Should you invest in your company’s Deferred Compensation Plan?

Although not as well known as other employee benefit plans such as 401(k) or 403(b) plans, deferred compensation (DC) plans pose a valuable opportunity for highly compensated company executives who want to reduce their tax burden. In this blog you will learn what a DC plan is, how it is different from a 401k plan, and the questions to ask yourself if you are wondering if you should invest in your company’s deferred compensation plan.

What is a deferred compensation plan?

So let’s say you are considering using your company’s deferred compensation plan. First you’ll have to know what exactly such a plan is, and who qualifies for one. A deferred compensation plan is available to company executives who tend to be highly compensated. The idea is that the executive earns enough money to fund his or her living needs without taking all of their compensation as take home pay in any given year.

It’s it noteworthy that you make contribution on a pre-tax basis. The assumption is that the executive is likely to be in a lower tax bracket during retirement which is when the distributions are taken from the plan, and hence will pay a lower overall tax burden on the money earned over the course of his or her lifetime.

How is a DC plan different from a 401k plan?

Deferred compensation plans are not the same as 401k plans, although they do tend to be used on conjunction with each other as part of an individual’s overall financial plan.

The main difference is the amount you can put in. As you can contribute up to half of your compensation to a deferred compensation plan, a deferred compensation plan permits you to sock away higher amounts of money, typically, than a 401k would.

However, by contributing to a deferred compensation plan you are essentially locking the money up without recourse. You can’t access the funds before distribution date, and you can’t borrow against the balance. This contrasts the more flexible access options offered by most 401k plans. You typically can borrow from your 401k plan and for some reasons may be able to access the money without penalty.

There’s nothing that says you have to choose one or the other. You may elect to contribute part of your income to a deferred compensation plan and part to a 401k plan.

Should you invest in your company’s deferred compensation plan?

If you are asking yourself the question of should you invest in your company’s deferred compensation plan, here is a list of questions to consider.

Can I live without this money?

Deferred compensation plans are not guaranteed by any governmental body like a pension is. You are relying on the good faith of the company to come through for you in your retirement. If your company has solvency issues or you doubt its financial stability, you may wish to take that into account.

Am I really likely to be in a lower tax bracket during retirement?

The main point of a DC plan is to defer income until a time when you are in a lower tax bracket. If you have reason to believe that this is not likely going to be the case, then you should take pause before contributing to a DC plan.

Can I really go without accessing these funds?

Once you put your money into a DC plan you are essentially saying goodbye to it for a long time. Make sure you have other sources of liquidity such as an emergency fund, line of credit, or liquid brokerage accounts to draw upon if you need to before you stash the money away into a DC plan.

What’s my withdrawal schedule likely to be?

To make a DC plan effective at saving you from paying higher taxes, you’d have to make sure that you withdraw from it strategically. Taking all the money out at one time, for example, would push you into a higher tax bracket and defeat the whole purpose of using a DC plan in the first place. Have you given thought to what your cash flow needs will be in retirement, and what part of that is coming from your DC versus other funding sources such as social security, pension, etc.?

Deciding if you should invest in your company’s deferred compensation plan

As there are many factors to consider, the decision to invest in your company’s deferred compensation plan is not one to be taken lightly. Please contact us if you have any questions to discuss.