For employees who earn enough to place their wages in the top income tax bracket in the United States, a deferred compensation plan is a way to contribute more funds toward a retirement or future need.
Imagine that you are earning $500,000 per year at your position. If you make the maximum deferral to your retirement plans using every option available, most people can divert less than $20,000 toward their future needs. How much will that let you enjoy your retirement years? Instead of saving 5% of your income or less, you can save significantly more if your employer permits a Section 409A deferred compensation plan.
The top individual tax bracket for 2018 was 37% for unmarried individuals or heads of households earning $510,300 per year, while for married individuals filing joint returns it was $612,350.
Under this plan, you can defer the income that would normally be received now to a later date. Most employees receive either a lump sum or a series of payments 5 to 10 years after they retire or leave their high-salary position. That allows you to have a retirement which is not severely underfunded when compared to your current lifestyle.
If you are thinking about using a Section 409A deferred compensation plan for your financial well being, then here are the pros and cons to consider.
This information is for general purposes only and should not be considered a replacement for professional financial advice.
List of the Pros of a Deferred Compensation Plan
1. The IRS allows unlimited contributions to a deferred compensation plan.
The Internal Revenue Service allows high wage earners the opportunity to contribute as much as they want to the Section 409A deferred compensation plan. It is the only option of its type that is available in a retirement situation for employees. There are some unique risks involved with this option because of this feature, so you will want to evaluate all of your potential options before deciding to transfer your salary to it.
If everything goes according to plan, then this option makes it possible for you to defer a significant portion of today’s income to become tomorrow’s retirement solution.
2. There are tax benefits that may apply with the 409A plan.
If you decide to defer your income through a 409A deferred compensation plan, then you can postpone your income in years when you are in the top income tax bracket. When you are no longer working, then the income levels you earn may be much lower. The deferred portion of your salary would then be taxed at the current bracket for the year you received the distribution instead of the top bracket when you were earning a higher level of income. This structure makes it possible to have your funds taxed at a lower rate, allowing you to keep more of your money.
3. Some employers offer investment options with their deferred compensation plan.
Some 409A deferred compensation plan options give you the opportunity to select specific investment options that allow your money to grow over time like they would in a 401k or an IRA. There may be some plans that provide investment solutions, but they will not allow you to select which one applies to your account.
Investment options are typically annuities, insurance arrangements, or securities. The funds can also be set aside in a trust, although the money would still count as part of the company’s general assets.
When this option is available, then you have the opportunity to increase your retirement earnings like any other retirement plan. You would still be subject to the fees and costs of administration, but it can be an effortless way to grow your cash while you worry about getting your work done every day.
4. It is only meant for the highest wage earners in the company.
There are rules in place with the 409A deferred compensation plan that help to lower the risks involved when making investments. The plan is often used to benefit executives, owners, and the highest-paid workers that are in the company. Other retirement plans will limit contribution or participation due to income discrimination rules. That is not something you need to worry about with this solution. As long as you earn enough to qualify for deferral, then you can send as much of your salary as you want into the plan.
5. You can decide to defer specific income events instead of a wage percentage.
When you are a highly compensated employee, then the 409A deferred compensation plan gives you an opportunity to save for retirement in several different ways. If you already earn a substantial income, then the provision of a financial bonus may not be necessary to make ends meet. You can elect to defer a portion – or all – of an annual bonus into this retirement option. That allows you to take your regular salary while also creating a direct contribution to your future years.
6. It offers a way to delay receiving a Social Security payment.
If you can contribute a significant amount to your deferred compensation plan, then this product can serve as your primary income source during the early years of your retirement. That means you could delay the distribution of your Social Security payments until you reach the age of 70.5, when the mandatory minimum distributions are sent no matter what. This structure makes it possible for you to enable your tax-deferred assets, such as a 401k plan, to continue growing for the maximum amount of time.
7. There are flexible payout options available through most deferred compensation plans.
Depending on the design of the 409A deferred compensation plan at your employer, you can opt to take withdrawals from the amount you saved for up to 10 years. Some employers cap that figure at 5 years, while others require a lump-sum payment immediately when the agreed upon date is reached. There are several employers that provide all three options from which to choose, allowing you to customize how you receive income during your retirement years without dealing with early withdrawal penalties like you would with other plans.
8. You have access to early withdrawal options during qualifying life events.
Although you cannot take out a loan against a Section 409A deferred compensation plan, there are times when you can access this cash should the need arise in your life. If there is an unforeseen emergency that occurs, such as an illness or a severe financial hardship, then you can access the deferred amount to take care of your needs. Employees who experience a disability for some reason can access their money immediately. Your heirs can also receive the deferred salary if something unexpected happens to you.
9. It is possible to access the cash during a merger or buyout.
One of the unique rules that you will find with a deferred compensation plan is that there are times when it is possible to access your money if the company creates a higher level of risk. You can take a payout, including a complete lump-sum of what you have, if your employer goes through a merger or a buyout. This option allows you to secure your income, albeit at what may be a higher tax rate than if you had waited to receive the distribution in future years.
10. You can still pursue your deferred salary in court.
When a deferred compensation plan gets sidetracked because of the poor performance of a company, then it is not unusual for the executives involved to take the organization into court to pursue their owed salary. That is why many companies decide to fund this option through a special trust instead of keeping it in their accounting department. This problem won’t resolve the creditor access that is possible should there be a bankruptcy filing, but it can reduce the legal exposure of the organization while providing a better chance to recover at least a portion of the funds.
