Understanding Deferred Compensation Plans and Their Implications

Deferred compensation plans offer tax-deferred savings, but require careful planning and consideration of company stability.

### Understanding Deferred Compensation Plans: Pros, Cons, and Considerations
* 💼 Deferred compensation plans allow employees to **defer a portion of their salary or bonuses to a future date**, which can be a **strategic tax-saving tool**.
* 📊 These plans are typically offered by larger companies and can help individuals build a self-funded pension by **delaying income until retirement**, potentially resulting in a **lower tax bracket**.
* 🧮 It’s crucial to assess your current tax rates and ensure you are in a position where you are **saving well beyond 25% of your gross income** before considering such plans.
* 🏢 However, one must evaluate the financial stability of the company offering the plan, as **deferred compensation becomes a promise from the company that could be at risk** if they face financial difficulties.
* 🔗 Additionally, deferred compensation can serve as a bridge for those retiring early, providing a **cash flow cushion** until other retirement funds become accessible.
* ⏳ It's important to note that once you choose to **defer**, you typically cannot access those funds for at least **five years**, making it essential to have a **solid financial plan** in place.
* ⚖ Lastly, careful planning is necessary to avoid tax pitfalls upon withdrawal, as **large distributions can lead to significant tax burdens** if not managed properly.
* 💡 Seeking professional advice can help navigate the complexities of **deferred compensation plans** and optimize their benefits for your **financial future**.

My wife got promoted twice and has access to a deferred compensation plan. We are going to skip it and keep using our brokerage account. Do you agree? We are barely under 40 in [location/step] 7. What do you think? Well, in true financial advisor fashion, our answer is going to be it

depends. Uh, we can't give you specific advice on whether you should or should not take advantage of it, but what I can tell you is what a deferred compensation plan is and how it works. So, a lot of companies—and it's traditionally uh, large companies—they'll have some sort

of retirement benefit in place. They say, 'Hey, instead of you getting your compensation today, instead of you receiving all of your compensation today, you can opt to defer some of that compensation into the future. And instead of us paying it to you out this year,

we'll pay it to you at some future year, or maybe we're going to spread it out over some number of years.' And so most plans will allow you to defer a percentage of your salary or a percentage of your bonus, and then you can choose when you want to receive it.

So, I don't want to get paid that money today; I'd rather get paid that money when I retire, and I want to get paid that money spread evenly over 5 years. That's a way that a lot of plans often work. And so it's a fantastic planning

tool for folks that are looking for more tax-deferred savings opportunities because when you put the money into a deferred comp plan, you don't have to pay income tax on it. You will pay income tax when you go to draw that money out. So it's a wonderful opportunity to be able

to push that money into the future, and it's also a great opportunity to be able to build a self-funded pension. Maybe you know that you make enough income right now to be able to provide for your current living expenses, but you want to build some sort of bridge to get you

from the time you retire until you begin drawing Social Security, or from the time that you leave the workforce until RMDs start, or whatever the case may be. This is a great tool that higher-income individuals can use to begin to build that bridge, but there are some things

you need to know about when it comes to Roth conversions, because it's not always just a no-brainer—for sure, I'm going to sign up and do this. Yeah, I wrote three quick things. You know, as Bo says, this is definitely part of the personal finance

part; it's the personal component, but I want to give you some things to think about so you actually leave watching this highlight or this question and feel like you know some homework steps you can do to apply this in your own financial life. First, how familiar are you with

where you are in your tax rates? Are you in... This is something you shouldn't even sniff around until you're really into that step seven of the financial order of operations, and you're saving well beyond 25% of your gross income. This is not entry-level; you're not doing

this instead of a Roth IRA; you're not doing this before you fund—um—maxing out the annual 401(k) at work. This is definitely a higher-level step seven of the financial order of operations. You need to be very familiar with where you are with your marginal tax rates. Take

Both your federal and state tax rates; are you in those higher tax brackets? Are you in a higher tax state where you're like, 'Man, wouldn't it be nice if I could create my own arbitrage situation where, while I'm in...

this huge tax income situation because of all my earned income and your wife's good work and promotions, you say, 'I bet when we retire, all of a sudden we're going to fall into a much lower tax rate situation because we just won't have all...

this earned income coming in. Why not play off of that arbitrage? That's what deferred compensation allows you to do; you can essentially push some of this high income—where it's coming in surplus—push it out to a future time where you're hopefully going to be in a...

