Participating in a Deferred Compensation Plan

October 13, 2010

Someone asked on our message board about whether it makes sense to participate in a deferred compensation plan, and we decided to post a response here so it might be seen by more visitors. There’s more to these plans than meets the eye: the true nature of the tax benefit is far from obvious — and the same is true of the plan’s risk.

Description of plan

A nonqualified deferred compensation plan allows you to have part of your compensation paid in a later year. You might, for example, decide you’ll receive half your bonus for the coming year at the usual time and put the remainder of that bonus into the plan to be paid five years later, or at termination of employment.

This arrangement would make no sense at all if you didn’t receive some kind of investment return on your deferred compensation. Specifics here depend on the design of your company’s plan. Your benefit may grow according to a fixed interest rate, for example, or it might be adjusted in accordance with the performance of the S&P 500 index.

In broad outline, the tax treatment is simple. Compensation you choose to defer isn’t subject to income tax until it’s paid out. At that time the full amount you receive will be treated as compensation income, even though part of it represents investment earnings.

Tax benefit

These plans provide essentially the same benefit as a 401k plan. They reduce your income in the year you put money into the plan and allow your money to grow without annual tax on the investment earnings. Like a 401k participant, you pay tax only when you receive the cash. You gain the benefit of tax deferral and, in some cases, the further benefit of shifting income from a year when you’re in a high tax bracket to a year when you pay at a lower rate.

One way of looking at the tax benefit is that it’s like receiving your investment earnings tax-free. This may seem impossible, because you end up paying tax on the entire payout, including the investment earnings. Consider this example, though.

To make the math easy, we’ll use a 25% tax rate and assume you’re thinking of deferring $4,000. The money you defer will be credited to an account that’s adjusted for changes in the value of some investment, such as the S&P 500 index. If you don’t defer the money, you’ll pay tax now and invest the after-tax proceeds in the same investment. Let’s see what happens if the investment doubles during the deferral period.

Without deferral, you pay 25% tax on the $4,000 and that leaves you with $3,000 to invest. We’re assuming the investment doubles, so you end up with $6,000 — minus whatever tax you have to pay on the investment earnings of $3,000.

If you choose deferral, though, $4,000 goes into the deferral account. It doubles to $8,000, and then you get the money, paying 25% tax on the full amount, including the investment earnings. That leaves you with $6,000 after paying the tax. This is the same amount you would have without deferral if you didn’t have to pay tax on your $3,000 of investment earnings. So you don’t avoid paying tax on the investment earnings, but you end up with the same result as if you took the money now and invested the after-tax amount in a tax-free account.

Advantages

The main advantage of these plans over a 401k is that they aren’t subject to dollar limitations. Participants are typically people who have already maxed out their 401k contributions and want to set aside more money in a way that provides a similar tax benefit. Consider, for example, the $144 billion in estimated bonuses being paid out this year by Wall Street firms. To many of the recipients, the dollar amount they can contribute to a 401k account is chump change.

Some of these plans offer advantageous investment alternatives. Deferred income may be adjusted by a fixed rate of interest you wouldn’t easily find in the marketplace. An adjustment based on the S&P 500 index might work out better than a similar investment in a 401k plan if it isn’t reduced by an index fund’s expenses or by plan administrative expenses.

Disadvantages

The plan won’t provide the tax benefits described above unless it meets certain requirements that can make it less advantageous than a 401k. One issue is a lack of flexibility. You have to choose your deferral arrangement farther ahead of time and stick with it. You have less freedom to change your investment.

In many cases, though, the most important disadvantage is payment risk. If the company maintaining the plan falls on hard times, you may not receive full payment of your benefit. You’re an unsecured creditor of the company.

Many of these plans set money aside in an arrangement known as a rabbi trust (so called because the first one ever approved by the IRS was set up for a rabbi). You may take some comfort from knowing the company has accumulated a fund that’s adequate to pay out these benefits. Yet if the company becomes insolvent, its other creditors have just as much claim to the assets in the fund as you. You stand in line with everyone else, even though a portion of your earnings went into the trust.

That’s not true for a 401k, of course. In that type of plan, your contributions go into a trust that’s insulated from the company’s creditors. Your investments within the plan can lose value, but you don’t face the risk that your account will be used to satisfy the company’s debts.

On balance

The benefit of tax deferral can be powerful enough to make these plans attractive, especially when there appears to be little reason to doubt the financial stability of the company. Keep in mind that bad things can happen to even the strongest companies. The financial turmoil of the last two years should be a reminder to expect the unexpected.

You may also want to take into account the possibility that you’ll end up paying tax at a higher rate in a later year when you receive the payout. For a short-term deferral, the result can be worse than if you’d paid tax on the money in the year you earned it. Over longer periods of time, the tax benefit of deferral can overcome the disadvantage of paying tax at a higher rate, but you’ll have to weigh this reduced benefit against the disadvantages described above.