List of the Cons of a Deferred Compensation Plan
1. Your wages run a substantial risk of forfeiture under a deferred compensation plan.
The most significant requirement of the 409A deferred compensation plan is that the salary you set aside could be forfeited should something happen to the company in future years. Unlike the other retirement accounts that use qualified assets for funding, this option is non-qualified. That means the assets are tied to the company’s financial wellbeing instead of being 100% yours – even though it is a wage you have already earned.
If your employer should fail for some reason, then the creditors of the organization would take the first priority in recovering their losses. You would only collect after all of the other debts were resolved.
2. Once you decide to use this option, then it cannot be changed.
When you choose to use the 409A deferred compensation plan, then you must make a decision about your future today. The election to defer your wages into this retirement option is irrevocable. You will also be determining how much you are setting aside and when it would be paid to you after leaving the company. There may be several different options available to you based on what the employer has in place as a benefit. Some may only offer 1-2 options. You may find there are tax consequences today and tomorrow if you follow through with this decision.
3. You may still have your wages taxed at the highest rate.
One of the significant advantages of using the 409A deferred compensation plan is that you can defer your income to a future year when your overall salary may be lower. If you earn nothing but the payments from this retirement option, then your income might fit into a lower tax bracket – allowing you to keep more of what you earned even though your overall income at the time it was awarded placed you in the highest bracket.
This design becomes a disadvantage if your deferred compensation plan requires a lump-sum payment at the time of its distribution. The only advantage some workers may have is the chance to have additional income they can use during their retirement because they elected to receive less earlier in their career.
4. It is possible to lose most, if not all, of your salary if you violate the terms of the plan.
When you decide to defer your wages to a 409A deferred compensation plan, then you are creating an agreement with your organization that you will remain employed for a set number of days. The terms of each plan may vary, and this disadvantage may not apply to you. If one of the conditions is that you work until a deadline, then your wages are not fully vested until you reach that date. If you decide to retire early, quit for a personal reason, or you are fired for just cause, then you could lose a large chunk of your salary.
This structure is why the 409A deferred compensation plan earns the nickname of the “Golden Handcuffs.” Companies use it as a way to keep their best employees around because the cost of leaving for some could be enormous.
5. There may not be any investment options available for the 409A plan.
Employees often choose to send their wages to a deferred compensation plan because their employer uses the funds as an investment vehicle to stabilize their income flow. Most plans have a robust profile in this area that can help your 409A plan grow, but not all organizations make this a top priority. You might find that there are zero investment options available, which would mean you could potentially earn more if you took the money as salary today and invested it on your own. If there are choices available to you, then you might discover that they have high expenses, limited options, or a poor reputation for growth.
6. You do not have any control over your assets with this plan.
When you choose a 409A deferred compensation plan, then you are making the choice to allow your employer to control your funds. You must agree to these terms as part of the IRS rules that allow for unlimited contributions in the first place. Because there is no control over your money, then you may have little say in how it is invested. There may not be a way to stop the company from going into bankruptcy. This process creates another set of “handcuffs” because you are forced into a position where you must do everything you can to save the organization to prevent a significant loss.
7. Deferred compensation plans in the U.S. are not portable.
Even if you leave an employer on friendly terms and your 409A deferred compensation plan does not require a penalty for the action, it is not something that you can take with you to another job. This retirement option is not portable like an IRA or 401k rollover. The funds will stay with the company until your agreed upon distribution date. Unless you experience a qualifying life event that triggers an early payment, this scenario would leave the future of your retirement in question up until the day that you receive payments or your lump-sum compensation.
8. You cannot take out a loan against a 409A plan.
If you find that your current salary is not enough to manage your living expenses, then the 409A deferred compensation plan does not offer you a way out. It is not permitted to take out a loan against the funds that are in this account because it is a non-qualifying structure. The money is not yours until the company sends you a distribution. That is another significant difference when comparing this retirement plan to the other options which are available in the marketplace today.
9. If you select the payment option, then you are taking on an additional credit risk.
Even if you reach the qualifying date for your first disbursement from the deferred compensation plan, there is still a credit risk to consider. Let’s say that you elected to take 10 years of payments from this retirement option as a way to give yourself a decade of structured income. If something happens to the company during that time, then your income is still at risk. Should a bankruptcy or judgment occur, creditors would still have access to your funds. That means your payments could dry up while you have little knowledge about how the business is being managed?
10. You may not be able to stop an accelerated payout from the Section 409A plan.
Even if you decide that the flexible payout solution is the best course of action to take with your Section 409A deferred compensation plan, there is no guarantee that the structure you choose is the one that you will receive. Companies may have the right to accelerate the terms of your repayment under the structure of the plan. This option is common for a circumstance where you need to leave unexpectedly. That results in your income receiving a large, unexpected sum of cash that could create a significant tax impact – especially if you receive a severance package along with this payment.
11. Your financial situation might change over time.
The quirk of forcing you to choose which compensation method you prefer at the time of the deferred compensation plan’s creation can be bothersome to some people over time. There is always the possibility that if you elect to take payments over time that a faster schedule or a lump-sum payment would have served your needs better. You will find that the opposite occurs as well. Some people choose to receive the lump-sum payment to reduce their risk exposure to forfeiture only to discover that they still have a decent income and would have preferred structured payments instead of a bump into the next tax bracket.
The pros and cons of a deferred compensation plan make it possible for high wage earners to defer a significant portion of their salary to maintain their lifestyle deep into their retirement years. If you are willing to accept the risks which are associated with this movement of cash, then it can be an excellent income resource with your other investments to create a comfortable life for yourself. It may also be wise to consider what investment options are available to see if you could beat the after-tax growth rate on your own as well.
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