lower tax situation. Now, here's the catch; what's the caveat here? What's the fine print? Um, you've got to know how strong the company is because realize part of deferred compensation is that you are saying, 'I am owed this money; this I have earned this money; this is money that I'm entitled to...

but so that I cannot pay income taxes, I'm going to let the company keep this income that I'm entitled to, and it's going to sit on their balance sheet as an obligation to me.' Um, the risk with that is that if they got in trouble...

and filed for bankruptcy, you would be a creditor. You—you know—you had money that was sure as going to come into your bank account that now is questionable because your company has gotten into financial trouble. And we've seen even big household names can very quickly fall.

into financial trouble and you're like, wow, that's sad. I thought that company was bulletproof, and then you find out, no, they have a lot of struggles; they have a lot of problems keeping up with innovation and other things. So ask yourself, how strong is this company?

Because you're basically turning money that should be in the bank into a promise from the company. So if they're not on good financial standing, you could have problems. The other thing, and Bo alluded to this, is what's your retirement bridge? You know, a lot of people will

will enter retirement, say, in their early 50s, especially if you're in the technology field or something like that. Well, you're too young to get access to your 401(k); you're too young—which is 55 if you're still

working—right? It's 59 1/2 on your IRAs, and you're like, 'Well, I need some type of money coming in to kind of bridge that period of time.' As I said, part of step seven of the financial order of operations, nothing wrong with looking at deferred compensation as being part of that

bridge program to give you kind of like—it's a little cash flow cushion for a period of time where this money's going to come in. Um, it's kind of a cool process, and I even have clients—because a lot of times my—I've had clients that

say, 'I don't know when I want to retire; I'm having too much fun right now.' Um, this does let you, essentially, in five-year increments, kick it down, kick it out, meaning that if you worked five years for this company and you're like...

Start showing. No, it lets you kick it to the end, to the next, so it does give you flexibility in the planning, to keep building your bridge. Love it! Fantastic, man! I thought you were going to add some more to it. I was...

going to. I thought about it, but these plans are fairly complicated. They're not all structured the same. Get some ability and flexibility, like we've seen it before, like with the whole 'kick it' thing. Yeah, okay, you can defer, but if you're going to defer, what you

cannot do is you cannot receive distributions any sooner than 5 years from when you originally said you were going to receive distributions. So a lot of times when you participate in a deferred comp plan, you need to have a really good plan in place because some

of the elections that you make on the day that you defer are going to have a long tail in terms of how they impact you. So this is one of those areas where, if you are facing a deferred comp and trying to make that decision of

does it make sense and how do I structure it well, this is one of those times where it might really make sense to take the relationship to the next level.  We've seen it before—uh, folks who got so excited about deferred comp, like, "Oh, I'm going to do it! I'm going to do it!"

I'm going to do it! I'm going to do it!" and they just defaulted to a lump sum at retirement distribution. Well, what ended up happening was, in the year that they retired, they got large seven-figure payouts, got crushed in taxes, all because they weren't thinking

About the distribution strategy, they were just thinking about saving taxes in the years that they were deferring. So they are complicated and nuanced. So if you're trying to navigate that, we would love to potentially be the team to help you figure out how to

work through making the deferred comp elections well.

How Deferred Compensation Actually Works

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Couple considering skipping a deferred compensation plan and using a brokerage account instead.

Explanation of deferred compensation plans: delaying compensation to a future date.

Companies offer deferring a percentage of salary or bonus for future payment.

Tax advantages: no income tax until withdrawal, useful for tax-deferred savings.

Building a self-funded pension as a bridge to Social Security or RMDs.

Considerations Before Using Deferred Compensation

Importance of understanding current tax rates (federal and state).

This is an advanced strategy, not suitable for early-stage financial planning.

Assess potential tax bracket changes in retirement for tax arbitrage.

Company financial strength is crucial, as deferred compensation is a company obligation.

Evaluate retirement bridge needs and the role of deferred compensation in bridging income gaps.

Complexity and Planning of Deferred Compensation

Deferred compensation plans have varying structures and complexities.

Long-term implications of initial deferral elections require careful planning.

Example of lump-sum distribution at retirement leading to high tax burdens due to poor planning.

Seeking professional help for navigating deferred compensation decisions is advised.