribution from the plan) to see if there is a substantial income tax rate difference.  If you are planning to move from Minnesota to a state without income tax such as Florida, your future income tax rate would be even lower if you can choose the 10-year installments or longer so that this income will be excluded from being taxed in Minnesota as non-resident income.
4. Can I afford to defer compensation?  Look closely at your cash flow needs and upcoming expenses to estimate whether you can afford to forgo income you expect in the coming years.  After you have selected a deferral amount, this action is irrevocable.  You should have a sizable taxable portfolio that you can tap into for living expenses in case you experience job loss and it may take you more than two years to find a new job.
5. Does the plan allow a flexible distribution schedule?  Some plans require you to defer compensation until a specific date (such as at least five years).  Other plans allow for various dates before and after your normal retirement date.  Distribution frequency can be lump sum, or installments.  Some plans allow you to make changes to the original distribution date in the future (for example, change the date at least five years forward), but the change needs to be made at least one year in advance of the original distribution date.  Depending on your personal situation and income needs, greater flexibility with distribution elections can be a significant advantage.
6. What investment choices does the plan offer?  Some NQDC plans offer the same investment choices as those in the company 401(k) plan.  Others allow you to follow major stock and bond indexes.  The more diversified investment choices available to you, the easier it is to fit an NQDC plan into your overall household diversified investment strategy.

Each NQDC plan has its own features and requirements ranging from investment options to distribution options (lump sum, installments).  Some plans allow you defer salary, cash bonuses and restricted stock.  Not everyone should choose to participate in the NQDC plans.  However, if you have this choice available to you as a part of your employment benefits package, you should certainly fully research the plan documents and conduct a thorough analysis to determine the possible outcomes based on various assumptions and deferred compensation strategies.  Your trusted advisor should be consulted when you make these decisions.  Your financial plan prepared by your advisor should be revisited by incorporating this scenario.  Visually seeing the Income Tax report for multiple years offers a clearer picture of your projected average income tax rate based on current tax laws.  Cash Flow Detail report year by year will also help you determine if you can afford deferring compensation.

For more information, refer to the IRS Section 409A Frequently Asked Questions (link) and the IRS description of 409A Nonqualified Deferred Compensation Plans (link).

Wednesday, November 23, 2016