In Part I of this series, we provided a basic definition of deferred compensation plans and introduced questions to ask your financial advisor.
We said a deferred compensation plan is one in which a portion of an employee's pay is held until a specified date, usually (though not always) retirement. A deferred compensation plan:
Can help highly-paid executives plan for retirement or the future by providing options beyond basic plans like a 401(k).
Gives executives the option to put funds into a special, separate account, not a paycheck, making it so taxes are also deferred.
Allows executives to choose when to take the compensation (for example, upon reaching a certain age, upon retirement, etc.).
A deferred compensation amount may or may not be invested. If investments are involved, they are typically limited but come with options of where the funds are invested.
In Part I, we focused on questions about qualifying and nonqualifying (NQDC) plans. In this article, we present more questions to ask your advisor in discussions on deferred compensation.
Here’s where you really need your financial advisor, because depending on your situation and the way your employer handles your deferred compensation, all choices are not equal. A company might offer both qualifying and nonqualifying plans. For example, there might be a 401(k) and an NQDC. Qualifying plans often favor the employee in terms of risk, but not so much the company. NQDC’s favors the company when it comes to risk. Remember what Fidelity says: “NQDC plans have the potential for tax-deferred growth, but they also come with substantial risks, including the risk of complete loss of the assets in your NQDC plan.” Ask your financial advisor to help you sort out all your options.
With both plans, taxes are taken out at the time of distribution. Fidelity says of NQDC plans in particular, “Participation is more appealing if you expect to be in a lower tax bracket when you retire (or whenever you plan to receive a distribution from the plan).” This is where it really helps to have a financial advisor familiar with at least some parts of the tax code. But before you take advice, be sure your advisor is up-to-date. As we all know, laws change. If you need to, refer to a qualified CPA in addition to meeting with your financial advisor.
The simple answer is, no. Taxes associated with deferred compensation plans are income taxes. This is actual compensation that you receive at a later date, so it is taxed the same way your pay is. Remember, though. You’re deferring income tax but not payroll tax. Especially if you’re an employer offering these plans, be sure to ask your advisor how this affects budgeting, saving and investing.
Most people can figure out what this term means based on the wording. However, the important thing here is to understand how much is distributed, in what way and when. If you’re putting your kids through college in five years, you might want to defer compensation for five years. That doesn’t mean you must retire in five years, though. Should you take a distribution pre-retirement? Should you borrow against your plan if your plan allows you to do so? These are important questions, the answers to which will affect your present and future.
This is where your financial advisor looks at the whole picture. By analyzing each piece of the deferred compensation pie, your advisor can help examine what you want your future to look like and plot a path to get there. Ask your advisor how you can use deferred compensation to meet your goals.
There are so many details, possibilities and contingencies when it comes to deferred compensation plans that during the conversation you have with your financial advisor, more questions are bound to come up. And when you are an executive, you have even more things to consider. This is why it’s so important to work with someone you trust who takes the time to review your options and assist you in making the best decisions. Find an advisor who can help deepen your level of understanding, and then ask the important questions. The time you invest doing so is as important as the financial investments you make.
Wood Smith Advisors, a woman-owned Registered Investment Advisor (RIA), is a fee-only financial services firm that partners with its clients to simplify their financial lives. We focus on women, entrepreneurs and individuals with complex financial situations, providing objective and competent advice, education and services to help them develop and build their businesses and reach their financial goals. We can be reached by clicking here.
"Finance Made Simple" blog posts are intended for educational purposes and not for specific advice. Each person’s situation is different. Consult your financial advisor for advice relating to topics discussed.