It's that time of the year again, when deferred compensation elections must be made ahead of the June 30 deadline.
Deferred compensation is a benefit to higher-paid employees as a way to set aside additional funds for retirement. It is also a key attraction and retention tool for executives in this competitive marketplace; deferred compensation can provide new key employees a greater fringe benefit, and an important employee can be deterred from leaving, if leaving means the loss of a match or appealing investment alternatives.
As such, many organizations have taken notice and increased the availability of company-sponsored non-qualified deferred compensation (NQDC) plans. While corporate executives have several retirement vehicles available to them, such as a 401(k) plans, there are limits on the amount that can be contributed in a given year. As an additional option, executives might consider NQDCs.
Significant wealth may be created in NQDC plans, where assets have the opportunity to compound tax-free and investment options are frequently attractive. Two times a year corporate executives are offered the option of deferring a portion of their compensation in order to put away money for their retirement in these plans. The June 30 deadline for deferring variable or incentive compensation for this year is rapidly approaching, so it's important to start examining the issue now.
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Basic modeling shows that assets invested inside a deferred compensation plan for 10 years would grow 1.86 percent more annually than the same amount invested for the same period receiving identical returns.
It is important to remember there are always risks associated with investing, as well as eventual tax payments. As such, below are six ways to help determine whether deferring compensation is a good choice for you:
- Find out if there is company matching and how much it could increase your final return. Often, the match will be paid in stock if you invest in stock, so be sure to find out if you can diversify within the plan at a later time. Also, make sure you consider the dividend, if any.
- It may be beneficial for you to get a loan so you have sufficient liquidity and can put more into a deferred compensation plan. Given the growth potential of tax-free compounding and today's low interest rates, if the borrowed money is invested, you can enjoy an interest-rate deduction against investment income.
- Feel comfortable with your company's credit risk. If your company goes bankrupt, you are merely one of its general creditors.
- Review the options with your financial planning team to determine the most compelling ones.
- If you work or reside in a state with an income tax, the benefit of deferring taxation is further enhanced. If you later move to a state with a lower income tax or no tax at all, you would realize additional, significant savings as long as the distribution is taken in 10 or more installments.
- The longer you are able to defer, the more cushion you have against rising rates. The length of the deferral depends on the investment choices and the rate of return in the plan.
While asking yourself these questions, it is important to consider the impact of deferring. For example, it is usually best to defer for at least seven years to take full advantage of tax-deferred growth. While there are no federal limits to contributions to NQDC plans generally, a company's particular plan may impose certain limits on the amount you can defer, either each year or as an aggregate over multiple years.
Typically, the human resources department will notify you prior to the election. It is important to review the risks and rewards, including the investment alternatives and whether the election is irrevocable under the terms of the plan. In completing the forms, you will decide how much to defer, for how long and ultimately how to take the distribution — that is, a lump sum or as annual installments. You can select a specific year or an event, such as retirement or separation from service, to start the distribution.
Now is the time to decide if a NQDC is right for you. If your company does not offer these plans, now might be the time to discuss the idea to get ahead of next year.
— By Robert K. Barbetti, head of executive compensation advisory at JP Morgan Private Bank
