By Bryan Lee, CFP®, MBA
Deferred compensation plans are a popular option for high earners. First of all, they can save professionals a lot of money during their working years—and in their retirement years as well. When using a deferred compensation plan, the professional can defer a portion of their income to the plan where it can grow tax-free.
Although there are some great advantages of deferred compensation plans, there are also some drawbacks. Take note of the following pros and cons before you decide if this is the best choice for you.
The Benefits of Deferred Compensation Plans
For highly paid professionals, deferred compensation plans can be a good way to save for retirement after maxing out contributions elsewhere because unlike retirement plans like your 401(k) or IRA, deferred compensation plans typically have no contribution limits. Consider these additional benefits:
Tax Mitigation Strategies
Do you live in a state with high income tax but are considering retiring to a state with no income tax, like Texas or Florida? Deferred compensation plans help you save on your tax bill by allowing you to put more money into your plan and potentially lower your tax bracket while you are working. Additionally, even if you aren’t planning on moving to another state without income tax for retirement, this could also provide some tax savings if you are in a high tax bracket now but plan to be in a lower tax bracket when you stop working.
Retirement Income Bridge
Deferred compensation plans can be used to generate income for a couple or individual as they begin retirement and want to maximize their Social Security income by not filing until age 70. It can also be used to supplement income before age 59 ½, which is traditionally the age when you can begin withdrawing from other qualified retirement plans without a 10% penalty.
Deferred Compensation Plan Drawbacks
While the benefits of deferred compensation plans seem like incredibly useful tools for your wealth management strategy, there are some drawbacks to consider when using a deferred compensation plan.
Company Solvency Risks
This may be the largest risk you can face when using a deferred compensation plan. If your company declares bankruptcy, your deferred compensation plan could be completely or partially dissolved in the bankruptcy. This is because when you participate in a deferred compensation plan, you are considered to be a creditor of the company. Also keep in mind that if you choose a longer-term payout option, this increases the risk that the company may go bankrupt during this time. You should closely examine your company’s plan and consult a trusted financial advisor before participating.
Lump Sums Could Affect Your Taxes
Most plans do not allow you to access the money earlier than your retirement (or at least several years in the future); however, if you change jobs, you may have to collect the money in one lump sum. Collecting one large lump sum could wreak havoc on your tax mitigation strategy for that tax year as a result.
Lack of Diversification
Deferred compensation should always be coupled with other retirement strategies that don’t involve your company. This is because as an executive, you may have a significant amount invested in your employer’s stock. If the company suffers an economic blow, your employer’s stock could lose value and your deferred compensation plan could also be in jeopardy. This could be devastating to your retirement plan.
We’re Here for You
Still not sure? Keep in mind that you don’t have to navigate financial decisions alone; it’s actually wise to enlist a seasoned and trusted professional to help review your options. We at Strategic Financial Planning would love to walk you through the ins and outs of your company’s deferred compensation plan. We know what to look for and what types of strategies you should use to protect your wealth management plan from any risks associated with the plan.
Our team enjoys helping clients discover, design, and live the life they want by aligning their finances with their vision and values. Call (972) 403-1234 or contact us online to set up a complimentary get-acquainted meeting so we can see if we are a good fit!
Bryan Lee is the founder and president of Strategic Financial Planning, Inc., an independent, fee-only financial advisory firm. With more than 27 years of industry experience, Bryan uses a unique client-first financial life planning approach and process to help his clients get the most out of life. Bryan earned his Bachelor of Business Administration in finance and his MBA in international finance from the University of North Texas. He is also a CERTIFIED FINANCIAL PLANNER™ professional.Bryan is actively involved in his community and industry and has served on the boards of several associations and charities, including the Dallas/Fort Worth chapter of the Financial Planning Association, the National Association of Personal Financial Advisors, Family Services of Plano, the CITY House, and the Journal of Financial Planning. Bryan has been featured in local and national media, including The Wall Street Journal, Investors Business Daily, CNNfn, USA Today, SmartMoney, Kiplinger’s Personal Finance, Financial Planning Magazine, The Dallas Morning News, and Dow Jones Newswires. And, he has been recognized as a Five Star Wealth Manager and one of Dallas’s Best Financial Planners in D Magazine every year since its inception and recently as a Top Wealth Manager. To learn more about Bryan, connect with him on LinkedIn.